An Illumination of Business Associations
Business Associations, Fall 2013, BYU Law, Prof. Smith
Note: I got a little lazy toward the end, so the last sections are not especially “distilled” and are more
like class notes. With Smith, the pattern is quizzes and a take-home final that is word-limited, but
not time-limited. This outline is more useful for quizzes, but you will want to review the relevant
chapters and practice quizzes before each quiz. The quizzes are tough! Do not underestimate them.
As far as the final goes, the best strategy is to be familiar enough with course material to be able to
pick out which textbook chapters control the answer. You will then want to review those chapters
intensely as you write your test answer. On the final, one question looked like it implicated as many
as three or four textbook sections/chapters. However, I felt like I should not waste valuable words
on attenuated issues and stuck to two issues. As I developed those two issues, I realized that they
were taking a lot more words than I would have thought because to get the hypothetical to the point
where it fit comfortably into those issues, I had to do some explanation. So, I felt like my decision to
stick to the two was justified.
On the second question of the final, I suspect that a lot of my classmates made the mistake of
glomming onto a single issue and drilling too deep. They looked up law review articles and used the
teacher edition of the textbook to get all sorts of new insights. I stuck to our textbook, and carefully
walked through the issues that the question called for me to examine, giving them as much weight as
they needed for a resolution. In essence, I struck a balance between going broad and going deep. My
final grade in the class suggests that I did extremely well on the final, considering how poorly I did
on the quizzes . . .
Contents
I. Law of Agency........................................................................................................................................... 3
A.
Existence of Agency Relationship .................................................................................................. 4
B.
Fiduciary Duty of Agent to Principal ............................................................................................. 4
C.
Actual Authority ................................................................................................................................ 5
D.
Apparent Authority ........................................................................................................................... 5
II.
General Partnerships ................................................................................................................................ 6
A.
Partnership Formation ..................................................................................................................... 6
B.
Management ....................................................................................................................................... 7
C.
Fiduciary Duty ................................................................................................................................... 7
D.
Financial Attributes ........................................................................................................................... 8
E.
Liability of Partners to Third Parties .............................................................................................. 9
F. LLPs ........................................................................................................................................................ 9
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G.
III.
Dissolution ......................................................................................................................................... 9
LLC ........................................................................................................................................................10
A.
Formation .........................................................................................................................................10
B.
Management .....................................................................................................................................10
C.
Limited Liability...............................................................................................................................11
D.
Fiduciary Duties ..............................................................................................................................11
E.
Dissolution .......................................................................................................................................12
IV.
Organization and Structure of Corporation ....................................................................................12
A.
Incorporation ...................................................................................................................................13
B.
Capital Structure ..............................................................................................................................13
1. Equity Claims ...................................................................................................................................14
2. Debt Claims .....................................................................................................................................14
C.
Directors and Shareholders ...........................................................................................................14
D.
Dividends and Distributions .........................................................................................................15
E.
Limited Liability/Piercing the Corporate Veil ............................................................................16
V.
Control of the Closely Held Firm ........................................................................................................16
A.
Shareholder Agreements ................................................................................................................16
B.
Transfer Restrictions.......................................................................................................................16
C.
Classified Shares ..............................................................................................................................17
D.
Cumulative Voting ..........................................................................................................................18
E.
Supermajority Requirements .........................................................................................................18
F. Preemptive Rights ...............................................................................................................................18
G.
Oppressing Minority Shareholders ...............................................................................................18
H.
Defined Terms from Facebook Case Study ................................................................................18
I.
VI.
Fiduciary Duty .....................................................................................................................................19
Shareholder Voting in the Publicly Held Firm................................................................................19
A.
Lecture ..............................................................................................................................................19
B.
Delaware ...........................................................................................................................................20
C.
Book ..................................................................................................................................................20
D.
Misleading Proxy Disclosures........................................................................................................22
E.
Related Notes...................................................................................................................................22
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VII.
A.
Corporate Duty of Care......................................................................................................................24
Business Judgment Rule .................................................................................................................24
1. Context of Decision ........................................................................................................................24
2. The Waste Standard ........................................................................................................................25
3. Shareholder Primacy Norm ...........................................................................................................25
4. Some Class Notes............................................................................................................................25
5. Bananagate .......................................................................................................................................26
VIII.
Duty of Loyalty................................................................................................................................26
A.
Oversight ..........................................................................................................................................26
B.
Duty of Good Faith ........................................................................................................................27
C.
Class Notes .......................................................................................................................................28
D.
Duty of Loyalty for Reals ...............................................................................................................29
IX.
A.
Demand Requirement ....................................................................................................................32
B.
Direct Versus Derivative Claims...................................................................................................33
C.
Class Notes .......................................................................................................................................33
X.
Special Litigation Committees ..............................................................................................................34
A.
XI.
A.
I.
LITIGATION TO ENFORCE DIRECTORS'/FIDUCIARY DUTY ....................................32
Class Notes .......................................................................................................................................34
Statutory Exculpation from Liability ................................................................................................35
Class Notes .......................................................................................................................................35
Law of Agency
Law is pervasive in business. When the owner starts interacting with people such as vendors,
customers, and employees, the law gets involved.
Franchising is a way to finance a business idea.
Involving one’s self with others can result in one person being responsible for another
person’s actions. It is accepted law that a principal is responsible for the actions of the agent.
Policy: Principals are responsible for the torts and contracts of their agents. The courts must
distribute burdens. It is fairer to put it on principal than a third party. Moreover, the
principal selects and controls the agent and can terminate the relationship.
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A.
Existence of Agency Relationship
Plaintiff will want to establish that an agency relationship exists. If we are speaking of
inward consequences (like loyalty questions), the courts will stick more to what the
agreement is. If outward consequences are involved, the courts will likely look to
what actually is going on, even if a contract exists that puts different names on
things.
Restatement of Agency §1.01 (Third): Agency is the fiduciary relationship that arises
when one person manifests assent to another person 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.
What does it mean to control? Two things are important—ability to give
instructions, and the ability to create some consequence for disobedience for
failure to follow instructions.
Nears v. Holiday Hospitality Franchising, Inc.: Control? Nears says that there was
annual management training, and a manual for people to follow. Managers are
supposed to be trained within 180 days of getting the position, etc. Further, there are
property inspections. The old general manager was fired for bad scores. Comment
cards sent directly to HQ. Setting standards for treatment of guests does not amount
to control. Moreover, the goal is guest satisfaction, not employee. There must be
evidence that HHFI controlled the manager's daily interactions. Here, corporate had
no control, did not provide funds, etc. No comingling of funds. No decisions about
employment. Corporate could not hire or fire. HHFI did not pay workers and did
not pay employment taxes. Nears did not report to HHFI. Paycheck did not come
from HHFI.
There needs to be a showing that there is control of day-to-day operations.
Possible for someone to be agent of multiple principals.
B.
Fiduciary Duty of Agent to Principal
Principal:
 Duty to perform contract obligation
 Good faith and fair dealing
 Indemnification in some cases
Agent:
 Performance of contract obligations (Restatement § 8.07)
 Duty to take actions only within scope of actual authority (Restatement
§ 8.09)
 Care, Competence, Diligence to level of skills (Restatement § 8.08)
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




Obedience (loyalty is the gauge where instructions ambiguous and later
disputed)
Loyalty (under RUPA, anti-theft, anti-self-dealing, anti-competition)
During relationship, non-competition personally or representatively, but can
prepare for later competition if not doing something wrongful (Restatement
§ 8.04)
Confidentiality (even past employment)
Disclosure
Once the relationship is over, the general rule is that players in the marketplace can
compete. But, that can be contracted around via non-compete contracts (how long,
where, what).
There are superior duties or interests than can override this—outing crimes, e.g.
Food Lion is the case. Deliberately acquiring adverse interest is disloyal.
C.
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 accordance with
the principal's manifestations to the agent, that the principal wishes the agent so
to act. (Restatement § 2.01)
Words, writing, and conduct can be indicative.
There is express actual authority and implied actual authority, which is the
power to do things necessary to do the actual authority items. The agent’s
understanding of implied things must be reasonable, based on situation.
