Corporations
Bradley
Spring 2006
Introduction
1) Business Forms
a) (Sole) Proprietorship
i) Business Debts: Yes
ii) Tort Liability for Acts of Others: Yes
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: No
v) Taxation: Individual (1 level)
b) General Partnership
i) Business Debts: Yes
ii) Tort Liability for Acts of Others: Yes
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: No
v) Taxation: Conduit (1 level)
c) Limited Partnership
i) General Partner:
(1) Business Debts: Yes
(2) Tort Liability for Acts of Others: Yes
(3) Tort Liability for Owns Acts and Those Supervised: Yes
(4) Organizational Formalities to Gain Status on Liability: Yes
(a) Certificate of Limited Partnership
(5) Taxation: Conduit (1 level)
ii) Limited Partner
(1) Business Debts: No
(2) Tort Liability for Acts of Others: No
(3) Tort Liability for Owns Acts and Those Supervised: Yes
(4) Organizational Formalities to Gain Status on Liability: Yes
(a) Certificate of Limited Partnership
(5) Taxation: (1 level)
d) Limited Liability Partnership (LLP)
i) Business Debts: No
ii) Tort Liability for Acts of Others: No
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: Yes
(1) Simple Certificate of Registration
v) Taxation: Conduit (1 level)
e) Professional Limited Liability Company (PLLC)
i) Business Debts: No
ii) Tort Liability for Others: No
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: Yes
(1) Certificate of Formation
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v) Taxation: Conduit (1 level)
f) Limited Liability Companies (LLCs)
i) Business Debts: No
ii) Tort Liability for Acts of Others: No
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: Yes
(1) Certificate of Formation
v) Taxation: Conduit (1 level)
g) Professional Corporation
i) Business Debts: No
ii) Tort Liability for Others: No
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: Yes
(1) Articles of Incorporation
v) Taxation: Corporate (Sub S election gives conduit treatment if <75 members)
h) Corporation
i) Business Debts: No
ii) Tort Liability for Act of Others: No
iii) Tort Liability for Owns Acts and Those Supervised: Yes
iv) Organizational Formalities to Gain Status on Liability: Yes
(1) Articles of Incorpation
v) Taxation: Individual (2 levels unless S election for <75 shareholders)
2) Choice of Entity
a) Two most important considerations
i) Personal Liability of Owners
ii) Tax Treatment
b) Advantages of creation/formation of a limited liability entity
i) Protection of Personal Assets
ii) Continuity of Life
iii) Prior to the 1970s, Corporations or Limited Partnerships were the only limited
liability entities available  new legislation has produced many options such as
LLCs, LLPs, PLLCs, etc. that have taxation qualities of a sole proprietorship or
general partnership with the limited liability traits of C corporations (i.e., the best of
both worlds)
iv) Disadvantages to entity formation: Costs and burden of formation, reporting,
additional tax burden.
Agency Law
1) Restatement (3d) of Agency (pg. 5 in text) (Rest. (2d) page 1 of supplement).
a) § 1.01: Agency Defined: Agency is the fiduciary relationship that arises when one
person (principal) manifests assent to another person (agent) that the agent shall act on
the principal’s behalf and subject to the principal’s control, and the agent manifests assent
or otherwise consents so to act.
b) § 2.01 Actual Authority: An agent acts with actual authority when, at the time of taking
action that has legal consequences for the principal, the agent reasonably believes, in
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accordance with the principal’s manifestations to the agent, that the principal wishes the
agent so to act.
i) Express,
ii) Implied
iii) See § 2.02 Scope of Actual Authority.
c) § 2.03 Apparent Authority: Apparent is the power held by an agent or other actor to
affect a principal’s legal relations with third parties when a third party reasonably
believes the actor has authority to act on behalf of the principal and that belief is traceable
to the principal’s manifestations.
d) § 3.11 Termination of Apparent Authority
i) The termination of actual authority does not by itself end any apparent authority held
by the agent.
ii) Apparent authority ends when it is no longer reasonable for the third party with whom
the agent deals to believe that the agent continues to act with actual authority.
e) § 2.04 Respondeat Superior: An employer is liable for torts committed by employees
while acting in the scope of their employment.
2) From Parker’s Outline
a) In a Partnership/corporation, the entity can only act through its agents
b) In other words, the agent (e.g. director) is authorized by the principal (the
partnership/corporation) to act
c) 3 Branches of Agency Law
i) Law of Authority- whether a given person has authority to bind another person (the
principal). Corporations can only act via their agents, so the corporation is the
principal who gives authority to its agents. In partnerships, every partner has
authority to bind other partners (choose your partners well)
(1) Actual authority- restatement § 201
(a) Express- ex- corporations need a certified authorization from the board of
directors about who can write checks (who is the agent)
(b) Implied- the implied power to bind another person. It’s not expressed, but if
you tell someone they’re in charge of running a store, they must have the
power to arrange certain items of business operation.
(2) Apparent authority- restatement § 203
ii) Respondeat Superior- restatement § 204; this is a torts theory
iii) Fiduciary Relationship- agent has a relationship with the principal that is fiduciary
(like a lawyer and a client). Because of this relationship, there is a duty of loyalty.
Important part of partnership and corporation’s law.
Partnerships
1) Entity Existence  Need for Written Agreement  UPA § 18
a) UPA § 6  Partnership Defined: A partnership is an association of two or more persons
to carry on as co-owners of a business for profit.
b) UPA § 7  Rules for Determining the Existence of a Partnership:
i) Except as provided by § 16, persons who are not partners as to each other are no
partners to third persons.
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ii) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common
property, or part ownership does not of itself establish a partnership, whether such coowners do or do not share an profits made by the use of the property
iii) The sharing of gross returns does not of itself establish a partnership, whether or not
the persons sharing them have a joint or common right or interest in any property
from which the returns are derived.
iv) The receipt by a person of a share of the profits of a business is prima facie evidence
that he is partner in the business, but no such inference shall be drawn if such profits
were received in payment:
(1) as a debt by installments or otherwise,
(2) as wages of an employee or rent to a landlord,
(3) as an annuity to a widow or representative or a deceased partner
(4) as interest on a loan, though the amount of payment vary with the profits of the
business,
(5) as the consideration for the sale of a good-will of a business or other property by
installments or otherwise.
c) Written Agreement: Vital unless you want to be bound to the general partnership law of
the state. Also, dealing contractually with issues that are likely to arise in the future will
save a great deal of headache in the future.
i) Note that § 18 of the UPA which lays out the general “Rights and Duties of Partners”
unless you have an agreement that states otherwise.
ii) § 40 of UPA: Unless there is an agreement, § 40 lays out the rules for distribution in
a partnership.
iii) Advantages of a written agreement (Parker’s outline)
(1) avoids future disagreements over what the arrangement actually was (general
partnerships)
(2) In the absence of a written agreement, the relationship between the parties is
governed by state partnership statutes, which are extremely unlikely to reflect the
expectations and understandings of the partners
(3) Loaned property - partners often lend rather than contribute property for the
partnership. A written agreement will clarify any loans, thus protecting that
partner’s interest in the loaned property
(4) Lawyers- failure to at least advise clients to consider a written agreement is
subject to malpractice.
(5) ***Aside: there is an inherent conflict of interest when an attorney creates a
partnership agreement for multiple partners  you should inform the clients that
there is a client and advise them to get outside counsel . . . at minimum get a
waiver signed.
2) Management of a Partnership
a) National Biscuit v. Stroud (1959) (actual authority)
i) Stroud and Freeman had a general partnership in which they ran a grocery with no
special agreement as to power and authority. Stroud had told NB that he was no
longer personally liable for purchases made by the partnership. Later, Freeman goes
and buys more bread. NB is trying to collect from Stroud.
ii) Holding: Freeman’s Acts bound the partnership and thus Stroud.
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iii) § 9 UPA: every partner is an agent of the partnership....for the purpose of carrying on
the business...and binds the partnership....unless he has no authority and the third
party has knowledge that he has no such authority.
(1) This establishes that Freeman bound the partnership.
iv) § 18(e) UPA: All partners have equal rights in the management and conduct of the
partnership business.
v) § 15 UPA: All partners are jointly liable for all debt and obligations of the
partnership....
vi) Dissolution: if a partner no longer trusts his co-partner, dissolution is about the only
foolproof solution.
(1) § 31 of UPA Causes of Dissolution
(2) § 701 of RUPA: calls it dissociation, allows a partner to get out of the partnership
and the rest of the partnership remain intact, in the old UPA, partnership existence
could only be continued if dealt with contractually.
(a) § 703 RUPA: dissociation does not necessarily discharge liability, but if a
party dissociates and gives notice, he will be protected from future liabilities
incurred by the partnership.
b) Smith v. Dixon (1965) (apparent authority)
i) Smith was basically the managing partner of a family partnership based on an oral
agreement. Smith was given actual authority to sell some land for not less than
$225k, however, he sold the land for only $200k. The rest of the family now wants
the transaction voided claiming Smith had no authority to make a transaction for
200k.
ii) Holding: Partnership bound by $200k sale price
iii) Reasoning: This is a case of § 2.03 Agency.
(1) It was customary in past transactions for the partnership to rely upon the Smith to
transact the business of the firm.
(2) The other partners had given 3rd parties outward manifestations that third party
would reasonably believe that Smith had authority which in turn gave Smith
apparent authority.
iv) To solve this problem: partners would have to notify 3rd party Smith only had
limited authority to bind the partnership.
c) Rouse v. Pollard (1941) (apparent authority?)
i) Fitzsimmons, partner of a law firm, secretly embezzled money from clients claiming
he would invest the money in mortgages for them.
ii) Holding: Because this was a law firm and not an investment firm, the partnership is
not bound by Fitzsimmons activities because it was not in the usual and ordinary
course of business.
iii) Rule: §§ 9, 13 UPA. Partners are responsible for another partner’s wrongful act only
if it was done in the usual and ordinary course of partnership business.
d) Roach v. Mead (1986) (apparent authority)
i) Attorney borrowed money from a client and never repaid. Client wants the money
from the partnership.
ii) Holding: Partnership is liable for the partner’s actions.
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iii) Reasoning: His duty as a lawyer included the duty to tell client that there was a
conflict of interest in making a loan. Thus, he failed in his duty as a lawyer, which is
the ordinary course of business for a law firm.
iv) § 13 UPA: Partnership bound by partner’s wrongful act if it is done in the ordinary
course of business.
3) Duties of Partners to Each Other
a) Meinhard v. Salmon (1928) (Duty of Loyalty)
i) Meinhard and Salmon form a partnership to lease and run a hotel with a lease of 20
years. Near the end of the lease, the owner approached Salmon with an offer of a
new lease for 80 years; Salmon accepted the offer without telling or including
Meinhard. Meinhard wants in on the lease claiming Salmon owed him a duty to bring
him on the lease.
ii) Scope: is this a joint-venture to lease the building for 20 years or is it a partnership in
the general real estate business.
iii) Holding: Salmon had a duty to tell Meinhard.
iv) Reasoning: The offer on the lease came to Salmon because of his position as a
partner in a partnership that was currently leasing the building. In essence, the offer
belonged to the partnership and not Salmon the individual.
v) This was a simple case for the court because it was basically an extension of the lease
on the building they had been operating for 20 years. Issue would be more difficult if
it was for a different building.
vi) § 20 UPA: Duty of Partners to Render Information: Partners shall render on demand
true and full information of all things affecting the partnership to any partner . . . .
vii) May the fiduciary duty be modified by an express agreement?
(1) See Rule RUPA § 103(b): says yes if the partnership agreement says so, but (b)
says the partnership agreement may not under (b)(3) eliminate the duty of
loyalty/care under § 404(b) or § 603(b)(3), etc.
b) General List of Partnership Duties:
i) Common Law Duty of Loyalty (Meinhard)
ii) § 20 UPA  Duty of Partners to Render Information
iii) § 404 RUPA  borrows heavily from RMBCA
(1) § 404(b): Duty of Loyalty
(2) § 404(c): Duty of Care
(3) § 404(d): Duty of Good Faith and Fair Dealing
(4) Duties of loyalty and care may not be waive by partnership agreement.
c) Remedy for Breach of Duty to Partnership
i) Addressing the remedy
(1) Remedy is based on § 21 of partnership act.
(2) Remedy here was that the lease be held in trust and the Meinhard be allowed to
participate, but that Salmon would be a 51% holder so that he would have
managerial control over the lease. The reason being that it was a feature of the
original partnership. (*this is the classic remedy)
ii) Note pg 71:
(1) § 21 UPA: Every partner must account to the partnership for any benefit, and hold
as trustee for it any profits derived by him without the consent of the other
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partners from any transaction connected with the formation, conduct, or
liquidation of the partnership or form any use by him of its property
(2) In RUPA, see §§ 403-4
(a) § 404 correlates with § 21: Bradley said the writers of the RUPA were stingy
in extending fiduciary duties of partners to each other.
(i) Bradley, referring to §404(c) says the “duty of care” is different than duty
of loyalty, he says it is a corporate theory (what the directors owe to the
shareholders, also note business judgment rule)
(ii) § 404(d): refers to “good faith and fair dealing”
4) Partnership Property (Part 5 of UPA)
a) §§ 24-28 of UPA
b) § 28 UPA  Charging Order: Basically a way for a person that you owe money to attach
and take the benefits of your partnership interest as a means of satisfying a judgment.
c) RUPA § 1001: If a partnership becomes a Limited Liability Partnership
5) Partnership Accounting: SKIPPED COME BACK  May Want to Ask Bradley if it’s
important.
6) Partnership Dissolution (Part VI of UPA, §§ 29-43)
a) § 29 UPA  Dissolution Defined: dissolution of a partnership is the change in the
relation of the partners caused by any partner ceasing to be associated in the carrying on
as a distinguished form the winding up of the business.
b) § 30: On dissolution the partnership is not terminated, but continues until the winding up
of partnership affairs is completed.
c) §§ 601-603 of RUPA deals with “dissociation”: the modern stance on dissolution is
much different.
d) Four Fundamentals of Dissolution § 601 (From Parker’s) outline
i) When a partner wishes to get out or dies, etc. that partner dissociates from the
partnership
(1) § 31 UPA did not use the word “dissociate” and had no provision for expelling
partner, had to be dealt with by contract.
ii) Dissociation and Dissociation does not end the partnership
(1) Leads to a winding up of the partnership, business continues but during the
winding up the scope of the partnership is narrowed to in effect tending to what
business is already there.
(2) See § 30 UPA
(3) But See § 801 et seq. of RUPA  No longer is the partnership dissolved every
time a partner leaves, thus the distinction between dissociation and dissolution in
the RUPA.
iii) The eventual end of the partnership does not end the business (1) business can continue under the old partnership act (UPA), the old partnership
has been dissolved and the new/remaining partners form a new partnership
(2) RUPA makes clear that the partnership does not come to an end, the exiting
partner dissociates
(a) RUPA dissolution  termination of the partnership
(b) RUPA dissociation  termination of partner
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e)
f)
g)
h)
(3) Well written partnership contracts have successfully contracted around
dissolution, leads to a winding up only to the extent of getting rid of the exiting
partner. See pg 84 in textbook.
iv) Partners always have the right to dissolve the partnership - § 601
(1) § 31 UPA
(2) § 601 RUPA: partner has the power to dissociate.
(3) § 701 RUPA: dissociation without dissolution
(a) if a partner is dissociated without dissolution, the partnership shall cause the
dissociated partner’s interest in the partnership to be purchased for buyout
price determined by subsection (b).
Collins v. Lewis (1955) (partner seeking judicial dissolution)
i) Collins was to pay for startup costs (which were more than double of what he though)
while Lewis was to provide management and know how for 30 year agreement to run
restaurant. A default on the part of Lewis would give Collins full ownership. Collins
wants the partnership dissolved:
ii) Methods of Dissolution
(1) § 31(1)(b) partnership dissolved without violation of agreement by express will
of partner when no definite term or particular undertaking is specified? NO, had
30 year term to agreement.
(2) § 31(2) dissolution in violation of the agreement, where circumstances do not
permit a dissolution under any other provision of this §, by the express will of a
partner? YES, but Collins would have been in breach of their partnership
agreement and thus subject to its breach provisions.
(3) § 32(1)(e) the partnership can only be carried on at a loss? NO, Collins argues
this but the court says that he is at fault for the loss profits and that Lewis is a
capable manager.
(4) Other ways it could have been dissolved: § 32(c), (d), or (e).
Cauble v. Handler (1973) (deceased partner)
i) Cauble died and Handler continued to operate the business, making substantial
profits. Cauble’s wife is suing to get ½ of the profits earned after dissolution (date of
death).
ii) § 42 of UPA governs rights of retiring or estate of deceased partner when the business
is continued. He may at his election
(1) have the value of his interest at the date of dissolution ascertained, and shall
receive as an ordinary creditor an amount equal an amount equal to the value of
his interest in the dissolved partnership with interest, OR
(2) in lieu of interest, the profits attributable to the use of his right in the property of
the dissolved partnership; provided that the other creditors of the dissolved
partnership have priority.
Adams v. Jarvis (1964)
i) 3 doctors in a partnership; one decides to leave. Claims that § 38 UPA entitles him to
1/3 of the profits, but they have contracted otherwise.
ii) § 38(1) says “unless otherwise agreed” so he had not rights except those granted in
the contract.
Maryland Associates LLP v. Sheehan (2000)
i) Issue over lease of an office building.
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ii) held that: (1) once general partner of lessee signed lease agreement, he became jointly
and severally liable for all existing and future obligations under that lease; (2) liability
of that partner was not terminated merely by his withdrawal from partnership before
breach of agreement; but (3) genuine issues of material fact existed as to whether that
partner formed an agreement releasing former partner from personal liability under
lease or whether any other defenses applied, precluding summary judgment as to that
partner; and (4) as a matter of first impression, lessor could not hold former partners
who were not partners at time of lease agreement and who withdrew before
subsequent partnership's default, personally liable under the lease.
Affirmed in part and reversed and remanded in part.
7) Inadvertent Partnerships
a) Often arise when creditors of the partnership are owed money by will not be paid b/c
there’s no assets. May claim the partnership has other members so the creditors could go
after them.
b) § 7 UPA give framework for determining whether a partnership exists
i) (3): sharing of gross returns does not in and of itself establish a partnership
ii) (4): receipt of profits is prima facie evidence of a partnership (rebuttable)
iii) Characteristics of debt may also create partnership interest.
c) § 202 RUPA gives rules for forming a partnership.
d) § 16  Partner by Estoppel:
i) If you act like you are in a partnership, you will be bound by acts of the other who
appears to third parties to be your partner.
ii) If a partnership holds you out as being a partner, they will be bound by your acts to
third parties as if you were a partner.
e) Martin v. Peyton (1927)
i) Banking business that was basically going under needed capital, was loaned money in
an agreement to receive 40% of the profits. Also, existing partners ownership
interests were offered as security for the debt. Also, life insurance policy was taken
out on one of the partners. Lenders had some veto power in the activities of the
corporation.
ii) Despite the rules laid out in § 7 for determining the existence of a partnership, the
court held that this was legitimate debtor/creditor relationship and not a partnership
contract, i.e. they apparently rebutted the presumption.
f) Smith v. Kelly (1971)
i) Guy who was working for an accounting partnership is claiming that he is a partner.
He was held out to the public as a partner, b ut never was a partner financially and
had little profit sharing or management responsibilities. Claimed this partnership
interest after he left.
ii) § 16 UPA partnership by estoppel only applies to 3rd parties.
iii) He would have to argue he was a partner based on formation rules.
iv) Court held that he was not a partner.
Additional Unincorporated Business Organizations
1) Limited Liability Companies (LLCs)
a) Provides the company’s owners with limited liability while also providing the flowthrough tax benefit of partnerships.
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b) LLC’s didn’t become feasible because of tax reasons until 1988 when it got a tax ruling
by the IRS. This ruling allowed flow through of income without double taxation.
i) Look at Chapter 3 on page 131 for discussion of tax issues regarding business
entities.
