Corporations Outline
Professor F. Scott Kieff – Spring 2012
OVERVIEW & THEORY
[To be addressed later.]
AGENCY
Who Is an Agent?
1. Agency law is a foundation for partnership law, which is the backdrop for corporate law, which is
the backdrop for LLC law.
2. Gorton v. Doty
a. Facts – Gorton was injured in an automobile accident after Doty loaned her vehicle to
Garst to transport Gorton and others to a football game. Doty required that Garst drive
her car.
b. Agency Law – Triangle: principal, agent, and third party.
i. Agent – Football coach (Garst).
ii. Principal – Doty.
iii. Third Party – Gorton.
c. Agency
i. Relation which exists where one person acts for another.
ii. Test – Relationship which results from the manifestation of consent by one
person to another that the other shall act on his behalf and subject to his control,
and consent by the other so to act. Rest. (2d) of Agency § 1(1).
1. Principal must be able to exercise control over agent. (Doty required
Garst to drive.)
2. Agent must consent to act as an agent for principal, and vice versa.
a. Agent need not communicate consent to principal.
3. Manifestation of consent; actual underlying consent is not at issue.
4. Principal must benefit in some way. (Doty is excited about football
game.)
a. Agency relationship can be gratuitous; agent does not benefit.
E.g., returning a friend’s library books.
5. Not based on how parties describe relationship, but on actual
circumstances.
6.  Avoiding Agency Relationship
a. Do not leave instructions for purported agent, i.e., do not require
Garst to drive the car. Shows no control over agent.
iii. Three Forms
1. Principal and agent.
a. Where one undertakes to transact some business or manage some
affair for another by authority and on account of the latter.
b. NOT REQUIRED
i. Contract.
ii. Agent promises to act as such.
iii. Either receives compensation.
2. Master and servant.
3. Employer or proprietor and independent contractor.
d. Public Policy Rationale – Garst was dead, and Doty had insurance. Owner of car is best
able to insure against these sorts of losses. Imposing liability on car owners creates
incentive for owners to insure.
3. A. Gay Jenson Farms Co. v. Cargill, Inc.
a. Facts – Plaintiffs entered into grain contracts with Warren Grain & Seed Co., which was
financed and controlled by Cargill, Inc., a separate entity.
b. Creating Agency Relationship
i. Requires agreement, but not necessarily a contract.
ii. Parties need not describe relationship as agency or intend legal consequences of
agency relationship to follow.
iii. May be proved by circumstantial evidence showing course of dealing.
1. If proved by circumstantial evidence  principal must be shown to have
consented to the agency since one cannot be the agent of another except
by consent of the latter.
c. Creditor/Debtor
i. A creditor who assumes de facto control of his debtor’s business may become
liable as principal for the acts of the debtor in connection with the business,
regardless of the terms of their formal contract.
1. Level of control signifies agency relationship.
ii. “A security holder who merely exercises a veto power over the business acts of
his debtor by preventing purchases or sales above specified amounts does not
thereby become a principal. However, if he takes over the management of the
debtor’s business either in person or through an agent, and directs what contracts
may or may not be made, he becomes a principal, liable as a principal for the
obligations incurred thereafter in the normal course of business by the debtor
who has now become his general agent. The point at which the creditor becomes
a principal is that at which he assumes de facto control over the conduct of his
debtor, whatever the terms of the formal contract with his debtor may be.” Rest.
(2d) of Agency § 14 O.
iii.  Factors showing Cargill’s control over Warren:
1. Cargill’s constant recommendations to Warren by telephone;
2. Cargill’s right of first refusal on grain;
3. Warren’s inability to enter into mortgages, to purchase stock or to pay
dividends without Cargill’s approval;
4. Cargill’s right of entry onto Warren’s premises to carry on periodic
checks and audits;
5. Cargill’s correspondence and criticism regarding Warren’s finances,
officers salaries and inventory;
6. Cargill’s determination that Warren needed “strong paternal guidance”;
7. Provision of drafts and forms to Warren upon which Cargill’s name was
imprinted;
8. Financing of all Warren’s purchases of grain and operating expenses; and
9. Cargill’s power to discontinue the financing of Warren’s operations.
iv.  Factors indicate an agency relationship, not a creditor-debtor one.
d. Buyer/Supplier – Rest. (2d) of Agency § 14K, cmt. a.
i. “One who contracts to acquire property from a third person and convey it to
another is the agent of the other only if it is agreed that he is to act primarily for
the benefit of the other and not for himself.”
ii. “Factors indicating that one is a supplier, rather than an agent, are: (1) That he is
to receive a fixed price for the property irrespective of price paid by him. This is
the most important. (2) That he acts in his own name and receives the title to the
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property which he thereafter is to transfer. (3) That he has an independent
business in buying and selling similar property.”
iii. “Under this approach, it must be shown that the supplier has an independent
business before it can be concluded that he is not an agent.”
1. “Factors” – Usually means that no one is necessary, but court holds that
an independent business is.
iv.  Warren had no independence, and so Cargill was not a buyer.
Liability of Principal to Third Parties in Contract
1. Agent’s Authority
a. Mill Street Church of Christ v. Hogan
i. Facts – Hogan was injured after he was hired by a church employee to paint the
inside of a church. Court held that Bill had implied authority to hire Sam
because the job required two men and the Church had allowed Bill to hire Sam in
the past.
ii. Types of Authority
1. Actual
a. Actual Express
b. Actual Implied
2. Apparent
3. Inherent
4.  Close to authority, but not quite:
a. Estoppel
b. Ratification
iii. Implied Authority – Actual authority circumstantially proven which the
principal actually intended the agent to possess and includes such powers as are
practically necessary to carry out the duties actually delegated.
1. Proving Implied Authority – Focus on agent’s understanding of her
authority.
a.  PREREQUISITE OF ACTUAL AUTHORITY.
b. Whether the agent reasonably believes because of present or past
conduct of the principal that the principal wishes him to act in a
certain way or to have certain authority?
c. Nature of task or job?
d. May be necessary in order to implement express authority.
e. Existence of prior similar practices?
f. Specific conduct by the principal in the past permitting the agent
to exercise similar powers?
2. Three-Step Process
a. Look to nature of the task.
b. Agent has the power or authority to do what is reasonably
necessary to accomplish the goal she has been assigned.
c. Determine what is reasonably necessary by looking to the
context, i.e., how this objective or similar objectives have been
accomplished in the past.
iv. Apparent Authority – Not actual authority but is the authority the agent is held
out by the principal as possessing. A matter of appearances on which third
parties come to rely.
v. Burden of Proof – Person alleging agency and resulting authority.
1. Mere description of relationship is insufficient.
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2. Circumstantial evidence showing course of dealing is sufficient.
vi. Belief of the third party is not relevant unless she knows or has knowledge or
reason to believe that the agent does not have the relevant authority.
b. Dweck v. Nasser
i. Facts – After engaging in a lengthy dispute with the plaintiff, the defendant
suggested to an attorney friend that he just wanted him to settle the matter, but
when the attorney accomplished that task, the defendant refused to be bound by
the terms of the settlement agreement.
1. Principal – Nasser
2. Agent – Shiboleth
3. Nasser’s Attorney of Record – Heyman
ii. An attorney of record in a pending action who agrees to the settlement of a case
is presumed to have lawful authority to make such an agreement.
1. Employment relationship alone does not give attorney authority to settle
a case on behalf of client. Client retains control.
iii. Three Sources of Agency Relationship
1. Actual Authority – Expressly granted authority either orally or in
writing.
2. Implied Authority – Derivation of actual authority and often means
“actual authority either (1) to do what is necessary, usual, and proper to
accomplish or perform an agent’s express responsibilities or (2) to act in
a manner in which an agent believes the principal wishes the agent to act
based on the agent’s reasonable interpretation of the principal’s
manifestation in light of the principal’s objectives and other facts known
to the agent.”
a. Authority that agent reasonably believes he has as a result of the
principal’s actions.
b. May be proved by evidence of acquiescence of principal with
knowledge of the agent’s acts, and such knowledge and
acquiescence may be shown by evidence of the agent’s course of
dealing for so long a period of time that acquiescence may be
assumed.
3. Apparent Authority – “Such power as a principal holds his agent out as
possessing or permits him to exercise under such circumstances as to
preclude a denial of its existence.”
a. When the principal permits the agent to do something that would
allow the principal to be seen as holding the agent out as his
agent, then the agent has apparent authority.
b. Depends on the perceptions of third parties.
c. Rest. (3d) of Agency § 2.03 – “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.”
iv. Shiboleth had actual and implied authority.
1. Actual Authority
a. Nasser said, “Do what you want;” “You can talk in my name;”
etc. These are powerful grants of broad, actual authority.
Important touchstones.
2. Implied Authority
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a. Context suggests implied authority. Look at the history of the
relationship between Nasser and Shiboleth.
3. Apparent Authority
a. Nasser said to the other parties that he would not read the
settlement agreement and that he would sign it if Shiboleth
recommended it.
c. Three-Seventy Leasing Corporation v. Ampex Corporation
i. Three-Seventy Leasing Corp. executed a document provided by an Ampex Corp.
representative for the purchase of computer leasing equipment, but Ampex never
executed the document. Court held that Ampex representative had apparent
authority.
ii. Apparent Authority
1. Generally, Two Steps
a. Principal must hold out agent as possessing authority.
b. Third party must reasonably believe agent has authority.
2. “An agent has apparent authority sufficient to bind the principal when
the principal acts in such a manner as would lead a reasonably prudent
person to suppose that the agent had the authority he purports to exercise.
Absent knowledge on the part of third parties to the contrary, an agent
has the apparent authority to do those things which are usual and proper
to the conduct of the business which he is employed to conduct.”
a. What must be apparent? A: An agency-type action manifested
by a principal.
3. “Absent knowledge of a limitation of authority by third parties, i.e., an
agent’s principal, that limitation will not bar a claim of apparent
authority.”
4. May be shown by course of dealing or custom, e.g., treasurer carries
certain recognized duties.
5.  Two Factors Showing Apparent Authority
a. Kays, Ampex representative, was employed by Ampex as a
salesman.
b. Joyce, lessor of computer equipment, indicated to Kays and
Mueller, Kays’ principal, that he wished all communications to
be channeled through Kays.
6.  Court focuses a lot on what the agent does that looks like an agent,
but it does not focus very much on what the principal does. It should
have focused more on Ampex’s actions in holding Kays out as an agent.
iii. Eliminating Apparent Authority – To communicate to third parties that
someone is no longer your agent, put out a press release saying, “X is no longer
our agent.” (Think about law firms issuing press releases congratulating former
partners on moving onto another position.)
iv. Implied Authority
1. Look at the fact that Kays is an employee of Ampex and then look at
what is within the scope of Kays’ employment.
2. What a third party believes is not as important here unless the third party
has knowledge that the agent has no authority.
d. Watteau v. Fenwick
i. Facts – Humble, prior owner, operated Fenwick’s tavern under Humble’s name
and credit and purchased foods from Watteau without Fenwick’s express
authority. Fenwick prohibited Humble from buying goods for the tavern, except
bottled ales and mineral water; Watteau was to provide all other goods. Humble
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violated Fenwick’s prohibition by buying cigars and Bovril from Watteau. When
Humble was in absentia, Watteau sued Fenwick for the cost of the cigars and
Bovril.
ii. Actual Authority – None because Fenwick (principal) gave Humble (agent)
specific instructions not to buy anything except bottled ales and mineral water.
iii. Apparent Authority – None because there was no holding out by the principal
(Fenwick). Watteau did not know that Fenwick existed.
iv. Inherent Authority – Humble had apparent authority. Fenwick is liable.
1. Inherent Agency Power – “Inherent agency power is a term used in the
restatement of this subject to indicate the power of an agent which is
derived not from authority, apparent authority or estoppel, but solely
from the agency relation and exists for the protection of persons harmed
by or dealing with a servant or other agent.” Rest. (2d) of Agency § 8A.
a. Gap filler.
b. Places the loss on the enterprise that stands to benefit from the
agency relationship.
c. Rule – If agent commits an unauthorized action, and there is no
actual, implied, or apparent authority, principal still may be
liable for the loss based on the notion of inherent authority.
2. Undisclosed Principal
a. Third party is bound despite not knowing about principal. Focus
is on whether an agency relationship/authority existed between
principal and agent. If so, third party is bound.
i. Exception – Third party may not be bound if agent
made a misrepresentation.
b. “A general agent for an undisclosed principal authorized to
conduct transactions subjects his principal to liability for acts
done on his account, if usual or necessary in such transactions,
although forbidden by the principal to do them.” Rest. (2d) of
Agency § 194.
c. “An undisclosed principal who entrusts an agent with the
management of his business is subject to liability to third persons
with whom the agent enters into transactions usual in such
businesses and on the principal’s account, although contrary to
the directions of the principal.” Rest. (2d) of Agency § 195.
3. Narrower Rule in Third Restatement
a. § 2.06 – Liability of Undisclosed Principal
i. “(1) An undisclosed principal is subject to liability to a
third party who is justifiably induced to make a
detrimental change in position by an agent acting on the
principal’s behalf and without actual authority if the
principal, having notice of the agent’s conduct and that
it might induce others to change their positions, did not
take reasonable steps to notify them of the facts.”
(emphasis added)
ii. “(2) An undisclosed principal may not rely on
instructions given an agent that qualify or reduce the
agent’s authority to less than the authority a third party
would reasonably believe the agent to have under the
same circumstances if the principal had been disclosed.”
b. More akin to estoppel than old inherent agency power.
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v. Apparent Authority v. Inherent Authority
1. (Partially) disclosed principal  requisite manifestation by principal
creates apparent authority.
2. Undisclosed principal  no communication or manifestation of
authority between principal and third party  inherent authority.
vi. Policy Rationale – Undisclosed principal is cheapest cost avoider/in best position
to avoid loss. Cheaper for undisclosed principals to take precautions than to
require all innocent third parties to do so.
2. Ratification
a. Botticello v. Stefanovicz
i. Facts – Botticello agreed with Walter Stefanovicz to lease property that he owned
as tenants in common with his wife, and the lease contained an option to
purchase. Botticello thinks he has bought a rent-to-own lease, but this is only the
case if Stefanovicz had authority to act as an agent for his wife and convey her
interest in the property. Court held that the wife did not ratify the agreement and
that Walter alone was liable.
ii. Elements of Agency Relationship – Rest. (2d) of Agency § 1.
1. A manifestation by the principal that the agent will act for him.
2. Acceptance by the agent of the undertaking.
3. An understanding between the parties that the principal will be in control
of the undertaking.
iii. Burden of Proof – Plaintiff; preponderance of the evidence.