Castillo v. Case Farms of Ohio: Farm hired company to recruit and hire. Was the
nasty housing implied authority? It was practically necessary to accomplish what was
required. Moreover, housing and transportation were matters the Farm previously
had overseen when doing the same things before delegating hiring to the company.
D.
Apparent Authority
Apparent authority 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. (Restatement § 2.03)
Manifestations are written, oral, and other conduct. It does not necessarily need to
be directed to the third party. The key is that it emanated from principal and the
third party reasonably believed it.
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Job titles can be manifestations.
Bethany Pharmaceutical v. QVC: The tricky part is whether QVC made any
representations. The court concludes that it did not.
II.
General Partnerships
General partnerships are popular because they are simple and treated favorably under tax
law. Building on common law, the UPA came around and allegedly treated partnerships as
aggregates. RUPA has gained traction in the West. It looks at partnerships as entities and
property as belonging to the partnership. Departure of a partner does not necessarily
dissolve partnership.
Partnership agreement governs, subject to restrictions in RUPA § 103. Partners can contract
around default partnership rules. Unless contracted around, partners have equal say and pay
regardless of contribution.
Partnership is an entity distinct from partners. RUPA § 201. It can own property and hire.
Partnerships can dissolve and expel.
Partners are personally liable. Partners share the good and the bad.
A.
Partnership Formation
RUPA § 202: (a) Except as otherwise provided in subsection (b), the association of
two or more persons to carry on as co-owners a business for profit forms a
partnership, whether or not the persons intend to form a partnership.
(2): [gross returns does not necessarily mean partnership]
(c)(3): A person who receives a share of the profits of a business is presumed
to be a partner in the business, unless the profits were received in payment:
(i) of a debt by installments or otherwise;
(ii) for services as an independent contractor or of wages or other compensation to
an employee;
(iii) of rent;
(iv) of an annuity or other retirement or health benefit to a beneficiary,
representative, or designee of a deceased or retired partner;
(v) of interest or other charge on a loan, even if the amount of payment varies with
the profits of the business, including a direct or indirect present or future ownership
of the collateral, or rights to income, proceeds, or increase in value derived from the
collateral; or
(vi) for the sale of the goodwill of a business or other property by installments or
otherwise.
Separating out employee and creditors can be a pain.
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Partners can contract around the default rules at formation.
Intent required. Existence can be implied where it seems the individuals have entered
into a relationship for profit, etc.
Urban Decay: Express agreement to share profits not prerequisite. Intent of parties
as revealed in circumstances is controlling. The “we” talking was sufficient.
With hypothetical, guy is basically sharing profits, but not losses. Employee is also
not management. Also, seems to be intent that it is not to be a partnership.
B.
Management
Absent an agreement to the contrary, all partners have equal rights. The majority
makes decisions. There must be unanimous consent for making amendments, adding
new partners, and extraordinary transactions. Expulsion of partners can be
contracted for.
Vecchitto: Court determined that suing a partner was extraordinary and had to be
unanimous. Prof. Smith thinks this was an overly narrow interpretation of what
qualifies as ordinary business of a partnership.
RUPA § 301: (1) Each partner is an agent of the partnership for the purpose of its
business. An act of a partner, including the execution of an instrument in the
partnership name, for apparently carrying on in the ordinary course the partnership
business or business of the kind carried on by the partnership binds the partnership,
unless the partner had no authority to act for the partnership in the particular matter
and the person with whom the partner was dealing knew or had received a
notification that the partner lacked authority.
(2) An act of a partner which is not apparently for carrying on in the ordinary course
the partnership business or business of the kind carried on by the partnership binds
the partnership only if the act was authorized by the other partners.
The above does not address apparent authority.
C.
Fiduciary Duty
UPA was scant on loyalty. There was no stealing, guaranteed access to records, true
information, accountings, etc., but no duty of care.
RUPA § 404: (a) The only fiduciary duties a partner owes to the partnership and
the other partners are the duty of loyalty and the duty of care set forth in
subsections (b) and (c).
(b) A partner's duty of loyalty to the partnership and the other partners is limited to
the following:
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(1) to account to the partnership and hold as trustee for it any property, profit, or
benefit derived by the partner in the conduct and winding up of the partnership
business or derived from a use by the partner of partnership property, including the
appropriation of a partnership opportunity;
(2) to refrain from dealing with the partnership in the conduct or winding up of the
partnership business as or on behalf of a party having an interest adverse to the
partnership; and
(3) to refrain from competing with the partnership in the conduct of the
partnership business before the dissolution of the partnership.
(c) A partner's duty of care to the partnership and the other partners in the conduct
and winding up of the partnership business is limited to refraining from engaging
in grossly negligent or reckless conduct, intentional misconduct, or a
knowing violation of law.
(d) A partner shall discharge the duties to the partnership and the other partners
under this [Act] or under the partnership agreement and exercise any rights
consistently with the obligation of good faith and fair dealing.
Policy: Liability is going to be imposed. This gives incentive to exercise due care and
monitor behavior of other partners. Equal sharing of partnership losses can be
reduced, but not eliminated.
Meinhard v. Salmon: Men were partners in running building. Lessor approached
managing partner in his capacity and made offer. He took opportunity to abscond
with the opportunity. Cardozo speaks of the punctilio of honor. The guy was kind of
an agent, too. Basically absconded with the opportunity.
As for the law firm departure case (Gibbs v. BAM), selflessness not required, but
fairness is. The problems were breaching confidentiality and perhaps competing
unfairly.
D.
Financial Attributes
There will be equal partnership rights for losses, gains, profits, etc. unless parties
contract around that. Profit percentages do not have to match original contribution
percentages.
Capital accounts will track contributions, share of profits and losses, withdrawals,
and gains or losses upon sale of the partnership or its assets. Loans and work for the
partnership (salary) are debts of the partnership. Labor does not really go into the
capital account.
Partners are entitled to repayment of capital contributions or advances made to
partnership. A partner can make a claim to be reimbursed or indemnified for
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liabilities incurred in the ordinary course of business. Partners who made advances
entitled to interest. Partners get their capital at withdrawal or termination.
Priority of payout: 1. Creditors who are not partners, 2. Amounts owed to partners
for other than capital or profits, 3. Partners for capital, 4. Partners for profit.
Kovacik: One guy contributed services in return for promise of half profits. The
financer lost out, and tried to claim that worker should pay half of startup, but court
held against that. Worker was not really a partner. Further, guy lost out on his labor.
E.
Liability of Partners to Third Parties
UPA formerly required exhaustion of partnership, and had a higher amount of
liability for wrongful acts or breaches of trust. But now, under RUPA 306, joint and
severable liability language is everywhere. Running away from partnership before tort
action filed does not help. It has to be tied to scope of partnership. Whether the guy
had authority or not, it was the partnership’s duty to take care of things.
306: All partners liable jointly and severally for all obligations of the partnership
unless otherwise agreed by claimant or provided by law. Partner not liable for stuff
before he entered. LLCs will shield people from liability based solely on partnership
status.
F.
LLPs
These are recent. They are less popular than LLCs, which need only one person.
Registration and a fee get the partners setup. Partners will not be liable beyond their
investment for what the other partners do. Liability is not avoided for personal
negligence or wrongdoing or direct control/supervision of wrongdoing.
Policy? It encourages investment and economic development. This puts a burden on
third parties. This might be more needed because businesses have bigger footprints.
Example is Frode Jensen. The defamers were agents of the partnership, managing it.
It was in scope of partnership. Associates? Authority? Role, scope? Perhaps they
were agents. Possibly a breach of fiduciary duty.
G.
Dissolution
Formation, then dissolution (event that triggers winding up such as partner leaving),
then winding up, then termination.
However, RUPA describes a dissolution as a dissociation and provides that the
partnership can continue without the dissociated partner. RUPA 801 discusses
events that trigger winding up. This can be dissociation, decision to end, or a
predetermined event. If the dissociation is not a dissolution of the partnership, then
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the departing partner must be bought out, and he is indemnified except for stuff he
was responsible for.
Partner can dissociate at any time, but it will be categorized as rightful or wrongful
based on terms of agreement. Wrongful is in violation of terms of partnership or
before a specific undertaking is completed. Wrongful dissociation makes the partner
liable for damages.