(1) Pass through entities file tax returns just to give the info to the IRS, but taxes are
actually paid by the shareholders.
c) Check the Box: what is required for an LLC to get pass through taxation. The IRS
basically gave up trying to determine whether an entity is should be taxed as a
corporation or a pass through
d) Characteristics
(1)
(2)
(3)
(4)
(5)
(6)
limited liability
partnership tax features
chameleon management- ability to chose centralized or direct member-management
creditor protection provisions
two member requirement
partnership assets not at risk an may participate in control of the business
e) LLCs are so relatively new and there is so little litigation, plus it is mainly statutory, so
no one knows whether the principal flavor going to regarded by courts as essentially a
partnership or as a corporation in terms of fiduciary duties and dissociation.
f) Elf, inc. v. Jaffari and Malek, LLC
i) In the operating agreement, there was an arbitration clause. Elf was not happy with
the way Jaffari was handling Malek and filed a derivative suit. The suit was
dismissed by the court because of the arbitration clause.
ii) The Court ruled that the provision was enforceable against the LLC.
iii) This decision made the Delaware LLC act especially appealing because it was treated
as a matter of contract
g) Poore v. Fox Hollow Industries:
i) Court held that LLC must have counsel, i.e. can’t go into court pro se. This treatment
is similar to corporations.
h) Meyer v. Oklahoma ABC: Because OK statutes didn’t address LLCs, court held that
LLCs could not get liquor license.
i) Point: Many times the law is not developed, or does not apply to LLCs because they
came about so recently.
i) Article 11 of ULLCA (page 487) in supplement addresses derivative actions for LLCs.
2) Limited Partnerships
a) A partnership w/ limited personal liability for the partners
b) General v. limited partners
i) § 7 ULPA- “a limited partner shall not become liable as a general partner unless, in addition
to the exercise of his rights and powers as a limited partner, he takes part in the control of the
business
ii) General partners are liable- in the 70’s and 80’s limited partnerships would consist of many
limited partners and one general partner, typically a corporation.
c) Important when lending money- b/c a partner’s assets are immunized in an LLP, a lender should
Require Ps to sign personal guarantees of repayment (lender is now sitting pretty assuming these
partners have substantial assets) – now the people who were counting on this limited liability
have bargained it away (happens all the time)
d) LLP- §§ 305-307
3) S Corporations
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a)
b)
c)
d)
e)
must have less than 75 shareholders
can elect to be taxed as a partnership
Other limitations not in LLC’s: LLCs are better in almost every way.
See pg 166.
S Corps. can engage in mergers, stock swaps, and other corporate reorganizations on a
tax-free basis, while LLCs cannot
i) MS allows LLCs to merge
Corporations
1) Formation of a Corporation
a) Where to Incorporate:
i) For small enterprises planning to transact business primarily in one state, the
corporation should usually incorporation in the state where business is conducted.
ii) For larger enterprises transacting in many states or all states, incorporation in any one
of the several states is usually feasible; most incorporations are in Delaware.
iii) Factors of decision
(1) dollars-and-cents analysis of the relative cost of incorporating, or qualifying as a
foreign corporation, under the statutes of the states under consideration, AND
(2) a consideration of the advantages an disadvantages of the substantive corporation
laws of these states.
b) How to incorporate:
i) MBCA §§ 1.20-26  Filing Requirements
ii) § 2.01  Incorporators
(1) Articles of Incorporation are executed by one or more persons called
incorporators. In modern practice, their principal function is to execute the
articles and receive the certificate of incorporation.
(2) “One or more persons may act as the incorporator or incorporators of a
corporation by delivering articles of incorporation to the secretary of state for
filing.”
iii) § 2.02 Articles of Incorporation
(1) Name of the corporation (must include inc., corp., LLC, etc.)
(a) Name uniqueness is required- cannot be deceptively similar b/c of unfair
competition
(b) Reservation of name- can reserve name for limited period of time
(c) Registration of name- foreign corporation can register name w/ the state to
assure that no local business obtains the right to use its name
(2) Duration- generally perpetual or indefinite
(3) Purpose(s)(a) Used to be important for ultra vires.
(b) Now, typically put “any legal business ventures”
(4) The securities it is authorized to issue
(5) Minimum Capital Requirements: most states do not require any amount of
minimum capital. However, thin capitalization may lead to application of the
piercing of the corporate veil doctrine and personal liability of the shareholders.
(6) Name of its registered agent and the address of its registered office- important for
location of officer and service of process
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(7) Names and addresses of its initial BOD
(8) Name(s) and address of the incorporator or incorporators
2) Ultra Vires (Latin for “beyond the powers”)
a) Doctrine doesn’t have much impact anymore. In the past, had to go to the legislature and
list the specific purposes of the corporation to get a charter, now corporations are formed
“for any lawful purpose” thus it is pretty hard to go beyond the powers anymore.
b) Chapter 3 of MBCA covers purposes and powers of the corporation
i) § 3.01 Purposes: Every corporation has the purpose of engaging in any lawful
business unless a more limited purpose is set forth in the articles of incorporation.
ii) § 3.02 General Powers: Unless its articles of incorporation provide otherwise, every
corporation has perpetual duration and succession in its corporate name and has the
same powers as an individual to do all things necessary or convenient to carry out its
business and affairs, including without limitation power to....
iii) § 3.04 Ultra Vires section limited the effectiveness of the ultra vires doctrine by
giving broad powers to corporations.
c) Modern areas of Ultra Vires Suit
(1)
(2)
(3)
(4)
(5)
whether the corporation can make political contributions
engage in lobbying to influence legislation
make large charitable donations that appear to provide no benefit to the corp.
guarantee the indebtedness of others that provided only incidental benefit
loaning of funds to officers & directors
d) 711 Kings Highway Corp. v. F.I.M.’s Marine Repair Service Inc.(1966)
i) P entered into a lease with D of property to used as a movie theater. D’s charter was
restricted to marine activities. P’s wanted to break the lease so they sued under ultra
vires to break the lease, claiming the D could only be engaged in marine activities.
ii) Court held that the Kinds couldn’t rely on Ultra Vires as a sword in cancelling the
lease. Note § 3.04  the validity of corporate action cannot be challenged except in
rare circumstances.
e) Tallahatchie Valley EPA v. Miss. Propane Gas Ass’n (2002)
i) Complaint that TVEPA was selling gas, which was not the purpose for which it was
formed. MSSC agreed it was an ultra vires claim, but refused to enjoin the TVEPA
from selling gas because it was a subsidiary which was a separate legal entity which
was selling the gas. However, the book says that the court did hold the TVEPA did
technically break the law by acquiring the gas company.
f) Sullivan v. Hammer (1990)
i) Occidental Petroleum gave away a huge amount of money for charitable purposes and
shareholders are complaining that corporation abused its powers in giving away that
much money, $70m. Claimed it was a waste of corporate assets and was not
maximizing shareholder value.
ii) § 3.02(13) MBCA  Corporations do have the power to make charitable donations
(1) Plaintiffs claimed that the donation was unreasonable and thus beyond the
powers. Corporation argued that it was part of the retirement contract it had with
Mr. Hammer.
(2) Business Judgment Rule comes up
iii) The Court applied a reasonableness standard and found for the Corporation.
3) Premature Commencement of Business
12
a) Promoters: are persons who assist in putting together a new business. These individuals
serve important social and economic functions.
i) Arrange for the necessary business assets and personnel so that the new business may
function effectively.
ii) Obtain the necessary capital to finance the venture.
iii) Arrange for the formation of the corporation.
b) Pre-incorporation Contracts: Promoter may enter into contracts on behalf of the venture
being promoted either before or after the articles of incorporation have been filed. Most
problems are created by pre-incorporation contracts. The legal consequences of these
contracts vary depending in part on the form of the contract itself.
i) Contracts entered into in the name of a corporation “To Be Formed”
(1) K will state “ABC Corp., a corporation to be formed,” showing that the corporation has
not yet been formed
(2) Look at intention of the parties; 4 possible results
(a) Promoter is personally liable and will remain severally liable along with the corp. if it
is subsequently formed and adopts the K; but the promoter may be indemnified by
the corporation (most common)
(b) Promoter is personally liable until the corp. is formed and adopts the K
(c) Promoter is not personally liable but promises to use best efforts to see the corp. is
formed and will adopt the K; liable if fails to use best efforts
(d) No one is liable until the corporation is formed and adopts the K
ii) Contracts entered into in the Corporate name:
(1) Different from above in that the K is entered into in the name of the corp. that has not yet
been formed AND one or both of the parties erroneously believe that the corp. has been
formed (pre incorporation + reliance)
(2) Liability
(a) Agency law- if the promoter represents himself as acting on behalf of the corporation
but knows that no steps have been taken to incorporate, they are personally liable
(b) MBCA (1984) § 2.04- “all persons purporting to act as or on behalf of a corporation
knowing there was no corporation under this act” are jointly and severally liable
iii) Stanley How Inc. v. Boss:
(1) Boss wanted to build a hotel on some land and form a corporation to run the hotel.
Entered into K with How (architect) to design the hotel. How does a bunch of
work, Boss decided he doesn’t want to build hotel or form corp. or pay the bill.
(2) Court looks to the intent of the parties to the contract. Was How looking solely at
the business assets for payment or was he looking at the promoter as an individual
as well.
(3) Rule: D has the burden of proving that the 3rd party was looking solely to the
assets of the corporation and not the promoter(s).
iv) There is really only one way to sign a K as a promoter to be certain you will not be
personally liable.
(1) Boss Hotels Inc. By ___________ Agent
(2) Bradley says that the architectural firm may want to add a line for him to sign as
an individual to guarantee payment.
c) Defective Incorporation (no longer a major because corporate formation is so simple)
i) §§ 2.02 & 2.03- show how easy the process is now
ii) Common Law Analysis- de jure v. de facto corporation
13
(1) De Jure- a de jure corporation has sufficiently complied with the incorporation
requirements so that a corporation is legally in existence for all purposes. There
may have been errors in filing, but they were so minimal as to allow the corp. to
come into existence.
(2) De facto- a de facto corporation occurs when the corporation is either partially or
defectively formed. These corp.’s are immune from attack by everyone but the
state. Traditional test for de facto existence is:
(a) There is a valid statute under which the corp. may incorporate
(b) There is a “good faith” attempt to comply with the statute
(c) There has been actual use of the corporate privilege
(3) Corporation by Estoppel- under this concept, a 3rd party who relies on an innocent
representation that the corporation is formed is “estopped” from denying the
existence of denying the existence of the corporation.
(a) Actually a “reverse estoppel” doctrine b/c the person who erroneously
representing the existence of the corporation is permitted to escape liability
while the person who relied on the representation is estopped. So, if you’re a
person trying to hold an officer/person personally liable for a defective
corporations breach of K, you can’t claim that a K is invalid b/c of defective
incorporation if you’ve acted in a manner recognizing the corporation’s
existence
(b) Representing party must have honest belief that articles of inc. have been filed
(c) Doctrine can be invoked if a Δ seeks to avoid liability on the ground that the
Π may not sue b/c it is not a lawful entity
iii) Modern Analysis- current statutes substitute a more objective test for the de facto/de
jure distinction. Under these statutes the acceptance of the articles of inc. for filing is
conclusive evidence that the corporate existence has begun:
(1) “All persons purporting to act as or on behalf of a corporation knowing there was
no incorporation under this act” are jointly and severally liable for liabilities
incurred. MBCA (1984) § 2.04
(a) If person does not know of defect, see corporation by estoppel
(b) Depends on knowledge of the person representing corporation
(2) Bright line test- date of the filing of art. of inc. is the line of demarcation, leading
to personal liability on all transactions taking place before that filing. But, not all
courts agree with this analysis.
iv) Robertson v. Levy (1964)
(1) K was dated 12/22 in the name of the corporation, Lease was assigned on Dec. 31
to Penn Records, Inc. signed by Levy as president. Articles of Inc. were rejected
on Jan. 2. Jan. 8 Robertson signed a bill of sale and a promissory note was
signed by Levy as president. Corporation actually came into existence on Jan. 17.
Robertson is suing Levy because the corporation has no assets to pay the note.
(2) Robertson wants Levy to be personally liable for obligations entered into before
the corporation was actually formed, i.e. prior to articles being accepted.
(3) Rule: All persons who assumed to act as a corporation without authority so to do
shall be jointly and severally liable for all of the debts and liabilities arising as
result.
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(4) Holding: Levy is liable for the lease because it was entered into prior to actual
incorporation.
v) Cranson v. IBM (1964)
(1) Cranson was told by his attorney that corporation had been formed so he buys
stock and becomes an officer and director. Enters into an agreement with IBM to
buy typewriters. Corporation is then formed and defaults on K with IBM.
(2) The court held that because IBM had dealt with Cranson’s corporation as a
corporation and not has the Cranson the individual, it was estopped to deny the
corporate existence.
(3) See page 246 of textbook for discussion of distinction between de facto
corporations and the doctrine of estoppel.
vi) Frontier Refining Co. v. Kunkel’s, Inc. (1965)
(1) Frontier sold gas to Kunkel’s and wasn’t paid. Frontier is claiming that Kunkel’s
is a partnership. Kunkel had approached two people asking for money to start a
business, they denied a loan, but agreed to be shareholders if he would
incorporate the gas station and he could run it. There was no written agreement
however. No corporation was ever organized.
(2) Plaintiff loses in this case. Why?
(a) “All persons who assume to act as a corporation without authority so to do
shall be jointly and severally liable for all debts and liabilities incurred or
arising thereof.” How did the plaintiff still lose.
(i) Fairfield and Beach never had any contact with Frontier
(ii) Documents were not clear the a corporation was taking on the obligation,
Frontier seemed to rely on the credit of Kunkel himself.
(iii)Fairfield and Beach claimed that they were creditors to Kunkel, not
business partners
1. This is how the court made its ruling.
(3) (****FIX THIS CASE****)
Disregard of the Corporate Entity
1) § 6.22 MBCA: “....a shareholder of a corporation is not personally liable for the acts or debts
of the corporation except that he may become personally liable by reason of his own acts or
conduct.
2) Common Law Doctrine of Piercing the Corporate Veil
a) Bartle v. Home Owners Coop. (1995):
i) Westerlea was a subsidiary or Home Owners. Westerlea was setup to shield Home
Owners, very thinly capitalized, same officers and board. Westerlea wouldn’t pay P,
so P tried to pierce the veil and go after Home Owners. No veil piercing allowed.
ii) Rule: The doctrine of piercing the corporate veil is invoked to prevent fraud or to
achieve equity.
b) Dewitt Truck Brokers v. Flemming Fruit Co. (1976)
i) a supplier to the corporation refuses to make further shipments unless paid in cash on
delivery. The shareholder orally promises to pay for the goods personally if the
corporation does not as an inducement to encourage the supplier to ship the goods
immediately. The supplier ships the goods in reliance of the guarantee. The
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corporation in question was really just an individual, never had meetings, had no
minutes, no assets, etc.
ii) Court upholds piercing the corporate veil
iii) Alter Ego Doctrine
(1) Threshold Question- no fraud is needed, but you do need the following:
(a) the parent and subsidiary operated as a single economic entity (see factors)
(b) an overall element of injustice or unfairness (must be present & also notice
that fraud is NOT a requirement)
(2) Then apply factors : (factors determine if single economic entity)
(a) Whether the corporation was grossly undercapitalized for purposes of a corp.
undertaking
(i) undercapitalization- whether the shareholders put an amount of finances
into the business that were reasonably foreseeable to meet the needs of the
business
(ii) Not enough on it’s own, but a very substantial factor
(b) Failure to observe corporate formalities
(c) Non payment of dividends
(d) Insolvency of the debtor corp. at the time
(e) Siphoning of funds of the corporation to a dominant stockholder (parent corp.)
(f) Non-functioning of other officers or directors
(g) Absence of corporate records
(h) The fact that the corporation is merely a façade for the operations of the
dominant stockholder or stockholders
iv) Factors mentioned in later cases:
(1) Commingling of assets [Atex]
(2) Payment by corporation of individual’s obligations [Arrow’s Bar]
c) Battz v. Arrow Bar (1990) (application of alter ego factors)
i) Baatz is severely injured when a patron of the Arrow Bar leaves drunk and hits him in
a head on crash. Arrow Bar was formed with only $5k of cash and a $150k loan.
ii) Court did an alter ego analysis similar to Dewitt.
iii) P’s arguments
(1) D’s personally guaranteed corporate obligations
(2) Corporation is an alter ego of Ds  Court said P failed to show Ds were
conducting business through the corporation
(3) Corporation is undercapitalized  Court said shareholders must equip
corporation with reasonable amount of capital for the nature of the business. P
present no evidence that capital was insufficient for running a bar.
(4) D’s failed to observe corporate formalities because no signs indicated that it ws a
corporation  Court said failure to follow mere formalities will not dictate veil
piercing, especially where the claimed defect has nothing to do with the resulting
harm.
d) There are two types of “piercing” cases: tort cases and contract cases
i) In a contract debt, there is some opportunity for the creditor to determine who exactly
they are extending credit to and do some due diligence
ii) In a tort action, the plaintiff is basically an involuntary creditor.
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(1) Minton v. Cavaney pg 272: person drowns in a swimming pool and the family has
filed a wrongful death action. The corporation that ran the pool had no assets.
This suit is against a lawyer who was a temporary officer and director in the corp.
The Court decided that Caveney could be held liable.
(2) Walkovsky: case in which a person was injured in the street by a taxi cab.
(3) pg 279: discussion of Texas law: Texas draws no distinction between tort and
contract actions to pierce the corporate veil
(4) Bradley says that courts generally don’t treat them differently, only commentators
iii) Piercing the corporate veil has been limited to closely held corporations, no veil has
been pierced in a corporation with more than 9 shareholders.
(1) note however that this has happened to parent and subsidiary corps.
e) Radaszewski v. Telecom Corp. (1992)
i) Rad was injured by a owned by an employee of Contrux, Inc. Contrux was a
subsidiary of Telecom. Rad is trying to get at the assets of the parent, Telecom.
ii) Three Part Test  To pierce the corporate veil, one must show:
(1) Control, not mere majority or complete stock control, but complete domination,
not only of finances, but of policy and business practice in respect to the
transaction attacked so that the corporate entity as to this transaction had at the
time no separate mind, will, or existence of its own; AND
(2) Such control must have been used by the defendant to commit fraud or wrong, to
perpetrate the violation of a statutory or other position legal duty, or dishonest and
unjust act in contravention of plaintiff’s legal right, AND
(3) The aforesaid control and breach of duty must proximately cause the injury or
unjust loss complained.
iii) One important thing to note from this case is that though the subsidiary was thinly
capitalized in an accounting sense, it had $11 million in liability insurance and thus
was not thinly capitalized in relation to ability to satisfy tort claims.
f) Fletcher v. Atex, Inc. (1995) (Internal Affairs Doctrine)
i) Fletcher sued Atex for carpel tunnel from keyboards. Kodak was the parent
corporation of Atex. Fletcher was trying to get at Kodak.
ii) Court applied Delaware law even though this case arose in New York
iii) Internal Affairs Doctrine: When there is a dispute about the internal operations of a
corporation, the governing law is the law of the state in which the corporation was
organized.
(1) Will apply in actions between shareholders and the corporation
(2) Will apply in action between parent and subsidiary
(a) that’s why internal affairs applied in this case
iv) Atex relied on the alter ego theory
(1) Atex participated in Kodak’s central cash management system.
(a) Court said this insufficient, just evidence of parent/sub relationship
(2) Kodak’s approval was required for major business decisions
(a) Same, just indicative of parent/sub relationship.
(3) Kodak dominated Atex’s board of directors
(a) Court said this was insufficient, Kodak owned Atex so board domination is to
be expected
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(4) Atex literature contained multiple references to Kodak thus creating an
appearance of control
(a) Court said this is not evidence that they acted as an economic entity
3) The Piercing Doctrine in Federal/State Relations
a) United States v. Bestfoods (1998) (CERCLA)
i) This was an action to force cleanup of industrial law.
ii) The SC never addressed the choice of law question between federal common law and
state law.
(1) 6th circuit said that this was in effect a piercing case so Michigan law should
apply and not federal.