1. Neither marital status nor common ownership of land is sufficient in and
of itself.
iv. Ratification – Affirmance by a person of a prior act which did not bind him but
which was done or professedly done on his account. Requires acceptance of the
results of the act with (1) an intent to ratify and (2) full knowledge of all the
material circumstances.
1. Somewhat of an equitable doctrine.
2. “Before the receipt of benefits may constitute ratification, the other
requisites for ratification must first be present. Thus if the original
transaction was not purported to be done on account of the principal, the
fact that the principal receives its proceeds does not make him a party to
it.”
3. Existence of an agency relationship is a prerequisite to ratification.
(Prior act must be “done or professedly done on his account.”)
4. Requires more than passive acquiescence.
5.  Wife did not convey her knowing acceptance of all of the terms of the
agreement.
6.  By the time of ratification, we must know (1) that the wife has full
knowledge of the terms of the agreement and (2) that her behavior is
uniquely responsive to her acceptance of the agreement, i.e., her behavior
cannot be explained in another way.
3. Estoppel
a. Hoddeson v. Koos Bros.
i. Facts – Hoddeson paid money for the purchase of furniture to an imposter
salesperson in Koos Bros. furniture store.
ii. Burden of Proof – Party seeking to impose liability must prove existence of
agency relationship. “It is not the burden of the alleged principal to disprove it.”
iii. Three Kinds of Agency Relationships
1. Express or real authority which has been definitely granted.
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2. Implied authority, that is, to do all that is proper, customarily incidental
and reasonably appropriate to the exercise of the authority granted.
3. Apparent authority, such as where the principal by words, conduct, or
other indicative manifestations has held out the person to be his agent.
a. “The apparency and appearance of authority must be shown to
have been created by the manifestations of the alleged principal,
and not alone and solely by proof of those of the supposed
agent.”
b.  No apparent authority because Koos’ failure to police its sales
floor does not constitute the requisite manifestation.
iv. Estoppel/Proprietor’s (Principal’s) Duty to Customer
1. Equitable doctrine. Binds defendant, but not plaintiff.
2. Definition – Some behavior (act or omission) that creates an appearance
or some reason to think that there is authority, but it must have been
reasonable for the third party to rely (to its detriment) on the appearance.
3. Duty – Proprietor must exercise reasonable care and vigilance to protect
customer from loss occasioned by the deceptions of an apparent
salesman.
a. Focuses on proprietor’s failure to take reasonable steps.
4. ESTOPPEL – When proprietor breaches its duty, it cannot claim the
defense of lack of an agency relationship.
a. Requires a change in position by the third party. (Hoddeson paid
money for the furniture, which the imposter stole.)
i. Without this change, only apparent authority is available
if there is the requisite manifestation.
5. Rest. (3d) of Agency § 2.05 – “A person who has not made a
manifestation that an actor has authority as an agent and who is not
otherwise liable as a party to a transaction purportedly done by the actor
on that person’s account is subject to liability to a third party who
justifiably is induced to make a detrimental change in position because
the transaction is believed to be on the person’s account, if
a. (1) the person intentionally or carelessly caused such belief, or
b. (2) having notice of such belief and that it might induce others to
change their positions, the person did not take reasonable steps
to notify them of the facts.
4. Agent’s Liability on the Contract
a. Atlantic Salmon A/S v. Curran
i. Facts – Curran purchased imported salmon from the plaintiffs, and the plaintiffs
sought to recover unpaid money from Curran individually.
ii. “If the other party has notice that the agent is or may be acting for a principal but
has no notice of the principal’s identity, the principal for whom the agent is
acting is a partially disclosed principal. . . . Unless otherwise agreed, a person
purporting to make a contract with another for a partially disclosed principal is a
party to the contract.” Rest. (2d) of Agency § 4(2).
iii. Agent Avoiding Personal Liability – “It is the duty of the agent, if he would
avoid personal liability on a contract entered into by him on behalf of his
principal, to disclose not only that he is acting in a representative capacity, but
also the identity of his principal.”
1. Not plaintiff’s duty to seek out identity of principal.
2. Agent has an obligation fully to reveal identity of principal.
a. Must provide plaintiff with actual knowledge or equivalent.
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b. No hardship to agent because it is easy to disclose identity of
principal.
c. No disclosure  presumption that agent intended to make
himself personally responsible.
iv. Disclosed Principal – Agent usually is not liable if there is a disclosed principal
unless the contract clearly states that the agent will be liable instead of or in
addition to the principal.
1. Presumption that intent was to bind principal only.
v. Partially or Undisclosed Principal  Principal and agent are liable. Agent is
liable as though he were a party to the contract. Third party may sue either, but
not both.
vi. Agent lacks authority and principal refuses to ratify./No actual agency
relationship and agent is fraudulently holding himself out.  Agent may be
personally liable.
1. Breach of contract.
2. Tort of deceit.
3. Breach of implied warranty of authority.
Liability of Principal to Third Parties in Tort
1. Servants & Independent Contractors
a. Generally
i. Types of Relationships
1. Master-Servant – High level of control. Principal is liable if agent acts
with authority or within the scope of its employment.
2. Master-Non-Servant Agent – Principal probably is not liable, except
for some special cases.
3. Master-Independent Contractor – Much less control. Principal is not
liable under agency law.
ii. Respondeat Superior – Master (employer) is liable for the torts of its servants
(employees).
iii. Master – “Principal who employs an agent to perform service in his affairs and
who controls or has the right to control the physical conduct of the other in the
performance of the service.” Rest (2d) of Agency § 2(1).
iv. Servant – “Agent employed by a master to perform service in his affairs whose
physical conduct in the performance of the service is controlled or is subject to
the right to control by the master.” Rest (2d) of Agency § 2(2).
v. Independent Contractor – “Person who contracts with another to do something
for him but who is not controlled by the other nor subject to the other’s right to
control with respect to his physical conduct in the performance of the
undertaking. He may or may not be an agent.” Rest (2d) of Agency § 2(3).
1. Agent – Agrees to act on behalf of another (principal) but not subject to
the principal’s control over how the result is accomplished.
2. Non-Agent – Operates independently; enters into arm’s length
transactions with others.
b. Humble Oil & Refining Co. v. Martin
i. Facts – Martin was injured by a vehicle that rolled away from the service station
owned by Humble Oil & Refining Co. but operated by another person
(Schneider) under contract.
ii. Schneider was Humble Oil’s servant. (Closely controlled by master.)
1. Schneider’s rent was based partly on sale of Humble products.
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2. Humble pays most of the utility bills.
3. Humble may require written reports from Schneider.
4. Humble sets hours of operation.
5. Humble could terminate Schneider’s contract at will.
6.  Schneider’s only power: hiring and firing employees.
c. Hoover v. Sun Oil Company
i. Facts – Hoover was injured when his car caught fire while a service station
employee was fueling it.
ii. Service station operator (Barone) was an independent contractor.
1. Sun Oil exerted similar oversight as Humble Oil.
2. Key Difference – Financial Arrangements
a. Barone’s rent was based partly on volume of gasoline sold, but
there was a minimum and maximum. Barone bore the overall
risks of profit and loss.
b. It is plausible that the party bearing the ultimate risk of financial
loss will insist on and possess control.
d. Murphy v. Holiday Inns, Inc.
i. Facts – Murphy slipped and fell in a motel owned and operated by a franchisee
under a license agreement.
ii. If the facts establish an agency relationship, parties cannot disclaim it by formal
consent.
1. Express language of the contract is relevant, but not dispositive.
iii. Control Test – In determining whether a contract establishes an agency
relationship, the critical test is the nature and extent of the control agreed upon.
iv. Franchise Contracts
1. May constitute agency relationships.
2. “If a franchise contract so ‘regulates the activities of the franchisee’ as to
vest the franchisor with control within the definition of agency, the
agency relationship arises even though the parties expressly deny it.”
3.  Look for consent. No agency relationship without consent.
e. Vandemark v. McDonald’s Corp.
i. Instrumentality Test – Franchisor can be vicariously liable for torts of
franchisee only if franchisor had control over the alleged instrumentality that
caused the harm.
1. “The weight of authority construes franchiser liability narrowly, finding
that absent a showing of control over security measures employed by the
franchisee, the franchiser cannot be vicariously liable for the security
breach.”
f. Rest. (2d) of Agency § 220(2) – In determining whether one acting for another is a
servant or an independent contractor, the following matters of fact, among others, are
considered:
i. (a) the extent of control which, by the agreement, the master may exercise over
the details of the work;
ii. (b) whether or not the one employed is engaged in a distinct occupation or
business;
iii. (c) the kind of occupation, with reference to whether, in the locality, the work is
usually done under the direction of the employer or by a specialist without
supervision;
iv. (d) the skill required in the particular occupation;
v. (e) whether the employer or the workman supplies the instrumentalities, tools,
and the place of work for the person doing the work;
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vi.
vii.
viii.
ix.
(f) the length of time for which the person is employed;
(g) the method of payment, whether by the time or by the job;
(h) whether or not the work is a part of the regular business of the employer;
(i) whether or not the parties believe they are creating the relation of master and
servant; and
x. (j) whether the principal is or is not in business.
2. Tort Liability & Apparent Agency
a. Respondeat Superior – “A master is subject to liability for the torts of his servants
committed while acting in the scope of their employment.” Rest. (2d) of Agency
§ 219(1).
i. Master is not liable for torts of non-servant agents, i.e., independent contractors.
b. Miller v. McDonald’s Corp
i. Facts – Miller was injured when she bit into a sapphire found in her Big Mac and
sued McDonald’s Corp.
ii. Right to Control Test – For principal to be vicariously liable for torts of agent,
principal must have the right to control the method by which the agent performed
its obligations under the agreement.
1. Fact Question
2. “Under the right to control test it does not matter whether the putative
principal actually exercises control; what is important is that it has the
right to do so.”
3. Application in Franchises – “If, in practical effect, the franchise
agreement goes beyond the stage of setting standards, and allocates to the
franchisor the right to exercise control over the daily operations of the
franchise, an agency relationship exists.”
iii. Apparent Agent Liability – “One who represents that another is his servant or
other agent and thereby causes a third person justifiably to rely upon the care or
skill of such apparent agent is subject to liability to the third person for harm
caused by the lack of care or skill of the one appearing to be a servant or other
agent as if he were such.”
1. Fact Question
2. Key Issues – (1) Whether the putative principal held the third party out
as an agent; (2) whether the plaintiff relied on that holding out.
3. Something about the tort must be connected through reliance to
something about the specialized skill or care that is connected with the
apparent agency.
4. Distinction from Apparent Authority – “Apparent agency creates an
agency relationship that does not otherwise exist, while apparent
authority expands the authority of an actual agent.”
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P’s Liability in Torts:
Summary
Traditional
Term
Modern P Controls*
P
A has Power P’s Liability in
Term
Physical
Controls* to Act on P’s
Torts
(Rest. 3rd) Conduct
Results
Behalf
Servant
Employee
P liable if A was
within scope of
employment
Independent
Contractor
(agent-type)
Nonemployee
agent
P not liable
except in
special cases
Independent
Contractor
(non-agent)
Non-agent
service
provider
P not liable
(in agency law)
*
Control in fact or the right to control
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c.
3. Scope of Employment
a. Conduct Within Scope of Employment
i. Generally – “Conduct of a servant is within the scope of employment if, but only
if:
1. (a) it is of the kind he is employed to perform;
2. (b) it occurs substantially within the authorized time and space limits;
3. (c) it is actuated, at least in part, by a purpose to serve the master, and
4. (d) if force is intentionally used by the servant against another, the use of
force is not unexpectable by the master.” Rest. (2d) of Agency § 228(1).
ii. Kinds of Conduct – “To be within the scope of the employment, conduct must
be of the same general nature as that authorized, or incidental to the conduct
authorized.” Rest. (2d) of Agency § 229(1).
iii. Acts Still Within Scope of Employment
1. Forbidden or done in a forbidden manner. Rest. (2d) of Agency § 230.
2. Consciously criminal or tortious. Rest. (2d) of Agency § 231.
a. Excludes “serious crimes.”
b. Ira S. Bushey & Sons, Inc. v. United States
i. Facts – A drunken sailor employed by the U.S. Coast Guard caused damage to
the plaintiff’s dry dock while returning to the ship from leave.
ii. Rule – If some harm is foreseeable, then the principal will be liable for the
tortious act of the agent, regardless of the type of harm, if it is within the scope of
the agent’s employment. (Kieff)
1. Virtually per se rule of strict liability for torts of employee as long as any
connection in time and space may be made between the conduct and
employment.
a. Need not show that agent was motivated by purpose to serve
master.
2. Foreseeability Rule
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5
a. If some harm is foreseeable, principal is liable, even if the
particular type of harm was unforeseeable.
b. Conduct by servant that does not create risks different from those
attendant on the activities of the community in general will not
give rise to liability.
c. Conduct must relate to employment.
iii. Rationale
1. Rejected economic and deterrence rationales. Principal cannot
internalize negative externalities (costs) of or prevent agent’s
unforeseeable actions.
2. Grounded in fairness, i.e., principal should not be able to disclaim
responsibility, which is related to foreseeability standard.
c. Manning v. Grimsley
i. Facts – Grimsley threw a baseball at Manning in response to Manning’s heckling
at a baseball game.
ii. Question – Is an intentional tort ever within the scope of employment? (No one
hires someone to commit intentional torts.)
iii. Miller Rule – “Where a plaintiff seeks to recover damages from an employer for
injuries resulting from an employee’s assault what must be shown is that the
employee’s assault was in response to the plaintiff’s conduct which was presently
interfering with the employee’s ability to perform his duties successfully.”
1. Use of force must be expectable by the master. See Rest. (2d) of Agency
§ 228(1)(d) (above).
2. Court found that Heckling could have rattled Grimsley so much that he
could not pitch effectively, i.e., presently interfered with his ability to
perform his duties successfully.
3. Rest. (2d) of Agency § 219(1) – “A master is subject to liability for the
torts of his servants committed while acting in the scope of their
employment.”
4. Statutory Claims
a. Arguello v. Conoco, Inc.
i. Facts – Several Hispanic plaintiffs were treated improperly in stores owned or
branded by Conoco, Inc.
ii. Agency Relationship (Conoco-Branded Stores) – “In order to impose liability on
a defendant under 42 U.S.C. § 1981 for the discriminatory actions of a third
party, the plaintiff must demonstrate that there is an agency relationship between
the defendant and the third party.”
1. “To establish an agency relationship between Conoco, Inc. and the
branded stores the plaintiffs must show that Conoco, Inc. has given
consent for the branded stores to act on its behalf and that the branded
stores are subject to the control of Conoco, Inc.”
iii. Scope of Employment (Conoco-Owned Stores) – “Under general agency
principles, a master is subject to liability for the torts of his servants while acting
in the scope of their employment. Some of the factors used when considering
whether an employee’s acts are within the scope of employment are:
1. The time, place and purpose of the act;
2. Its similarity to acts which the servant is authorized to perform;
3. Whether the act is commonly performed by servants;
4. The extent of departure from normal methods; and
5. Whether the master would reasonably expect such act would be
performed.”