In Fischer there was a wrongful dissociation. Buy, lease, and sell property was a
definite undertaking.
III.
LLC
LLCs encourage business. Corporations provide limited liability, but they get taxed unless
you can get an S-corporation. Partnerships do not get taxed. So, the LLC is combining
limited liability and pass-through taxation. This was difficult under the IRS rules until the
check-the-box rule came out. RULLCA and DLLCA are the best known. LLCs are cheap
and easy to start.
A.
Formation
File certificate with the state. Also, an operating agreement. With conflicts, the
operating agreement controls inwardly, but the certificate outwardly.
Stone v. Jetmar: Victim quit claimed property to fake LLC under fraud. Fake LLC
used this to get a mortgage. The creditor tried to foreclose and the victim’s defense is
that he did not in fact make a valid quit-claim. Creditor wants to say that it was
corporation by estoppel. The rule on that is there needs to be a law for a corporation
to exist, then a colorable and bona fide attempt to perfect organization, and user of
rights claimed to have been conferred by the law. Here, you cannot have a colorable
attempt without success because LLCs are so easy. Corporation by estoppel has also
been abolished by statute in some instances.
B.
Management
Default is member management, but a manager can be appointed. Can be centralized
or not. Generally, need a lot more managers/members on board to do extraordinary
things. Remember that LLCs are highly contractual entities. RULLCA goes majority,
but unanimous consent of even members to do big things. DLLCA looks to
agreement or at least the proportion interest in profits to determine management
rights.
Policy: Unanimity because LLCs are closely held and people want veto power over
extraordinary transactions. But, this is not popular because consensus can be
difficult, because liability is limited anyway, and a disgruntled member can leave.
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Members that are not managers cannot bind in RULLCA. But, under DLLCA, all
members and managers can bind.
Gottsacker: The members need to act fairly, even when they have conflicts of
interest. With regard to allocation of power, court interpreted so as to make it so that
unanimous consent was not needed for every transaction. I guess the question was
one of interpretation of contracts.
Jerez: Partner went into debt and absconded despite agreement limiting power. Utah
law gives power to managers to bind, but another statute gives specific instances
where that is not so. Unfortunately, statute interpretation is that more specific statute
is exception only.
C.
Limited Liability
Members and managers are personally liable for their own acts, omissions, and
obligations undertaken by agreement, but they are not personally responsible for
what other members do.
Piercing the corporate veil is a way to nail shareholders and is quite drastic. The
question is whether that translates over to LLCs. With corporations, a lack of
formality is a good sign of trouble, but RULLCA specifically allows informality.
Netjets: Guy was a turkey, using the LLC as his piggy bank and having it default on a
pretty big bill. Needs to show that 1) the business owner and LLC were one entity
and also 2) that there was an overall element of unfairness or injustice, and not
getting paid does not necessarily count. For mingling, think about the capital
company had for undertaking, solvency, formalities, siphoning, and facades.
Reasonable fact finder can find unfairness.
Direct liability does not require piercing. If the person was dishonest, then it is highly
likely it was unfair, and vice-versa.
D.
Fiduciary Duties
There is always implied covenant of good faith and fair dealing, but a question of the
fiduciary duty of loyalty and care. Delaware does not explicitly include a fiduciary
law. But, Auriga (golf course LLC pushes out minority investors) is where they say
that the default rule of equity introduces fiduciary duty. Fiduciary relationship is a
special relationship of trust. Focus on fiduciary duties being imposed where one
person has discretion over something that belongs to another person. Delaware
allows people to contract out of fiduciary duty, but not good faith and fair dealing.
Most importantly, conflict of interest does not invalidate. You look for fair dealing.
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Not on exam: Direct suits can be brought for wrongs against shareholders, but
derivative for wrongs against the company. Some courts allow direct for minority
shareholders.
Not on exam: NY allows derivative suits to come against LLCs. The court reasoned
that this was something invented by common law and that the actual face of the
statutes did not prevent it, even if there was questionable legislative history.
E.
Dissolution
Early statutes made LLC dissolution something that happened easily because LLCs
were very comparable to partnerships. If members start dropping, the LLC is
jeopardized.
RULLCA is identical on dissociation to RUPA.
DLLCA treats an LLC as perpetual unless the LLC agreement provides for
dissolution, 2/3 of the members vote to dissolve, there are no members, or a court
dissolves the LLC. Dissolution is not required if a single member dies, retires,
resigns, is expelled, or goes bankrupt.
Court may decree dissolution where it is no longer practicable to carry out the
business in conformity with the LLC agreement.
Valinote v. Ballis, 7th Cir. 2002: Valinote sold his membership share in a failing LLC
to the last remaining member as per a buy/sell provision in the agreement. But then,
the bank came after him for a personal guarantee when the LLC defaulted. He wants
to claim that Ballis should indemnify him. However, it is an LLC—no piercing. All
membership rights were sold. Valinote has a personal claim against the LLC. The
LLC can have only so many claims against the members. Ballis cannot go after
Valinote for anything because he bought the other shares and cut off Valinote’s
liability to the LLC.
Haley v. Talcott, Delaware 2004: Talcott owned and started the Redfin Grill, and
Haley was the employee manager. All of this looked like a partnership. He entered an
LLC and it got ugly, and he was frozen out. Given that it is not fair for Haley to have
to leave and be at mercy of other guy, and considering that it is not reasonably
practicable to continue the business, the LLC is dissolved.
IV.
Organization and Structure of Corporation
Corporations are designed on idea that shareholders are passive or standing some distance
away from control functions. You have the owners/shareholders, officers, and directors.
Directors are elected to supervise officers. Directors make decisions on behalf of hundreds
or thousands of shareholders. Decision-making is centralized.
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Shareholders have limited liability and can control who the directors are. They may also vote
on fundamental transactions.
There are public corporations and closely held corporations. Public corporations have more
onerous disclosure requirements. Public corporations prefer Delaware; closely held
corporations will stay at home.
In-class exercise:
 Articles must set forth an acceptable corporate name
 Different shares get different classes and serial numbers.
 Par value is rock bottom price of the share. Usually, this is set very low.
 Name and street address of agent required.
 Purpose clause: “any lawful activity” is best.
 Bylaws by statute may amended by shareholders, so you cannot prohibit things
guaranteed by statute, though you can depart from laws that are merely defaults.
 Probably should not lock director number in the Articles, can also have a range
 Liabilities can be controlled by statute
A.
Incorporation
Certificate or Articles of Incorporation get the corporation going. Name, stock,
agent, etc. should be included. Sometimes initial directors can be specified, but a
Board meeting can get things launched.
Corporate purpose: Formerly a creature of legislative incorporation. Any lawful
purpose is acceptable. You do not want a problem of ultra vires things. Enforcement
happens via shareholder suit against corporation, corporate suit against directors,
involuntary dissolution proceeding by the attorney general.
Management provisions might be included in Articles—something like a director
being removed only for cause.
Director liability can be specified.
Grant v. Mitchell, Delaware 2001: Incorporator failed to declare who was on the
board via the official method. However, there was evidence that he had intended.
Also, there was a foreign corporation certificate.
B.
Capital Structure
The capital structure is the combination of claims sold by the corporation. The
capital structure is controlled by the board, as is the sale of stocks etc. (In Grimes, the
CEO promised a sale to an investor, but that was held to be not binding.) Overall, a
closely held corporation might prefer to do bonds or get some sort of loan to
prevent shareholder dilution.
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1.
Equity Claims
Articles of incorporation authorize issuance of equity interest, namely shares,
by saying what type and what number may be sold. Shares are divided into
classes and series. Together, this is the capital stock. Sheer number of shares
is not determinative. You must know what percentage of what class that
represents, and then what power that class has.
Shares issued are sold. Shares are outstanding if the shareholder holds them.
If the corporation repurchases shares, it can hold them as treasury shares,
which are issued but not outstanding, or authorized by not issued. Articles
set forth number of shares to be issued and delineate rights of shareholders.
For instance: dividends, liquidation rights, voting rights, conversion rights,
redemption rights, and preemptive rights.
Common shares usually have unlimited voting rights and rights to the
residual assets of the corporation. There must always be at least one common
share of stock.