(2) See note 3 on page 296 regarding employment discrimination law.
iii) Did the parent operate the facility? There has to be evidence that the parent operated
the facility in order to be held liable under CERCLA.
(1) Director who works for both the parent and sub. could cause the parent to be
operating. Even just a shared employee could trigger “operation”
iv) Justice Souter, held that: (1) when the corporate veil may be pierced, a parent
corporation may be charged with derivative CERCLA liability for its subsidiary's
actions; (2) a participation-and-control test looking to the parent corporation's
supervision over subsidiary cannot be used to identify operation of a facility resulting
in direct parental liability under CERCLA; and (3) direct parental liability under
CERCLA's operator provision is not limited to a corporate parent's sole or joint
venture operation with subsidiary.
b) Title VII of Civil Rights Act of 1964 and Piercing
i) Oncale v. Sundowner (1998): the court stated that the test was whether the parent and
subsidiary were part or a “single, integrated enterprise,” and there was a four-fold test
for this determination:
(1) interrelation of operations,
(2) centralized control of labor relations
(3) common management, AND
(4) common ownership or financial control
c) Social Security
i) Stark v. Flemming (1960)
(1) Stark put her assets, a farm and duplex, into a corporation and began collecting
$400 a month salary as a means of qualifying for social security payments. SSA
claimed that the corporation was a sham and refused benefits.
(2) Court held that there was proper adherence to the normal corporate routines and
the Secretary must recognize the corporation.
d) Unemployment Compensation
i) Roccograndi v. Unemployment Board (1962)
(1) P’s had a family owned corporation and when business got slow, the corporation
would layoff some of the family members so that they could apply for
unemployment benefits to offset the slow times. Unemployment Board saw
through the sham and denied them benefits.
(2) Court held that the corporate entity may be ignored in determining whether the
claimants, in fact, were “unemployed” under the act, or were self-employed
persons whose business merely proved to be unremunerative during the period for
which such benefits were claimed.
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3) “Reverse Piercing” (using corporate assets to satisfy personal liabilities)
a) Sweeney v. Kane (2004)
i) Kane’s had a debt for legal fees in Florida. They bought a house in NY and assigned
it to a corporation in order to protect the house from a default judgment that had been
entered against them.
ii) FL law applied because reverse piercing is an internal affairs issue.
iii) FL law for reverse piercing:
(1) A corporation’s veil will be pierced where the corporation’s controlling
shareholders form or used the corporation to defraud creditors by evading liability
for preexisting obligations.
iv) In this case, the veil was reverse pierced and the house was available to satisfy
judgment.
b) Worker’s Compensation: Courts generally do not allow parent corp. to reverse pierce
and get immunity from tort when an employee has sued the parent after getting hurt
working for the subsidiary.
c) Pepper v. Litton (1939) (Bankruptcy Doctrine of Subordination)
i) Litton was the main shareholder in a corporation and when the corporation was about
to bankrupt, he sued the corporation for back salary and basically liquidated what was
left. Pepper sued the corporation for mining royalties, but while his case was
pending, Litton liquidated everything, so there was nothing left for him to collect on.
This action seeks to subordinate Litton’s claim so that Pepper can satisfy his
judgment.
ii) Rule: the shareholder is fiduciary who owes a duty of good faith to the corporation
and those interested therein, including creditors. The test for good faith of a
shareholder is whether the transaction bears the earmarks of an arms length bargain, if
not the transaction will be set aside in equity.
iii) Deep Rock Doctrine: shareholder’s claims typically subordinate general claims,
same applies for claim of parent against subsidiary.
iv) Note that the bankruptcy court sits as a court of equity and thus has power to do
equity.
4) Successor Liability:
a) Nissen Corp. v. Miller (1991)
i) Brandt purchased a treadmill built by Tredex, Tredex then sold out to Nissen. Brandt
then was injured by the treadmill and wanted to sue Nissen. Nissen’s contract to
acquire Tredex said that Nissen would not be responsible for liabilities based on
previously manufactured products.
ii) General Rule  Corporation which acquires all or part of the assets of another
corporation does not acquire the liabilities and debts of the predecessor, unless:
(1) there is an express or implied agreement to assume the liabilities,
(2) the transaction amounts to a consolidation or merger,
(3) the successor entity is a mere continuation or reincarnation of the predecessor
entity, OR
(4) the transaction was fraudulent, not made in good faith, or made without sufficient
consideration.
iii) Rule: in a pure merger, surviving corporation has all of the obligations of the merged
corporation.
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(1) This can be avoided with a triangular merger.
iv) Bradley also used this case to discuss dissolution of a corporation.
(1) Administrative dissolution: § 14.20
(2) See also §§ 14.01 and 14.30.
Financial Matters and the Corporation
1) Debt and Equity Capital
a) Examples
i) Borrowing money from friends or commercial sources & repaying with interest (debt)
ii) Capital contributions from the owners of the firm (equity)
iii) Capital contributions from outside investors who thereafter remain inactive or become active
co-owners of the firm (equity)
iv) Retaining earnings of the business rather than distributing them to owners (equity)
2) Planning the Capital structure of the Company
a) In reviewing the proposed capital structure of a company, an attorney will have the
following basic concerns:
i) Will the structure work (i.e. will it stand up against disagreement or attack)?
ii) Will the structure actually provide the desired result?
iii) Will the desired tax treatment be available; or more likely; is the structure created one
that makes the desired tax treatment more probable than not?
iv) Might the structure give rise to unexpected liabilities?
v) Are the client’s financial contributions reasonably protected and reasonable fair
treated in the event of unexpected or calamitous occurrences causing a sudden
termination of the venture?
vi) Same issues as in partnerships and limited-liabilities
b) Types of Equity Securities: shares  § 1.40(21) (MBCA) Shares means the units into
which the proprietary interests in a corporation are dividend.
i) Common stock: entitled to vote and net assets in form of dividends or liquidation
distribution and right to inspect records and right to sue on behalf of the corporation
(1) Directors make the decision to pay dividends, shareholders elect directors.
(2) Common characteristics as stated by the USSC
(a) right to receive dividends contingent upon apportionment of profits
(b) negotiability (capable of being transferred )
(c) ability to be pledged or hypothecated (pledged as collateral)
(d) conferring of voting rights in proportion to the # of shares owned
(e) capacity to increase in value.
(3) Classes of common shares- MBCA §§ 1.40(2), 6.01(a)- ex. Class “A”, Class “B”,
etc…
(a) Each class must have a “distinguishing designation”
(b) All shares within a single class must have identical rights
(c) Rights & designations of various designations & classes must be set forth in
the articles of incorporation
ii) Preferred stock: holders entitled to a specific distribution before anything is paid to
common shares (i.e. dividend priority), but usually limited in some way (such as no
voting rights)
(1) Special rights of publicly traded preferred shares:
(a) cumulative dividend rights - dividends add up if not paid
20
(b) voting - usually nonvoting
(c) liquidation preferences - preference over common stock, usually a fixed price
of redemption.
(d) redemption rights - often the corporation has the right to redeem the preferred
shares at a fixed price without consent of preferred shareholder
(e) conversion rights - often a ratio at which preferred shares can be converted
into common stock, preferred shareholders can profit using this
(f) protective provisions - money set aside by the corporation to redeem preferred
stock
(g) participating preferred - entitled to the specified dividend and, after the
common shares receive a specified amount, they share with the common in
additional distributions on some predetermined basis.
(h) classes of preferred
(i) series of preferred - See § 6.02(a)(2)
c) Issuance of Shares: subscriptions, par value, and watered stock
i) Share Subscriptions and Agreements to Purchase Securities  § 6.20 MBCA
ii) Authorization and Issuance of Common Shares Under the MBCA - Can issue any
number of shares at any price so long as (# of shares * price) = value.
iii) Par Value and Stated Capital:
(1) Par value is an arbitrary dollar value assigned to shares of stock which, after being
assigned, represents the minimum amount for which each share may be sold.
(2) MBCA and most states have eliminated entirely or made optional the requirement
of par value.
(3) Par value and purchases (shareholder can sell stock for less than par value)
(a) Common law analysis:
(i) Hanewald v. Bryan’s Inc.
1. Business was incorporated and articles call for 100 shares with a par
value of 1000 each. The Bryan’s didn’t pay 1000 for each share. The
corporation went belly-up and now Hanewald wants the Bryan’s to
basically pay the whole par value for each share to corporation so it
can pay him.
2. Court held that they had to pay the difference
(ii) Watered stock - shareholder did not pay par value when they purchased
stock
1. Discount stock - shareholder contributes property worth less than the
par value of the stock received in exchange
2. Bonus stock - no payment at all
(iii)Trust Fund Doctrine - shareholders with watered stock should be required
to pay par value of upon default of the corporation.
(b) Modern Analysis - § 6.01  modern practice is that issued shares be given
either no par value or nominal par value.
(i) § 6.21(c) shareholders are required to pay for their shares.
(ii) § 2.02(b)(2): articles of incorporation may include par value for authorized
shares or classes of shares.
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(iii)However, shareholders remain liable for up to the par value of their shares
if they haven’t paid that much or got the shares for free. Thus a creditor
could come after the shareholder.
1. Since most stock’s maximum par value ranges from one cent to one
dollar, the risk exposure is just not that great.
iv) Stock for Services
(1) Old view- “no corp. shall issue stock or bonds except for money, labor done, or
money or ppty. actually rec’d; and all fictitious increase of stock or indebtedness
shall be void” [Hanewald]
(2) Modern View: § 6.21(b)  The board of directors may authorize shares to be
issued for consideration consisting of any tangible or intangible property or
benefit to the corporation, including cash, promissory notes, services performed,
contracts for services to be performed, or other securities of the corporation.
d) Debt Financing:
i) Bonds and Debentures are evidences of long term indebtedness that are usually
referred to as “debt securities.”
(1) Both involve unconditional promises to pay a stated sum in the future, and to
make payments of interest periodically until then.
(2) Debenture is an unsecured corporate obligation
(3) Bond is secured by a lien or mortgage on corporate property
ii) Debt financing usually supersedes equity financing in a large corporation.
iii) Debt/Equity ratio is important
iv) Tax Treatment
(1) For the corporation, interest payments are deductive, for the bond holder interest
payments are ordinary income
v) Debt may be reclassified as Equity for tax purposes which can cause major problems
because interest payment will be become dividends and the corporation will lose its
deduction.
e) Public Offerings
i) The goal for a closely held corporation is to “go public,” that is, to raise substantial
amounts of capital by making public offerings of their securities through the services
of an underwriter. This is beneficial in that it raises capital and reducing the
company’s reliance on a bank’s funding. However, in going public, often the amount
of disclosure and cleaning up of financial statements can be burdensome. See pp.
346-47
ii) 2 Bodies of Law arise in public offerings:
(1) Blue Sky laws (state)
(2) Federal securities laws- for federal law to apply there had to be some form of
interstate commerce involved – telephone can be instrumentality of IC (very
broad use of IC power by Congress)
(a) governed by the SEC
(b) requires full disclosure as a safeguard- protects offerees of stock by providing
them with information necessary to make an informed investment decision.
[Purina]
(c) filing with the SEC requires:
(i) prospectus- document distributed to potential & actual investors
22
(ii) registrations statement- additional information not included in prospectus
but that most be made available
(d) Securities Act of ’33 requires registration with SEC to sell stock
(e) Securities Act of ’34  12(g) regulates trading of securities.
iii) Investment Contracts
(1) Must determine whether the issuance is a security (versus an interest)?
(2) The transaction is an investment k when it involves:
(a) an investment of money
(b) a common enterprise (i.e. the fortunes of the investor are interwoven with and
dependant upon the efforts of the offeror of a 3rd party); and
(c) with profits to come solely from the efforts of others- whether the efforts
made by those other than the investor are significant ones, those essential
managerial efforts which affect the failure or success of the company
iv) Smith v. Gross (1979)
(1) D sold worms (at $ 2.25) and instructions for raising them to investors with
promises to purchase the offspring at $2.25/lb. and exaggerate claims of growing
rates and time needed for raising worms.
(2) Test for Investment Contract is whether the scheme involves:
(a) an investment of money,
(b) a common enterprise (= the fortunes of the investor are interwoven with and
dependant upon the efforts of offeror or 3rd party)
(c) whether the efforts made by those other than investor are the significant ones,
those essential managerial efforts which affect the failure or success of the
business.
f) Issuance of Shares by a Going Concern: Preemptive Rights, Dilution, and
Recapitalizations.
i) § 6.30 MBCA  The shareholders of a corporation do not have a preemptive right to
acquire the corporation’s unissued shares except to the extent the articles of
incorporation provide.
(1) The right of preemption is the right of a shareholder to buy a number of shares to
keep himself in the same position to have the same rights to voting, earnings, etc.
ii) Common Law Right of Preemption
(1) Stokes v. Continental Trust Co. (1906)
(a) Stokes owned 221 shares. Corporation voted to issue more shares. Stokes
claimed he had a right to buy a portion of the stock to maintain his
proportionate interest.
(b) Court held that Stokes had a common law right to maintain his share.
(i) ***Note that this is 1906 common law case, statutes no longer provide
this right unless it’s in the articles of incorporation.
iii) Freeze Outs in Closely Held Corporations (1) Katzowitz v. Sidler (1969)
(a) 3 member closely held corporation, 1/3 interest each. 2 of the three directors
voted to issue new stock, Katz dissented, but was given the right to buy a
proportionate share and dissented. Katz ends up with 5 shares and the other
two with 30 shares each. Corporation is liquidated and he gets 1/6 of what
they got. Challenged the transaction.
23
(b) Rule: “we will enjoin this type of transaction on the theory that it is
oppressive and serves no business purpose”
(c) Rule: Transactions that issue shares to the majority at unfair prices or
transactions that affect the balance of power may be set aside if they have no
valid business purpose.
(2) Majority has a duty to the minority not to use their position to harm the minority’s
financial interest (i.e. reduce their proportionate share of the company).
(3) Some freeze-out cases have been brought under the theory that the plan
constitutes a violation of fiduciary duties.
(a) can be invalid even though the transaction follows all statutory requirements.
(b) When a conflict of interest transaction is challenged, the court typically does
not apply the business judgment rule.
(i) business judgment rule: if the directors/management acted in good faith,
the court will not second guess it.
(ii) in the conflict of interest cases, the Court will put the burden on the
directors to show that they met the standard of “entire fairness”
(4) Lacos Land Co. v. Arden Group, Inc. (1986)
(a) Proposal to amend the articles of incorporation to create a new class of stock
which basically vest all power to run the corporation in the power of one
shareholder. The existing shareholders did have a right to buy this new class,
but there were disincentives installed so that they wouldn’t. Briskin, the
shareholder made threats that he would scuttle profitable transactions for the
company if this didn’t go through.
(b) The court had to first determine whether to look at Briskin’s actions as a
shareholder or an officer/director.
(i) Shareholder could look out for his own interest
(ii) Officer/Director owes duty of loyalty to corporation and shareholders
(c) Court found that he was acting as an officer/director because that would be the
only way to screw up the transactions. Hence, the class of stock was invalid.
(5) The modern trend seems clearly to be running in the direction of imposing a
fiduciary duty on dilutive transactions such as those involved in Katzowitz:
(a) “that traditional view that shareholders have no fiduciary duty to each other,
and transactions constituting ‘freeze-outs’ or ‘squeeze-outs’ cannot be
attacked as a breach of duty of loyalty or good faith to each other, is
outmoded.” Fought v. Morris (Miss. 1989).
iv) Distributions by a Closely Held Corporation
(1) Gottfried v. Gottfried (1947)
(a) Family owned corporation. Family didn’t get along too well and majority of
the shareholders decided to fire the minority shareholders from their jobs with
the corporation and stop paying dividends. They gave themselves high
salaries and no-interest loans. After this suit was filed, the majority decided to
start paying dividends.
(b) Court held that the failure to pay dividends for a time was not actionable.
This is basically a bad case....court refused to even look at the totality of the
circumstances to see that the minority members were being pushed out.
Applied a Bad Faith Test:
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(i) If an adequate corporate surplus is available for the purpose of
distribution, directors may not withhold the declaration of dividends in
bad faith.
(ii) But, the mere existence of an adequate surplus is not sufficient to invoke
court action to compel such a dividend.
(iii)There must be bad faith, which can be proven by the following factors:
1. Hostility- intense hostility of the controlling faction against the
minority
2. Exclusion- exclusion of the minority from employment by the
corporation
3. High salaries- high salaries, or bonuses, or corporate loans made to the
officers in control
4. High income taxation- the fact that the majority group may be subject
to high personal income taxes if substantial dividends are paid
5. Desire to acquire minority interest- the existence of a desire by the
controlling directors to acquire the minority stock holders interests as
cheaply as possible
a. *** if the factors are not motivating causes, they do not constitute
bad faith
(2) Dodge v. Ford (1919)
(a) Dodge were basically subcontractors of Ford who had some stock, Ford was
still a closely held corporation. Henry Ford didn’t want to pay dividends and
he was in control of the corporation bc of plans to help the employs and
reinvest the profits.
(b) “A corporation is created primarily for the profit of shareholders and the
power of directors are to be employed for that end. The directors may decided
the means to attain that end, but may not change the end itself. Although the
acts of the board will not be scrutinized by the court so long as they are within
lawful purposes, it is not within such purposes to conduct the affairs of the
corp. for the primary purpose of benefiting others.”
(c) So the decision wasn’t in bad faith— see BJR?
(3) Wilderman v. Wilderman (1974)
(a) 50/50 corporation between husband and wife, get divorced, husband is
president. Pays himself way too much and her too little. She sues claiming
the salary is unreasonable.
(b) Analysis: This is a conflict of interest transaction because the husband is
paying himself (self dealing), hence the business judgment rule doesn’t apply
and the court applied the ‘entire fairness’ standard.
(i) To remedy, the court got an expert to testify to the value of the husband’s
services and reduced the salary down to that amount.
(4) Donahue v. Rodd Electrotype Co. (1975) (Redemption)
(a) Rodd was the majority shareholder of the corporation, and Donahue was a
minority shareholder. When Rodd got old, he gave most of his shares to his
kids who became directors of the corporations. The kids, acting as directors,
then redeemed the rest of his shares in exchange for cash. Donahue is now
claiming that he had a right to redeem his shares for the same price.
25
(b) Court found that there was a fiduciary duty between the shareholders/directors
and the other shareholders because this was a closely held corporation, which
is similar to a partnership, including the duty of the majority not to abuse the
minority.
(c) Ruling: Rodd either had to buy Donahue’s shares for the same price or
Donahue had to give his shares back.
(d) Notes:
(i) The Donahue analysis has generally not been applied to termination of
employment of minority shareholders.
(ii) Courts have generally followed Donahue for unfair redemptions.
(iii)Delaware deals with the issue contractually, i.e. through the articles of
incorporation.
g) Legal Restrictions on Distributions
i) MBCA § 6.40
(1) no distribution shall be made if the corporation will not be able to pay its debts as
they become due in the normal course of business
(2) the corporations total assets would be less than the sum of its total liabilities pubs
the amount that would be needed, if the corporation were dissolved at the time of
distribution, to satisfy the preferential rights upon dissolution of shareholders
whose preferential rights are superior to those receiving the distribution.
ii) Non-Model Act Statutes
(1) Pure Insolvency Test
(2) earned surplus dividend statutes
(3) impairment of capital dividend statutes
(4) distributions of capital under earned surplus statutes
Management and Control of the Corporation
1) The Traditional Roles of Shareholders and Directors
a) Model for corporate governance- shareholders elect BOD  BOD oversee running of
corporation/selecting officers  officers have authority given to them by BOD
b) The Statutory scheme in general- corporation statutes contain specific provisions with
respect to the management structure of the corporation.
i) Shareholders- ultimate owners of the corp. Because of the separation of ownership
and control, they have only limited power of management & control. Their power is
exercised indirectly through the election or removal of directors
(1) At common law, director could be removed only for cause, a term that implies
dishonesty, misconduct, or incompetence.