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iv. “Although Conoco could not have expected Smith to shout racial epithets at
Arguello and Govea, Smith’s actions took place while she was performing her
normal duties as a clerk.”
5. Liability for Torts of Independent Contractors
a. Majestic Realty Associates, Inc. v. Toti Contracting Co.
i. Facts – Majestic Realty Associates, Inc. suffered property damage to its building
caused by the negligent demolition of an adjacent building.
ii. General Rule –“Ordinarily where a person engages a contractor, who conducts
an independent business by means of his own employees, to do work not in itself
a nuisance (as our cases put it), he is not liable for the negligent acts of the
contractor in the performance of the contract.” (Master is not liable for torts of
independent contractor.)
1. Three Exceptions
a. Where the landowner retains control of the manner and means of
the doing of the work which is the subject of the contract;
b. Where he engages an incompetent contractor; or
c. Where, as noted in the statement of the general rule, the activity
contracted for constitutes a nuisance per se.
i. Includes inherently dangerous activities (activities which
can be carried on safely only by the exercise of special
skill and care and which involve grave risk of danger to
persons or property if negligently done).
1. Razing of buildings in a busy, built-up section of
a city.
ii. Does not include ultra-hazardous activities.
iii. Ultra-Hazardous Activity – Activity which (a) necessarily involves a serious
risk of harm to the person, land or chattels of others which cannot be eliminated
by the exercise of the utmost care, and (b) is not a matter of common usage.
1. Absolute liability.
2. Distinct from inherently dangerous activities.
Fiduciary Obligations of Agents
1. Duties During Agency
a. Generally
i. “An agent is a fiduciary with respect to matters within the scope of his agency.”
Rest. (2d) of Agency § 13.
ii. Duty of Care – Rest. (2d) of Agency § 379.
1. “(1) Unless otherwise agreed, a paid agent is subject to a duty to the
principal to act with standard care and with the skill which is standard in
the locality for the kind of work which he is employed to perform and, in
addition, to exercise any special skill that he has.”
2. “(2) Unless otherwise agreed, a gratuitous agent is under a duty to the
principal to act with the care and skill which is required of persons not
agents performing similar gratuitous undertakings for others.”
3.  Related Duties
a. Duty of good conduct [Rest. §380]
b. Duty to give information [Rest. §381]
c. Duty to keep and render accounts [Rest. §382]
d. Duty to act only as authorized [Rest. §383]
e. Duty not to attempt the impossible or impracticable [Rest. §384]
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f. Duty to obey [Rest. §385]
g. Duty not to act as agent after termination of agency relationship
[Rest. §386]
iii. Duty of Loyalty – Violated in the following situations:
1. Payment from transactions (e.g., kickbacks, bribes, tips). Rest. (2d) of
Agency § 388.
2. Secret Profits
a. From transacting with principal without principal’s knowledge
(e.g., real estate agent secretly buying house without informing
seller) Rest. (2d) of Agency § 389.
b. From use of position involving third party. Reading.
3. Usurping business opportunities from principal. Singer.
4. “Grabbing & Leaving.” Town & Country.
b. Reading v. Regem
i. Facts – Reading obtained payment for accompanying unlawful contraband past
civilian police checkpoints while employed by the British army.
ii. Duty of loyalty case.
iii. Rule – Servant unjustly enriches himself solely by virtue of his service without
his master’s approval  must turn over all profits to master.
1. Servant’s service creates opportunities for profit outside of his service 
may keep profits.
iv. Rest. (3d) of Agency § 8.02 – “An agent has a duty not to acquire a material
benefit from a third party in connection with transactions conducted or other
actions taken on behalf of the principal or otherwise through the agent’s use of
the agent’s position.”
v. Rest. (3d) of Agency § 8.05 – “An agent has a duty (1) not to use property of the
principal for the agent’s own purposes or those of a third party. . . .”
c. General Automotive Manufacturing Co. v. Singer
i. Facts – Singer, while employed by General Automotive Manufacturing Co.,
secretly concealed profits earned by accepting personal orders from plaintiff’s
customers. Concerns usurpation of business opportunities.
ii. Singer had a duty to “exercise good faith by disclosing to Automotive all the
facts regarding this matter.”
1. Failure to disclose transactions  liability.
2. Because Singer (agent) had a duty to obey Automotive’s (principal)
instructions, he needed its informed consent.
2. Duties During & After Termination of Agency: Herein of “GRABBING AND LEAVING”
a. Generally
i. Rest. (2d) of Agency § 386 – “Unless otherwise agreed, an agent is subject to a
duty not to act as such after the termination of his authority.”
ii. Rest. (2d) of Agency § 396 – Limitations on A’s use of confidential information
after termination of agency. Among limitations: prohibition on using, in
competition with the principal or to his injury, confidential information given to
A only for the principal’s use or acquired by the agent in violation of duty. But
agent is allowed to use general information concerning the method of business of
the principal and the names of the customers retained in his memory, if not
acquired in violation of duty.
b. Town & Country House & Home Service, Inc. v. Newberry
i. Facts – Newberry and other defendants established a competing housekeeping
business using methods and techniques similar to those plaintiff had developed.
Town & Country expended much effort building up a list of customers, which the
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court held to be a trade secret. Defendants solicited the same customers after
resigning from Town & Country and starting a competing business.
ii. Rule – “Even where a solicitor of business does not operate fraudulently under
the banner of his former employer, he still may not solicit the latter’s customers
who are not openly engaged in business in advertised locations or whose
availability as patrons cannot readily be ascertained but whose trade and
patronage have been secured by years of business effort and advertising, and the
expenditure of time and money, constituting a part of the good-will of a business
which enterprise and foresight have built up.”
1. Decisive Factor – Client list could not have been obtained by looking up
names in a phone book or by going to an advertised location. Client list
took years of hard work to compile.
PARTNERSHIP
Formation & Fiduciary Obligations
What Is a Partnership? And Who Are the Partners?
1. Partners Compared with Employers
a. Types of Business Associations
i. Partnerships
1. General
2. Limited
3. Limited Liability
4. Limited Liability Limited
ii. Corporations
1. Closely Held (or Private)
2. Public
a. Very highly regulated out of an interest to protect the investing
public.
b. Chief regulator is Securities and Exchange Commission.
iii. Limited Liability Company (in between partnerships and corporations)
b. Generally
i. Governed by statutory state law.
1. Uniform Partnership Act (1914) [“UPA”]
2. Uniform Partnership Act (1997) [“RUPA”]
ii. Definition of Partnership [UPA §6(1); RUPA §101(6)]: “an association of two
or more persons to carry on as co-owners a business for profit.”
1. Includes “not-for-profit” businesses.
iii. ‘Co-owners’ means:
1. Shared (1) control and (2) profits of the business.
iv. No formal creation requirements. Doing business as co-owners results in creation
of partnership by operation of law.
v. UPA §7(1): Persons who are not partners to each other are not partners as to third
parties, except for partnership by estoppel [UPA §16].
vi. Liability – The partners are personally, and jointly and severally liable for the
partnership.
1. General Partners – Full liability.
2. Limited Partners – Limited liability.
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vii. Tax Liability – Partnerships are a pass-through tax entity. Income tax on the
money that a partnership takes in is taken out of the partners as part of their
personal income tax.
viii. Agency Law – Partnership law essentially is agency law. Partners are principals
and agents of each other.
c. Fenwick v. Unemployment Compensation Commission
i. Facts – Chesire (receptionist) and Fenwick entered into a partnership agreement,
pursuant to which Fenwick contributed all capital investments, possessed
exclusive control over the management of the business, and bore the risk of all
business losses. Fenwick argues that Chesire is a partner so that he is not subject
to the state unemployment statute and is not required to pay into the fund.
ii. Factors in Determining Existence of Partnership
1. Intention of parties.
2. Right to share in profits.
a. Sharing of profits is prima facie evidence of partnership but no
such inference shall be drawn if such profits are received in
payment as wages of an employee.
3. Obligation to share in losses.
4. Ownership and control of partnership property and business.
5. Community of power in administration.
6. Language in the agreement.
7. Conduct of parties toward third persons.
8. Rights of parties on dissolution.
9.  NO writing requirement.
iii. Burden of Proof – Upon the one who alleges that a partnership exists.
iv. No partnership because although Chesire shared in profits, Fenwick retained
substantial control over everything else.
v. What could Fenwick have done to create a partnership but retain substantial
control over his business?
1. Give Chesire a measure of formal control.
2. Assign one vote each to Fenwick and Chesire.
3. Assign multiple votes to Fenwick and Chesire, but give Fenwick an extra
vote.
a.  This will give Chesire definite participation rights, but it will
not give her ultimate control over the business. She will have
input, and if these formalities are followed, she will have soft
control. This will satisfy the requirements of a partnership
because it has been shown that soft control is able to affect
outcomes to some degree. Soft control is not merely pro forma
control; courts accept it.
4. Allow Chesire to share in the losses of the business.
5. Give Chesire a residual claim upon dissolution of the partnership.
vi. Chesire as Independent Contractor – “I want a receptionist with these qualities:
X, Y, and Z. You figure out how to make it happen.”
d. Liability in General Partnership
i. UPA §15: All partners are liable
1. (a) Jointly and severally for everything chargeable to the partnership
under sections 13 and 14 [e.g., torts and breaches of fiduciary duties]
2. (b) Jointly for all other debts and obligations of the partnership... [e.g.,
contracts]
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ii. UPA §40(b): The liabilities of the partnership shall rank in order of payment, as
follows:
1. I. Those owing to creditors other than partners;
2. II. Those owing to partners other than for capital and profits...
iii. Due to these rules, a creditor of the partnership who becomes a partner suffers a
“double whammy”: Her debt is subordinated to the debt of non-partner creditors,
and worse – she is personally liable for the partnership’s debt.
2. Partnership by Estoppel
a. Young v. Jones
i. Facts – Young and others invested money in reliance upon a fraudulent audit
statement prepared by Price Waterhouse-Bahamas. Plaintiffs relied on a letter
printed on PW letterhead. They thought they were dealing with a bank and
deposited in the purported bank based on the letter printed on PW-Bahamas
letterhead. Plaintiffs did not sue the purported bank or PW-Bahamas probably
because they were judgment-proof.
ii. General Rule – “Persons who are not partners as to each other are not partners
as to third persons.”
iii. Partnership by Estoppel – “A person who represents himself, or permits
another to represent him, to anyone as a partner in an existing partnership or with
others not actual partners, is liable to any such person to whom such a
representation is made who has, on the faith of the representation, given credit to
the actual or apparent partnership.”
1. RELIANCE BY THE PLAINTIFF IS KEY.
a. Here, there is no evidence that the plaintiff relied on anything
that PW-US did that evidenced partnership.
2. The thing relied on has to be (1) about PW-US and (2) by PW-US.
3. There was no “holding out” by PW-US to the plaintiffs of any
partnership.
4.  These two requirements (holding out and reliance) are necessary for
partnership by estoppel.
iv. Partner Liability – “Jointly and severally liable for everything chargeable to the
partnership.”
v. No partnership because none of the Fenwick factors were present. Shared PW
brand alone is not sufficient.
vi. RUPA – People that misrepresent the existence of a partnership will be liable as
if there is a partnership, i.e., jointly and severally liable.
1. Close to estoppel, but not quite. More formal than estoppel.
Fiduciary Obligations of Partners
1. Introduction
a. Meinhard v. Salmon
i. Facts – Salmon terminated a lease belonging to his joint venture with Meinhard
to enter into a new lease on behalf of his solely owned business.
ii. Duty of Loyalty for Partners – “Joint adventurers, like copartners, owe to one
another, while the enterprise continues, the duty of the finest loyalty. Many
forms of conduct permissible in a workaday world for those acting at arm’s
length are forbidden to those bound by fiduciary ties. A trustee is held to
something stricter than the morals of the market place. Not honesty alone, but
the punctilio of an honor the most sensitive is then the standard of behavior.”
1. Two Functions of Strong Language
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a. Shame as a social sanction.
b. Establishes a bright-line rule.
2. Logical Extension of This Extreme Position – Nothing ever gets done,
and business clogs. (Therefore, partners must maintain some thought of
themselves in reality.)
3.  Deliberate ambiguities strongly suggest the need for ex ante planning
and resolution through contract.
iii. “A co-adventurer has the duty to concede and reveal any chance to compete and
any chance to enjoy the opportunity for benefit that had come to him alone by
virtue of his agency.”
1. Cardozo wants partners to provide each other NOTICE.
iv. Default Rule – Theories
1. Gap-Filling – The rule that the parties would have agreed to otherwise.
2. Penalty – A very disagreeable rule that will cause the parties to explain
very precisely why the rule is disagreeable. This rule coaxes information
out of the participants, unlike the gap-filling default rule, which is
applied when information already is present.
3. Breaking the Collective Action Problem
a. Partners recognize that there will come a point at which they will
want to undercut each other’s interests. By discussing their
eventual distrust extensively up front, they reduce their
emotional apprehension about moving forward together. This is
the mechanism by which coordination between partners may
break down, and it justifies the law stepping in up front to
resolve this issue.
4.  The law will allow this sort of coordination upfront to varying
degrees. Delaware in particular and New York to some degree have very
enabling (as opposed to protective) contract law.
5.  Uniform Acts § 103(b)(3) – You may not eliminate the duty of
loyalty, but you may identify specific acts or categories that do not
violate the duty of loyalty.
a. Information-forcing statute. Requires parties to specify very
precisely the actions that will not violate the duty of loyalty.
b. Includes a catchall: exceptions must not be “manifestly
unreasonable.” This applies to all exceptions contracted by
parties.
v. Revised Uniform Partnership Act – § 404 General Standards of Partner’s
Conduct
(a) The only fiduciary duties a partner owes to the partnership and the
other partners are the duty of loyalty and the duty of care set forth in
subsections (b) and (c).
(b) A partner’s DUTY OF LOYALTY to the partnership and the other
partners is limited to the following:
(1) to account to the partnership and hold as trustee for it any
property, profit, or benefit derived by the partner in the conduct
and winding up of the partnership 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
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(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.
(e) A partner does not violate a duty or obligation under this [Act] or
under the partnership agreement merely because the partner’s conduct
furthers the partner’s own interest.
 Means that a partner can think of himself despite Cardozo’s
strong language.
(f) A partner may lend money to and transact other business with the
partnership, and as to each loan or transaction the rights and obligations
of the partner are the same as those of a person who is not a partner,
subject to other applicable law.