Preferred shares usually have some preference or priority in payment over
common shares. The terms are set out in the articles or in a separate
document called a certificate of designations.
2.
Debt Claims
These are bonds. Basically, the company has a loan and will be paying
interest. Holders of registered bonds receive their interest payments in the
mail. Holders of bearer bonds mail in coupons.
Corporation can call bonds and repurchase them at a specified price .The
company might do this if it can get loan at better right. Bonds can be senior,
subordinate, or senior subordinated. It might be possible for bond holder to
convert into stock. Bonds are rated. Lower than a Baa or BBB is a junk
bond.
Bonds can be advantageous because interest payments are tax-deductible
where dividends are taxable.
Bond debt can enable the company to leverage shareholders’ investment.
C.
Directors and Shareholders
The authority is with directors. Shareholders can vote yearly or on specific proposals.
Directors determined by bylaws. Private corporations do not need directors.
Management might nominate a board. Inside directors work for the corporation.
Outside directors do not. Elections can be staggered. Removal of director can be
arbitrary or cause might be required based on articles or law. Vacancies and new
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directorships are easily made. Meetings can be held anywhere, even by phone. The
board can have committees, like an audit committee.
As for shareholder voting: common stock is 1:1. Shareholders vote on directors and
fundamental transactions such as amending charter, by-laws, mergers, sale of assets
not in ordinary course of business and approving dissolution. Votes can be by proxy.
Majority vote wins, though director election require only a plurality. Straight voting is
the default, unless cumulative voting allows people to concentrate all votes on a
directorship.
Shareholders vote, sell shares, sue directly or derivatively, and can contract with each
other and the corporation. Meetings can be judicially set, annual, or specially called.
The subject of meeting will be announced or the action is voidable. Can set a record
date to establish invite list.
Alderstein v. Wertheimer, Del. Ch. 2002: Jackass shareholder was subject to trickery
and deceit. Although the result was necessary, you cannot achieve it that way.
D.
Dividends and Distributions
Paying of dividends is up to the directors. The company can also purchase and retire
stock as a way to pay off people. Either way, this is a corporate distribution, and is
limited based on two types of tests.
Solvency test: The board cannot leave the corporation without money to pay its
debts. There is also fraudulent conveyances to think about, too. This is not
Delaware.
Balance sheet tests: (1) Impairment of capital test allows distribution of surplus,
which is all capital in excess of the aggregate par values of the issued shares. (2)
Technical insolvency test involves the total assets being insufficient to pay the sum
of the corporations liabilities and any liquidation preferences that would be owing if
the corporation dissolves at the time of distribution.
The policy goal is to protect the creditors of corporations.
Legal capital is the par value times the number of shares outstanding. Distribution
can be made out of surplus. Beyond that and you have impairment of capital. Model
Act does not follow this, but it is part of Delaware.
With the Smith’s case, the court concluded that on the balance sheet test, the board
can rely on financial statements reasonable under the circumstances. As in—the
latest report might not be accurate, and as long as the board is acting in good faith,
the distribution is legit.
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E.
Limited Liability/Piercing the Corporate Veil
The advantage of limited liability is that people can diversify investments without
risk. It allows free transfer of shares in public markets. It allows people to not
monitor managers or other shareholders excessively. But, it increases the cost of debt
and presents a moral hazard for people managing money that is not there.
Involuntary creditors can get screwed, too. Another level of shadiness is added when
a corporation sets up another corporation that it owns and something bad happens.
There is a difference between a shareholder being directly liable and being liable
because they are a shareholder.
If there is no direct liability of a shareholder and you want to stick it to the
shareholder, the first question is whether corporate formalities have been observed.
If formalities are there, piercing probably well not happen. There is also the question
of fairness—there needs to be a showing of injustice or unfairness.
Undercapitalization is insufficient.
V.
Control of the Closely Held Firm
Shareholders in closely held firms often decide to vary the default rules. Highly tailored
arrangements allocating control are often feasible. This are of the law is highly contractual
with a lot of bad contracts.
Analysis: Who owns the company? Who is the majority and who is the minority? What
agreements are there? Majority may have contracted decisions away. What are the financial
rights? The default is that people get equal dividends, but contracts can change that.
The core problem of closely held firms is the relationship between majority and minority
owners. There are tools to prevent or solve the problem.
A.
Shareholder Agreements
Control can be allocated via simple contract among shareholders. Vote pooling
agreements, typically enforced by courts, obligates shareholders to vote together as
one block, usually for director candidates nominated by specified shareholders.
Bargains can also specify veto rights, right to name certain officers, right to
employment, right to salary/dividends, etc. With Ronnen, the brother had contracted
for right to vote sister’s share on day-to-day operations and management. The board
manages. So, the brother had a right to vote on directors.
B.
Transfer Restrictions
These are widely used to control selection of business associates, to provide certainty
in estate planning, and to ensure that the corporation complies with small
corporation regulations. They are imposed in charters, bylaws, or separate
agreements.
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Test for validity: 1) Must comply with formal requirements relating to adoption of
the restriction and must be conspicuously noted on certificates. 2) Restrictions must
be for proper purpose. The test is reasonableness.
Types:
 Shareholder must offer corporation or other shareholders option to purchase
at agreed price or at price offered by prospective third-party purchaser
 Corporation or other shareholders are obligated to purchase shares
 Corporation or other shareholders must approve the transfer
 Simple prohibition on transfers to certain persons or certain classes of
persons.
Option and buy-sell agreements are usually enforced. Prior approval is enforceable
so long as approval may not be unreasonably withheld. Flat prohibitions are not
favored. And, you cannot backdate restrictions.
Buy-sell is the most common. It gives liquidity for shareholders. It provides a price
when nobody knows whether they will be buying or selling. The principals of the
corporation can plan with certainty.
Price of buy-sell varies: Fixed price that is updated constantly, book value based on
historical costs, appraisal based on something, complicated formulas.
With Capital Group Cos. v. Armour, Del 2005: Wife was being divorced. Marital
property included a lot of the stocks that had employee-owned restrictions. Proposal
that gave wife benefits without in-name ownership did not fly because it was the
same as owning stock. Contestor must prove that is unreasonable. The court looks at
the restriction on its face, not application. Here, it was reasonable, and market
participants are just that.
C.
Classified Shares
A corporation can do practically anything in classifying shares. Some classes might
not vote, might have veto power, might have targeted voting power, or might have
inflated voting power. Delaware claims to interpret corporate charters as ordinary
contracts, but when reading terms of preferred stock, they say that “any rights,
preferences and limitations of preferred stock that distinguish that stock from
common stock must be expressly and clearly stated and will not be presumed or
implied.”
With Benchmark, the other classes tried to block something one was doing, but
could not because the language in the grant of veto power(?) was just not specific
enough to allow the one class to enforce rights.
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D.
Cumulative Voting
This ensures minority representation. Whether it is the default or something you can
contract for depends on the state law. Formula to elect a director under cumulative
voting is like this: [Shares Voting/(Directors to be Elected +1)] + 1 = Shares
Required. If the board is staggered, this does not work.
E.
Supermajority Requirements
Requiring a supermajority or high quorum for certain votes is a way to give veto
power. A simple majority vote can impose supermajority requirements in Delaware.
But, in the Model Act, you need the same amount or a supermajority vote to impose
supermajority restrictions. Repealing is based on getting something out of the charter
or based on the bylaw imposing the supermajority. Getting rid of a charter provision
generally requires a supermajority, but not so much under bylaws.
F.
Preemptive Rights
A preemptive right is to purchase as much as new stock as you won of old stock.
These rights are no longer the default in a lot of places, though some places do make
them the default. Public companies are not fond of these provisions. Private
corporations do like them. There might be restrictions on what counts as a new
offering. Basically, it would have to be totally new stock. The calculation of
percentages might not be what you would expect.
G.
Oppressing Minority Shareholders
The minority could get fired from a job and not receive dividends. He might be
frozen out from the board or any control. There are two approaches: Massachusetts
and Delaware.