(2) Hence, at common law the selection/removal of more directors would have to
wait until the next annual meeting. [Matter of Auer v. Dressel]
ii) Directors- have general power of management and control. They may either oversee
the management or actually manage.
c) McQuade v. Stonham (1934) (Strict Common Law Approach)  Agreements between
shareholders that attempted to resolve questions that are the responsibility of the board of
directors were against public policy as expressed in the corporation statute and therefore
were unenforceable and may be ignored by the parties to the agreement.
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d) Galler v. Galler (1964)  Court will uphold substantially any shareholder agreement as
long as all the shareholders agree to it.
i) TEST: Was there a slight impingement or great impingement on director discretion?
(1) factors examined regarding the contract
(a) Duration of the agreement
(b) specified periods of times for officers
(c) purpose of the provision
(d) dividend requirement
(e) salary agreement
e) MBCA
i) See §§ 2.02, 8.01, 7.31, 7.32  shareholder agreements have to power to:
(1) to eliminate the board of directors
(2) can run the corporation anyway they want
ii) no longer governed by statutory norm governed by shareholder agreement.
f) [Galler v Galler]- ruled in the other direction form [McQuade] this court does not think the
statutory norm must be followed.
i) For a close corporation, “as the parties to the action are the complete owners of the
corporation, there is no reason why the exercise of the power and discretion of the directors
cannot be controlled by valid agreement b/w themselves, provided that the interests of
creditors are not affected.”
ii) Courts can no longer fail to expressly distinguish b/w private and public issue corporations –
one-size fit all does not in fact fit closely held corporations and the court finally realizes this
iii) Therefore, distinguish b/t voting trusts in closely held corp. v. publicly held Courts can no
longer fail to expressly distinguish b/w private and public issue corporations – one-size fit all
does not in fact fit closely held corporations and the court finally realizes this
(1) Closely held- can agree to virtually anything
(2) Public- can agree in a manner that contradicts norm of corporate governance
g) 2 Factors to look at in Shareholder agreements against the BOD (agreements that reallocate the
corporate powers):
i) Level of impingement on directors
(1) if there is a slight impingement on the directors… that’s one thing – a whole
impingement might sterilize the directors from making proper decisions
(2) Works in conjunction w/ second factor: if level of impingement great, doesn’t matter if
everyone signed. But, if level of impingement moderate, the fact that all SH’s signed
could sway the court.
ii) Did all shareholders sign the agreement? [Galler v. Galler]
(1) If all shareholder agree, the court will permit “‘slight deviations’ from corporate ‘norms’
in order to give legal efficacy to common business practices”
(2) [Clark v. Dodge]- says SH agreement was enforceable – difference was that all the SHs
signed the agreement (argument is that since all signed there was no one to raise the
complaint)
(3) [Long Park (1948)] – court says that the contract takes away all the powers of the BOD…
which goes too far – K was unenforceable. This was so even though all SHs signed and
it was not enforceable… so this in itself is not enough
h) Zion v. Kurtz (1980): “We conclude that when all of the stockholders of a Delaware
corporation agree that, except as specified in their agreement, no “business or activities”
of the corporation shall be conducted without the consent of minority stockholder, the
agreement is, as between the original parties to it, enforceable even though all formal
steps required by the statute have not been taken.”
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i) Matter of Auer v. Dressel (1954) (FILL THIS IN, NOT SURE)
2) Shareholder Voting and Agreements
a) MBCA §7.31-32 – voting agreements
i) § 7.32- says a SH agreement is enforceable if complies with certain req’ts … if it
does, then SHs can agree to run business any way they want to… even if they wanted
to eliminate BOD
(1) (a) – list of things that agreement can provide for
(2) (7) – shows you can bring in certain things that are available for partnerships
(3) (b) – if provision is in bylaws, then not subject to public scrutiny (not public
record)
(4) element of partnership by being contractual and saying that all SH must sign it to
be bound by the agreement – does not have to be in the articles or the bylaws…
must be made known by the corporation (so would probably file with the
corporation so it would be in public record) – valid for no more than 10 yrs.
unless the agreement provides otherwise
ii) “two or more SH may provide for the manner in which they will vote their shares by
signing an agreement for that purpose” contractual
iii) p. 463 – note 1 –SH had agreement as to how they would vote
(1) test to see if SH will vote in the way the SH agreement tells them to
(2) court will issue an injunction that will prevent you from voting your shares
contrary to the voting agreement – but will not issue an injunction that
affirmatively requires the voting of the share in conformity with the agreement
(3) §7.31(b) – “voting agreement created under this section is specifically
enforceable” – if they will not honor the agreement, court will enforce the
agreement
b) Salgo v. Matthews (1973) (beneficial owners vs. record owners)
i) Shares in the name of Pioneer Casualty Co. Individual who owned the shares of PCC
was broke and his shares went into receivership.
ii) Issue over who has right to vote the shares.
iii) Holding: When the record owner and beneficial owner are different, the beneficial
owners has ultimate authority to vote the shares. (Check this!!!!)
c) § 7.23(a) A corporation may establish a procedure by which the beneficial owner of share
that are registered in the name of a nominee is recognized by the corporation as the
shareholder. The extent of this recognition may be determined in the procedure.
d) Cumulative vs. Straight Voting: page 449
i) Cumulative voting- allows shareholder to “bunch” all the votes he may cast in an
election for directors on one or more candidates. The effect is that it increases
minority participation in voting.
(1) Why don’t big corporations follow cumulative voting?
(2) They know that a minority group(s) can organize and in effect pool their voting
power to elect some membership on BOD. Idea is that “we don’t want those
people… we want our people so they will vote our way”
ii) Straight voting- allows a shareholder to vote only the number of shares he/she owns
for each candidate. In straight voting, the majority of the shares elects all directors
and a minority cannot elect a single director
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iii) Mechanics of voting- Example: corp. with 2 shareholder: A (18 shares) & B (82
shares). There are 5 directors, and each shareholder nominates 5 candidates. The
five persons receiving the most votes are elected.
(1) Straight voting- A may cast 18 votes for each of five candidates, while B may cast
82 votes for each of the five candidates. Result all 5 of B’s candidates are
elected
(2) Cumulative Voting(a) first compute the number of total votes each shareholder may cast:
(i) A = 18 *5 = 90 votes
(ii) B = 82 * 5 – 410 votes
(b) So, if A casts all his 90 votes for his first nomination that candidate is assured
election b/c B cannot divide his votes in a manner as to give each candidate
more than 90 votes (410/5 = 82)
iv) Minimization of Effect of Cumulative Voting- can reduce effect by:
(1) eliminating the privilege entirely
(2) reduction of the number of positions to be filled at a single meeting
(a) e.g. reducing the size of the board or dividing the voting terms to that only a
fraction of directors are elected at each meeting 3 out of 9 elected each
year; then rotate
(b) [Humphries]- upheld staggered elections- “minority shareholders have only
the right to cumulative voting,” but they do not “necessarily guarantee the
effectiveness of the exercise of that right to elect representation”
(c) § 8.06-6- terms of directors and staggering of directors – today, articles of
incorporation do not have to name the number on the BOD (can merely be in
the by-laws)
(3) removal of minority director; or “working around” such a director
e) Humprhys v. Winous Co. (1956)
i) Illinois constitutional provision guaranteed the right to vote cumulatively.
ii) Court said that it guarantees the minority shareholders only the right to cumulative
voting and does not necessarily guarantee the effectiveness of the exercise of that
right to elect minority representation on the board of directors.
(1) MBCA §8.05: says that directors are elected to one year terms unless the terms
are staggered under § 8.06
(a) They would serve two years terms if ½ staggered, 3 years if 1/3 staggered.
(b) This can be used to nullify/dilute the power of cumulative voting for the
minority.
(i) Courts have approved staggering if cumulative voting was only
guaranteed by statute, but have ruled differently if guaranteed by
constitution.
f) Proxy Votingi) §7.22 – proxies – SH may vote his shares by attending the meeting in person or by
proxy (designating someone else to vote for you)
ii) Proxy appointments must be in writing and, under the MBCA, can be valid for
whatever period specified in the appointment form.
g) Voting Trusts
i)
Voting trust v. shareholder agreement- trust can only last 10 years, shareholder agreement can
last longer
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ii) Voting Trusts- formal devices by which the power to vote may be temporarily but irrevocably
severed from the beneficial ownership of shares. In a voting trust shares are registered in the
name of one or more voting trustees on the records of the corporation. An arrangement that
has the economic of legal effect of a voting trust, such as a limited partnership or a contract,
may be treated as an informal voting trust subject to the rules set forth below.
(1) Uses of voting trusts- preservation of control, assuring stability of management, or
protecting interests of corporate creditors
(2) §7.21 – one share = one vote… UNLESS provided otherwise in the articles (the articles
can have a provision that deviates from this idea of one share = one vote)
(3) Criteria for a voting trust {Lehrman]:
(a) The voting rights of the stock are separated from the other attributes of ownership
(b) The voting rights granted are intended to be irrevocable for a definite period of time
(c) The principal purpose of the grant of voting rights is to acquire (maintain?)
voting
control of the corporation
iii) Brown v. McLanahan (1945)  Shares were in a voting trust. Trustees were voting
as if the represented debenture holders.
(1) Holding: it was an abuse of trust to use the voting power for their own benefit
and the benefit of corporations in which they were interest and to the detriment of
preferred shareholders who were the beneficiaries of the trust.
(2) Rule: Seem the trustees of the voting trust have a duty of loyalty to the
beneficiaries of the trust.
iv) See 7.30 et seq. MBCA Voting Trusts and Agreements
v) Lehrnman v. Cohen (1966)
(1) Two families owned a corporation. Each family had a right to elect two directors,
but became deadlocked. Articles had a provision for a new class of stock which
had no rights but to elect a fifth director. Is this legitimate?
(2) Held: Class of stock okay. Did not offend the statutory norm of corporate
governance; was not against public policy; agreed to by all of the shareholders; no
different than hiring an arbitrator.
(a) Π’s arg.- since D’s stock receives no dividends, it is a voting trust and since
formalities were not met, no valid voting trust exists.
(b) Holding: using the 3 part test above, an appropriate provision in the art. of
incorporation granting Danzansky a tie breaking vote on the BOD was valid (i.e. no
voting trust was created, so it wasn’t subject to the 10 year limit on trusts in the
statute).
h) Transfer Limitations
Definition- contractual restrictions on the free transferability of shares. Restrictions on
transfer are universal on closely held corporations, but very nonexistent in publicly held
companies.
(1) Common law (closely held)- does it unreasonably restrain or prohibit transfer
(2) Establishing the price
ii) Buy Sell Agreements in Closely-held Corporation- K obligations to offer of sell shares either
to the corporation or to other shareholders, or to both successively, on the death or retirement
of the shareholder or before she sells or disposes of the shares to another person
(1) 3 types of restrictions:
(a) mandatory buy/sell agreement
(b) option to purchase
(c) right of first refusal; giving the corporation or other shareholders the opportunity to
meet the best price the shareholder has been able to obtain from 3rd parties
i)
30
(2) Issues normally arise in valuation of the shares
iii)
iv)
v)
vi)
(a) Closely held- if not in agreement, one method is to have provision as to how to select
people (arbiters?) who will decide on value. Could also use the “book value”
(i) recognition that ownership of a fractional interest is not worth that fractional
interest of the whole thing (must deal with other people’s interest as well)
(ii) reliable formulas are hard to find- problem is that there’s no reliable market value
to go by (e.g. closely held corporation is not publicly traded)
(iii) p. 496,499, 522-23 in supplement
(b) Publicly held- FMV of the shares
§ 6.21- Issuance of shares- is a certificate required?
(1) not in publicly held corporations, but is an issue in closely held corporations
(2) in a large corporation, stock is easily bought and sold with not many limitations – in the
case of a closely held corporation there is no market for those shares (probably provision
in articles stating what will happen to the shares… sort of like a partnership)
§ 6.25- Form and Content of Certificates- most large publicly held companies don’t provide a
paper certificate anymore, unless you ask for it. However, in closely held corporations, this is
not the case. Instead, there are restrictions on transferability of stocks in order to protect the
small number of shareholders from taking on new owners (similar to partnerships- imagine
all of a sudden having a new partner). If there are no restrictions, the stock is assignable w/o
prohibition.
§ 6.26- corporation can issue stock and does not have to be represented by a certificate (much
of this is in electronic form now… records, etc…. however, can get a certificate if you want
one)
§ 6.27- Restrictions on Transfer of Shares
(1) Notice
(2) Conspicuousness- reasonable person standard
(a) § 1.4(3)- a reasonable person against whom the writing is to operate it would notice.
(b) see [Ling v. Trinity Savings & Loan]
vii) Ling v. Trinity Savings (1972) (Transfer Limitations) (Stock Certificates)
(1) Rule: There are often serious restrictions on the transferability of stock,
especially in closely held corporations. See § 6.27
(2) Rule: Shares need not be represented by certificates. See §§ 6.25, 6.26
viii) Essential Attributes of Transfer Restrictions
(1) Whether purchase is optional or mandatory
(2) The persons who may or must purchase the shares and the sequence in which they
may purchase
(3) The manner in which the price is to be determined
(4) The time periods during the persons may decided whether or not to purchase (if
an option)
(5) the events (e.g. proposed sale, death, bankruptcy, family gift, etc.) which triggered
the restriction.
ix) See § 6.27 MBCA for statute regarding restraints on transfer. See also page 522 in
supplement for transferability provision in model LLC Operating Agreement; page
233 sample partnership agreement transfer provisoin
(1) § 6.27(d): very important.
(a) obligate the shareholder first to offer the corporation or other persons
(separately, consecutively, or simultaneously) an opportunity to acquire
restricted shares
(b) obligate the corporation or other persons to acquire restricted shares
31
(i) §6.40 allows extended payment schedules.
(c) require the corporation, the holders of any class of its shares, or another
person to approve the transfer of the restricted shares, if the requirement is not
manifestly unreasonable
(d) prohibit the transfer of the restricted shares to designated persons or classes of
persons, if the prohibition is not manifestly unreasonable.
i) Mississippi Cases
i) Fought v. Morris (Miss. 1989)  Dealings between shareholders of a closely held
corporation should be “intrinsically fair”
ii) Baxter Porter v. Venture Oil (Miss. 1986)
(1) Two very similar corporations, same owners and management. VP makes oral
contract with another company and breached. Baxter sued the one corporation
and it was judgment proof so he’s suing the other.
(2) Rule: Looking to partnership law, the court held  the executive officer of a
close corporation, in carrying on the usual business of the corporation has the
same apparent authority as a partner in a partnership as against 3rd parties who in
good faith rely upon his representation.
iii) Missala Marine Services v. Odom (Miss. 2003)
(1) Closely held corporation in which minority shareholder was intentionally frozen
out. Court agreed that there was a breach of fiduciary duty to the minority
shareholder, but could agree completely on damages.
(2) All judges agreed on actual damages for the breach, but only five agreed to award
punitive damages.
(a) Bradley says it’s not unusual that there be punitive damages because a freeze
out is basically an intentional tort.
iv) Ross v. National Forms (Miss. 2004)
(1) Ross was an employee of National Forms and claims that he was elected president
without his own knowledge. He then decided to go and work for another
company and took most of the employees with him. National the sued Ross for
breach of fiduciary duties.
(2) I think that the point of this case is that an officer and not a shareholder or director
being charged with breach of fiduciary duty.
v) Matthews Brink Hunting Club Inc. (Miss. 1985)
(1) Hunting Club corporation had a provision in the bylaws that upon death of a
shareholder the corporation would by back the share for book value to be
determined by majority vote of the club. The club voted to determine a book
value, but it was worth about 1/10th of what his share was really worth.
(2) Court held that the bylaws may not be enforced because it was contractual and the
consideration was grossly inadequate.
j) Deadlocks
i)
Definition- control arrangements that effectively prevent the corporation from acting or
making decisions. They typically involve 2 factions or 2 shareholders in a control structure
that does not permit either to have effective working control. It is possible for a corporation
with more than 2 factions to become deadlocked , but it is much less common.
(1) Differentiate Dissension- refers to internal squabbles, fights, or disagreements in a
corporation that has clearly defined the controlling shareholders.
32
(2) Deadlock occurs when the control arrangements prevent the corporation from functioning
(matter of degree b/t the 2)
ii) Typical deadlock situations:
(1) 2 factions own 50% of outstanding shares each
(2) there are an even number of directors, and 2 factions have power to select the same
number
(3) a minority shareholder has retained veto power in one of the ways previously described
iii) Deadlocks can occur at 2 levels
(1) Shareholder- if shareholders are deadlocked, the corporation may continue to operate
under the guidance of the BOD in office when the deadlock arose
(2) Directors- a deadlock at the directorial level may prevent the corporation from
functioning at all, though more commonly the president/general manager may continue
operations (often at the exclusion of others)
iv) Gearing v. Kelly (1962) A and B are the sole shareholders in a corporation, owning 50%
each. There are 4 directors (straight voting), so that 2 directors are elected by each director.
The articles state that a quorum is 3 directors. One of B’s directors resigns and new one
cannot be elected b/c of the deadlock (2 to 1 will not carry vote). B’s lawyer tells her director
not to attend b/c it will create a quorum, thus allowing A’s directors to conduct business. A’s
two directors elect a 4th director in the absence of B.
(1) Π brings action to invalidate the election of the 4th director
(2) Holding: B’s director breached her duty by staying away from the meeting and cannot
complain about the lack of quorum caused by her
(3) How could this be resolved?
(a) § 8.10- Filling Director Vacancy- vacancy can be filled by directors or
shareholders if vacant office was held by director elected by a voting group of
SHs, only holders of shares of that voting group are entitled to vote to fill vacancy if
it is filled by the SHs
(b) § 8.10(a)(3)- if remaining directors are fewer than a quorum, then the majority of
remaining directors can fill the vacancy (not valid in above case b/c remaining
directors is not less than quorum)
(c) Another solution- create 2 classes of stock, A and B, whereby each class
elects 2 directors
(4) Involuntary Dissolution: [In re Radom & Neidorff, Inc]- Radom and Neidorff are
equal shareholders in a profitable business that has operated successfully for
many years. Neidorff dies and his shares are inherited by his wife, Radom’s
sister. Brother and sister do not get along, and Mrs. Neidorff does not participate
in the management of the business but remains an officer and must countersign all
checks. She refuses to permit the corporation to pay Radom’s salary.
(a) Radom, as a result, petitioned the court for an involuntary dissolution— due to
irreconcilable difference— of the company. When dissolution of company
occurs, there is a sale of the business – pay off SH if anything is left after
paying debts, etc.
(b) Holding: even though the court recognizes that grounds for dissolution exist,
dissolution is denied b/c it will give Radom an unfair advantage in the future.
(c) Reasoning:
(i) Radom’s personal abilities largely explain the corporation’s success, and it
is unlikely that an outsider could continue to operate the business at the
same level. However, the value of the business is in part explained by
Neidorff’s contributions prior to death
33
(ii) If the corporation were dissolved and the assets sold, Radom could buy the
assets at a favorable price and thereafter continue to operate the business
without sharing the fruits w/ Mrs. Neidorff. He would capture the
contribution made by Neidorff without compensating his wife.
(d) So, after dissolution denied, Radom must negotiate with his sister to purchase
her shares.
(5) Analysis of Neidorff:
(a) Look at undisputed material facts
(i) The company was profitable
(ii) stockholders only dislike each other
(iii)no stalemate exists as to corporate policies
(iv) only complaint for radom is paychecks, which is not valid reason to
dissolve corporation
(b) Dissolution only proper when competing interests “are so discordant as to
prevent efficient management: and the “object of its corporate existence
cannot be attained”
(6) Rule Judicial Dissolution is an equitable remedy, thus the court has discretion
to dissolve a corporation in deadlock… it’s not mandatory
v) Modern Remedies for Oppression, Dissension, & Deadlock- oppression is denying a
shareholder his rights as a shareholder
(1) Judicially Ordered Buyouts- a significant modern trend is the increased
recognition that courts may order a buyout of shares rather than an involuntary
dissolution in order to resolve problems of oppression & deadlock. Buyout orders
are specifically authorized by statute in some states, and may be viewed as part of
the inherent judicial power in states where they do not have express statutory
sanction.