2. Opting Out of Fiduciary Duties
a. Perretta v. Prometheus Development Company, Inc.
i. Facts – The general partner in a California limited partnership proposed a merger
and obtained the approval of a bare majority of the partners, counting itself, and
the limited partners objected.
ii. Self-Interested Transactions
1. Might not violate duty of loyalty.
2. “The question is not whether the interested partner is benefitted, but
whether the partnership or the other partners are harmed. Partnership is a
fiduciary relationship, and partners may not take advantages for
themselves at the expense of the partnership.”
3. Burden of Proof – “A partner who seeks a business advantage over
another partner bears the burden of showing complete good faith and
fairness to the other.”
iii. Disclosure & Ratification – No breach of duty of loyalty.
1. Disclosure – “There is no breach of a fiduciary duty if there has been a
full and complete disclosure, if the partner who deals with partnership
property first discloses all of the facts surrounding the transaction to the
other partners and secures their approval and consent.”
2. Ratification – “Upon a showing of proper ratification by the partners,
any claim against the partner for a violation of the duty of loyalty is
extinguished.”
iv. “California law permits a partnership agreement to vary or permit ratifications of
violations of the duty of loyalty only if the provision doing so is ‘not manifestly
unreasonable.’”
1. Allowing interested partners to vote on self-serving transactions is
manifestly unreasonable. Three reasons:
a. “California statutes in related areas of the law support the idea
that interested partners should not be allowed to count their votes
in a ratification vote.”
b. “For California corporations, the applicable statute mandates that
conflicted actions be ratified in elections ‘with the shares owned
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by the interested director or directors not being entitled to vote
thereon.’”
c. “Allowing an interested partner to participate in a ratification
election subverts the very purpose of ratification itself.”
2. California law is very protective of minorities.
3. California ultimately uses a substantive unconscionability test to
determine what is manifestly unreasonable. This is very different than
contract interpretation. California does not care what the contract says; it
does not allow partnerships to engage in certain behaviors that it
considers to be destructive. This is fundamentally different than the
enabling approach of Delaware.
3. Grabbing and Leaving
a. Meehan v. Shaughnessy
i. Facts – Meehan, Boyle, and Cohen separated from Parker Coutler, their former
law partnership, to form a new law firm with cases removed from Parker Coulter.
ii. Rule – As a partner, you may compete with the entity of which you are a partner
as long as you do not violate your duties of loyalty or care.
iii. Permissible Actions (Absent a Non-Competition Agreement)
1. Jump ship to a new firm.
2. Start looking for new office space if you want to start a new firm.
3. Inform clients with whom one has an established professional
relationship about one’s new firm.
a. Probably able to remind clients about their freedom to retain
counsel of their choice.
iv. Impermissible Actions
1. Abandoning firm on short notice.
2. Using confidential firm information to lure away clients or associates.
3. Luring firm clients without disclosing one’s intentions to one’s partners.
4. Misleading one’s partners as to one’s intentions.
v. ABA Committee on Ethics & Professional Responsibility – Notice to clients
when lawyer leaves firm:
(a) the notice is mailed;
(b) the notice is sent only to persons with whom the lawyer had an active
lawyer-client relationship immediately before the change in the lawyer's
professional association;
(c) the notice is clearly related to open and pending matters for which the
lawyer had direct professional responsibility to the client immediately
before the change;
(d) the notice is sent promptly after the change;
(e) the notice does not urge the client to sever a relationship with the
lawyer's former firm and does not recommend the lawyer’s employment
(although it indicates the lawyer’s willingness to continue his
responsibility for the matters);
(f) the notice makes it clear that the client has the right to decide who
will complete or continue the matters; and
(g) the notice is brief, dignified, and not disparaging of the lawyer’s
former firm.
vi. Court found a violation.
1. The letters sent to the clients did not make clear that it was the clients’
choice whether to remain with the old firm or migrate to the new firm.
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2. Lawyers owed a duty to inform the firm from which they were departing
a little earlier about their impending departure. The old firm probably
would not have invested many more resources in the departing partners
and associates, e.g., the firm would not have worked on the matters that
the departing partners were taking with them.
4. Expulsion
a. Lawlis v. Kightlinger & Gray
i. Facts – Lawlis (alcoholic) was expelled from the law partnership of Kightlinger
& Gray despite complying with all conditions for his continued relationship.
ii. Dissolution by Expulsion – “Dissolution is caused: (1) Without violation of the
agreement between the partners, . . . (d) By the expulsion of any partner from the
business bona fide in accordance with such a power conferred by the agreement
between the partners.”
iii. Valid Expulsion – “When a partner is involuntarily expelled from a business, his
expulsion must have been ‘bona fide’ or in ‘good faith’ for a dissolution to occur
without violation of the partnership agreement. If the power to involuntarily
expel partners granted by a partnership agreement is exercised in bad faith or for
a ‘predatory purpose,’ the partnership agreement is violated, giving rise to an
action for damages the affected partner has suffered as a result of his expulsion.”
1. “The fiduciary relationship between partners to which the terms ‘bona
fide’ and ‘good faith’ relate concern the business aspects or property of
the partnership and prohibit a partner, to-wit a fiduciary, from taking any
personal advantage touching those subjects.”
2. “Where the remaining partners in a firm deem it necessary to expel a
partner under a no cause expulsion clause in a partnership agreement
freely negotiated and entered into, the expelling partners act in ‘good
faith’ regardless of motivation if that act does not cause a wrongful
withholding of money or property legally due the expelled partner at the
time he is expelled.”
iv. Two Claims (Both rejected.) – (1) Wrongful expulsion. (2) Breach of fiduciary
duties.
1. Wrongful Expulsion – PA allowed expulsion without cause by two-thirds
vote. Other partners complied by voting in accordance.
2. Breach of Fiduciary Duties – No breach. Other partners’ motives were
irrelevant (even if they expelled Lawlis because he was costing the firm
money).
a. No breach unless they wrongfully withheld money that Lawlis
was due.
v. Squaring with Meinhard (“duty of the finest loyalty”) – Expansive notion of ex
ante private ordering. Partners can substantially limit by contract—albeit not
eliminate—the duties they owe each other.
Property, Raising Capital, Management & Dissolution
Partnership Property
1. Generally
a. UPA § 24 Extent of Property Rights of a Partner – “The property rights of a partner
are (1) his rights in specific partnership property, (2) his interest in the partnership, and
(3) his right to participate in the management.”
i. Two Defining Characteristics of Partnership
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1. Shared Profits (“interest in the partnership”)
2. Shared Control (“right to participate in the management”)
b. UPA § 26 Nature of Partner’s Interest in the Partnership – “A partner’s interest in the
partnership is his share of the profits and surplus, and the same is personal property.”
c. UPA § 25 Nature of a Partner’s Right in Specific Partnership Property
(1) A partner is co-owner with his partners of specific partnership property
holding as a tenant in partnership.
(2) The incidents of this tenancy are such that:
(a) A partner, subject to the provisions of this act and to any agreement
between the partners, has an equal right with his partners to possess
specific partnership property for partnership purposes; but he has no right
to possess such property for any other purpose without the consent of his
partners.
 Using partnership property for personal purposes requires
consent of other partners.
(b) A partner’s right in specific partnership property is not assignable
except in connection with the assignment of rights of all the partners in
the same property.
d. Hypotheticals
i. Three-partner firm. Can A sell his partnership to a third party? A: No.
ii. Partnership owns a computer. Partner cannot cash out his interest in one-third of
the computer. Partnership property rights are not assignable.
iii. What can you transfer? A: Right to payment, e.g., X’s right to receive money
from the partnership. That is all that a partner can transfer.
2. Putnam v. Shoaf
a. Facts – Putnam sold all her interest in her partnership to Shoaf in exchange for Shoaf’s
assumption of personal liability on a bank note.
b. Rules
i. “The right in ‘specific partnership property’ is the partnership tenancy possessory
right of equal use or possession by partners for partnership purposes.”
ii. “This possessory right is incident to the partnership and the possessory right does
not exist absent the partnership.”
iii. “The possessory right is not the partner’s ‘interest’ in the assets of the
partnership. The real interest of a partner, as opposed to that incidental
possessory right before discussed, is the partner’s interest in the partnership
which is defined as his share of the profits and surplus and the same is personal
property.”
iv. “Therefore, a co-partner owns no personal specific interest in any specific
property or asset of the partnership. The partnership owns the property or the
asset. The partner’s interest is an undivided interest, as a co-tenant in all
partnership property. That interest is the partner’s pro rata share of the net value
or deficit of the partnership.”
v. “For this reason a conveyance of partnership property held in the name of the
partnership is made in the name of the partnership and not as a conveyance of the
individual interests of the partners.”
c. Court rejects argument that Putnam had intended only to convey her share of the tangible
property of the FJG to the Shoafs—and not her interest in the partnership.
i. Partners individually cannot sell underlying assets.
d. Partnership as Aggregation v. Separate Entity
i. Court – Partnership is an entity distinct from its partners. Property acquired by
the partnership is property of the partnership, not the partners.
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ii. Many legal questions turn on whether individuals intended to aggregate as a
partnership.
iii. If one becomes a partner because, e.g., she exercised too much control in the
management of the business, then her property may become partnership property.
Raising Additional Capital
1. Initial Capital Contribution
a. UPA is silent.
b. “Service Partnership” – One in which one partner contributes only labor.
2. Capital Account – Running balance reflecting each partner’s ownership equity. Each partner has
her own capital account.
a. UPA (1997) § 401 Partner’s Rights and Duties – (a) Each partner is deemed to have an
account that is:
(1) credited with an amount equal to the money plus the value of any other
property, net of the amount of any liabilities, the partner contributes to the
partnership and the partner’s share of the partnership profits; and
(2) charged with an amount equal to the money plus the value of any other
property, net of the amount of any liabilities, distributed by the partnership to the
partner and the partner’s share of the partnership losses.
b. Fluctuations
i. Allocation of profits increases capital account.
Partnership Capital Account:
Profit Allocated
Initial Contribution
Year 1 Profit
Alice
Bob
$10,000
$1,000
$1,000
$1,000
Year 1 Capital
$11,000
Account Balance
ii. Allocation of losses decreases capital account.
$2,000
7 of 42
Partnership Capital Account:
Loss Allocated
24
Year 1 Capital
Alice
Bob
$11,000
$2,000
Partnership Capital Account:
Loss Allocated
Alice
Bob
Year 1 Capital
Account Balance
$11,000
$2,000
Year 2 Loss
($2,000)
($2,000)
$9,000
$0
Year 2 Capital
Account Balance
iii. Taking a “draw” (distribution) decreases capital account.
8 of 42
3. Three Ways of Raising Additional Capital
a. Take on debt.
b. Get new partners.
c. Get more money from existing partners. Problems:
i. People might not want to join the partnership.
ii. New partners will reduce the size of the pie that each partner gets.
iii. New partners will be able to exercise some degree of control over the
management of the partnership.
Rights of Partners in Management
1. RUPA § 401 Partner’s Rights and Duties
a. (f) Each partner has equal rights in the management and conduct of the partnership
business. See also UPA § 18(e).
b. (i) A person may become a partner only with the consent of all of the partners.
c. (j) A difference arising as to a matter in the ordinary course of business of a partnership
may be decided by a majority of the partners. An act outside the ordinary course of
25
2.
3.
4.
5.
business of a partnership and an amendment to the partnership agreement may be
undertaken only with the consent of all of the partners. See also UPA § 18(h).
Partner’s Authority – UPA § 9 Partner Agent of Partnership as to Partnership Business
a. (1) Every partner is an agent of the partnership for the purpose of its business, and the act
of every partner, including the execution in the partnership name of any instrument, for
apparently carrying on in the usual way the business of the partnership of which he is a
member binds the partnership, unless the partner so acting has in fact no authority to act
for the partnership in the particular matter, and the person with whom he is dealing has
knowledge of the fact that he has no such authority.
b. (2) An act of a partner which is not apparently for the carrying on of the business of the
partnership in the usual way does not bind the partnership unless authorized by the other
partners. See also RUPA § 301.
c.  To avoid liability for actions that may be seen as carrying on the business in the usual
way, there must be neither actual nor apparent authority.
d.  RUPA § 303 suggests a method of clarifying authority, by filing a Statement of
Partnership Authority.
Profits & Losses
a. Both are divided equally by default. Initial capital investments do not matter.
i. Can be changed only by contrary agreement provided in the Partnership
Agreement.
b. It is possible to have a Partnership Agreement that says, “I get all the profits, and you get
all the loses,” but it will be subject to the manifest unreasonableness test (duty of loyalty)
and Cardozo’s edict that partners must be selfless.
Voting
a. Absent agreement otherwise, every partner gets an equal vote. Agreements otherwise are
subject to the manifest unreasonableness test (duty of loyalty) and Cardozo’s edict that
partners must be selfless.
b. One can become a partner only with the consent of all of the partners. Unanimity is a
strict requirement.
c. Ordinary Course Business – Requires majority approval.
d. Non-Ordinary Course Business – Requires unanimity.
National Biscuit Company v. Stroud
a. Facts – Freeman purchased bread from National Biscuit Co. although his partner, Stroud,
had informed Freeman and the plaintiff that he would no longer be responsible for
additional bread purchases. Freeman demanded payment from Stroud, and Stroud
refused to pay.
b. Agency Law – If any of the partners is liable, then all of the partners are liable. Joint and
several liability.
c. Second Question – Is buying bread in the ordinary course of business? An apparent
authority question.
i. Exceptions to Apparent Authority: Express Denunciation of Authority –
How can one partner disclaim the authority of another?
1. The partnership has not concluded that the partner did not have authority
to order bread. Only one partner decided this, and the partnership was
deadlocked. Therefore, it is not the case that the partner had been denied
authority by the partnership to order bread.
d. Evenly Divided Partners – “In cases of an even division of the partners as to whether or
not an act within the scope of the business should be done, of which disagreement a third
person has knowledge, it seems that logically no restriction can be placed upon the power
to act. The partnership being a going concern, activities within the scope of the business
26
should not be limited, save by the expressed will of the majority deciding a disputed
question; half of the members are not a majority.”
i. Two-person law firm partnership. A has lost confidence in B and does not want
B representing clients anymore. A cannot impose restrictions on B and retain
partnership.
ii. Three-person law firm partnership. If cutting out B and telling him to get his life
together are decisions in the ordinary course, then only two partners need to
agree. If the decisions are not in the ordinary course, then unanimity is required.
e. One partner can avoid liability by dissolving the partnership.