Massachusetts: Donahue held that majority owe a heightened fiduciary duty to
partners—utmost faith and loyalty. But, board can claim legitimate business
purposes. The minority then tries to establish that the same objective could have
been achieved through an alternative course of action less harmful. The case is Leslie
with the jackass partner that was not doing so much heavy-lifting. The court required
the board to let him on, get dividends equal to what the partners were giving
themselves, but without involving him in other things.
Delaware: If you are a minority shareholder, you get what you deserve.
H.
Defined Terms from Facebook Case Study
 Staged financing: Multiple offerings of preferred stock.
 Liquidation preferences: Person gets extra money that might be left after
normal liquidation.
 General voting rights and targeted voting rights: self-explanatory
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I.
VI.
Conversion: Can change preferred shares to common. This could be
mandatory.
Redemption: Repurchase of shares. A “put” allows capitalists to force
buyback. A “call” allows company to do so. Obviously, calls are not common
if venture capitalists are involved.
Venture capitalist: Brings money, value-added services such as know-how,
networks of contacts, customers, suppliers, future officers
Protective Provisions: special voting rights. Anything that gives an
entrepreneur power
Dividend preference: One class gets more
Registration rights: Venture capitalists want to make sure they can sell off
their shares to make money after a certain time. Demand rights allow a
request after certain time. Piggyback involves being able to register if other
shares are
Rights of first refual for future offerings
Conversion Rate and price
Mandatory conversion—IPO
Fiduciary Duty
Duty of the board, where discretionary judgment is to be exercised to prefer interests
of common stock over the interests created by special rights, preferences, etc. The
board honors contracts, but fiduciary is to common stock. Perhaps the board might
find it better to breach contract with preferred for a net benefit. A common
stockholder cannot sue board and require breach, though.
Shareholder Voting in the Publicly Held Firm
A.
Lecture
In olden days, corporation was a tool to get money for big projects—bridges, canals,
etc. Also, banks. They were rare. Limited liability was the key to getting people to
invest. Legislature did not want to tax. So, often pure motive, but sometimes bribery
cold be involved. Limited liability and monopoly made sure these corporations were
profitable. These charters for a limited time, often.
Robber barons, etc. came onto the scene. States had general incorporation statutes
by now, but these statutes contemplated relatively small organizations with all of
their assets in one estate. Corporation in each state. Rockefeller’s lawyers put shares
into a trust. This led to anti-trust legislation. Some states started thinking about the
advantages corporations bring, especially after they saw that they could incorporate
companies and then charge taxes. Delaware copied New Jersey, but nothing initially
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happened. Woodrow Wilson convinced New Jersey to rollback their statute. Ooops.
So why do corporations stay in Delaware? Who knows?
Burleigh and Meads conclude that part of cause of stock market crash was the fact
that shareholders owned the company but did not govern the corporation. There
was a separation of ownership and control. They were not accountable to anybody.
So, how do you make them accountable. We need to know more about what the
people in the corporation are doing. Require them to disclose. Congress adopts two
pieces of legislation—Securities Act and Securities & Exchange Act. This is when we
get disclosure on a large scale.
THE THEME of this section is dealing with the separation between ownership and
control.
Most of the voting rules are federal—securities rules. Federal law involves trading of
securities (which we don’t cover) and federal laws regarding corporate governance.
This area of law has been taken over by Congress, and the SEC. Basically, voting is
what the rules are after.
SEC drafts and adopts regulations.
Other stuff—60% of corporations are in Delaware. Even if not in Delaware, people
will look at Delaware.
B.
Delaware
The DGCL—kind of difficult, purposefully. Most important section is 141(a).
Business and affairs managed by or under direction of the board of directors.
Exception is what law or articles say. Shareholders mostly respond to the board.
Statute will require board to request approval from shareholders in certain instances.
Problem, board has broad grant of power. The stockholders are given authority to
amend bylaws. Those bylaws can have any provision relating to business. Bylaw
cannot be inconsistent to law. But the bylaw would infringe on board’s law-granted
power. But, the power is excepted.
C.
Book
The only thing shareholders can do is vote for different directors, or sell stock. The
vote is what legitimizes the director's power over stuff they do not really own.
Activist shareholders have been causing trouble. Voting is unpredictable, and
perhaps more important.
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Poison pills are rights extended to existing shareholders to buy shares at a deep
discount. This can prevent hostile takeovers, or make them really expensive.
Unisuper Ltd et al v. News Corporation: Board basically made board policy to
not employ a poison pill for more than a year without shareholder approval. The
court allowed a trial because although board policies can be kicked out by the board,
it is possible the board made a contract in some of its statements to the shareholders.
More and more, shareholders are trying to force their ideas on corporations rather
than just selling the shares they don't like. They try to do this by introducing bylaws.
That can be expensive to get the proposal in front of shareholders. Have to get it
only the proxy statement. Companies can exclude stuff if the proposal is not a
proper subject for action by shareholders under the laws of the jurisdiction of the
company's organization.
Conflict of two provisions:
141(a): Shareholders power to adopt bylaws is limited by law, which includes power
of board to manage or supervise management
109: Board limited by law, which includes the shareholder power to adopt bylaws.
Basically, the AFSCME case says that shareholders cannot be blocked from making
bylaws because they always have that power. But, bylaws cannot be mandating
outcome of board decisions—procedures only. As for mandating the board to spend
money always in a certain situation, that would be a breach of fiduciary duty because
sometimes the board should not be paying out money in those situations.
Shareholder organizations are often trying to get their boy on the board. Companies
and the business community have resisted efforts to make this possible. Indeed,
boards can keep the shareholder nominees off of the proxy statement. The latest
strategy is making proposals to change the procedures set out in the bylaws of
individual companies to allow shareholder-nominated candidates.
AFSCME v. AIG, 2d Cir 2006: SEC’s original interpretation of an ambiguous
regulation or whatever is controlling. Hence, shareholder proposals that indirectly
affect elections are okay.
2007: Anything that results in a contested election is not something that has to be
included on the proxy materials!
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2009: Delaware passes a proxy reform which allows access. SEC follows, kind off.
Nominating shareholders must meet certain conditions. DC Circuit whacked the
SEC for being arbitrary and capricious.
The board can come up with reasons to not do things:
1. Improper proposal under state law--cannot command directors to do
something.
2. Not relevant--effects less than 5 percent of a company's assets or earnings or
sales.
3. Proposal relates to ordinary business/management functions. Operational
details may be excluded, policies not
4. Proposal relates to elections
D.
Misleading Proxy Disclosures
Company can get busted for misleading proxy disclosure.
The standard is that companies cannot make false statements of material fact or omit
to state material facts in proxy statements. Material is what “a reasonable shareholder
would consider important in deciding how to vote.”
Financial facts about value of securities or transactions are material.
Environmental/social stuff is not material.
E.
Related Notes
Conflict between shareholders and management: Kind of like an agency relationship,
but not an agency relationship under law. It is a unique relationship between
shareholders and directors with roles defined by law and cases.
In corporations, there is special provision for a management/decision-making body.
As per Delaware §141, business shall be managed under direction of board. There
are a lot of constituencies involved. People near, in, customers, etc.
If the board manages, what do the shareholders. Shareholders vote, sell, sue,
contract. This is how they influence corporate decision-making.
Board policy: Who controls board policy? The board. If they make it, they can
unmake it. That comes from 141(a). Unisuper deals with idea that perhaps a contract
could limit board’s discretion. Problem is that contracts where a fiduciary breaches
duty are unenforceable as a matter of public policy. Because the shareholders are a
party, the contract is not against public in Unisuper. If it had been a third party, there
would be some problems.
Substantive questions: what can shareholders do? Hypothetically, they can do a lot.
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Process questions: How can shareholders exercise their control? Voting is the key
thing. Showing up to a meeting or signing consent. Proxy voting. For an action
outside of a meeting, Model Act requires unanimous written consents. Delaware
allows basic majority for stuff outside of meeting.
Federal Regulation of Shareholder Voting (Process): Proposals: A recommendation
or requirement that the company and/or the board take action. If proposers can
meet the requirements put down by SEC, can require board to put stuff on the proxy
materials. Procedural question is who will pay. To get something voted on, basically
need to get it mailed to everybody.
Eligible to submit a proposal? $2k or 1% of company investment. Continue holding.
Don’t want to prevent people from cheaply buying into a proposal.