(a) § 14.34- Election to Purchase in Lieu of Dissolution
(i) if a shareholder files suit asking for dissolution, then the shareholder has
agreed that the majority may buy them out
(ii) in case of corporation where shares are not traded… if SH files dissolution
suit, triggers a right on other side to buy that person out (suddenly gives a
caution to a minority SH… says that if you file a dissolution suit the
corporation or other SHs have right to buy you out)
(b) § 14.34(d)- if unable to agree on price, FMV is used
(c) § 14.34(e)- judicial buy is proper when repair of the relationship is unlikely
and the only good solution is to buy out at the FMV; may be set by an
arbitrator and may be made in installments; court can also employ someone to
find a market for the shares (closely held corp.) in order to set a fair price for
the shares.
(2) Davis v. Sheerin (1988)- Davis owns 55% with he and his wife working for a
corporation. Sheering owns 45%; and Davis will not let Sheerin view the
corporation’s books unless he produces his stock certificate. Davis claims that
Sheerin made a gift to Davis of the 45% interest. Sheerin asks for the remedy of
buyout:
(a) Under what instances is a buyout appropriate?
34
(3)
(4)
(5)
(6)
(i) Courts, under the general equity power, may grant a buyout when less
harsh remedies (injunction; liquidation) are inadequate to protect the rights
of the parties such a case would be oppressive conduct by the majority
shareholder
(ii) Oppression:
1. Lack of fair dealing to prejudice the minority shareholder
2. violation of fair play as to the other shareholders
(b) Oppressive conduct in this case:
(i) jury found that there was “conspiracy to deprive [Sheerin] of his stock, on
the evidence and arguments, and on its conclusion that appellants acted
oppressively against [Sherrin] and would continue to do so”
(ii) D’s also used funds for bonuses & personal legal fees
(c) Holding: while an injunction may remedy some of the breach of fiduciary
duty violations, oppressive conduct in trying to deprive the Π of any interest
or voice in the corporation warrants a “buyout”
Note that though most of these Oppression cases involve actions by minority
shareholders, minority shareholders also owe duty the majority and breach of
these duties may be viewed as oppressive in some instances.
Capital Toyota v. Gervin (Miss. 1980) (Remedy)
(a) A and B form corporation and purchase Toyata franchise. Gervin is brought
on as general manager. A and B orally promise to give Gerbin a 25% share in
the corporation once the debts are paid off and it becomes profitable.
However, they kept the corporation from being “profitable” by paying
themselves lavish salaries, buying a yacht, etc. Gervin sued wanting the
corporation dissolved.
(b) SC found that Gervin had been oppressed however denied dissolution as
relief. Stated that dissolution is an extreme remedy reserved for gross
oppression and awarded Gervin 25% of the book value of the corporation.
(i) Aside: Bradley said that fair market value would have been a better
remedy because book value doesn’t include the value of the business as a
going concern.
Abreu v. Unica Indus Sales, Inc. (1991) (Provisional Directors)
(a) 50/50 split in ownership of a corporation. One of the owners was accused of
using another business to compete against the corporation. The court
appointed a provisional director, but it was the complaining director/owner’s
son-in-law.
(b) Does the provision director have to be impartial: Not necessarily, it is more
important to appoint a provisional director who has knowledge of the
business.
(i) Also, court said that the provisional director was an officer of the court
and owed a duty to the court and could be held accountable under that
duty.
Arbitration Alternative: Mandatory arbitration, usually handle by a clause in the
articles of incorporation or by statute can be a cheaper, faster, and more efficient
way to solve corporate deadlocks. The attributes also likely increase the odds of
the corporation “healing” quicker and getting back down to business.
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3) Actions by Directors and Officers (Binding the Corporation)
a) Baxter Porter v. Venture Oil (Miss. 1986) oral K made b/w J.W. Harris Corp. and Baxter-Porter.
BP did the work of the K but the bill was never paid… BP filed suit against JH and got a
judgment against JH… but could not collect judgment against this company. Could not collect
b/c there was inability to find assets which they could levy execution on
i) Venture Oil Corp. and Lilly (VP) were both Δs in the second suit – two companies had shared
office… and James Harris was president of both corp. and Lilly was VP of both corp. and
they both were on the board of both corporations
ii) Judge said that this is an occasion where debt is in one company and assets are in another
company – too much of an opportunity for foul-play
iii) Point?(1) In case of closely held corp., officers have same authority to bind corporation as
they do in a partnership – judge said there was evidence in this case for a jury to decide
that Harris had authority to bind Venture
(2) Even if divided into separate entities… not a safety net for all entities being liable for
judgments against one
iv) To avoid, see estoppel principle in next case:
v) In re Drive-in Development Corp. (1966) The lender in this case has asserted in bankruptcy a
claim against Drive-n (the bankrupt party) on the basis of a cosigned note. The lender is
asserting claim against the guarantor. There was a question of whether the guarantor
corporation authorized its officers to guarantee the debt. The bankruptcy hearing determined
that the officer had no authority to sign the guarantee, “either actual or implied.”
(1) Did corp. ever authorize officers to guaranty this debt? Nothing in DID’s minutes about it
– no evidence that corp. actually authorized him or anyone else to guaranty debt
(2) Holding: Bankruptcy court’s ruling reversed. DID was bound by guaranty even if there
is no evidence that corp. authorized signing guaranty
(a) Estoppel from Denying Authority (by the Δ)- DID is estopped from denying the
officer’s authority to sign the guarantee
(b) They were estopped from denying b/c the Secretary was acting within the scope of
his authority when he kept the record and provided it to the bank. Therefore, they
were also estopped from denying the truthfulness of facts stated in the Bank’s
certificate
(3) Review actual & implied authority- §§ 2.01, 2.02
vi) Keystone v. Peoples Protective Life Ins (1981)- the court will refuse to grant 3rd persons the
benefit of the estoppel principle set forth in Drive-In where the 3rd person “must have been
aware” that the transaction had not been authorized by the BOD (i.e. if the bank “must have
been aware” that the officer did not have authority, they cannot benefit from the estoppel
principle)
vii) Lee v. Jenkins (1959) - president and chairman of the BOD promised the Π to pay him a
pension whether or not he worked with the company until he reached the pension age (60).
The Π was later fired and the corporation refused to pay the pension and claimed that the
president did not have authority to make such a promise.
(1) Did the president have apparant authority to make such a promise?--> holding: YES
(2) Rule- the president has authority to bind his company by acts arising in the usual and
ordinary course of business but not for K’s of an extraordinary nature
(a) Regular course- hire and fix compensation
(b) Extraordinary- employment K’s for life when only consideration is the employee’s
promise to work for that period.
(3) How do you avoid this problem?--> documentation
4) Transactions in Controlling Shares
a) There is a duty of good faith & fair dealing
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b) Corporate Looting- what duty does a majority shareholder have to the minority when selling his
shares to a person who he has facts indicating a reasonable likelihood that the buyer will loot the
corporation?
i) DeBaun v. First Western Bank ( 1975) - Johnson started the company, and, at the time of his
death, owned 70% of the stock. This ownership passed to the bank. The company became
increasingly profitable, and the bank decided to sell its share of the company. The bank
chose not to notify anyone of the sale. Once the word got out about the sale, the remaining
owners were approached about selling their shares, which they refused b/c they had a “good
job.”
(1) The potential buyer, Mattison, of the bank’s shares had a sketchy past. He claimed that
he had outstanding payments b/c he took over failing companies, and that the debts
weren’t his. He also was warmly received at a country club. Because of this, the bank
made Mattison enter a detailed security agreement, and, unknown to the remaining
shareholders, the corporation’s assets were listed as collateral. Mattision was then
elected director of the company. They did no further investigation.
(2) Upon taking over, Mattison began to loot the corporation. The agreement was eventually
breached, and the bank sold the company’s stock.
ii) Was the bank’s failure to investigate and ultimate sale a breach of duty by the majority
shareholder to the minority?
(1) majority has duty to the minority “in any transaction where the control of the corporation
is material”, in which the majority should exercise “good faith and fairness” in
transactions from the viewpoint of the corporation and those therein
(2) Should conduct a reasonable investigation of the buyer to satisfy this duty
(3) So, the Bank owed duty to minority in light of the info they had
iii) See ALI Principles of Corporation Governance page 1287 in supplement.
c) Usurpation of Corporate Opportunity (Comes up later again I think)  If there is an offer made
to the corporation and a majority shareholder steals the opportunity by commanding a premium
price for his shares to sell majority of control and leaving the minority shareholders left behind.
The majority shareholder is not allowed to keep the premium price paid for control, it belongs to
all the shareholders or the corporation.
i) Perlan v. Feldman (1955): Feldmann was a majority shareholder and director of Newport
Steel. During this time, there was a ceiling on steel prices, yet there was excess demand.
There was a grey market surrounding steel, and one method used was to get control of a steel
company in order to get priority of delivery. Feldmann sold his majority stake for premium
price and the minority shareholders were left out. Shareholders say that the premium price
can be attributed to a sale of “corporate power” which belongs to all the shareholders, not just
the majority.
(1) Because Feldman was a shareholder he owed a duty to all shareholders, and because he
was director he owed a duty to the corporation.
(2) The court held that he breached this duty and the premium was to be re-distributed
among all of the shareholders. ss
ii) McCaw Wireless
Duty of Care and the Business Judgment Rule
1) Directors and the Duty of Care- directors have a duty of care when operating the company.
The duty of care is broad, and can be interpreted many ways:
a) To whom do the directors owe a duty of care?
i) Shareholders
ii) Creditors
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iii) MS version of §8.30 (handout) – MS is one of 30 states that have enacted statutes that
authorize corporate directors to consider, in addition to the LT and ST interests of the
corporation, these various groups (including present or retired employees, suppliers,
customers, creditors, the local community in which the principal corporate facility is
located, and so forth)
b) BJR
i) The BJR is a defense to a charge of breach of the duty of care
ii) Material information includes the type of information that would influence someone
iii) BJR can apply to a decision process as well as the actual decision (i.e. decision made
too hastily, without sufficient investigation, etc…)
2) § 8.30-31: Duty of Care for Directors
a) Old MBCA
i) (a) A director shall discharge his duties as a director, including his duties as a member
of a committee:
(1) in good faith;
(2) with the care an ordinarily prudent person in a like position would exercise under
similar circumstances; and {**negligence standard)
(3) in a manner he reasonably believes to be in the best interests of the corporation
ii) The negligence standard was very contentious- it created problems with “risk-taking”
b) New MBCA- changed the negligence standard why? we expect business people often
to make decisions about risk-taking (business risks) and it is not certain to turn out right –
if looked at in hindsight we can see they are negligent then unrealistic to expect people to
have such good fortune and discourages people from being members of BOD
i) New statute requires that directors, “when becoming informed in connection with
their decision making function,” exercise the care “that a person in a like position
would reasonably belief appropriate in similar circumstances”
ii) §8.01(b) is different from older version as well -- BOD are not held to same level of
conduct that other corporate statutes had expressed
iii) Therefore, a director who is acting in good faith has met the standard of care when:
(1) The director is informed with respect to the subject of his judgment to the extent
he reasonably believes to be appropriate under the circumstances
(2) He is not financially interested in the manner; and
(3) He rationally believes that his business judgment is in the best interest of the
corporation
c) § 8.30-.31- read statutes and comments
d) 3 Requirements for the BJR
i) good faith- there is a presumption of good faith (don’t forget can’t be financially
interested)
ii) informed
iii) rational belief (common law has also defined as reasonable)
e) 7 responsibilities of director (in order to comply with the duty of care):
i) Must have at least a rudimentary understanding about the business
ii) Must keep informed with activities of the business
iii) General monitoring of corporation’s affairs and policies
iv) Regular attendance of meetings
v) Regular review of financial status of company
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vi) Assure use of proper accounting methods/standards
vii) Duty to inquire anytime there is anything that looks like it needs further inquiry
f) Though business judgment rule deference is now the norm; it is subject to many
exceptions which serve to remove the deference given to the decision. In addition,
though there is no precise analogy, gross negligence is seen as a comparable measure of
business judgment deference. See Smith v. Van Gorkom. Exceptions include:
i) fraud
ii) illegality
iii) conflict of interest is a major one
3) Case law analysis of Duty of Care  See §§ 8.30-31 MBCA, ALI 4.01-03 and comments
at page 1313 in supplement.
a) Litwin v. Allen (1940)  issue of the standard of care and level or risk aversion is
industry specific. This is a banking case.
i) Banking is a very risk averse business (look at level or regulation) and these directors
entered into a transaction that had no upside and a large risk of loss. This was not the
action of a reasonably prudent banker, thus they violated their duty of care.
b) Shenskly v. Wrigley (1968)  Directors were sued by shareholders because the refused to
install lights in the stadium as all other pro teams had. Shareholders claimed that the
team would be more profitable with night games and that Wrigley (controlling
shareholder/director) refuses to have lights on principal that baseball was a day game.
i) Court said they will not interfere with the presumption of honest business judgment
of the directors unless there is a showing of fraud, illegality, or a conflict of interest.
ii) See § 8.30(f)(3) (old MBCA)  directors may consider community and societal
interests....they don’t have to look solely at the interests of the shareholders or the
corporation.
c) Smith v. Van Gorkom (1985)  Directors accepted an offer to purchase the corporation
after a 30 minute presentation was made on a Saturday morning. They basically did no
research into whether it was a fair price or whether they were other buyers willing to pay
more.
i) Court found that the directors had breached their duty of care.
ii) No BJR deference given in the case because the decision was not an “informed” one.
iii) There is disagreement over the real impact of this case:
(1) Some say its holding is that there is a higher duty of care when selling a company
bc it is the most important decision the directors can make.
(2) Some say its holding is that you better put in some research when making
decisions or you will get no BJR deference.
(3) See 8.30(c), (e) stating that directors may rely on other directors in making
decisions.
d) See Francis v. United Jersey Bank (failure to make decision)  BJR not available to
board figurehead director because she didn’t participate and neglected her duty to be
informed about the corporation as her sons siphoned out all the money.
i) Seven Responsibilities:
(1) rudimentary understanding of the business
(2) keep informed about the activities of the business
(3) general monitoring of the corporations affairs and policies (often accomplished
via committee)
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(4) regular attendance at meetings
(5) regular review of the financial status of the company
(6) assure the sue of proper accounting method and standards (generally deals with
hiring a public accounting firm to audit
(a) levels of audit vary by cost
(b) usually an audit committee
(c) duty to inquire anytime there is anything that looks like it needs further
inquiry
e) In re Caremark (1996) (duty to control lower employees)  Employees were paying
doctors kickbacks for Medicare. Company gets caught and hit with $250m fine.
Shareholders are now suing claiming company would have lost $250m if they had
stopped the kickbacks.
i) In order to show breach, must show either:
(1) that the directors knew, or
(2) should have known that violations of law were occurring, AND
(3) that the directors took no steps in a good faith effort to prevent or remedy that
situation
f) Malone v. Brincat (1998)  directors of a corporation knowingly disseminated false
statements which overstated earnings. When the fraud was exposed the shareholders lost
a ton of money. Stockholders claimed that this violated duty because the directors caused
the stockholders damage. This is basically a duty of loyalty issue because the directors
were not looking out for the shareholders’ best interest. (**not sure exactly what this
case adds other than duty of full disclosure or honesty)
i) Could be said that this holding creates a duty of honesty or a duty of full disclosure.
g) Reliance upon Experts- directors may rely on information, opinions, reports, or statements
including financial statements and other financial data prepared or presented by a responsible
corporate officer, employees, legal counsel or public accountants, if the directors have confidence
in the persons upon whom they’re relying
h) Cases Involving A Failure to Make a Decision (Failure to Direct)
i) The BJR applies only when decisions are made. If the director fails to participate in a
decision, the BJR is inapplicable and the director’s conduct is evaluated under the “prudent
man” standard
ii) This is limited- can’t hold BOD liable for wrongdoing at a remote level of the company
unless they should’ve known and did not due to a failure to investigate. [In Re Caremark]
iii) [Allis Chalmers]- BOD found negligent for failure to have internal auditing system- auditing
is essential and a duty of the directors
Duty of Loyalty and Conflict of Interest
1) In General
a) Duty of Loyalty - “Directors must disclose and not withhold relevant information
concerning any potential conflict of interest with the corporation (conflict of interest),
and they must refrain from using their position, influence, or knowledge of the affairs of
the corporation to gain personal advantage (corporate opportunity)
b) Directors must discharge their duties in good faith and in the best interests of the corp.
2) Self Dealing
a) Defined: Transactions between the corporation and director that are sufficiently
substantial as to likely affect the director’s judgment. The danger of self-dealing
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transactions is that the director may favor his personal interest over the corporation’s
interests.
b) Common Law Tests: The original common law test was that self-dealing transactions
were voidable without regard to fairness. Gradually this view changed and it became
accepted that self-dealing should be evaluated on the basis of fairness with weight also
given to ratification or approval of the transaction by disinterested directors or
shareholders, i.e., conflict of interest transactions do not get BJR deference.
i) Burden shifting  if plaintiff can show that there was a conflict of interest, D get’s
burden of showing the transaction was intrinsically fair.
c) Modern test- just b/c there is a conflict of interest does not mean you can set aside a K
(violation of duty of loyalty but will not make the K voidable) – subject to very close
scrutiny
i) Look to DE § 144:
(1) If there was a full disclosure to the BOD that one exists on both sides of the
transaction, this further validates the transaction even though conflict of interest
exists
(2) disclosure is part of the process by which the decision is made
(3) If the decision is put to a SH vote…. Full disclosure to the SH
(4) If the transaction is fair as to the corporation (time it is authorized, approved, or
ratified by BOD or SH
ii) § 8.60-.63 MBCA  COI transaction may not be voided if:
(1) approved by a disinterested majority of the BOD after full disclosure
(a) If approved burden shifts to Π to show lack of fairness
(b) If not present burden shits to Δ to show fairness
(2) approved by a disinterested majority of shareholders after disclosure
(a) If approved burden shifts to Π to show lack of fairness
(b) If not present burden shits to Δ to show fairness
(3) Transaction was intrinsically fair (burden on Δ to show fairness)
d) So, a COI transaction is NOT voidable IF:
i) full disclosure- disclosure of all facts known by Δ that an ordinary, prudent person
would reasonably believe to be material to a judgment made by the corporation (i.e.
any material facts known to Δ)
ii) disinterested majority
iii) fairness to corporation(1) intrinsic fairness (i.e. entire fairness)
(2) Fair = fair dealing + fair price [Weiberger]
e) See note #2 on p. 762 for a number of tests
f) Note 3 – p. 763 – while many transactions b/w directors and their corporation have been held to
be valid in the absence of a controlling statute, considerable confusion exists in the case law as to
the circumstances which my validate such transactions. If one examines the results of cases (as
contrasted with statements in the opinions), the following comments accurately reflect most of the
decisions:
i) If court feels transaction to be fair to the corporation, it will be upheld;
ii) If court feels transaction involves fraud, undue over-reaching (the transaction “smells” funny
substantively) or waste of corporate assets (e.g., a director using corporate assets for personal
purposes without paying for them), transaction will be set aside; and
41
iii) If court feels transaction does not involve fraud, undue over-reaching or waste of corporate
assets, but it is not convinced that transaction is fair, transaction will be upheld only where
interested director can convincingly show that transaction was approved (or ratified) by a
truly disinterested majority of BOD without participation by interested director or by majority
of disinterested SHs, after full disclosure of all relevant facts.
g) Burden of proof: BJR v. COI §§ 8.61-.62
i) Business Judgment Rule (combined with duty of care)  says that the law presumes that a
decision made by the directors is valid… if a person is challenging that, person has burden of
proof of showing elements (not in good faith, process by which decision was made, etc.)
ii) Conflict of Interest transaction  we do not trust a decision made… do not indulge in any
presumption that the BOD properly made the decision – instead, CL rule at one time said you
strike it just for that reason – CL rule changed so that if a challenge of a transaction could be
upheld on certain findings by a court. Look to test to see who has the burden and under what
circumstances.
h) Case Law
i) Marciano v. Nakash (1987)  two families each own 50% of Gasoline Corp. and the
Nakash family has loaned $2.5m to the corporation. After a deadlock, the corporation
is to be liquidated. Nakashes want the loan repaid, Marciano’s are claiming the
transaction was void.