6. Summers v. Dooley
a. Facts – Summers incurred expenses when he hired a partnership employee despite
Dooley’s objection. Two-person partnership; one partner hired a third employee, and the
other partner objected.
b. Ordinary Business Requires Majority – “Any difference arising as to ordinary matters
connected with the partnership business may be decided by a majority of the partners.”
i. “Business differences must be decided by a majority of the partners provided no
other agreement between the partners speaks to the issues.”
c. Here, the contract is not binding because the majority did not consent to the hiring.
d. With respect to third parties, every partner is an agent of the partnership and has the
power to bind it.
i. With respect to other partners, this is not the case.
e. Deadlock – Big Issue in Two-Person Partnerships. Solutions:
i. Dissolution.
ii. Agree how to deal with deadlock ex ante, i.e., when drafting the Partnership
Agreement. However, it sometimes is difficult to get other partners to come
onboard.
1. Pick a partner to decide.
2. Pick a trusted, intermediary tiebreaker (e.g., a local community leader) to
decide.
iii. Pick an arbitrator to decide. This sometimes is done ex ante.
f. Tradeoff between centralized management done by (1) consensus and (2) authority.
i. Consensus – Requires similar information and similar interests among partners.
Collective actions costs must not be too high.
ii. Authority – Centralized decision maker has power. Desirable when partners
have diverse interests and information, or when the collective action costs are
high. Commonly employed by corporations.
Partnership Dissolution
[See page 91.]
1. Right to Dissolve
a. Dissolution v. Winding Up
i. Dissolution
1. Not going out of business.
2. Changing the relationship of the partners when one partner leaves and
the partnership continues.
ii. Winding Up – Putting the partnership out of business. It does not exist anymore.
b. Two Real Options
i. Prohibited dissolution, but allow a partner to exit. This allows a partnership to be
long-lasting, but it requires the ability to transfer interest in the partnership.
27
ii. Force dissolution and limit suits between partners while they are partners. This is
the approach most commonly adopted for partnerships.
c. “There always exists the power, as opposed to the right, of dissolution.” Collins v.
Lewis. Partnership always may be dissolved, but it is not always legal.
d. UPA § 31 Causes of Dissolution – Dissolution is caused:
(1) Without violation of the agreement between the partners,
(a) By the termination of the definite term or particular undertaking
specified in the agreement,
(b) By the express will of any partner when no definite term or particular
undertaking is specified,
(c) By the express will of all the partners who have not assigned their
interests or suffered them to be charged for their separate debts, either
before or after the termination of any specified term or particular
undertaking,
(d) By the expulsion of any partner from the business bona fide in
accordance with such a power conferred by the agreement between the
partners;
(2) In contravention of the agreement between the partners, where the
circumstances do not permit a dissolution under any other provision of this
section, by the express will of any partner at any time;
(3) By any event which makes it unlawful for the business of the partnership to
be carried on or for the members to carry it on in partnership;
(4) By the death of any partner;
(5) By the bankruptcy of any partner or the partnership;
(6) By decree of court under section 32.
e. Three Types of Dissolution
i. By act of one or more partners [UPA §31(1)-(2)]; e.g.:
1. At the termination of the partnership’s term or particular undertaking, or,
if it has none, at the will of any partner;
2. Wrongful dissolution: In contravention of the agreement between the
partners, by the express will of any partner at any time.
ii. By operation of law [UPA §31(3)-(5)]
1. Due to death or bankruptcy of a partner, or due to bankruptcy or
unlawfulness of the partnership.
iii. By court order [UPA §31(6); §32]
f. Owen v. Cohen
i. Facts – Court dissolved Owen’s and Cohen’s partnership upon finding that the
parties could not practicably continue in business together. Partnership for
bowling alley. Cohen refuses to do any work or leave partnership. Owen
therefore sues for dissolution.
ii. No Court-Ordered Dissolution for Trifling Grievances – “Trifling and minor
differences and grievances which involve no permanent mischief will not
authorize a court to decree a dissolution of a partnership.”
iii. Court-Ordered Dissolution for Big Problems – “Courts of equity may order
the dissolution of a partnership where there are quarrels and disagreements of
such a nature and to such extent that all confidence and cooperation between the
parties has been destroyed or where one of the parties by his misbehavior
materially hinders a proper conduct of the partnership business.”
1. Small problems may add up; be enough for dissolution.
iv. UPA § 32 Dissolution by Decree of Court – (1) On application by or for a
partner the court shall decree a dissolution whenever:
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(c) A partner has been guilty of such conduct as tends to affect
prejudicially the carrying on of the business,
(d) A partner willfully or persistently commits a breach of the
partnership agreement, or otherwise so conducts himself in matters
relating to the partnership business that it is not reasonably practicable to
carry on the business in partnership with him,
(f) Other circumstances render a dissolution equitable.
v. Wrongful Dissolution
1. Does not stop dissolution.
2. Adverse consequences will follow to the partner that does the dissolving.
She will have to compensate the non-dissolving partners.
vi. Aftermath
1. Court typically will sell the partnership to the highest bidder.
2. Practical Effect – Owen and Cohen must buy each other out.
3. Consequences of Termination Partnership
a. Changes relationships between partners.
b. May result in a winding up.
g. RUPA § 801 Events Causing Dissolution and Winding Up of Partnership Business –
A partnership is dissolved, and its business must be wound up, only upon the occurrence
of any of the following events: . . . (5) on application by a partner, a judicial
determination that:
(i) the economic purpose of the partnership is likely to be unreasonably
frustrated;
(ii) another partner has engaged in conduct relating to the partnership business
which makes it not reasonably practicable to carry on the business in partnership
with that partner; or
(iii) it is not otherwise reasonably practicable to carry on the partnership business
in conformity with the partnership agreement
2. Consequences of Dissolution
a. Process of Terminating
i. UPA
1. Dissolution does not terminate the partnership [UPA §30]. Rather, it
limits all partners’ authority to act for the partnership [UPA §33-35], and
prompts the “winding up” of the partnership.
2. “Winding up” consists of disposing of the partnership’s assets/business,
then dividing between the partners the remaining assets or the liability
for remaining losses.
3. Subject to certain limitations, some partners may pay off other partners
and continue the partnership after dissolution [UPA §38(2)(b)].
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4.
ii. RUPA
1. Triggering event is “disassociation” [RUPA §601]. After that:
a. Business may be continued under Article 7
i. Purchase of disassociated partner’s interest [RUPA
§701]
ii. Disassociated partner not automatically released from
liability [RUPA §703]
b. Business may be dissolved (and “wound up”) under Article 8
i. Not every event allowing disassociation also allows
dissolution [cf. §801 w/§601]
ii. Limitation on partner’s authority to act for the
partnership [RUPA §804]
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2.
b. Prentiss v. Sheffel
i. Facts – Upon dissolution of a partnership, the former partners purchased the
partnership assets at a judicial sale.
ii. Prentiss claimed that S&I had an unfair advantage, i.e., paper dollars.
1. Paper Dollars – S&I effectively has 85% of the partnership. It needs to
buy Prentiss out of only 15%. It can easily do this.
2. Court allowed S&I to bid.
iii. Rule – Absent bad faith or breach of fiduciary duty, one or more partners are free
to bid on the partnership’s assets at a judicial sale.
1. No bad faith in excluding 15% partner from management of partnership.
Others partners had a valid reason: inability to function harmoniously in
a partnership relationship.
2. No harm to plaintiff because the other partners were the highest bidder,
thereby giving him the most money for his 15% interest.
3. Not a forced sale of 15% partner’s partnership interest. He could have
bought the other 85% of the partnership assets too. If you are worried
about being bought out, you should worry about this before buying in.
c. Pav-Saver Corporation v. Vasso Corporation
i. Facts – Vasso Corporation alleged that Pav-Saver Corporation wrongfully
dissolved the partnership, seeking to continue the partnership business.
ii. UPA § 38 Rights of Partners to Application of Partnership Property
(2) When dissolution is caused in contravention of the partnership
agreement the rights of the partners shall be as follows:
(a) Each partner who has not caused dissolution wrongfully shall
have,
II. The right, as against each partner who has caused the
dissolution wrongfully, to damages for breach of the
agreement.
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(b) The partners who have not caused the dissolution wrongfully,
if they all desire to continue the business in the same name,
either by themselves or jointly with others, may do so, during the
agreed term for the partnership and for that purpose may possess
the partnership property, provided they secure the payment by
bond approved by the court, or pay to any partner who has
caused the dissolution wrongfully, the value of his interest in the
partnership at the dissolution, less any damages recoverable
under clause (2a II) of this section, and in like manner indemnify
him against all present or future partnership liabilities.
(c) A partner who has caused the dissolution wrongfully shall
have:
II. If the business is continued under paragraph (2b) of
this section the right as against his co-partners and all
claiming through them in respect of their interests in the
partnership, to have the value of his interest in the
partnership, less any damages caused to his co-partners
by the dissolution, ascertained and paid to him in cash,
or the payment secured by bond approved by the court,
and to be released from all existing liabilities of the
partnership; but in ascertaining the value of the partner’s
interest the value of the good-will of the business shall
not be considered.
iii. Dissolution effectively creates a NEW PARTNERSHIP.
1. Creditors of old partnership become creditors of new partnership.
2. Departing partners are entitled to a fair value accounting.
3. Departing partners generally are held liable for business up the point of
departure.
4. New partners are liable to at least some extent for old debts and
unlimitedly with respect to new debts.
iv. Wrongful dissolution allows the non-dissolving partners to continue operating
the partnership.
d. RUPA § 701 Purchase of Dissociated Partner’s Interest
i. Partner withdraws from partnership in contravention of PA  partnership does
not necessarily dissolve.
ii. Partnership must buy out dissociated partner for amount equal to her share of the
value of the assets of the partnership if “sold at a price equal to the greater of the
liquidation value or the value based on a sale of the entire business as a going
concern without the dissociated partner.”
iii. Amount is reduced by damages for wrongful withdrawal.
e. Continuation Per Agreement (After Dissolution)
i. Effect on the partnership
1. Technically, this creates a new partnership (confusing treatment in
Putnam v. Shoaf)
2. Creditors of former partnership automatically become creditors of the
new partnership [UPA §41]
ii. Effect on the departing partner(s)
1. Departing partner entitled to an accounting
a. Fair value of the partnership, plus interest from the date of
dissolution in the event of an unreasonable delay in payment.
32
2. Departing partner remains liable on all firm obligations unless released
by creditors [UPA §36, RUPA §703]
iii. Effect on a new partner
1. A new partner that joins the partnership when it continues after
dissolution is liable to old debts, but his liability can only be satisfied out
of the partnership assets (i.e., he has no personal liability) [UPA §41(1),
RUPA §306(B)].
f. Continuation Following Wrongful Dissolution
i. Effects of wrongful dissolution (e.g., early termination of a term partnership):
1. Wrongful dissolver subject to damages for breach of the partnership
agreement [UPA §38(2)(a)(II)];
2. Wrongful dissolver limited in participation in winding-up [UPA §37];
3. Remaining partners have the right to continue the business even absent
an agreement to do so, subject to payment to the wrongful dissolver
[UPA §38(2)(b)-(c)]
a. Wrongful dissolver entitled to the fair value of his interest in the
partnership (not including the value of the partnership’s
goodwill), minus any damages caused by the breach of the
partnership agreement.
4. RUPA has very similar rules, except that the fair value of the interest to
which the wrongful dissolver is entitled includes the value of the
partnership’s goodwill.
g. Dissolution Review
i. A partnership may be for a term or at will. The default rule is at will. But a term
may be implied—for example, when it is contemplated that a debt will be repaid
out of profits and the inference is that the term is the period of time necessary to
achieve the repayment.
ii. Partners are entitled to share in control. At a minimum this means that they must
have access to information and must be consulted and allowed to vote. This rule,
again, may be altered by agreement.
iii. When a majority deprives a partner of participation in control, it violates the
partnership agreement.
iv. Upon dissolution there is supposed to be a winding up. The partnership continues
for the purpose of winding up.
v. In some circumstances (e.g., where dissolution is caused by the death of a
partner), the winding up will be accomplished by the partners who are still
available to do so. If this is not feasible, or if there is disagreement, a court may
order a sale. The court has discretion as to the appointment of a receiver and as to
how the sale is to be accomplished (e.g., auction, use of a broker, or some other
methods).
vi. The partners may bid for the assets of the partnership, including its goodwill.
That is, partners may bid to buy its assets piecemeal or as a going concern.
vii. Partners owe each other a fiduciary obligation, so they cannot dissolve in bad
faith. An example of bad faith: One partner knows that the other partner does not
have and cannot raise the money to bid on the partnership, and that there will be
no other bidders at a fair price (that is, a price reflecting the value of the assets to
either of the partners in the absence of capital constraints on capital), and
dissolves in order to be able to buy the partnership assets at an unfairly low price.
In effect, then, when a partner dissolves and bids for the assets of the partnership,
he or she must pay a fair price. Otherwise, a court may find bad faith and a
violation of the fiduciary duty.
33
3. Sharing of Losses
a. UPA § 18 Rules Determining Rights and Duties of Partners – The rights and duties of
the partners in relation to the partnership shall be determined, subject to any agreement
between them, by the following rules:
(a) Each partner shall be repaid his contributions, whether by way of capital or
advances to the partnership property and share equally in the profits and surplus
remaining after all liabilities, including those to partners, are satisfied; and must
contribute towards the losses, whether of capital or otherwise, sustained by the
partnership according to his share in the profits.
i.  Partners that share profits equally must share losses equally.
b. UPA § 40 Rules for Distribution – In settling accounts between the partners after
dissolution, the following rules shall be observed, subject to any agreement to the
contrary:
(b) The liabilities of the partnership shall rank in order of payment, as follows:
I. Those owing to creditors other than partners,
II. Those owing to partners other than for capital and profits,
III. Those owing to partners in respect of capital,
IV. Those owing to partners in respect of profits.
(d) The partners shall contribute, as provided by section 18(a) the amount
necessary to satisfy the liabilities [set forth in § 40(b)] . . . .
i.  When a partnership has no liabilities, its only responsibility on dissolution is
paying back the capital input of the partners.
c. Kovacik v. Reed
i. Facts – Kovacik sought recovery from Reed of one-half of the money capital that
he invested in a losing business venture. Kitchen remodeling partnership, Reed
to superintend and share in profits, Kovacik to finance. No specification on what
would happen if partnership lost money on contracting jobs. Job did lose money
and Kovacik sued when Reed refused to pay Kovacik half the loss. Court found
Reed not liable for losses.
ii. General Rule – “In the absence of an agreement to the contrary the law
presumes that partners and joint adventurers intended to participate equally in the
profits and losses of the common enterprise, irrespective of any inequality in the
amounts each contributed to the capital employed in the venture, with the losses
being shared by them in the same proportions as they share the profits.”
iii. Rule – “Where one partner or joint adventurer contributes the money capital as
against the other’s skill and labor, neither party is liable to the other for
contribution for any loss sustained. Thus, upon loss of the money the party who
contributed it is not entitled to recover any part of it from the party who
contributed only services.”