Only one proposal per person. There is skepticism. Nickname for these people,
corporate gadflies.
Proposal may not exceed 500 words. Lightens burden. Most proposals are not going
to receive much support.
Deadline—looks at last year’s proxy statement.
Failure to follow requirements—company has to tell you, let you fix it.
If company does not like proposal, it can put it proxy statement (never happens),
write back and say they will just exclude it and put the ball in proponent’s court, goes
to SEC and gets a no-action letter.
You or rep has to be present.
Other reasons to exclude proposal? Improper under state law, violation of law or
proxy rules, personal grievance, relevance (less than 5% of net earnings, gross sales,
assets, absence of power/authority, management functions (ordinary course), relates
to an election, conflicts with company’s proposal, substantially implemented or
duplicative, resubmissions, specific amount of dividends.
Cannot use the rule for getting your proposal if it affects the election. Director
elections: If proposal would disqualify a nominee who is standing, would remove a
director before term expires, or questions competence judgment or character of one
or more directors, seeks to include specified individual in company’s proxy materials,
or otherwise would affect outcome of upcoming election, you cannot have a
shareholder proposal.
What does the company have to do to exclude proposals? File documents. Might ask
for no-action letter.
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If company includes proposal—must also include name, address, number of shares.
What if company puts proposal on proxy and you disagree? Express own view
properly.
VII.
Corporate Duty of Care
Directors are essentially agents, but is the principal the shareholders or the company? They
have a duty of care toward the principal, but courts are going to be deferential to the
directors.
A.
Business Judgment Rule
Originally, this was a common law matter. The Model Business gives some rules,
though Delaware is more influential. Generally, the courts do not want to be the
ones deciding whether business leaders know what they are doing. Thus, if you try to
nail a director for violating duty of care, the court will defer to business judgment
unless you can say something was wrong with the process. Selfish interest or just
stupid/uninformed.
We want business leaders to take risks and try to do new and better things. Problem
is that somebody not being responsible for financial disasters so long as they were
not self-dealing presents a little bit of a moral hazard.
Self-interest will move court. Theoretically, also extreme, crazy, unexplainable
negligence.
Gagliardi: Where a director is independent and disinterested, there can be no liability
for corporate loss, unless the facts are such that no person could possibly authorize
such a transaction if he or she were attempting in good faith to meet their duty.
So basically, need conflict of interest or an unsound decision-making process.
1.
Context of Decision
Courts become suspicious in two situations:
1. Directors are subject to a conflict of interest with respect to the
challenged decision--duty of loyalty.
2. Directors fail to gather requisite information to make the challenged
decisions--gross negligence
Van Gorkom involved the Board making some decisions based on allegedly
not even reading the proposal, etc. Dissent argues they knew what they were
doing.
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2.
The Waste Standard
So, what if the procedural aspects are okay? Courts speak of waste or
perhaps will say that there was no rational business purpose. Waste usually comes
up in the context of executive compensation.
Disney case--dismissed for crappy pleading, but the court was highly
concerned about an overpaid CEO--it said it needed to see facts to show that
no reasonable business person would have made the decision the Board did
under those circumstances.
3.
Shareholder Primacy Norm
AKA--board owes duty of care to the shareholders.
Ford v. Dodge is the big case: The corporation exists to profit the
stockholders. The Board cannot change that purpose, cannot reduce profits,
and cannot refuse to distribute profits. Ford was doing some outrageous
things to spend his money, but he couldn’t spend enough even after buying a
new plant and raising wages. So the court said to knock it off. KEY is that
the court said that the idea of the business is to profit the stockholders. Of all
the groups that have claim to the corporations affections, the Board has to
consider first and foremost the shareholders.
BUT, just because an activity is profitable doesn’t mean that it is mandatory.
Moreover, corporations are generally not allowed to engage in illegal activity.
Obviously, though, the board still has discretion and business judgment in
most issues.
Foreign countries are more about stakeholder capitalism.
Kahn v. Sulivan, Del. 1992
The Board has been pouring money into an art collection and showcases it
often, particularly in cities where it is trying to do business.
The company has also been donating the megabucks to an art museum.
Settlement reasonable, given the amount of money involved. The higher
court isn't about to disturb absent a clear abuse of discretion.
4.
Some Class Notes
Courts really do not want to be thinking about the merits of the decision very
much. They especially recognize that hindsight is different.
Gagliardi admits that it is theoretically possible that a decision could be so
awful that a court would have to stick it to the Board and ignore the business
judgment rule. If there is any rational business purpose, you are in good shape.
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Problem: Trying to make bylaws about executive compensation. Possibly
under the Model Code the bylaw could be made and shielded from the
Board. Overall, it would be difficult to put a constraint on.
Corporate culture has changed a bit in the past 15 years. Strategy is more the
domain of the executive officers while the boards are better at monitoring.
You want someone who is independent, well-informed, competent for
business judgment.
5.
VIII.
Bananagate
Foreign corrupt practices act. Cannot be bribing government, though you
can pay them for other reasons.
Duty of Loyalty
Duty of loyalty is implicated anytime director or manager might be interested by self-interest.
Awarding themselves stock options is a conflict because they want more, but their duty
should be to give themselves less while making sure their compensation is competitive with
other compensation in the industry.
Good faith has been held as an element of the duty of loyalty.
Directors do not get the benefit of the doubt that they do with duty of care. Courts are
skeptical. Directors will try to use procedural mechanisms to get the business judgment rule
invoked.
A.
Oversight
Director not liable for any decision to take or not take action unless the other party
establishes that the conduct consisted or was the result of a sustained failure of the
director to devote attention to ongoing oversight of the business and affairs of the
corporation.
Caremark: My interpretation of Graham is that absent grounds to suspect deception,
neither corporate boards nor senior officers can be charged with wrongdoing simply
for assuming the integrity of employees and the honesty of their dealings on the
company's behalf.
Board cannot satisfy its duty without having systems to provide senior management timely and
accurate information.
I am of the view that a director's obligation includes a duty to attempt in good faith
to assure that a corporate information and reporting system, which the board
concludes is adequate, exists. Failure in theory will render a director liable.
To show that directors are liable, the plaintiffs would have to show that
1. Directors knew or
2. Should known that violations of law were occurring
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3. AND THEN, that directors took no steps in good faith effort to prevent or
remedy
4. AND such failure proximately resulted in the losses complained of
#2 is failure to monitor. Need an utter failure to have reporting and information
systems.
B.
Duty of Good Faith
Failure to monitor will establish the lack of good faith that is a necessary condition
to liability.
Bad faith overcomes exculpation clauses.
On care, the Disney people weren't so good at best practices, but seems to be acting
in a reasonably informed state, following process, etc.
Chancellor said that bad faith is intentional dereliction of duty, conscious disregard
for one's responsibilities. Inaction in face of duty to act.
Three different categories of fiduciary behavior that could be bad faith:
1. Subjective bad faith—fiduciary conduct motivated by an actual intent to do
harm.
2. Gross negligence, no malevolent intent. Problem with this one is that
legislature allows people to get away with violations of a duty of care, but not
bad faith.
3. Intentional dereliction of duty, a conscious disregard to one's responsibilities.
This qualifies as bad faith that is non-exculpable.
Stone v. Ritter, Del. 2006
Caremark has the necessary conditions for assessing director oversight liability. The
standard was properly applied in this case.
Bank screwed up on following the law.
Nobody blamed the board.
Directors are exculpated from duty of care violations, but not loyalty or bad faith.
Caremark looks like the third example of bad faith discussed in Disney.
Oversight liability is based on bad faith.
Where directors fail to act in the face of a known duty to act, thereby
demonstrating a conscious disregard for their responsibilities, they breach
their duty of loyalty by failing to discharge that fiduciary obligation in good
faith.
No bad faith here.
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Key Disney passage on bad faith—failure to act in good faith may be shown where
the fiduciary intentionally fails to act in the face of a known duty to act,
demonstrating conscious disregard for duties.
This behavior is fully consistent with the lack of good faith conduct that the
Caremark court held was a necessary condition for director oversight liability.