(1) Court looked to the transaction to determine if there was intrinsic fairness and
found there to be, so the transaction was upheld.
(2) §§ 8.61(b), 8.62  gives a conflict of interest transaction deference if there has
been full disclosure and it has been approved by a majority of disinterested
directors.
ii) Heller v. Boylan (1941)  Small tobacco company amended its bylaws and SHs voted in
favor of bylaw amendment saying it would give executive compensation as a percentage of
its earnings – made sense at the time but by the late 1920s their bonuses were more than 3x
their salaries (claim is that directors gave these payments to the officers)
(1) Challenge is that this amounts to waste of corporate assets – if decision made by BOD
ever amounts to waste of corporate assets, it would violate duty of care b/c an irrational
decision was made
(2) The transaction was eventually upheld
(a) It was something more powerful than a disinterested majority, it was an approval by
the shareholders
(b) Look at the Weinberger case after this for the method
iii) Brehm v. Eisner (2000)  Micheal Ovitz was chosen as president of Disney. He
stayed on for 14 months and then was pushed out; his severance package was worth
$140m. The severance package was actually worth more than if he had stayed with
the company for the term of the contract. Shareholders charge waste in such a stupid
compensation package.
(1) P’s claimed that Eisner who was chairman dominated the board. They claimed
that since Eisner had a conflict of interest, the whole board did; hoping to fail the
disinterested vote test. Court didn’t buy the board domination theory.
(2) Further claim that the board did not make an informed decision on the approval of
Ovitz contract since no idiot would allow a severance package worth more than
the actual employment K. Court said they reasonably relied on the compensation
expert hired to do facilitate the deal.
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(3) Because those two argument were rejected, the board got BJR deference the board
approval of the compensation package was upheld.
iv) Sinclair v. Levien (1971)  97% owned subsidiary had board dominated by members
of the parent corporation. Subsidiary’s policy was to pay out all earnings in
dividends and did not attempt to reinvest the profits and grow the company. 3%
minority shareholders sued saying this policy was a conflict of interest transaction of
sorts because the best way to handle the profits was to grow, and that the parent was
just using the subsidiary as a cash machine. Thus, the minority is claiming that the
director’s duty of loyalty was to the parent and not the sub.
(1) Though there appears to be a conflict of interest here, the court held that since all
shareholders were treated alike, there wasn’t one. Hence, the defendants got BJR
deference instead of being forced to show intrinsic fairness.
(2) Rule (shaky at best): dividends will get BJR deference as long as all shareholders
treated equally.
v) Aside: One way to avoid conflict of interest problems is to get rid of minority
shareholders whose interests do not align with yours.
(1) This can be taken care of with a merger. See § 11.02 of MBCA.
vi) Weinberger v. UOP (1983)  Signal owned about 51% of UOP and they wanted to
own the whole corporation so they create a shell and merge UOP with that and cancel
all of the UOP stock in exchange for $21 per share. 6 Signal employees were on the
board of UOP and new that the transaction would be profitable if they paid $24 per
share. However, they didn’t disclose that to the rest of the UOP board.
(1) Shareholders challenged this on the grounds that the Signal directors on UOP’s
board had a conflict of interest. Though they were employees of Signal, they still
owed a duty of loyalty to all shareholders of UOP. Based on that duty, they had a
duty to disclose that $24 was good price for the deal.
(2) Signal was smart in one sense, they had the merger approved by disinterested
majority.
(3) Fairness requires Procedural Fairness (fair dealing) and Substantive Fairness (Fair
Price)
(a) Transaction will be de jure unfair if there is failure to disclose.
(b) Not quite solid on the whole intrinsic fairness test
i) Remedy: Valuation method
i) It used to be the “Delaware Block” method
(1) this was severely criticized because it was not a true valuation of stock price
ii) This court said that fair price requires consideration of all relevant factors.
(1) There are other methods such as discounting cash flows.
(2) Should use valuation methods actually used in business
iii) Appraisal statutes typically say that as long as you have not voted in favor the
transaction, you have the right to a judicial appraisal. Once you ask for an appraisal,
you are no longer a shareholder, you only have a right to receive cash from the
judicial appraisal.
(1) “The appraisal remedy we approve may not be adequate in certain cases,
particularly where fraud, misrepresentation, SELF DEALING, deliberate waste of
corporation assets, or gross and palpable overreaching.” i.e. if these situations are
present, appraisal is not the only remedy for the plaintiff.
43
(2) Is there a valid business purpose for getting rid of the minority used to be the test,
this court didn’t really put anything else in place of it in terms of a standard for
getting rid of the minority. What’s in place of it is a valuation procedure that is
more favorable to the shareholders who are complaining about being cashed out.
See III page 794.
(a) don’t have to justify the buyout anymore, but the plaintiffs have more
favorable relief options.
iv) Note 2 page 795: There are at least 5 problems with the appraisal remedy in its
traditional form.
3) Corporate Opportunity Doctrine  A director who personally takes advantage of a
corporate opportunity may have to account to the corporation for his or her profits.
a) Defined: The test for whether a transaction is a corporate opportunity is basically
whether the transaction, under all the relevant facts, fairly belonged to the corporation.
b) Tests- the test for whether a transaction is a corporate opportunity is basically whether a
transaction, under all relevant facts, fairly belonged to the corporation. Court have adopted the
following tests:
i) Interest & Expectations test- “usurpation… more complex showing will be required…
logically related to business’s existing or prospective…” (really the “interests or expectation”
test) – interest means a ppty. interest and expectancy means the idea was already present
ii) Fairness test- look to whether 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.
iii) Line of business test (p. 800)- “whether the opportunity was so closely associated with the
existing business activities as to bring the transaction within that class of cases where” the
director’s entering into the transaction “would throw him into competition with his company”
(1) Problem- often, determining the line of business is difficult to answer
(2) In addition, look to see if the corporation is financially capable of entering the
transaction.
iv) Line of business + Fairness
(1) Determine whether a particular opportunity was within the corporation’s line of business
(2) Then, scrutinize “the equitable considerations existing prior to, at the time of, and
following the officers” pursuit of the opportunity
v) Collateral Matters
c) § 5.05- ALI (see p. 802)
i) General Rule: director may not take advantage of corporate opportunity unless:
(1) Director first offers the corp. opportunity to the corporation and makes disclosure
concerning the COI and the corp. opportunity
(a) is rejected by the corporation, and
(b) either
(i) rejection is fair to the corporation
(ii) rejection is by disinterested directors/supervisor in a manner satisfying the BJR
(iii) rejection is in advance or ratified
ii) Definition of Corp. Opportunity
iii) Burden of proof
d) Northeast Harbor Golf Club v. Harris (1995)  Harris was president of the Golf Club.
A realtor approached her in her role as president to offer the club an opportunity to buy
some land that adjoined the course. Harris didn’t tell the members of the board and
bought the land for herself. Harris then disclosed that she bought the land, but claimed
44
she wasn’t going to develop it. Later the land was developed. P’s are claiming that D
breached a fiduciary duty by purchasing the lots without giving the corporation this first
opportunity.
i) The Court uses the ALI 5.05 test.
(1) Director/Officer may not take advantage of a corporate opportunity UNLESS:
(a) He first offer the opportunity to the corporation and makes a disclosure of
COI regarding the opportunity
(b) Corporation rejects the opportunity
(i) if improper rejection, D can defend actions by showing fairness.
(c) And either
(i) rejection is fair to corporation, or
(ii) rejected by a majority of disinterested shareholders
(2) ALI definition of corporate opportunity (Disclosure Approach)
(a) Any opportunity to engage in a business activity in which a director/officer
become aware either
(i) in a capacity as a director/officer
(ii) through use of corporate information or property
(b) If a director learns through her own sources, and knows it is closely related to
business the corporation is engaged in, apply one of 3 testss.
(i) line of business test
(ii) interest or expectation
(iii)flexible line of business
(3) Burdens of Proof (process of analysis)
(a) P has burden to show corporate opportunity and invalid rejection
(i) Once the club learned that the opportunity is corporate, it must show either
that the president did not offer the opportunity to the club or that the club
did not reject it properly
(ii) if the club shows that the board did not reject, the president could defend
her actions by showing fairness to the corporation
(iii)BUT, if the president failed to disclose at all, no defense of fairness is
allowed.
(b) D has burden to show intrinsic fairness.
ii) Plaintiffs win in this case  Harris usurped a corporate opportunity
(1) Could D win by showing intrinsic fairness  NO, there was no disclosure, a
condition precedent to being allowed that defense.
e) Ellzey v. Fyr-pruf, Inc. (Miss. 1979) (Bradley seems to like this test)
i) Where usurpation of a corporate opportunity as opposed to self-dealing is alleged in
the complaint, a more complex showing will be required to sustain the complainant’s
initial burden of proof:
(1) First, plaintiff must show by a preponderance of the evidence under all the facts
and circumstances the business is logically related to the corporation’s existing
prospective activities
(2) Second, the plaintiff must prove that the corporation either
(a) not insolvent in the balance sheet sense at the relevant times, OR
(b) financially disabled as a result of nonpayment of a debt or breach of a
fiduciary duty by one or more of the defendants.
45
(3) Once the complainant satisfies these two elements by proof, the business
opportunity may be regarded as a corporate one and the burden shifts to the
fiduciary to absolve himself of liability in accordance with the principle stated in
Knox. Good faith alone, even in the absence of harm to the corporation, will not
suffice to absolve the fiduciaries of liability; it must be clear that the duty of
fidelity and diligence, as well as the duty of continuing disclosure of material
facts, has been fully discharged.
ii) Defense of Inability of the Corporation to Capitalize: Bradley says that the majority
of the case law says that if the corporation does not have financial ability to pursue
the corporation opportunity, then the officer can take the opportunity for himself
without offering first refusal to the corporation.
(1) proving lack of financial ability is a defense under many state law doctrines.
(2) It provided a disincentive for the director to help the corporation get the money.
f) Remedy:
i) Court will give a judgment that recognizes that people who violated the duty hold that
opportunity in trust for the corporation
ii) If in this case the CC had won, remedy would be that each tract of land where there
was a usurpation of corporate opportunity would be held in a trust by the president
and the corporation would just have to compensate her for the land.
iii) Court has problem with finding for the P - because how many times does the
corporation sue claiming corporate opportunity.
(1) Corporations tend to sue when they stand to make a profit
(2) Seems like there is a good estoppel argument if the corporation waits to see if it’s
a good deal and then decides to sue.
4) Duties to Corporate Constituencies other that Common Shareholders: page 806
a) Preferred Shareholders
b) Holders of Convertible Securities (corporation has issued securities which are convertible
into common stock)
i) There is a divergence of interest between the common stock holders and holders of
convertible securities. Why? because one side will come out better than the other if
there is a conversion in most cases
(1) ex. conversion may dilute the value of the common stock
(2) if the directors give advice which is not in the interest of the common stock
holders, who exactly do the directors owe a duty of care/loyalty to
ii) To fulfill their duty to both groups, it is best for the directors to make a full an
accurate disclosure.
c) Creditors
i) “As a general rule, directors do not owe fiduciary duties to creditors.”
ii) BUT, “When a corporation is insolvent and the shareholders have no viable economic
interest in the enterprise but the corporation is not in federal bankruptcy proceedings,
the directors’ primary duty shifts from the shareholders to the creditors to preserve
the value of the corporate assets for eventual distribution to them.”
d) Other Constituencies
i) Miss. along with about 30 other states allows the directors to consider interests other
than the shareholders in determining what is in the best interest of the corporation.
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(1) Miss. Code Ann. § 79-4-8.30(f)  For purposes of this section, a director, in
determining what he reasonably believes to be in the best interests of the
corporation, shall consider the interests of the corporation’s shareholders and, in
his discretion may consider the following:
(a) the interests of the corporation’s employees, suppliers, creditors, and
customers
(b) the economy of the state and nation
(c) community and societal consideration
(d) the long-term as well as short-term interests of the corporation and its
shareholders, including the possibility that these interests may be best by the
continued independence of the corporation
Derivative Actions
1) Derivative Suits, Litigation Committees, and the BJR
a) Shareholder derivative actions are regarded as equitable action. They are also known as
“strike suits.” Most derivative litigation today is disposed of at a preliminary stage and
does not go to trial on the merits. BJR plays heavily in the area of derivative lawsuits.
b) Application of the Business Judgment Rule  A controversial issue is the effect to be
given to a recommendation or decision by a litigation committee composed of directors
that decides that pursuit of the litigation is not in the best interests of the corporation.
i) In Delaware, in a “demand required” case, the decision by a committee of
disinterested directors (or the entire board of directors if a majority is disinterested)
that meets the requirements of the BJR is given conclusive effect. If the case is a
“demand excused” case a recommendation by such a committee is reviewed by a
court, which may evaluate the quality of the decision and, in addition, may utilize its
own independent business judgment as to whether or not to dismiss the litigation.
ii) Under the MBCA, a “good faith” decision to dismiss litigation that meets the
requirements of the BJR is apparently given conclusive effect.
iii) Some states do not give preclusive effect to litigation committee decisions.
c) Failure to Meet Procedural Requirements  A plaintiff who fails to meet the “security
for costs” or similar procedural requirements will have his suit dismissed. Such a
dismissal is without prejudice to a late re-filing by the same or a different plaintiff.
i) Procedural requirements are designed to keep people out who don’t care about
recovering for the corporation and just want to get a strike suit settlement.
d) Substantive Defenses  Defenses available to 3rd party defendants may result in a
dismissal with prejudice. Such defenses usually may not be raised by the corporation.
e) Case Law (See Bradley’s Chart)
i) Gall v. Exxon (1976) (decision to sue or not)  Exxon learns that over $50m of
questionable payments have been made by an Italian subsidiary (it was paying
bribes). A minority shareholder brings a derivative suit on behalf of the corporation
against persons who were directors at the time of these payments. A committee of
uninvolved directors is formed to review the desirability of pursuing this litigation;
the committee decides that it is in the best interests of the corporation not to pursue
the claim and the corporation moves that this be dismissed.
(1) Rule: There was no conflict of interest in the decision not to sue since the
committee was disinterested so the committee’s decision gets BJR deference.
47
(2) However, what does disinterested really mean when directors are deciding to sue
or not to sue other directors.
ii) Zapata v. Maldonado (1981)  Zapata’s board of director adopted a stock option
plan where certain officers and directors were granted options to purchase stock at
$12.15 per share to be exercise on July 14. Zapata was planning a tender offer for
2.3m shares which would increase the price of stock. In order to reduce tax liability,
Zapata’s directors accelerated the date on which the options could be exercised to
July 2. On July the tender offer was announced and the price rose to $24.50.
Maldanado brought suit as individual shareholder but he did not first demand that the
board bring the action, instead stating that that such a refusal was futile since all the
name Ds were on the board. Four years later, new board members were appointed
and sat on an independent investigation committee which concluded that the suit was
not in the corporation’s best interest.
(1) Two step test if the committee recommends that demand be excused lawsuit by
shareholder should be dismissed:
(a) First, the committee has the burden of proving independence, good faith, and
a reasonable investigation (may even have limited discovery), AND
(b) Second, the court will determine, applying its own independent business
judgment, whether the motion to dismiss should be granted.
(i) This business judgment is not the same as BJR deference.
iii) Aronson v. Lewis (1984) (no demand made) 75 year old Fink owns 75% of
corporation and enters into transaction where he will be paid $150k a year for 5 years
and at least 100k a year for the rest of his life; Fink’s compensation was not to be
affected by any inability to perform his consulting services. P alleged that this K was
approved only because Fink appointed all of the directors to the corporation and that
this appointment coupled with the fact that all directors had been named as D’s made
demand on the board futile.
iv) Issue when is demand excused for futile?
v) Rule for futility of demand  under particularized facts a reasonable doubt is
created that:
(1) the directors are disinterested and independent, and
(2) the challenged transaction was not the product of a valid exercise of business
judgment.
vi) Disinterested = directors can neither appear on both sides of a transaction nor
expect to derive any personal financial benefit from it in the sense of self dealing
as opposed to a benefit which devolves upon the corporation or shareholders as a
whole. There mere threat of personal liability is not enough.
vii) Independent = decision is based on corporate merits rather than extraneous
considerations or influence. It is not enough to charge that a director was elected
by a shareholder and therefore at his behest.
viii)
Holding: P has failed to allege facts with particularity, lack of
independence, or took action contrary to corporate best interest in order to create
reasonable doubt as to the applicability of the BJR.
ix) Demand will almost always be required unless a majority of the board is so
directly self-interested that there is serious doubt that the BJR would protect the
transaction.
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f) Summary of Tests
i) Demand Excused  Zapata Test
ii) Demand excused but asked for and refused  BJR, skip Aronson test
iii) Demand required and refused  BJR
iv) Demand required and not sought  BJR
g) Spiegel v. Buntrock (1990)  When shareholder makes a demand, he thereby tacitly
acknowledges the absence of facts to support a finding of futility thus making thus
making the board decision fall under the BJR. “Waiver rule”
i) As a result of this rule, plaintiffs today rarely make demand.
h) Levine v. Smith (1991)  Addressing a request for limited discovery to show to refused
demand was improper, the court stated: Discovery should not be permitted following a
refused demand, and to obtain judicial review of the claim of wrongful refusal, the
plaintiff must allege particularized facts that create reasonable doubt that the refusal was
a proper exercise of business judgment, i.e. judicial review of a decision rejecting a
demand was subject to the same pleading standard established in Aronson to determine
whether demand was excused.
i) Cuker v. Mikalauskas (Penn. 1997)  Management audit reveals some problems with
management. Minority shareholders sue based on the information in the audit. An
independent litigation committee was formed and rejected the demand.
i) Court adopted factors from the ALI Principles of Corporate Governance
(1) Disinterested Board
(2) Assisted by Counsel
(3) Prepare written report
(4) Independent
(5) Adequate investigation
(6) Rationally believed decision was in corporation’s best interest  if all of these
factors are satisfied then the court will apply the BJR and likely dismiss the
action.
2) Both ALI and MBCA say that demand has to be made in all circumstances, except MBCA
has a small exception.
a) § 7.44 MBCA gives direction in forming a litigation committee.
b) ALI has a different set of rules for derivative actions in small corporations, treated as a
direct action.
3) Direct Action v. Derivative Action : shareholders will favor direct actions, must pay security
for costs in derivative actions, but may get attorney’s fees in derivative suits.
a) Examples of Direct Actions
i) enforce voting rights
ii) preemptive right (Katsowitz)
iii) suit to require dividends (Dodge v. Ford)
iv) suit to enforce shareholder agreement
v) shareholder v. director for selling his stock, i.e. fraud
vi) Smith v. Van Gorkham, direct because claim that shareholders were harmed directly,
no harm to corporation
vii) suit to require shareholder meeting
viii) suit challenging fundamental change in the corporation
ix) suit to compel dissolution
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b) Examples of Derivative Actions
i) Francis v. Jersey Bank
ii) breach of fiduciary duty (insider trading)
iii) breach of duty of care
iv) usurpation of corporate opportunity
Transactions in Shares: Rule 10b-5, Insider Trading, and Securities
Fraud
1) Rule 10b-5
a) Background:
i) SEC Rule 10b-5 is promulgated under the authority of the Securities Act of 1934.
ii) ’33 regulates the issuance of securities
iii) ’34 act regulates outstanding issues of stock
iv) Rule 10b-5: Employment of Manipulative and Deceptive Devices: It shall be
unlawful for any person (includes close corps.), directly or indirectly, by the use of
any mean or instrumentality of interstate commerce (full federal powers, see note 7,
page 815), or of the mails or of any facility of any national securities exchange,
(1) to employ any device, scheme, or artifice to defraud,
(2) to make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in light of the circumstance
under which they were made, not misleading, or
(3) to engage in any act, practice, or course of business which operates or would
operate as a fraud or
v) Private causes of action are generally allowed under 10b-5. Most are class-actions in
federal court.