1. Services-only partner does not share in loss of the amount initially
invested by the capital-only partner.
2. Exception – If a service partner had made a capital contribution or been
paid for his work, then a court would not refuse to require the service
partner to share in the monetary losses.
iv. RUPA § 401(b) rejects Kovacik. Partners share profits and losses equally,
regardless of capital contributions.
1. RUPA § 401 Partner’s Rights and Duties – (b) Each partner is entitled to
an equal share of the partnership profits and is chargeable with a share of
the partnership losses in proportion to the partner’s share of the profits.
2. “Subsection (b) establishes the default rules for the sharing of partnership
profits and losses. The UPA Section 18(a) rules that profits are shared
34
equally and that losses, whether capital or operating, are shared in
proportion to each partner's share of the profits are continued. . . . The
default rules apply, as does UPA Section 18(a), where one or more of the
partners contribute no capital, although there is case law to the contrary
[citing Kovacik].” RUPA § 401 cmt. 3.
4. Buyout Agreements
a. Definition – Agreement that allows partner to end her relationship with other partners
and receive a cash payment, series of payments, or some assets of the firm in return for
her interest in the firm.
b. Issues
i. What triggers?
1. Death, disability, or voluntary opt out?
ii. Who is obliged to buyout the opting-out partner, and what happens if the relevant
individuals refuse?
1. Firm or other investors?
2. Consequences of refusal to buy: (1) if there is an obligation or (2) if there
is no obligation?
iii. How do we determine the price?
1. Partnership agreement, book value, appraisal, formula (e.g., five times
earnings), third-party determination, set price annually, or relation to
duration (e.g., lower price in first five years)?
iv. Will payment be in cash or in installments (with interest) over time?
v. Will the opting-out partner be responsible for partnership debts?
vi. What will the procedure be for offering either to buy or sell?
1. First mover sets price or fist mover forces other to set price?
c. G&S Investments v. Belman
i. Facts – G&S Investments’ partner died while suit for dissolution was pending,
triggering the PA’s buyout provisions. Nordale had been abusing cocaine, and
the other partners sued him for wrongful dissolution.
ii. Dissolution by Court – “When: (1) a partner becomes in any other way
incapable of performing his part of the partnership contract; (2) a partner has
been guilty of such conduct as tends to affect prejudicially the carrying on of the
business; or (3) a partner willfully or persistently commits a breach of the
partnership agreement, or otherwise so conducts himself in matters relating to the
partnership business that it is not reasonably practicable to carry on the business
in partnership with him.”
1. Court found that Nordale’s abuse of cocaine and subsequent behavior
constituted wrongful dissolution.
2. Value of Nordale’s interest in the partnership was determined according
to the formula set forth in the PA.
iii. “Because partnerships result from contract, the rights and liabilities of the
partners among themselves are subject to such agreements as they may make.”
iv. Validity of Buy Out Agreement – “Partnership buy-out agreements are valid
and binding although the purchase price agreed upon is less or more than the
actual value of the interest at the time of death.”
Limited Partnerships
1. Generally
35
a. A limited partnership is composed of at least one general partner, and of at least one
limited partner. The formation of the partnership requires filing certain documents
(typically with the state’s Secretary of State).
b. The death of a limited partner does not cause the dissolution of the partnership, and
limited partnership shares are often transferable. Limited partners may have restricted
voting rights.
c. The general partner is personally liable to creditors. However, some states allow the
general partner to be a corporation. This allows both unlimited life to the partnership, and
limited liability to all the people involved.
d. According to RULPA (Uniform Limited Partnership Act (1976), which replaced ULPA
(1916)) §303(a), limited partners are liable only to the extent of their contributions,
unless:
i. They are also general partners
ii. They exercised control or had a right to exercise control – in such case, they are
liable only to persons who reasonably believed, based on the limited partner’s
conduct, that the limited partner is a general partner).
2. Holzman v. De Escamilla
a. Facts – Holzman, as bankruptcy trustee, sued the limited partners of a bankrupt
partnership to establish them as general partners liable for their creditors’ debt.
b. Rule – “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.”
i. The more a limited partner participates in management, the more she is a general
partner, the less limited her liability is.
3. RULPA § 303 Liability to Third Parties
(a) A limited partner is not liable for the obligations of a limited partnership unless the
limited partner is also a general partner or, in addition to the exercise of his rights and
powers as a limited partner, he takes part in the control of the business. However, if the
limited partner takes part in the control of the business and is not also a general partner,
the limited partner is liable only to persons who transact business with the limited
partnership and who reasonably believe, based upon the limited partner’s conduct, that
the limited partner is a general partner.
(b) A limited partner does not participate in the control of the business . . . solely by . . .
(2) consulting with and advising a general partner with respect to the business of the
limited partnership.
a.  Create “safe harbors” of activity that is not deemed as participation in control.
Consulting with and advising a general partner isn’t enough.
4. LLPs & LLLPs
a. Limited Liability Limited Partnership (LLLP) – Similar to a limited partnership, but
grants general partner limited liability as well (somewhat similar to making a corporation
the general partner).
b. Limited Liability Partnership [Article 10 of RUPA]
i. Acts like a general partnership, but with limited liability.
ii. Formed by filing a ‘statement of qualification’ (usually, with the state’s Secretary
of State).
iii. General partnership may convert to LLP. Conversion does not cause a dissolution
[RUPA §201(b)]
iv. Liability – RUPA §306(c): “An obligation of [a limited liability partnership]... is
solely an obligation of the partnership... A partner is not personally liable... solely
by reason of being... a partner.”
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v. Some states restrict the liability limitation to tort actions, and leave contract
liability unlimited.
BASICS OF CORPORATIONS
Promoters, Limited Liability & Derivative Actions
Promoters & the Corporate Entity
1. Three-quarters of businesses in the U.S. are sole proprietorships; then corporations; then
partnerships.
a. Gross receipts: 1-17-1. Corporations bring in 17 times more gross revenue then either
other form.
2. Types of Corporations
a. Public Corporations
i. Public – Shareholders; how widely dispersed the shareholders are.
ii. E.g., Microsoft.
iii. Shares are owned by public at large, and there is a huge market for those shares
(secondary market). People buy shares from the corporation on the primary
market.
iv. Trade across formal (NYSE) and informal markets.
b. Closely Held Corporations
i. Held by a small number of people.
ii. Generally, there is no secondary market for the corporation’s shares.
iii. Usually, a small number of shareholders.
iv. Resemble partnerships because of small size.
1. However, the formal rules are different.
3. Critical Attributes of Corporations
a. Separate legal persona. E.g., corporations can enter into contracts.
b. Distinct from shareholders.
c. Citizens United – Corporations have First Amendment rights.
d. Pay income tax on the money they earn. Tax also is paid by the shareholders on any
money distributed to them.
e. Limited Liability – Very different from joint and several liability under a partnership.
f. Separation of Ownership and Control
i. Shareholders do not participate in decision making.
ii. Board of Directors oversees officers, and officers oversee the employees, who do
the work of the corporation.
1. Several layers of principal-agency relationships.
g. Shareholders may react to a Board of Directors’ decisions by voting on directors; articles
of incorporation and bylaws; and fundamental business activities (e.g., mergers and
acquisitions).
i. Shareholders essentially have no direct say in ordinary, day-to-day operations.
ii. Selection of independent auditors also requires a shareholder vote.
iii. Shareholders also may respond to the Board’s decisions by taking their money
and leaving. Voting with their feet. This will shrink a corporation’s worth.
h. Secondary Market – A lot of liquidity in stock market. Easy to buy and sell shares.
i. Fairly Flexible Capital Structure – Two main forms of securities: stocks (equity) and
bonds (debt). Infinite number of ways to package a corporation’s capital structure.
i. Bond contains two basic rights:
1. Right to receive a stream of payments, i.e., interest.
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2. Right to receive return of principal.
3.  This creates a debtor-creditor relationship.
ii. Stock or shares represent a slice of the corporation. Shareholders are residual
claimants of corporate assets. When a corporation is winding down, all debtor
claims must be satisfied, and then the rest of the money is split up and given to
the shareholders.
1. Shareholders also get a vote in big corporate deals, election of Board of
Directors, and other things.
2. Board alone decides to issue a quantity of stock, and shareholders are
free to buy it or not. Shareholders may be involved in decisions to create
different kinds of stock.
3.  Board also can issue debt for any purpose.
4. Sources of Corporate Law
a. Mostly state law. Every state has a corporate law statute providing the rules for
corporations incorporated within that state. State common law clarifies the gaps in these
statutes and provides important principles.
b. Some federal law, e.g., Sarbanes-Oxley, Dodd-Frank. No federal corporation statute
exists. However, federal laws like the Federal Securities and Exchange Act of 1934 add
additional layers to corporate regulation.
c. MCBA – In 1950, the American Bar Association (ABA) promulgated the Model
Business Corporation Act (MCBA), which a majority of states (38 as of 2002) have
based their own corporate statutes on.
d. ALI Principles of Corporate Governance – ALI embarked on a project to unify basic
standards of corporate structure and published its Principles of Corporate Governance in
1993. The project has not received the same level of support as the Restatements.
5. Forming a Corporation
a. Formal procedure, unlike with partnership formation.
b. Choose a state for incorporation. Paul v. Virginia (1869) (One state cannot exclude a
corporation from another state.). Thus, a business can be incorporated in state A and do
business in states B, C, and D.
i. Foreign Corporation – From another state.
ii. Alien Corporation – From another country.
iii. Internal Affairs Doctrine – Law of the state of incorporation governs the
internal operations of the corporation.
1. Some states regulate to some extent the internal affairs of corporations
not incorporated in their states, but having substantial operations in their
states. Operates on top of law of host state.
iv. External Affairs – E.g., a tort committed by a corporation. The relevant law is
determined by state choice of law rules. Generally, look to the locations of the
parties and activity.
v. Most corporations incorporate in Delaware.
c. Draft articles of incorporation.
i. Model Act § 202(a), (b) – Terms that must and may be included, respectively.
Mandatory and optional terms.
d. Incorporator will file articles of incorporation with the secretary of state in the state of
your choosing.
e. Then, you have a corporation!
i. Next steps generally are done simultaneously.
f. Next, draft bylaws and adopt them as your first act.
g. Hold an organizational meeting to appoint a Board and officers. At this point, you may
be ready to work.
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h. Issue stock to raise capital.
6. Delaware’s Dominance
a. More than 300,000 companies are incorporated in Delaware including:
i. 60 percent of the Fortune 500.
ii. 50 percent of the companies listed on the NYSE.
b. Why? A: Very enabling corporate law.
i. Race to the Top or Race to the Bottom?
c. Details
i. No minimum capital requirements.
ii. The need for only one incorporator (a corporation may be the incorporator).
iii. Favorable franchise tax in comparison to other states.
iv. For companies doing business outside of Delaware:
1. No corporation income tax.
2. No sales tax, personal property tax, or intangible property tax on
corporations.
3. No taxation upon shares of stock held by non-residents and no
inheritance tax upon non-resident holders.
v. A corporation may keep all of its books and records outside of Delaware and may
have a principal place of business/address outside of the state of Delaware too.
vi. Highly competent judiciary in company law and extensive and detailed case law
on this subject.
7. Comparing Partnerships & Corporations
a.
8. Liability for Pre-Incorporation Activity
a. Promoter – Someone who purports to act as an agent of the business prior to its
incorporation. Owes fiduciary duties to her principal.
b. Once articles of incorporation are filed, parties must draft a contract to accept the articles.
i. Express Ratification
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ii. Implicit Ratification – By accepting the benefits of the contract. If the
corporation gets up and running and starts accepting the benefits of deals, then
the contract is ratified.
c. If the corporation breaches, Model Act says that the promoter still is liable.
i. Only other party may release the promoter from liability in the event of breach.
d. If the articles are not filed for some reason, the promoter is liable—even if the
corporation never comes into existence.
9. Defective Corporations
a. Definition – Business that failed to meet the necessary legal requirements at the time of
its formation.
b. De Facto Corporation – A court may treat an improperly incorporated firm as a
corporation if organizers:
i. Acted in good faith to incorporate;
ii. Had the legal right to incorporate; and
iii. Acted as if they were incorporated.
c. Corporation by Estoppel – A court will also treat a firm improperly incorporated as a
corporation if third parties:
i. Thought the business was a corporation; and
ii. Would earn a windfall if they were now allowed to deny that the business was a
corporation.
d.  Significant overlap between doctrines, but not always. E.g.:
i. If firm did not act to incorporate, it cannot be a de facto corporation.
ii. If firm incurred liability by committing a tort, the injured party likely did not
choose to deal with the firm as a corporation. Still may be de facto corporation.
10. Southern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc.
a. Facts – Southern-Gulf Marine Co. signed an agreement as a corporation to purchase a
156-foot supply vessel from Camcraft, but it did not incorporate until later. The deal did
not go through because the overall value of the boat changed. Its value went up, and
thus, the deal was no longer as attractive to Southern-Gulf Marine Co.
b. Corporation by Estoppel
i. “One who contracts with what he acknowledges to be and treats as a corporation,
incurring obligations in its favor, is estopped from denying its corporate
existence, particularly when the obligations are sought to be enforced.”
ii. “Where a party has contracted with a corporation, and is sued upon the contract,
neither is permitted to deny the existence, or the legal validity of such
corporation. To hold otherwise would be contrary to the plainest principles of
reason and of good faith, and involve a mockery of justice.”
c. Basis for Holding – Defendant had been going along with the deal, and it should not be
allowed to get out of it now, once the market had fluctuated. There is some holding out
and reliance.
d. If the corporation never had formed, defendant may have had a contract claim.
11. Corporate Officers
a. The top management of a corporation is appointed by the board of directors. These
individuals are called corporate officers.
i. MBCA § 8.40(a): “A corporation has the offices described by its bylaws or
designated by the board of directors in accordance with the bylaws.”
ii. MBCA § 8.40(b): “The board of directors may elect individuals to fill one or
more officers of the corporation. An officer may appoint one or more officers if
authorized by the bylaws or the board of directors.”
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b. Corporate officers usually include a chief executive officer (CEO) or president, a chief
financial officer (CFO), a treasurer, and secretary. In addition, a vice-president usually
oversees each functional area.
The Corporate Entity & Limited Liability
1. Generally
a. Allows corporate actors to diversify; to put their money into different activities.
b. Allows exposure to the upside and mitigates the downside.
c. Pension funds, which are corporations, invest on Wall Street, and limited liability
protects them and future retirees.
d. Makes trading shares very easy.
e. A creditor gets hurt by limited liability when there is not enough money to pay the
liability.
i. However, voluntary creditors should know when they initiate business with a
corporation that it is subject to limited liability.
f. A debtor may get hurt by limited liability in several ways.
g. Shareholders are not liable, but corporations are.
h. Limited liability does not mean no liability. One still may lose what one has invested in
the corporation.
i. Shareholder may lose limited liability.