NO MORE TRIAD of care, loyalty, and good faith. No more good faith. Just care
and loyalty. Just two different kinds of loyalty. Caremark loyalty and traditional
loyalty. So, although they said triad, now they say there isn’t such a thing.
C.
Class Notes
Really understand the facts when you are approaching a fiduciary claim. You then
classify under particular doctrines. Loyalty and care are the big headings, and you try
to pick one. Are we complaining about negligence or self-serving behavior? The
above stuff seems to be like negligence, but also like self-serving behavior.
Caremark becomes a duty of oversight case. The board of directors had an obligation
to oversee the operations of the company in a way that fulfilled a fiduciary duty. Loss
eventuates not from a decision, but from unconsidered inaction. Decision to not act
is more like Van Gorkom, because there is a decision on the line. The judge says that
Caremark is not a loyalty case. Stone v. Ritter turns this into a loyalty case.
Nature of the Caremark claim is that it is more of a care case. People did not do
what they perhaps ought to have done. Judge says that inaction needs to be in bad
faith.
So, if they had a system, you judge them on the system they decided was good.
But, what if you have no system? Only a sustained or systematic failure of the board
to exercise oversight—such as an utter failure to attempt to assure a reasonable
information and reporting system exists—will establish the lack of good faith that is a
necessary condition to liability.
If you attempted to have a system, you’re off the hook.
Problem 8-1: In context of Caremark alone:
Disney: Big deal. Triad of loyalty, care, and good faith. Is bad faith the same as not
acting in good faith?
What is bad faith? Traditionally, illegal, fraudulent, or ultra vires.
Substantive Due Care idea: Decision so egregious that it is a breach of duty. Idea
killed. Doctrine of waste is the only successor.
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Bad faith as irrationality: Irrationality may tend to show that the decision is not made
in good faith.
In Disney Round 2, the plaintiffs come up with idea of “bad faith,” and the court
refused to dismiss.
In Round 3, Chandler comes up with rules of good faith. Consciously and
intentionally disregarded their duties. This is different from Caremark. This is
thinking about it and then deciding not to do something. This is not what Disney
did.
THE NEW CAREMARK: Carmark is oversight liability claims, which is different
from conflict of interest claims. You can breach duty of oversight by utterly failing to
implement any reporting or information system or controls, or consciously failing to
use the system. Imposition of liability requires a showing that directors knew they
were not discharging their fiduciary obligations. They breach loyalty by failing to
discharge fiduciary obligation in good faith.
Need CONSCIOUS INACTION
D.
Duty of Loyalty for Reals
Conflict of Interest Transactions Generally
Law tolerates conflict-of-interest transactions because their benefits are often high.
Often, only the directors are willing to invest in a corporation. Courts try to weed
out the bad transactions. The key is fair v. unfair.
Majority or Controlling Shareholders: These are fiduciaries who should not cause
the corporation to effect transactions that would uniquely benefit the fiduciary
or that would benefit the fiduciary at the expense of the minority
shareholders.
A majority or controlling shareholder on both sides of a transaction has a
burden of proving the entire fairness of the actions--fairness of procedure to
approve the transaction and the fairness of the price.
What is a controlling shareholder?
Williamson v. Cox Communications, Inc.
A couple of cable companies that controlled company caused it to enter into a
transaction about which the plaintiff is unhappy.
TCI founded At Home. Cox and Comcast bought minority shares of At Home.
AT&T took over TCI. It had to do some bargaining with the cable companies,
giving the cable companies veto power on the board.
Then, AT&T had to essentially buy back complete control. This really benefited the
Cable Companies at the expense of At Home. The Cable Companies made off like
bank robbers.
The process of pushing through the agreement did not involve a lot of
consideration.
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A shareholder is a controlling one if she owns more than 50% of the voting
power or if she exercises control over the business and affairs of the
corporation. Where a controlling shareholder stands on both sides of the
transaction, the transaction will be viewed under the entire fairness standard as
opposed ot the more deferential business judgment standard.
Actual control of the transaction is necessary--not just potential control.
Ability to appoint the directors important.
Powerful customers show that there was some strong influence.
Veto power could be helpful, but would have to show some threat or something like
that resulted in actual control.
These things in isolation don’t work, but they come together with a nexus to really
suggest control.
This is good enough to withstand a motion to dismiss.
Judicial Review: Conflict of interest transactions are not void or voidable if the
material facts are disclosed to the board or shareholders AND either the
disinterested directors or shareholders authorize, approve, or ratify the transaction.
Also, not void or voidable if FAIR. So, procedurally or substantively fair. But
substantive will often trump. Substantive fairness comes from fair price and fair
dealing.
That's Delaware.
Under Model Act, you need board approval, shareholder approval, or fair
transaction.
Wheelabrator, 1995 Del. Chancery
WTI merged in WM, and now shareholders sue.
Plaintiff argues that defendants breached duty to disclose, also loyalty and care This
court thinks that there is no evidence on disclosure. The voting extinguishes duty of
care claim, but not loyalty claim. Summary judgment partially granted.
Majority of disinterested shareholders approved the merger.
The board made statements that made their bargaining skills look good, when in fact
their skills were useless.
As to duty of care, they claim they did not do due diligence on WM.
As to loyalty, they claim the directors were not disinterested.
So, WTI and WM decided that a merger would be nice. WM was a major
shareholder. It's people did not participate in the important votes. Board voted,
shareholders voted. Lawyers said it fair, etc.
Disclosure claim tossed.
The vote extinguishes duty of care. As to loyalty, that is a business judgment
standard because of the vote.
Full disclosure and shareholder vote extinguishes claim that board failed to exercise
due care in negotiating and approving the merger. Van Gorkom involved the court
saying that a failure to make an informed business judgment could be cured by
shareholder approval.
Loyalty: Not sure that shareholder vote can extinguish loyalty claims.
Voidable act is performed in interest of corporation but beyond power of
management and are ratifiable. Void actions are ultra vires, fraudulent, or a waste of
corporate assets.
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But, the law only extinguishes voidable loyalty claims with shareholder ratification in
two instances. 1. Good faith. 2. No informed business judgment.
Ratification decisions that involve duty of loyalty claims are of two kinds:
1. Interested transaction cases between a corporation and directors. Where
shareholders approve, the business judgment rule applies.
2. Cases involving a transaction between the corporation and its controlling
shareholder. The result is to shift burden to plaintiff to prove that the
transaction was not entirely fair once the shareholders approve.
WM did not have a de jure or de facto control, therefore this is a transaction
between WTI and its directors. Business judgment applies.
Class interpretation of Wheelabrator.
RATIFICATION. Director misconduct > evidence > disinterested/independent
director approval? If yes, then business judgment rule and defendants win. (Duty of
Care claims categorically involve disinterested directors.) With a loyalty situation, the
loyalty problem is cleansed because there are disinterested directors. If no
disinterested/independent director approval, did disinterested shareholders approve?
If no, then an entire fairness review. (Both breaches of care and loyalty could result
in fair transaction, and thus no liability.) If yes, then it starts to matter whether this
was a care or loyalty question. Care claims allow defendants to win (Van Gorkam—
failure of Board to reach informed judgment constitutes a voidable rather than void
act, Hence the transaction can be sustained, notwithstanding the infirmity of the
Board’s actions, if its approval by majority vote of the shareholders is found to have
been based on an informed electorate). If it is a loyalty claim, there is further inquiry.
Was it a director or controlling shareholder that was involved as a conflicted party? If
director (effect of shareholder ratifications in cases not involving a controlling
stockholder is to make business judgment the applicable review standard and shift
the burden of proof to the plaintiff stockholder), then business judgment rule and
defendants win. If a controlling shareholder, then disinterested shareholder
ratification shifts the burden of proof on the fairness issue from the controlling
shareholder to the challenging plaintiff. And then an entire fairness review because
even if disinterested shareholders approve, court is still skeptical.
Think of Section 144 of the Delaware business code. Won’t void if there was
disclosure and then the board or shareholders approved. OR, third option, if thing is
fair—but sketchy because courts don’t seem to act that way. Might have to show was
entirely fair anyway even if above ones are okay.