(1) Federal court is the best forum: nationwide service of process, liberal discovery
rules, established precedent, etc.
vi) State common law COA’s were the remedy before 10b-5, but those classic doctrines
such as fraud and misrepresentation just didn’t work well with securities law.
vii) Statute of Limitations:
(1) Sarbines Oxley Act of 2002 set it at two years after discovery of the facts
constituting a COA, but no more than five years after the COA accrued.
viii) Scope of Rule 10b-5 as defined by USSC (check this, may be out dated)
(1) The plaintiff must establish scienter. Ernst and Ernst
(2) The plaintiff must have been a purchaser or seller of securities. Blue Chip Stamp.
(3) Rule 10b-5 requires deception, it is not a general prohibition of unfairness.
Hence, a fully disclosed unfair transaction is not a violation of 10b-5. Santa Fe
Industries.
(4) Reliance on false statements by buyers and sellers can be presumed because of the
efficiency of securities markets. Basic v. Levinson.
(5) Claims based on “aiding or abetting” are not available. Gustafson.
(6) Claims for contribution among defendants are available. Central Bank of Denver.
b) Narrowing of 10b-5: During the 1970s, the application of 10b-5 was narrowed via court
interpretation.
i) Blue Chip Stamps v. Manor Drug Stores (1975)  Plaintiffs claimed they didn’t buy
any stock because a misleading prospectus painted a gloomy picture.
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(1) Rule: Court adopted the 2nd circuit’s Birnbaum rule: must have been involved
with purchase or sale of the security to have standing under 10b-5
ii) Ernst and Ernst v. Hochfelder (1976)  Nay was the CEO of a corp. He was
stealing money by offering escrow accounts and promising high interest, however he
was just pocketing the money. Ernst accounting firm gave the corporation a clean bill
of health despite the problems. Ernst argued that it was only negligent and thus didn’t
meet the mens rea requirement.
(1) Rule: Plaintiff must prove scienter, that is “intentional wrongdoing or a mental
state embracing intent to deceive, manipulate or defraud.”
(2) Many lower courts have held that recklessness or reckless disregard for the truth
will meet the scienter requirement.
iii) Santa Fe v. Green (1977)  Majority shareholders undervalued its stock to affect a
merger to the detriment of the minority, but did disclose, i.e. it was a bad decision.
(1) Rule: 10b-5 is limited to situations involving deception, unfair transactions that
are adequately disclosed cannot be attacked under 10b-5; mismanagement is not a
10b-5 violation.
iv) But See In re Enron (2002)  This is a suit against banks, law firms, and accounting
firms stemming from the collapse of Enron.
(1) Though aiding and abetting is still not actionable under 10b-5. The court held
that secondary violators could be within its reach.
c) Look at page 66-67 of copy-time outline. Seems like I need to put that in.
2) Insider Trading:
a) Rule 10b-5 as a prohibition against insider trading:
i) Rule 10b-5 is the source of most of the case law prohibiting trading of securities by
persons with inside information that is not publicly available.
(1) Rule 10b-5 is violated when a person employed or affiliated with the issuer of
securities on the basis of information that is not publicly available.
(2) Rule 10b-5 may also be violated when a person obtains information that is not
publicly available in violation of duty owed by that person to some else and trades
on that information. This is known as the “misappropriation” theory and has been
used, for example, to hold a columnist for the WSJ liable for trades in stocks that
are favorably reviewed in the column in advance of the publication of the column.
See Carpenter v. U.S.
(3) A ‘tippee’ is a person who acquires inside information form another person and
trades on it. A tippee generally is liable if he has reason to know that the insider
providing the information breached his fiduciary duty to the issuer when the
information was originally provided. This is established by determining whether
the insider personally benefited from the disclosure.
(a) An attorney, accountant, or other person in a position of confidence with an
issuer is a “temporary insider,” not a tippee, and is subject to the rules
applicable to insiders.
(b) the ‘tipper,’ the person providing the tip, is also liable for unlawful insider
trading by a tippee.
(4) The 1984 and 1988 insider trading statutes provide significant remedies against
insider trading. These statutes assume that 10b-5 prevents such trading.
51
(a) The SEC and US may impose civil penalties up to an amount equal to 3 times
the trading profit or loss avoided and criminal penalties for willful violations.
(b) A person who is in control of another person that violates the inside trading
prohibitions may also be liable for civil penalties.
(c) An informant who provides information leading to the imposition of a
statutory penalty is entitled to a bounty
(d) Contemporaneous traders may bring a private suit for damages against an
inside trader (limit to the profit gain or loss avoided by the trader).....Persons
who engage in transactions in derivative securities options, puts calls, etc. may
also bring a private suit for damages against an inside trader.
b) Case law
i) SEC v. Texas Gulf Sulpher (1968)  While doing geologic tests, company finds a
mineral deposit, but needs more investigation to determine how large it is. Officers
buy a bunch of stock. Report comes in that it’s huge, officers buy more stock. Later,
corporation issue a misleading statement to quash rumors about the find. Finally, the
corporation issues a correcting statement, some of the officers buy 15 minutes after
the correcting statement is issued.
(1) Rule: Insider must disclose or abstain for trading.
(a) Here, insiders couldn’t disclose because the didn’t know the scope and they
needed to buy the mineral rights to the find.
(2) Rule: Materiality  if there is a substantial likelihood that a reasonable investor
would regard the information as important in making an investment decision,
whether the information would be significant in the mix of total information in
making an investment decision.
(3) Rule: Once information is disclosed insiders must wait until the information has
been reasonably disseminated to the investing public before trading.
(a) 15 minutes here was not enough.
ii) Chiarella v. United States (U.S. 1980)  Criminal prosecution of blue collar
employee of legal printing company who could deduce the name of corporations that
were being taken over from documents he was printing. He would then buy stock in
the target corporations.
(1) The issue in this case was finding a duty for Chiarella. He wasn’t an insider in the
traditional sense.
(a) TC and 2nd circuit said that he owed a duty to everyone under a “level
playing field theory.”
(2) SC said that he did not violate 10b-5 because he didn’t owe a duty to the general
public or the issuer. Because there was no duty, there could be no fraud.
(a) Court passed on the probably the best chance of conviction, he was under
contract to keep the information secret, and thus owed a duty to his employer
and the company that hired his employer. However, this issue was not
presented to the jury so the court passed on it.
(3) Rule 14e-3 following Chiarella, the SEC adopted this rule that makes it unlawful
for any person who obtains non-public, material information either directly or
indirectly from the issuer about a cash tender offer to use that information in
securities transactions. The rule establishes a specific duty to “disclose or
52
iii)
iv)
v)
vi)
abstain” and is similar to the approach taken in TGS and Cady, Roberts. No
fiduciary duty is required.
Carpenter v. U.S. (U.S. 1987)  Criminal prosecution of Carpenter. Carpenter was
a writer for WSJ and was involved in a “heard it on the street” column which was
popular enough to cause price changes based on its contents. Carpenter started giving
the info to his friends before it was published and they would then trade on it. WSJ
had a policy not to divulge information. Carpenter was convicted under the
misappropriation theory as well as mail fraud.
(1) Carpenter argued that he had no duty to the corporations, so no fraud.
(2) Prosecutors argued that he owed a duty to his employer not to use the information
that belonged to the WSJ.
(3) Court split 4-4 which means the conviction was affirmed. The WSJ policy was
apparently enough of a duty to violate 10b-5.
Misappropriation Theory: When an “outsider” breaches his duty to a principal by
gaining non-public information and not disclosing to the principal and then using the
information for his benefit while harming the trading public; defrauds the principal of
exclusive use of the information.
(1) Relation of trust and confidence leads to confidential information
U.S. v. O’Hagan (U.S. 1997)  O’Hagan was a partner in a law firm that was
retained to represent Grand Met in a potential tender offer for the common stock of
Pillsbury. D did not work on the case, but did receive confidential information and
used it to buy Pillsbury shares.
(1) Rule: A person who trades in securities using confidential information
misappropriated in a breach of fiduciary duty to the source of the information is
guilty of a 10b-5 violation.
(a) The court found that O’Hagan owed a duty to Grand Met.
Dirks v. SEC (U.S. 1983)  Dirks was an officer of a brokerage firm that
specialized in providing investment analysis of insurance company securities. A
former officer of Equity Funding Corp. came to Dirks with allegations of fraudulent
corporate practices, i.e. Equity’s books were cooked. Dirks investigated and some
officers verified the accusations. Dirks tried to make the information public, but no
one would bite. He also told some of his clients who owned stock in Equity and they
traded on the information.
(1) Holding: A tippee assumes a fiduciary duty to the shareholders of a corporation
not to trade on material nonpublic information only when the insider has breached
his fiduciary duty to the shareholders by disclosing the information to the tippee
and the tippee knows or should have known that there has been a breach.
(a) Remember that the tipper must benefit for him to breach.
(2) Rule: outsider liable if:
(a) misappropriation, or
(b) outsider might acquire fiduciary duty and become constructive insider when
relationship of trust and confidence yields information
(3) Rule: outsider can be liable if:
(a) he knows or should know that tipper/insider revealed nonpublic information,
AND
53
(b) he knows or should know that revealing is a breach of tipper’s/insider’s
fiduciary duty, AND
(c) the tipper/insider will benefit either direct or indirectly from the
disclosure/breach.
vii) Examples of violations and valid COAs
(1) A corporate officer provides information to the writer of an industry newsletter in
order to get a “reputational benefit.” The writer violates 10b-5 if he trades on the
information. SEC v. Gaspar
(2) The CEO of a publicly held corporation provides material inside information to
his mistress, who trades on the basis of this information. The SEC charged the
CEO claiming that he received a personal benefit because of his “close personal
relationship.”
(3) SEC charged father tipper even though there was no evidence that father intended
to benefit his son the tippee.
(4) Barry Switzer was a his son’s track meet when he unobtrusively overheard a
business man’s conversation and profited by trading on the information.
(a) Held: If the insider is unaware of the eavesdropper’s presence there is no
expectation of a benefit and therefore no breach of fiduciary duty. SEC v.
Switzer.
viii) U.S. v. Chestman (2d Cir. 1991)  Controlling shareholder tells his sister about the
impending sale of the family business because he needs access to her shares. She
tells her daughter; daughter tells her husband (tells him not to tell anybody). Husband
then tells Chestman and he trades on it.
(1) Question comes down to whether Kieth has a fiduciary duty to keep the info
secret.
(a) Marriage doesn’t create a duty de jure
(2) Came down to the discussion between daughter and Kieth. Daughter told Kieth
the info and then told him not to tell anyone. It wasn’t a “pledge of secrecy” in
the legal sense so it created no duty.
(3) Because Keith has no duty, he could not pass the duty on to Chestman, thus the
10b-5 violation was reversed.
ix) Family Relationship: In 2000, the SEC promulgated 10b-5-2, designed to provide a
more bright-line test for certain enumerated family relationships.
(1) The rule sets for a non-exclusive list of three situations in which a person has a
duty of trust or confidence for purposes of the misappropriation theory
(a) where a person agrees to maintain information in confidence
(b) when two people 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 confidentiality, OR
(c) a “bright line” rule that states that a duty of trust and confidence exists when a
person receives or obtains material nonpublic information from spouses,
parents, children, or siblings
(i) It may be noted that an automatic relationship of trust or confidence is not
created between unmarried domestic properties, step-parents, or step-
54
children (though such a relationship might arise under alternatives (i) or
(ii))
x) Basic, Inc. v. Levinson (U.S. 1988)  In September ’76 Basic officers and directors
met with another company concerning the possibility of a merger. In October ’77
Basic issued 3 public statements denying that is was engaged in any merger
negotiations. In December ’78, Basic asked the NYSE to suspend trading in its
shares and endorsed a $46 tender offer for all of its outstanding shares. The
respondents are former Basic shareholders who sold their stock after Basic’s October
’77 statement and before the suspension of trading.
(1) TC granted D’s motion for summary judgment, claiming the P’s failed the
materiality requirement because information regarding a merger was no material
until an agreement in principal is reached.
(2) SC Rule on Materiality: Materiality will depend at any given time upon a
balancing of the indicated probability that the event will occur and the ancitipated
magnitude of the event light of the totality of the circumstances.
(a) SC said mergers are very high magnitude
(b) Aside: the only safe bet when there is a leak is “no comment” even though
that will likely give away the answer.
(3) Presumption of Reliance and the “Fraud on the Market” theory (not a majority)
(a) If the misrepresentation relates to a publicly traded security, a purchaser or
seller as plaintiff will be entitled to a rebuttable presumption of reliance.
(b) Reasoning: the price of a publicly traded company’s stock is determined by
the market based on information available to the public; misleading statements
will therefore defraud purchasers and sellers even if they do not directly rely
on the statements because the effect on price will happen anyway; modern
securities markets involve millions of transactions a day and differ from the
face to face transactions contemplated by early fraud cases.
(c) Rebutting the presumption
(i) Any showing that severs the link between the alleged misrepresentation
and either the price received (or paid) by the plaintiff, or his decision to
trade at a fair market price, will be sufficient to rebut the presumption of
reliance.
1. could show that the price actually reflected the news even though it
wasn’t public
2. could show that people got rid of stock for reasons other than market
price
xi) Summary: Elements of a 10b-5 action
(1) Standing  P must have been a buyer or seller of stock
(2) Materiality of the information relied on
(3) Scienter
(4) Causation: reliance, transaction, and loss
(a) causation: person entered into transaction in reliance of the
misrepresentation/nondisclosure
(b) causation: person suffered a loss because of the reliance
xii) Categories of 10b-5:
(1) face to face misrepresentation
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(2) face to face non-disclosure
(3) market transactions misrepresentation
(4) market transactions nondisclosure
Face to Face
Face to Face
Misrepresentation Nondisclosure
Yes
Reliance
Required
Rebuttable
Presumption of
Reliance
Allowed
Market
Transaction Mis.
Market
Transaction Non.
Allowed (Basic)
Allowed (Litton)
3) Section 16 of the Securities Exchange Act § 16 of the original Securities Act of ’34 is
designed to prevent in-and-out short term trading in publicly traded securities by officers,
directors, or 10% shareholders of the issuer. It requires any profit made by a covered person
from a purchase and sale, or sale and purchase, of the issuer’s stock during any six month
period, be paid to the corporation. Scienter or actual use of inside information is not
necessary to establish liability; innocent transactions within any six month period
automatically give rise to liability. The need for this in terrorum statute has been questioned
in light of the application of Rule 10b-5 to insider trading.
a) Purpose  § 16’s purpose is to prevent the unfair use of information which may have
been obtained by a person subject to the section. It also may prevent attempts at market
maintenance or market manipulation by persons covered by this section.
b) Disclosure of Transactions  § 16(a) requires that persons subject to § 16 file reports
describing their initial ownership of the issuer’s shares and subsequent reports each
month reporting each acquisition or disposition of the issuer’s shares. These reports are
publicly available.
c) Limitations of § 16(b)  A sale on the basis of inside information not accompanied by a
purchase within a six month period, or vice versa, is not a violation of § 16(b) though it
may violate Rule 10b-5.
d) Enforcement Mechanism  § 16(b) permits any shareholder to bring suit on behalf of the
corporation and recover profits under § 16(b). Attorney’s fees are payable to a successful
attorney or one who brings a § 16(b) violation to the attention of the corporation, and
such fees are the motivation for most § 16(b) litigation.
e) Measurement of Recoverable Profit  Profits on short swing trading are measured by a
matching pattern that ensures that all possible profit is squeezed from a sequence of
transactions: the highest sale price is matched with the lowest purchase price, the next
highest with the next lowest, and so on until all possible profit is eliminated. Losses are
ignored in this calculation and do not offset profits.
4) Liability for Securities Fraud
a) Criticism of Class Actions under 10b-5  Fraud claims under Rule 10b-5 relating to
publicly held corporations are usually brought as class actions. For many years,
corporations complained that these class actions were brought by plaintiffs’ attorneys for
personal gain based on any public forward looking statement that turn out not to be true,
and the dynamics of this litigation were such that defendants found it necessary to settle
even claims that lacked merit.
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i) This view is often stated by attorneys who represent corporations that are involved in
class action litigation. They rely on personal experience, on impressions, and on
anecdotal evidence.
ii) Lawsuits instituted for the settlement value of cases and for the benefit of the
plaintiffs’ attorneys are called ‘strike suits.’
iii) Most class action litigation is attorney-fueled litigation. Plaintiffs’ attorneys find
possible false or misleading statements and then seek to find a plaintiff in whose
name suit may be brought.
iv) The lead attorney in pursuing litigation is typically the first to file. As a result there is
an unseemly “race to the courthouse” by plaintiffs’ firms
v) Plaintiffs’ attorneys advance the litigation costs to pursue the litigation and as a result
have financial interest in the litigation that exceeds that of any single plaintiff. The
litigation is directed and conducted by the plaintiffs’ attorneys who are motivated at
least by their financial interest in the litigations.
vi) Following the filing of a complaint, plaintiffs’ attorneys launch a vigorous discovery
campaign in an effort to find scienter and other prerequisites for recovery. The cost
of discovery to the corporation may be substantial and disruptive.
vii) Most of this type of litigation is settled. In settlement negotiations, fees to paid to
plaintiffs’ attorneys are normally a major element to be resolved. Agreements as to
fees must be approved by the court as part of the settlement process.
viii) A major complaint about this litigation is that it involves current shareholders
compensating earlier shareholders for losses suffered from inaccurate predictions of
future events.
b) The Private Securities Litigation Reform Act of 1995 (PSLRA)  In 1995 Congress
enacted this legislation designed to limit this type of litigation. It is basically a large
procedural hurdle for the plaintiffs’ to jump over. The principal provisions of the PSRLA
are:
i) “Lead Plaintiffs” provisions were designed to encourage plaintiffs with large stakes in
the litigation to be in charge of the litigation rather than the “first to file.”
ii) “Safe harbor” rules for forward looking statements were significantly broadened.
iii) Discovery was restricted until motions to dismiss were resolved.
(1) discovery allows P to threaten for settlement or he will air corporation’s dirty
laundry
iv) Proportionate liability was substituted for joint and several liability in many instances
v) Greater distribution of information about proposed settlements was mandated
vi) Sanctions for filing unjustified suits were strengthened for securities fraud cases.
vii) Pleading requirements of particularity for allegations of fraud were tightened
viii) Rules for measurement of damages were tightened
ix) Aiding and abetting liability in suit brought by the SEC were clarified.
c) Management of corporations is given safe harbor for forward looking statements they are
required to make in their disclosures to the SEC.
d) PSLRA led to surge in state law actions for securities fraud.
i) Securities Litigation Standards Act of 1998 (SLUSA): was passed in response
(1) SLUSA preempted state law prosecution of these state action.
(2) However, the “Delaware Carveout” left many of the state actions in place.
(3) See page 945 in book for discussion.
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ii) See also Class Action Fairness Act of 2005 which puts limits on all class actions.
e) MDCM Holdings v. Credit Suisse First Boston (2002)  Corporation sued underwriter
for offering IPO stock at too low of a price. Credit Suisse (D) was trying to remove to
federal court claiming it was preempted under SLUSA.
i) S.D.N.Y. held that this was a simple case of breach of contract, thus a state law
matter and it was not preempted.
Indemnification and Insurance
1) Generally  Indemnification permits a corporation to a limited extent to assume and pay
the litigation expenses of corporate officers and directors. It may also permit the corporation
to an even more limited extent to pay judgments, settlements, and criminal fines incurred as a
result of their actions as a director or officers. Liability insurance for directors and officers
(D & O insurance) provides traditional third party liability insurance at some risks.
2) Indemnification and Public Policy
a) Policies with respect to indemnification: given litigation costs today, indemnification is
essential if responsible persons are to be willing to serve as directors. To indemnify a
person found guilty of a willful misconduct seems clearly against public policy. On the
other hand, indemnification seems entirely appropriate if a person is absolved of charge
of negligence or misconduct in connection with their actions on behalf of the corporation.