2. MBCA § 6.22(b) – “Unless otherwise provided in the articles of incorporation, 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.”
3. Walkovszky v. Carlton
a. Facts – A pedestrian struck by a taxicab sued the corporation in whose name the taxi was
registered, the cabdriver, nine corporations in whose names other taxicabs were
registered, two additional corporations, and three individuals.
b. Limited Liability – “The law permits the incorporation of a business for the very
purpose of enabling its proprietors to escape personal liability but, manifestly, the
privilege is not without its limits.”
c. Piercing the Corporate Veil – “The courts will disregard the corporate form, or, to use
accepted terminology, ‘pierce the corporate veil,’ whenever necessary to prevent fraud or
to achieve equity.”
i. Important Factors
1. All cabs shared a garage.
2. All of the small corporations did not follow the formalities of corporate
operations, i.e., holding regular meetings, etc. (Most important)
ii. Two-Prong Test
1. Respecting the corporate form, i.e., the corporate formalities. E.g.,
annual meeting, keeping minutes, electing officers, keeping corporate
funds separate and distinct, etc. (Crucial)
a. If these things are present, a corporation has a much better
chance of protecting itself against veil piercing.
b. Plaintiff’s knowledge is irrelevant to piercing the corporate veil.
“Hey, I know that you never had any meetings.”
2. Preventing injustice.
d. Shareholder Liability – “In determining whether liability should be extended to reach
assets beyond those belonging to the corporation the court is guided by general rules of
agency. Whenever anyone uses control of the corporation to further his own rather than
the corporation’s business, he will be liable for the corporation’s acts upon the principle
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of respondeat superior applicable even where the agent is a natural person. Such liability,
moreover, extends not only to the corporation’s commercial dealings, but to its negligent
acts as well.”
e. Alter Ego Theory – “It is one thing to assert that a corporation is a fragment of a larger
corporate combine which actually conducts the business. It is quite another to claim that
the corporation is a ‘dummy’ for its individual stockholders who are in reality carrying on
the business in their personal capacities for purely personal rather than corporate ends.
Either circumstance would justify treating the corporation as an agent and piercing the
corporate veil to reach the principal but a different result would follow in each case. In
the first, only a larger corporate entity would be held financially responsible, while, in the
other, the stockholder would be personally liable. Either the stockholder is conducting
the business in his individual capacity or he is not. If he is, he will be liable; if he is not,
then, it does not matter—insofar as his personal liability is concerned—that the enterprise
is actually being carried on by a larger ‘enterprise entity.’”
i. Simpler Restatement of Alter Ego Theory – Shareholder may be personally
liable for a corporation’s acts and debts on a principal-agent theory if the
shareholder uses her control of the corporation to further her own, rather than the
corporation’s, interests. The corporation is treated as the agent of the
shareholder-principal, and liability is imposed on the shareholder under the
tort/agency-law doctrine of vicarious liability.
ii. Essentially a one-part test: are you treating the corporation as yourself?
f. No Basis for Piercing Corporate Veil
i. None of the ten corporations has a separate identity; each is part of a single
enterprise through which Carlton operated the taxicab business.  Insufficient
justification because there is nothing wring with multiple corporations acting
together.
ii. Carlton divided the taxicab business among ten corporations just to take
advantage of limited liability and therefore is defrauding the public.  Nothing
intrinsically fraudulent about dividing a single enterprise into multiple
corporations.
g. Enterprise Liability – Two-Part Test:
i. There must be such a high degree of uniform activity that the entities’ separate
existences had de facto ceased.
ii. Treating the entities as separate would sanction fraud or promote injustice.
1. Merely dividing a single enterprise among multiple corporations is
insufficient.
2. There must be some intent to defraud or element of unjust enrichment.
iii.  Used to hold an entire corporate group liable, not a shareholder individually.
iv.  Factors in Olympic Financial Ltd. v. Consumer Credit Corp.:
1. Common employees;
2. Common record keeping;
3. Centralized accounting;
4. Payment of wages by one corp. to another corp.’s employees;
5. A common business name;
6. Services rendered by the employees of one corporation on behalf of
another;
7. Undocumented transfers between corporations;
8. Unclear allocation of profits and losses between the corporations;
9. The same officers;
10. The same shareholders;
11. The same telephone number.
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h. Three Methods of Piercing Corporate Veil Here
i. Enterprise Liability
ii. Respondeat Superior
iii. Piercing the Corporate Veil
4. Sea-Land Services, Inc. v. Pepper Source (7th Cir. 1991) (Ill.)
a. Facts – Pepper Source owed Sea-Land Services, Inc. for the cost of shipping peppers;
however, Pepper Source was dissolved before Sea-Land could enforce a judgment against
it.
b. Two-Prong Test for Veil Piercing
i. “First, there must be such unity of interest and ownership that the separate
personalities of the corporation and the individual or other corporation no longer
exist.”
1. Four Factors (Weighed, but Not Required)
a. (1) The failure to maintain adequate corporate records or to
comply with corporate formalities;
b. (2) The commingling of funds or assets;
c. (3) Undercapitalization; and
d. (4) One corporation treating the assets of another corporation as
its own.
ii. “Second, circumstances must be such that adherence to the fiction of separate
corporate existence would sanction a fraud or promote injustice.”
1. Proof of intent to defraud is considered, but not required.
2. Sufficient Showings
a. Sanctioning of a fraud, i.e., intentional wrongdoing.
b. Promotion of injustice.
c. Unjust enrichment. B. Kreisman & Co.
3. “The promote injustice feature of the veil-piercing inquiry has been
interpreted and summarized as some element of unfairness, something
akin to fraud or deception or the existence of a compelling public interest
must be present in order to disregard the corporate fiction.”
4. Some wrong beyond a creditor’s inability to collect must result. E.g.:
a. The common sense rules of adverse possession would be
undermined.
b. Former partners would be permitted to skirt the legal rules
concerning monetary obligations.
c. A party would be unjustly enriched.
d. A parent corporation that caused a sub’s liabilities and its
inability to pay for them would escape those liabilities.
e. An intentional scheme to squirrel assets into a liability-free
corporation while heaping liabilities upon an asset-free
corporation would be successful.
c. Reverse Veil Piercing – Permits a shareholder to disregard a corporation’s separate
identity, just as “forward” veil piercing permits a creditor to do so.
i. Shareholder must make the same showing as a creditor in a “forward” veil
piercing case.
ii. Outsider Reverse Veil Piercing – Personal creditor of a shareholder seeks to
disregard a corporation’s separate legal existence to reach the assets of the
corporation to satisfy the creditor’s claims against the shareholder.
5. Roman Catholic Archbishop of San Francisco v. Sheffield
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a. Facts – After Sheffield did not receive a dog that he had purchased from a monastery in
Switzerland, he sued the Roman Catholic Archbishop of San Francisco in California state
court for breach of contract.
b. Alter Ego Theory – “The terminology ‘alter ego’ or ‘piercing the corporate veil’ refers
to situations where there has been an abuse of corporate privilege, because of which the
equitable owner of a corporation will be held liable for the actions of the corporation.”
c. Requirements of Alter Ego Theory
i. “It must be made to appear that the corporation is not only influenced and
governed by that person [equitable owner of a corporation],”
ii. “But that there is such a unity of interest and ownership that the individuality, or
separateness, of such person and corporation has ceased,”
iii. “And adherence to the fiction of the separate existence of the corporation would
sanction a fraud or promote injustice.”
iv.  Factors to Be Considered
1. Commingling of funds and other assets of the two entities;
2. The holding out by one entity that it is liable for the debts of the other;
3. Identical equitable ownership in the two entities;
4. Use of the same offices and employees; and
d. No Respondeat Superior Between Subagents – “The ‘alter ego’ theory makes a
‘parent’ liable for the actions of a ‘subsidiary’ which it controls, but it does not mean that
where a ‘parent’ controls several subsidiaries each subsidiary then becomes liable for the
actions of all other subsidiaries. There is no respondent superior between the subagents.”
e. Inability to Collect Is Insufficient – “It is not sufficient that the plaintiff will not be able
to collect if the corporate veil is not pierced. In almost every instance where a plaintiff
has attempted to invoke the doctrine he is an unsatisfied creditor. The purpose of the
doctrine is not to protect every unsatisfied creditor, but rather to afford him protection,
where some conduct amounting to bad faith makes it inequitable . . . for the equitable
owner of a corporation to hide behind its corporate veil.”
6. In re Silicone Gel Breast Implants Products Liability Litigation
a. Facts – Breast implant recipients brought a products liability action against Bristol-Myers
Squibb Co., which was the sole shareholder of Medical Engineering Corp., a major
supplier of breast implants.
b. Parent Corporation – Owns all the shares of common stock of another corporation, the
subsidiary corporation.
c. General Rule - Parent corporation is not liable for the debts of its subsidiary. Parent can
undertake activities without risking its own assets, beyond those it decides to commit to
the subsidiary.
d. Alter Ego Theory – “When a corporation is so controlled as to be the alter ego or mere
instrumentality of its stockholder, the corporate form may be disregarded in the interests
of justice.”
i. Totality of circumstances used “in determining whether a subsidiary may be
found to be the alter ego or mere instrumentality of a parent corporation.”
ii. All states require a showing of substantial domination.
iii. Fraud Not Required – Piercing the corporate veil does not require a showing of
fraud if a subsidiary is found to be the mere instrumentality or alter ego of its sole
stockholder.
1. Contract v. Tort – “Many jurisdictions that require a showing of fraud,
injustice, or inequity in a contract case do not in a tort situation.”
iv. Factors:
1. The parent and the subsidiary have common directors or officers;
2. The parent and the subsidiary have common business departments;
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3. The parent and the subsidiary file consolidated financial statements and
tax returns;
4. The parent finances the subsidiary;
5. The parent caused the incorporation of the subsidiary;
6. The subsidiary operates with grossly inadequate capital;
7. The parent pays the salaries and other expenses of the subsidiary;
8. The subsidiary receives no business except that given to it by the parent;
9. The parent uses the subsidiary’s property as its own;
10. The daily operations of the two corporations are not kept separate;
11. The subsidiary does not observe the basic corporate formalities, such as
keeping separate books and records and holding shareholder and board
meetings.
e. Direct Liability – “One who undertakes, gratuitously or for consideration, to render
services to another which he should recognize as necessary for the protection of a third
person or his things, is subject to liability to the third person for physical harm resulting
from his failure to exercise reasonable care to perform his undertakings, if: (a) his failure
to exercise reasonable care increases the risk of harm, or (b) he has undertaken to perform
a duty owed by the other to the third person, or (c) the harm is suffered because of a
reliance of the other or the third person upon the undertaking.”
i. “Under the theory of negligent undertaking, frequently applied in connection
with safety inspections by insurers or with third-party repairs to equipment or
premises, a duty that would not otherwise have existed can arise when an
individual or company nevertheless undertakes to perform some action.”
ii. “The potential liability for failure to use reasonable care in such circumstances
extends to persons who may reasonably be expected to suffer harm from that
negligence.”
iii. Not an assertion of derivative liability but one of direct liability, since it is based
on the actions of defendant itself.
iv. Existence of a parent-subsidiary relationship is no defense.
f. Lesson – Shows that with a strong enough public policy argument, you may get veil
piercing or enterprise liability. Shows that public-interest factors do show up and may be
outcome-determinative.
7. Frigidaire Sales Corporation v. Union Properties, Inc.
a. Facts – Frigidaire Sales Corp., a creditor of Commercial Investors, a limited partnership,
brought an action against the corporate general partner and its limited partners
individually when the partnership failed to pay installments due on contract.
b. Corporations as General Partners
i. Totally acceptable.
ii. General Partner – Unlimited liability, but corporations are limited liability
entities.
1. Some states do not allow corporations to be general partners, and these
states do not want to give into limited liability.
iii. Limited Partnership with Corporation as General Partner – Tax shelter. No
individual is liable for the debts of the partnership.
c. Capitalization – “Because Washington’s limited partnership statutes permit parties to
form a limited partnership with a corporation as the sole general partner, a concern about
minimal capitalization, standing by itself, does not justify a finding that the limited
partners incur general liability for their control of the corporate general partner. If a
corporate general partner is inadequately capitalized, the rights of a creditor are
adequately protected under the ‘piercing-the-corporate-veil’ doctrine of corporation law.”
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d. Rule – “When the shareholders of a corporation, who are also the corporation’s officers
and directors, conscientiously keep the affairs of the corporation separate from their
personal affairs, and no fraud or manifest injustice is perpetrated upon third persons who
deal with the corporation, the corporation’s separate entity should be respected.”
i. Corporate formalities are very important.
ii. If limited partners scrupulously separate their actions on behalf of the
corporation, i.e., the only general partner, from their personal actions, i.e., as
limited partners, the limited partners cannot be held generally liable.
iii. Triumph of form over substance. But then again, corporate law is all about form.
Shareholder Derivative Actions
1. Generally
a. Shareholder Derivative Suit – Lawsuit brought to right a wrong done to a corporation.
Derivative suit belongs to the corporation.
b. Derivative actions are brought when there is a (1) duty of care or (2) loyalty or (3)
business judgment violation.
c. Why would a corporation itself not sue?
i. Bad for business; expensive (whether or not a corporation is at fault); gives you a
bad, litigious, quarrelsome reputation; requires an immense amount of focuses
emotional and intellectual attention.
ii. Corporation is made up of people that act in its best interest (most of the time).
Somebody inside the corporation took the corporation to the point where a
derivative action seemed to be necessary (perhaps by breaching a duty of care or
loyalty).
iii. Agency Costs – Corporation does not want to air its dirty laundry publically.
iv. Hostage litigation; sham litigation; strike suits; etc. Shareholders may bring suit
simply for its harassment/settlement value.
d. Incentives to Bring Derivative Suit
i. A way to become involved/active in the operations of the corporation.
ii. Plaintiffs’ lawyers often bring derivative suits in order to earn a piece of the
ultimate judgment. Because they want money, this encourages lawyers to police
corporate activity and takes some heat off cops and prosecutors.
iii.  Remember, the derivative suit is owned by the corporation, and any relief will
go to the corporation.
e. Virtue of Derivative Suits – Allows shareholders to hold corporation accountable—rein
in board of directors. One of the only ways for stockholders to put pressure on the
directors.
f. Settlements – Corporations may settle easily so that the actual wrong is not aired in
public.
i. Arguments for Public Disclosure
1. If the wrong is not aired, society may not learn anything that it can use in
the future, and the same wrong may recur.