ENTIRE FAIRNESS REVIEW: The concept of fairness has two basic aspects: fair
dealing and fair price. (PROCESS & SUBSTANCE (does not have to be completely
fair, but if combo looks pretty good). The former embraces question of when the
transaction was time, how it was disclosed to the directors, and how the approvals of
the directors and the stockholders were obtained. The latter aspect of fairness relates
to the economic and financial considerations of the proposed merger, including all
relevant factors, assets, market value, earnings, future prospects, and any other
elements that affect the intrinsic or inherent value of the company’s stock.
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Interested director has a conflict. Independent director is disconnected enough.
IX.
LITIGATION TO ENFORCE DIRECTORS'/FIDUCIARY DUTY
A.
Demand Requirement
When directors/officers harm company, company has a claim, but the
directors/officers are not about to sue themselves Courts of equity allowed the
derivative suit.
There is basically two suits involved--the one compelling the corporation to sue, and
the one against the officers of the corporation. Recovery goes to the corporation, but
plaintiffs can collect attorney fees. This makes attorneys the parties in interest. The
court shave made procedural requirements.
1. Plaintiffs must have been shareholders at time of breach of duty
(contemporaneous ownership)
2. Plaintiffs must remain shareholders (standing requirement)
3. Shareholders must demand that the board of directors take action before the
shareholder assumes control of the litigation (demand requirement)
4. Court must approve any settlement once it has begun
In Delaware, standing is common law. The rest are part of the court rules.
Demand requirement is not always mandatory. Futile. Problem is that you have to
claim demand is futile or else the courts will review the board's refusal to do anything
based on the business judgment rule after a demand has been made.
Our view is that in determining demand futility, the Court of Chancery in the proper
exercise of its discretion must decide whether, under the particularized facts alleged,
a reasonable doubt is created that (1) the directors are disinterested and independent
or (2) the challenged transaction was otherwise the product of a valid exercise of a
business judgment.
Easiest way to meet standard is to show that a majority of the current directors were
interested in the challenged transaction.
Proof of majority ownership of company does not strip directors of presumptions of
independent. You must show that they are beholden to the controlling person,
somehow.
The care, attention, and sense of individual responsibility of performance controls,
not the method of election.
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Delaware has loosened demand futility somewhat. (Delaware wants there to be law suits so
they can have business.)
The Model Act requires demand in every instance, and allows shareholder action after 90 days.
Beam ex rel Martha Stewart Living v. Stewart, Del. 2004
We affirm dismissal under the demand futility requirement.
Stockholder may not pursue a derivative suit to assert a claim of the corporation
unless (a) she has first demanded that the directors pursue the coporate claim and
they have wrongfully refused to do so or (b) such demand is excused because the
directors are deemed incapable of making an impartial decision regarding the pursuit
of the litigation.
The issue in this case is the quantum of doubt about a director's independence that is
reasonable in order to excuse a pre-suit demand.
There is a presumption that directors were faithful to their fiduciary duties.
Burden is upon the plaintiff in a derivative action to overcome that presumption. At
pleading stage, plaintiff must allege particularized facts that create a reasonable doubt
that majority of board acted independently.
A director is unable to act objectively if he or she is interested in outcome of
litigation or is otherwise not independent. Personal benefits or detriments to
directors as result of decision are good showings.
Basically, is the director deciding based on corporate merits or is something outside
affecting judgment.
Independent---independent from whom and independent for what purpose?
Need to achieve a balance between deterring costly suits and allow stockholders to
sue when they can articulate facts showing reasonable doubt that majority of board is
independent or that underlying transaction is protected by the business judgment
rule.
Friendship must be bias-producing nature.
Attending same weddings, in same social circles not enough.
As for the guy who called another board to prevent publication of a bad biography,
that could have been helping the company, too. And that isn't a lot anyway.
Special Litigation Committees on the Board must prove that they are above
reproach.
B.
Direct Versus Derivative Claims
Tooley v. Donaldson, Lufkin, & Jenrette, Inc., Del. 2004
Whether it is derivative or direct depends on these things: 1. Who suffered the
alleged harm, 2. Who would receive benefit of any recovery or other remedy?
Special injury.
C.
Class Notes
Director Misconduct > Allegations > Derivative or Direct claim?
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If direct: Class certification.
Derivative: > Demand Requirement: Has there been a demand? (Demand
requirement acknowledges that the board should be solving the problem.) Must
bring a demand unless it would be futile.
If Demand is honored, then of course the case is missed. If the demand is not
honored, the business judgment rule goes into effect and the defendants win! By
making demand, shareholder tacitly acknowledges the board’s independence.
Demand? No. Is the Demand futile? To prove futile, establish reasonable doubt that
directors are disinterested and independent OR transaction was a valid exercise of
business judgment. If not futile, you have to go make a demand. If demand is futile,
then demand is excused and the plaintiff wins the motion to dismiss.
Independence? Is director’s judgment based on merits of the decision or something
outside merits of the decision.
X.
Special Litigation Committees
Where a demand is properly excused, the company will still want to take control and will
appoint a Special Litigation Committee and then delegating power to the committee to
determine if it is in company’s best interest to pursue the litigation. (It might be necessary to
add directors to get enough disinterested people.) Unsurprisingly, these committees usually
are against litigation.
Business judgment rule is not the appropriate rule to review these actions. We want
companies to get rid of frivolous actions, but we want them subject to good actions.
Zapata: Board should prove independence, good faith, and reasonable investigation with
reasonable bases for conclusions. Court then should apply own independent business
judgment to make sure that nothing is sneaking by the first prong.
Other courts are less suspicious—they look for reasoned and principled decisions.
In re Oracle Corp, Derivative Litigation, Del. Chanc. 2003: SLC must convince me that
nothing calls into doubt its independence. For any substantial reason, is a director incapable
of making a decision with only the best interests of corporation in mind The SLC is
“investigating” fellow Stanford professors/mentors/colleagues and Stanford donors. There’s
no way they can be totally independent. The test of independence is any substantial reason
kills it, it is very contextual.
A.
Class Notes
Derivative or Direct? Distinction turns solely on following questions—who suffered
alleged harm? Who would receive benefit of any recovery?
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Discredited Test #1—Does injury fall equally upon all stockholders? Could be
corporation harmed everybody equally or could be that derivative harm was equally
spread as would be expected.
#2: Special Injury: Separate and distinct from other shareholders. Special injury is a
good indicator, but it could be that certain actions affect shareholders differently.
Demand? No. Futile? Yes, go ahead. Not futile, stop. Demand? Yes. Honored
demand? Yes. Then stop. Not honored, BJR.
Question of Independence is not a question of domination or control. It is a
question of bias. Impartiality and objectivity.
XI.
Statutory Exculpation from Liability
Directors may be insulated from violations of duty of care, but not breaches of duty of
loyalty. Breach of duty of good faith may not be exculpated.
A.
Class Notes
In the case, the judge emphasizes consciously being indifferent to problems. This is
really hard to prove. Caremark and then the later interpretation of Caremark are
successively harder to prove.
Why limit officer and director liability? Protect against baseless litigation, encourage
risk-taking by board, protect central decision-making by the board. Risk is it might
encourage harmful behavior. So, they do not limit exposure for bad actors.
102.b.7 came after Van Gorkom, allowing exculpation.
No exculpation for breach of loyalty, actions or omissions in bad faith, misconduct
intentional, knowing violation of law, unlawful payment of dividends, any improper
personal benefit transaction
Emerald Partners: A 102.b.7 is an affirmative defense. You say this is a duty of care
claim, and it is exculpated. Just because plaintiff calls it good faith or loyalty doesn’t
make it that.
Malpiede—if you’re left with duty of care and nothing else, as a matter of law,
102.b.7 bars the claim.
So, the preceding paragraphs are pre-trial—motions to dismiss and whatnot.
Trial > Evidence > Business Judgment Rule (got to find a way to move the court off
of that rule) > Rebut the presumption? If not, no damages. Can show breach of
loyalty, good faith and maybe care to overcome business judgment. If you can rebut
the presumption, even with a duty of care that will be dismissed, the court will move
onto a question of entire fairness. If it is fair, then the defendants win. If it was not
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fair, then what is the ration decindi—the reason of the unfairness? If it was a lack of
care, then no damages because of exculpatory provision. If it was loyalty, then you
get damages.
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