Between the two extremes lie the difficult cases.
b) Sources of Power to Indemnify  State statutes expressly grant corporations power to
indemnify corporate directors and many cover corporate officers as well. Corporations
may also authorize or grant broader indemnification, or limit statutorily authorized
indemnification, by appropriate provisions or articles of incorporation or bylaws.
i) Many states provide expressly that they are not exclusive, and that corporations may
create broader rights of indemnification up to limitations of public policy.
ii) The MBCA and some state statutes make the statutory provisions exclusive but
permit corporations to broaden the rights granted by the statute so long as the rights
are consistent with the general limitations set forth in the statute.
c) Voluntary Restriction of the Right or Duty to Indemnify  Corporations may generally
“opt out” of the indemnification statutes by restricting or eliminating indemnification in
the articles or bylaws. A corporation may do this in order to conserve limited resources
or to limit the right of former directors or officers to demand indemnification.
3) Scope of Indemnification Under Modern State Statutes  The Delaware GCL, the Model
Act, and the MBCA for the basis for most modern indemnification statutes.
a) Indemnification when the defendant has been successful in the proceeding  under
modern statutes the defendant is entitled to indemnification as a matter of statutory right
if she “is wholly successful on the merits or otherwise.” A director with a valid
procedural defense is therefore entitled to indemnification without regard to the merits.
California omits the phrase “otherwise.”
b) Permissive Indemnification  Indemnification is permitted as a matter of discretion (but
not as a matter of right) where the defendant acts in good faith and in the best interest of
the corporation but is not successful on the merits or otherwise in the litigation. For
example by entering into a settlement. Directors cannot compel corporations to grant
indemnification for conduct entitled only to permissive indemnification unless the
corporation has voluntarily agreed to make such indemnification mandatory.
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c) “Authorization” and “Determination” of Indemnification  A “determination” relates to
the eligibility of the officer or director for indemnification while an “authorization” is a
corporate judgment that an appropriate use of corporate resources is to pay the director or
officer the amount so “determined”
i) Determinations of indemnification are to be made by directors who are no parties to
the litigation, but he shareholders, or by special legal counsel.
ii) Authorization of indemnification may be made by the board or directors or by the
shareholders and is viewed to be a matter of business policy for the corporation.
d) Court approved Indemnification  A person not otherwise eligible for indemnification
may petition a court for a determination that he is “fairly and reasonably” entitled to
indemnification of expenses. A corporation may avoid court-ordered indemnification
only by so providing for in its articles of incorporation.
e) Advances for Expenses  A corporation may advance expenses of a proceeding as they
are incurred without waiting for final determination of eligibility for indemnification if
allowed by statute. Claimants for advances must promise to return the advances if it is
ultimately concluded that they are not entitled to indemnification.
i) If control of the corporation has changed, the corporation may resist making advances
for expenses to former directors
ii) Some courts have refused to grant advances for expenses upon making a preliminary
determination that the claimant engaged in wrongful conduct
iii) Other court has accepted what appears to be the policy behind advances for expenses
and refused to consider the probability that the claimant may ultimately be found not
to be entitled to indemnification.
f) Indemnification of Officers, Employees, and Agents  Under the MBCA,
indemnification of an officer, agent, or employee who is not a director is not subject to
the limiting principles applicable to indemnification of directors. An officer (but not
employees or agents) has the same right to mandatory indemnification as a director and
may apply for court-ordered indemnification. A director who is also an officer or
employee is limited to the indemnification rights of a director.
g) Notification of Indemnification  The MBCA requires the corporation to notify
shareholders of all indemnifications or advances of expenses.
4) D & O Liability Insurance
a) Structure of D & O Policies  D & O policies are complementary to indemnification.
Most publicly held corporations provide both indemnification and insurance.
i) D & O insurance is almost always “claims made” insurance. It insures only for
claims that are presented to the insurer during the period of insurance, though policies
provide extensions of the reporting period. See McCullough.
ii) D & O insurance protects the corporation against payments it is obligated or
permitted to make to officers or directors under its indemnification obligations that
are not indemnifiable by the corporation but which are not within the insurance
exclusions of the policy.
b) Once an employee leaves an employer, he is no longer covered unless notice is given to
insurance carrier.
c) Insurable Risks  D & O policies only cover insurable risks, thereby eliminating
wrongful misconduct and self-dealing transactions, among others, from coverage
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d) Policy Coverage and Exclusions  D & O policies generally cover all officers and
directors of the corporation. Applications require full disclosure; nondisclosure of known
risks may void the entire policy. Policies also contain significant exclusions so that these
policies do not cover many potential risks.
e) State Statutes  Many state statutes specifically empower corporations to purchase D &
O insurance though in absence of statute, power to acquire such insurance is probably
implicit. Some states expressly authorize corporation to engage in self insurance through
the creation of trust funds or captive insurance subsidiaries that are not true insurers
because the spreading of risk is limited.
5) Cases
a) Merrit-Chapman Corp. v. Wolfson (1974)  In a criminal securities case, D pleads nolo
on one count as part of a plea bargain that results in dismissal of the other counts.
i) § 8.52 Mandatory Indemnification: “corporation shall indemnify director who was
successful, on the merits or otherwise...”
ii) Holding: D is entitled to indemnification for expenses with respect to the dismissed
counts.
(1) Court basically separated out successful versus unsuccessful.
b) McCullough v. Fidelity & Deposit Co. (1993)  FDIC had insured the deposit of this
bank. The bank went belly up and the FDIC had to pay on the claims. Hence, FDIC sued
former directors and officers, including McDullough, for their mismanagement of the
bank. The bank had an insurance policy for directors and officers, but it was cancelled
when the bank went belly up. FDIC is now claiming the D&O insurance company
should indemnify, D&O is claiming that they were not given notice of the action and thus
do not have to pay.
i) “Claims Made” vs. “Occurrence” (claim arose) policy
(1) Claims made policy provides coverage for claims first made against an insured
during the policy period
(2) Claims Arose Policy: provides coverage for injuries that take place during the
policy period regardless of when the claim was asserted.
ii) This was a claims made policy that required the directors or officers to give notice of
a specific wrongful act for there to be coverage if the legal action comes after the
policy has expired.
iii) The Court upheld summary judgment for the D&O insurance company because there
was no specific notice given about the wrongful act(s).
Takeovers
1) Defined
a) This is basically just were and “acquirer” goes after a “target” corporation, and changes
things in order to have control over the target.
2) William Allen Articles
a) Takeovers became popular in the late 1960s. There are always reasons for trends in
takeovers.
b) Proxy Fight: Groups try to drum up proxy votes through campaigns basically trying to
persuade the shareholders to elect friendly directors to gain control of the management of
the company.
i) No longer very popular, but was the common method in the 60s.
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ii) It is a political takeover, not an economic one.
iii) Quorum is needed for the election to count.
iv) SEC rules require that a shareholder can put something on the agenda for the directors
to decide. People use to use political issues in there, such as asking Dow chemical to
quit making Napalm.
v) SEC now has disclosure requirement for when you solicit for proxies.
vi) Proxy fights are now more difficult due to staggered terms of directors. i.e, you can’t
pull one of these off in one year.
3) Cash Tender Offers (Cash Buyout)
a) You buy enough stock to give you control of the company. You buy the stock to get
enough votes to get control.
i) You typically do not have to buy 51% of the stock. Working control is generally
thought to occur at 25-30%.
ii) Methods of buying stock:
(1) Most of the time, a premium price would be offered and the offer would only be
open for short period of time.
b) Williams Act of 1968
i) The central idea behind the Williams Act was not to stop tender offers altogether, but
rather:
(1) to slow down the process, and give shareholders information about the offer, and
give mgt a chance to respond, and
(2) to assure that the shareholders would be treated equally and get the highest price
possible, in part by increasing the chances for a competing bid to arise.
ii) Williams Act 
(1) Provides for disclosures by the bidder before the transaction occurs, but not
before the offer is made. Disclosure includes the source of the funding.
(a) If anybody acquires as much as 5% of a 12(g) company, a disclosure must be
filed with the SEC.
(2) There are rigorous anti-fraud provisions in the act
(3) the Act provides a set of bidding rules to govern the conduct of tender offers.
(a) offer must stay open at least 20 business days.
(b) a shareholder has the right during the offer to withdraw shares tendered
(c) all tendering shareholders must receive the highest price paid in the offer
(d) if the offer is over-subscribed then all shareholders may have their shares
purchase pro rata in proportion to the number of shares they tendered
iii) Devices to minimize the impact of the Williams Act
(1) Loaded two-tier Tender Offer: offering an attractive premium to buy a certain
percentage of the stock and then announcing that the remainder of shares will get
FMV or less.
iv) There was a surge of hostile takeovers in the 1980s.
(1) Hostile takeover: the management of the target corporation does not want to be
taken over
(2) Golden Parachute: Provisions were put in employment contracts of executives
that allowed them to exit with huge severances in the case of being taken over.
c) Leveraged Buyout: You borrow money to buy the corporation and then use the income
stream and assets of the corporation to pay off the debt.
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i) Generally this debt is still given junk status, i.e., not investment grade.
ii) Sometimes the money was generated by selling off division of the company to get
cash to service the debt.
iii) Many times they would fail and the target company would go into bankruptcy.
iv) However, the people who always make money are the investment bankers, lawyers,
accountants, and corporate appraisers.
d) Why do these takeovers occur:
i) Companies see the target as having great potential but lacking good management.
4) Defenses:
a) State Legislation
i) State’s did this to prevent out of state companies from coming in and taking away
their home grown corporations.
ii) MITE case: Anti-takover law was struck down by a plurality of the SC for violating
the Commerce Clause
iii) CTS v. Dynamics Corp.
(1) Dynamics wants to takeover CTS, an Indiana corporation. Indiana’s state law
would make it very difficult for them to takeover. Dynamics files suit claiming
the Indiana law was unconstitutional violation of commerce clause and it
conflicted with the Williams Act and was thus preempted.
(2) TC and AC held that it was preempted and did violate commerce clause.
(a) Posner wrote for the AC and he said that there is an interstate market in
securities and corporate control and thus regulation should be a federal issue.
(b) This is basically relying on an economic efficiency justification for keeping
state laws from interfering.
(3) SC reverses and holds that it does neither.
(a) Majority was a group of state’s rights judges.
(b) Said that the Williams Act was not underminded by the state legislation, thus
is not in conflict and not preempted.
(c) Commerce issue: said there was not burden on interstate commerce.
iv) MS 79-25-1 Shareholder Protection Act v) MS 79-27-1 Controlled Share Act 5) MBCA Provisions important to takeovers.
a) Chapter 11 Mergers and Share Exchanges
i) § 11.02 is the operative provision for Merger
(1) (a) One or more domestic business corporations may merge with one or more
domestic or foreign corporations or eligible entities pursuant to aplan of merger,
or two or more foreign business corporations or domestic or foreign eligible
entities may merge into a new domestic business corporation to be created in
themerger in the manner provided in this chapter.
(2) (c) The plan of merger must include....
(a) Bradley: The plan of merger might say: “Company A will be the surviving
corporation.” The documents would be filed in the state of the merged
corporation, and also in the state of the surviving corporation. It will also
give the terms of the merger, such as ratio of the survivor stock to merged
stock.
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(b) If it is a stock merger, the merged corporation has to value both it’s stock and
the acquiring corporation’s stock to make sure they are getting the true value.
It will be easiest if A’s stock is publicly traded, much more difficult if it isn’t
in terms of valuation.
(3) (e) plan of merger MAY include....
ii) § 11.03 Share Exchange: is a new method, it is cleaner and easier provision to use
than a merger. However, mergers have been used for a long time and have been
tested in litigation.
(1) Lawyers are comfortable with mergers.
b) What shareholder is required to accomplish merger. § 11.04
i) Plan must be adopted by the board
ii) Except as provided in subsection (g) and 11.05 (merger between parent and
subsidiary), after adopting the plan of merger or share exchange the board of directors
must submit the plan to the shareholders for their approval....
(1) § 11.05 can come into play in two ways
(a) Company A has a subsidiary that it is merging with.
(b) § 11.05: A domestic parent corporation that owns shares of a domestic or
foreign subsidiary corporation that carry at least 90 percent of the voting
power of each class and series of of the outstanding shares of the subsidiary
that have voting power may merge the subsidiary into itself or into another
subsidiary, or merge itself into the subsidiary, without approval of the board
of directors or shareholders of the subsidiary, unless the articles of
incorporation of the corporations otherwise provide....
(2) Subsection (g): approval is not required if
(a) the corporation will survive the merger or is the acquiring corporation in a
share exchange
(b) except for amendments permitted by § 10.05, its articles of incorporation will
not be changed;
(i) may need to change articles to get up enough shares to buy the other
corporation.
(c) each shareholder of the corporation whose shares were outstanding
immediately before the effective date of the merger or share exchange will
hold the same number of shares, with identical preferences, limitations, and
relative rights, immediately after the effective date of change.
(d) the issuance in the merger or share exchange of shares or other securities
convertible into or rights exercisable for shares does not require a vote under §
6.21(f).
(3) Subsection (h): If as a result of the merger or share exchange one or more
shareholders of a domestic corporation would become subject to owner liability
for the debts, obligations, or liabilities of any other person or entity, approval of
the plan of merger or share exchange shall require the execution, by each
shareholder, of a separate written consent to become subject to such owner
liability.
(a) Bradley said shareholder liability is not a big issue with public corporations,
this would arise with small private corporations.
(b) Comment 5 on page 920.
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6)
7)
8)
9)
c) § 11.04(e): Unless the articles of incorporation, or the board of directors acting pursuant
to subsection (c), requires a greater vote or a greater number of votes to be present,
approval of the plan of merger or share exchange requires the approval of the
shareholders.....
i) Bradley says this is the majority approval of the shareholders present at the meeting
(can be present by proxy). Not a majority of all the shares, used to be 2/3 of all the
shares.
ii) Majority of each class of stock is required.
d) Delaware law has a streamlined version of this statutory scheme that allows action
without a meeting. Allows no meeting if everyone who is entitled to be present at the
meeting signs off.
§ 11.07 Effect of Merger or Share Exchange:
a) When a merger becomes effective:
i) The corporation or eligible entity that is designated in the plan of merger as the
survivor continues or comes into existence, as the case may be;
ii) the separate existence of every corporation or eligible entity that is merged into the
survivor ceases;
iii) all property owned by, and every contract right possessed by, each corporation or
eligible entity that merges into the survivor is vested in the survivor without
reversion or impairment.
iv) Continues through 8
There may be a shell/straw corporation created so that the target corporation does not go
directly into the acquiring corporation as a way of stop contingent liabilities that may exist.
For example, if the target produced a bad product for years that people want to sue for.
Defenses: Poison Pills
a) Mentor Graphics Corp. pg 1009(Poison Pill Case)
i) Mentor announced an unsolicited tender offer for all outsnading common shares of
Quickturn.
ii) It would be followed by “second step merger”
(1) Once Mentor got enough shares to elect a majority board of directors, quick turn
and mentor would merge and the shares of quick turns who had not sold to mentor
would receive cash and the quick turn corporation would no longer exist.
Takeover Defenses and Judicial Review
a) Three important cases involving takeover defenses in Delaware, page 1028
b) Unocal Corp v. Mesa Petro  The Unocal directors fought the takeover attempt by
Mesa. They adopted a procedure that would be triggered by the takeover. They would in
effect get rid of all of their cash before the takeover and leave in a lot of debt to make the
company look unattractive.
c) Unitrin v. American General  Unitrin fought the takeover attempt. Similar to Unocal,
had a scorched earth policy of war with the acquiring corp. The Delaware SC upheld the
defense tactics. Directors had been sued to stop the defense of the suit.
i) In both Unocal and Unitrin, directors resisted the takeover by using the poison pill.
That is one class of case.
d) Revlon v. MacAndrews (change of control case): Management of Revlon (target) were
not resisting takeover, they were just resisting being taken over by Pantry Pride. They
were shopping around for other potential acquiring corps. Court said when there is a
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change of control, then the directors effectively have an obligation to the shareholders to
auction the company off (it is part of the duty of care to the shareholders).
i) “Revlon Duty” is to get the best price for the company when it appears ripe for
takeover.
ii) Note page 1033: there is a lot of unclarity in the law as to how you are supposed to
go about getting the highest price for the company.
e) The standard of duty for the directors is measured differently:
i) sometimes they may be sued for not accepting the offer (such as in Unocal and
Unitrin) because the shareholders had an opportunity to sell for more than market
price. Business Judgment Rule comes up again.
(1) BJR analysis
(a) Were the directors personally interested? i.e., is there a conflict of interest
taking away bjr deference.
(b) If there is a conflict of interest, what is the standard by which they are to be
judged?
(c) Unocal introduced a standard: Was the defense asserted proportional to the
harm perceived by the directors?
(i) Harm perceived: directors may claim the takeover is not in the long term
best interests, citing employees, community interests, suppliers.
(ii) Bradley says it is a fuzzy standard.
f) Lockups:
i) Lockups occur where control is going to change. The deal is not sealed however with
who exactly is going be the winner in terms of acquiring corporations. . The lockup
is the provisions that the target agrees to certain things. Lockups are a way of
guaranteeing that the potential/attempted acquiring corporation can make money, but
may not end up with the target corporation after all.
(1) stock option: acquiring company is given the option to buy stock in the target
company for a fixed price, i.e.
(2) Asset option: if someone else tops our bid, you the target agree to sell to us a
particular division or subsidiary of the company.
(3) Topping fees: target corporation must pay the initial bidder a fee if another
corporation gets the target for a higher price.
(4) Expense reimbursement provision: if the target accepts another bid, then the
target reimburses the initial prospective acquirer for any costs incurred during the
initial unsuccessful attempt to merge.
(5) Break up fee: If the target terminates the merger, they must pay a certain
percentage of the price of the failed transaction.
ii) Lockups and the business judgment rule:
(1) Can operate as a poison pill, or can operate as a Revlon type case.
Corporate Books and Records
1) Chapter 16 in MBCA as well
a) § 16.01 Corporation is required to keep and maintain records
i) maintain is the make the records
ii) keep is to hold on to.
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b) § 16.20
i) Corporation is required to furnish at least once a year, financial information to its
shareholders
(1) balance sheet
(2) income statement
(3) changes in shareholder equity during the year
ii) If the company is a 12(g) company subject to ongoing disclosure requirements, then
the SEC has much more elaborate requirements about making available financial
information
iii) Other Agencies may also have disclosure/filing requirements of financial information.
c) § 16.22
i) Corporation must file annual report with the secretary of state.
ii) Matter of public record.
iii) It is not a matter of public record who the shareholders are.
d) § 16.02 gives a right of inspection of the records to shareholders.
i) A shareholder is entitled to inspect and copy, during regular business hours at the
corporation’s principal office, any of the record of the corporation described in §
16.01(e) if he gives the corporation written notice of his demand at least five business
dates before the date on which he wishes to inspect and copy.
ii) (b): gives more rights to inspect and copy records if the shareholder meets the
requirements of subsection (c). These scope of these records is much broader than
the scope of records available in subsection (a). It includes who is the shareholders.
(1) Why would shareholders care who else owns stock?
(a) § 7.20: another provision about access to shareholder ownership records, cites
to § 16.02(c). Can only copy if you meet requirements of § 16.02. § 7.20
method is used for solicitation of proxies.
(i) Under 7.20, not proper purpose required to view, but proper purpose
required to copy. Bradley says that soliciting for proxies is a property
purpose.
(b) If you want to make a tender offer: you need the share ownership information
to make the most cost effective offer.
(i) You can also get a good amount of the information about big blocks of
shares because institutional shareholders publish their stock ownership.
iii) (c): can only inspect the records if in good faith and for a proper purpose
(1) proper purpose is a term of art:
(a) proper purpose:
(i) it was not a proper purpose to look at the records to determine if
management had been screwing up. The reasoning was that these
shareholders did not own stock at the time of the alleged mismanagement.
(ii) Person seeking to view the records has the burden of proving proper
purpose.
(iii)Bradley says that proper purpose overlaps with discovery for derivative
actions.
iv) § 16.04: court can also order inspection of records
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