2. Want to educate victims (about how not to become victims), corporations
(about why their actions are bad), and courts and society (as informed
third parties).
g. Direct v. Derivative Actions
i. Direct – Shareholder brings a lawsuit in her own name. Action and judgment
belong to her. Available if an injury flows directly to the shareholder.
ii. Derivative – Brought by a shareholder on behalf of corporation. Arises out of an
injury to the corporation as an entity, and any judgment flows to the corporation.
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iii. Other Options
1. Plaintiffs could form a class and bring a direct class action suit.
2. Plaintiffs could leave the corporation by selling stock, thereby driving
down the value of the stock and the corporation. Hurts the corporation.
3. Takeover – When a board controls a corporation badly, there are ways
that the plaintiffs can take over control of the corporation.
iv.  Same behavior can give rise to direct and derivative causes of action.
v. “The distinction between a direct claim and a derivative claim depends upon the
nature of the wrong alleged and the relief, if any, which could result if plaintiff
were to prevail.” Grimes v. Donald.
h. Insulating Risk to Corporation
i. Fee-shifting rule.
ii. Bond-posting rule. Plaintiff must post a bond to cover the corporation’s legal
expenses. Protection against sham litigation.
iii. Demand requirement.
iv. Special litigation committee.
2. Plaintiff Qualifications
a. Contemporaneous Ownership
i. MBCA § 7.41(1) Standing – A shareholder may not commence or maintain a
derivative proceeding unless the shareholder: (1) was a shareholder of the
corporation at the time of the act or omission complained of or became a
shareholder through transfer by operation of law from one who was a shareholder
at that time [i.e., devolution].
1. MUST OWN STOCK AT THE TIME.
ii. Continuing wrongs.
iii. MBCA § 7.42 – Must be a shareholder when suit commenced.
iv. Many states say plaintiff also must remain a shareholder through final judgment.
b. Fair & Adequate Representative
i. MBCA § 7.41(2) – A shareholder may not commence or maintain a derivative
proceeding unless the shareholder: . . . (2) fairly and adequately represents the
interests of the corporation in enforcing the right of the corporation.
ii. Grounds for Challenging Plaintiff’s Fairness & Adequacy
1. Conflicted interests, such as bringing suit for unrelated strategic purposes
2. Unclean hands
3. Cohen v. Beneficial Industrial Loan Corp.
a. Facts – David Cohen brought a shareholder’s derivative suit against Beneficial Industrial
Loan Corp. and others, and Beneficial brought a motion seeking to have Hannah Cohen,
David’s executrix, post security for the expenses associated with prosecuting the lawsuit.
b. Rule – NJ statute (1) that requires a holder of less than 5% of a corporation’s outstanding
shares who brings a derivative suit to pay for all expenses of defending that suit and
(2) that requires security for the payment of these expenses should be enforced in cases
prosecuted under federal diversity jurisdiction.
i. NJ law is substantive, not merely procedural, because it creates new liability.
See Erie (“[I]t creates a new liability where none existed before, for it makes a
stockholder who institutes a derivative action liable for the expense to which he
puts the corporation and other defendants, if he does not make good his claims.”)
1. Once it is determined that state law will apply, choice-of-law rules
determine which state’s law will apply.
ii. Effects of NJ Law/POLICY – “Its general effect is to make a plaintiff having so
small an interest liable for the reasonable expenses and attorney’s fees of the
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defense if he fails to make good his complaint and to entitle the corporation to
indemnity before the case can be prosecuted.”
c. Corporate Law Lesson - If an action affects only intra-corporate activities, then the law
of the state of incorporation applies.
Demand Requirement, Special Committees & Role
The Requirement of Demand on Directors
1. Generally
a. Two Rules
i. MBCA § 7.42 Demand – No shareholder may commence a derivative
proceeding until:
(1) a written demand has been made upon the corporation to take suitable
action; and
(2) 90 days have expired from the date the demand was made unless the
shareholder has earlier been notified that the demand has been rejected
by the corporation or unless irreparable injury to the corporation would
result by waiting for the expiration of the 90 day period.
1.  Universal requirement to make a demand in every case. Make a
demand and wait 90 days, unless two categories of exceptions apply:
a. Board has rejected demand.
b. Irreparable harm would flow from the delay of 90 days.
ii. FRCP 23.1(b)(3)(A)–(B) – The complaint must be verified and must: . . . state
with particularity: . . . any effort by the plaintiff to obtain the desired action from
the directors or comparable authority . . . the reasons for not obtaining the action
or not making the effort.
iii.  How is the highlighted language different?
b. MBCA § 7.44 Dismissal – Three alternatives for the review of the demand:
i. (1) If the independent directors constitute a quorum, the demand may be
reviewed by the board.
ii. (2) In all cases, the independent directors may appoint by majority vote a
committee of two or more independent directors to review the demand.
iii. (3) Upon motion by the corporation, the court may appoint an independent panel.
c. Reviewing Demand
i. Quorum requirements. Directors of sufficient number must be independent from
the action.
ii. Then, the board may review the demand.
iii.  Also, Board or court could appoint a committee to review demand.
iv. Review Process
1. Board makes its own (1) independent and (2) good-faith determination
after reasonable investigation.
2. If both requirements are met, a court should defer to the determination of
the board or committee. Court would dismiss any lawsuit.
3.  Burden of Proof – Resides with shareholders if the board is
independent.
a. The more that it appears that the decision is “clean,” the higher
the burden placed on the shareholders.
b. If a majority of the directors are not independent, then the
corporation bears the burden of proving the above two
procedural points.
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d. Distinguishing Corporate Control of Suit v. Plaintiff’s Attorney Control of Suit – Two
Kinds of Demand Requirements
i. Universal Demand Requirement – Shifts the focus of threshold litigation from
whether the demand is excused to whether directors’ decision to terminate the
suit is entitled to deference.
ii. New York & Delaware – Do not have a universal demand requirement. Focuses
on two factors:
1. How objective are the directors?
2. Does their decision embody good judgment?
e. Demand Futility (MBCA Does Not Apply)
i. Demand requirement allows the company either to take over the cause of action
(and sue directly) or resist the suit. The decision is up to the business judgment
of the directors.
ii. But where the directors cannot be expected to make a fair decision, demand
would be futile and is excused.
iii. Standard for Demand Futility
1. Del: Grimes v. Donald
2. NY: Marx v. Akers
2. Grimes v. Donald (DELAWARE)
a. Facts – Grimes, who learned of the extremely generous compensation package DSC
Communications had extended to Donald, demanded that DSC cancel Donald’s contract.
b. Directors’ Duties Entitled to BJR
i. Management matters at heart of corporation. Strategy and affairs.
ii. Decisions to delegate tasks.
1. “A court cannot give legal sanction to agreements which have the effect
of removing from directors in a very substantial way their duty to use
their own best judgment on management matters.”
2. “Business decisions are not an abdication of directorial authority merely
because they limit a board of director’s freedom of future action.”
iii. Directors’ salaries.
c. Aronson Test for Demand Futility – “For purposes of a stockholder derivative claim,
one ground for alleging with particularity that demand would be futile is that a reasonable
doubt exists that the board of directors is capable of making an independent decision to
assert the claim if demand were made. The basis for claiming excusal would normally be
that: (1) a majority of the board has a material financial or familial interest; (2) a majority
of the board is incapable of acting independently for some other reason such as
domination or control; or (3) the underlying transaction is not the product of a valid
exercise of business judgment. If the stockholder cannot plead such assertions consistent
with Del. Ch. Ct. R. 11, after using the tools at hand to obtain the necessary information
before filing a derivative action, then the stockholder must make a pre-suit demand on the
board.”
i. Disjunctive – Only one prong need be satisfied.
ii. Director’s Non-Independence
1. Certain financial or familial ties.
2. Director may be appointed by Board/named as defendant/have voted for
the transaction and remain independent.
iii. Reasonable Doubt – “There is a reason to doubt.” Flexible concept. Claim is
not based on mere suspicions or stated solely in conclusory terms.
iv. Tools at Hand – External sources of information, e.g., media reports, corporate
regulatory filings, etc.
v. Policy Rationales
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1. By requiring exhaustion of intracorporate remedies, the demand
requirement invokes a species of alternative dispute resolution procedure
which might avoid litigation altogether.
2. If litigation is beneficial, the corporation can control the proceedings.
3. If demand is excused or wrongfully refused, the stockholder will
normally control the proceedings.
d. Right to Response from Board – “A stockholder who makes a demand is entitled to
know promptly what action the board of directors has taken in response to the demand.
A stockholder who makes a serious demand and receives only a peremptory refusal has
the right to use the tools at hand to obtain the relevant corporate records, such as reports
or minutes, reflecting the corporate action and related information in order to determine
whether or not there is a basis to assert that demand was wrongfully refused.”
e. “The stockholder does not, by making demand, waive the right to claim that demand has
been wrongfully refused.”
f. Board’s Refusal of Demand (BJR)
i. “If a demand is made and rejected, the board rejecting the demand is entitled to
the presumption of the business judgment rule unless the stockholder can allege
facts with particularity creating a reasonable doubt that the board is entitled to the
benefit of the presumption. If there is reason to doubt that the board acted
independently or with due care in responding to the demand, the stockholder may
have the basis ex post to claim wrongful refusal.”
ii. “Where a stockholder has shown that there is reason to doubt that a board of
directors acted independently or with due care in responding to a stockholder’s
demand that it take action, the stockholder then has the right to bring a derivative
action with the same standing which the stockholder would have had, ex ante, if
demand had been excused as futile.”
g. Strategic Disadvantages of Demanding
i. Concession that it was a demand-required case.
ii. If demand is required and you do not make it, it is not favorable to your case.
This results in a no-harm, no-foul situation.
iii. Making demand does not give up a lot of control because the directors usually
refuse it.
iv. Demand refusal rule applies BJR to the decision to refuse the demand. Demand
excusal rule provides a few more options.
3. Marx v. Akers (NEW YORK)
a. Facts – A shareholder brought a derivative action charging breach of fiduciary duty and
corporate waste by IBM’s board of directors for excessive compensation of IBM’s
executives and outside directors.
b. Purposes of Demand Requirement – The purposes of the demand requirement are to:
i. (1) relieve courts from deciding matters of internal corporate governance by
providing corporate directors with opportunities to correct alleged abuses;
ii. (2) provide corporate boards with reasonable protection from harassment by
litigation on matters clearly within the discretion of directors; and
iii. (3) discourage “strike suits” commenced by shareholders for personal gain rather
than for the benefit of the corporation.
c. New York’s Demand Futility Test – In New York, a demand by a shareholder that the
corporation initiate an action would be futile if a complaint alleges with particularity that:
i. (1) a majority of the directors are interested in the transaction; or
ii. (2) the directors failed to inform themselves to a degree reasonably necessary
about the transaction; or
50
iii. (3) the directors failed to exercise their business judgment in approving the
transaction.
iv.  One prong must be satisfied w/r/t majority of the board.
v.  Requisite interest must be in underlying transaction.
vi.  Passive acquiescence by majority of board is insufficient.
vii.  Differences from Delaware: New York does not incorporate a reasonable
doubt standard, and it requires particularity in the pleadings.
d. Demand Excusal (Same as Demand Futility Test Above)
i. Demand is excused because of futility when a complaint alleges with
particularity that a majority of the board of directors is interested in the
challenged transaction. Director interest may either be self-interest in the
transaction at issue (receipt of “personal benefits”), or a loss of independence
because a director with no direct interest in a transaction is “controlled” by a selfinterested director.
ii. Demand is excused because of futility when a complaint alleges with
particularity that the board of directors did not fully inform themselves about the
challenged transaction to the extent reasonably appropriate under the
circumstances. A director does not exempt himself from liability by failing to do
more than passively rubber-stamp the decisions of the active managers.
iii. Demand is excused because of futility when a complaint alleges with
particularity that the challenged transaction was so egregious on its face that it
could not have been the product of sound business judgment of the directors.
e. Self-Interested Directors – Receive a direct financial benefit from the transaction which
is different from the benefit to shareholders generally. Always interested in director
compensation.
f. Challenge to Director Compensation (Surviving Motion to Dismiss) – Must allege:
i. Compensation rates excessive on their face or other facts which call into question
whether the compensation was fair to the corporation when approved,
ii. The good faith of the directors setting those rates, or
iii. That the decision to set the compensation could not have been a product of valid
business judgment.
The Role of Special Committees
1. Special Litigation Committees Generally
a. Used when board is not independent.
b. Committee is constituted of disinterested people.
c. Court defers to its judgment.
2. Auerbach v. Bennett (NEW YORK)
a. Facts – A corporation appointed a special committee to investigate the basis of a
shareholders’ derivative suit charging mismanagement of corporate funds, and the
committee determined that the suit should be terminated.
b. Two Tiers of Questions in SLC Review
i. Challenged transaction.
ii. Committee’s recommendation that action be dismissed.
1. Ultimate substantive decision is insulated from judicial review: BJR.
c. Two Areas of Judicial Review
i. SLC’s disinterested independence.
1. Lack of prior affiliation may be key. No demonstrable contact with
corporation or board to show disinterested independence.
51
ii. Adequacy and appropriateness of procedures by which SLC’s decision was
made.
1. Court may investigate (1) committee’s good faith in choosing procedures
and (2) whether the investigation was directed and the appropriate
subjects and complete (as opposed to pro forma or shallow or halfhearted).
2. Court may not investigate committee’s underlying facts; decisionmaking process; or evidence supporting its conclusion.
3. Court may make sure that all of the papers are in the file, but it may not
read them.
iii.  Burden of Proof – On plaintiff.
1. SLC may bear initial burden of showing reasonableness of its
procedures.
iv.  If either is not satisfied, action will not be dismissed and review of the first
tier (challenged transaction) is not foreclosed.
v.  If both are satisfied, action is dismissed without reaching merits. BJR.
3. Zapata Corp. v. Maldonado (DELAWARE)
a. Facts – Maldonado, a Zapata Corp. shareholder, sued Zapata’s officers and directors for
breach of fiduciary duty, but Maldonado did not ask Zapata’s board to bring the action,
considering the request to be futile.
b. Two-Step, Sequential Procedure
i. Court must inquire into (1) independence and (2) good faith of SLC.
1. Also must inquire into bases supporting committee’s recommendations.
2. Burden of Proof – Corporation must prove independence, good faith,
and reasonable investigation.
3. Difference from Auerbach – Delaware court investigates reasonableness
of basis for committee’s decision.
ii. If first step is satisfied, court may (but need not) apply its own business judgment
as to whether the action should be dismissed.
1. Purpose – To catch cases complying with the letter, but not the spirit, of
the first step. Court should not dismiss meritorious derivative suits
simply because SLC followed correct procedure.
2. No real guidelines for applying court’s own business judgment. Court
weighs:
a. Corporate interest in dismissal.
b. Corporation’s best interests.
c. Matters of law and public policy.
3. Way to let meritorious cases go through when something fishy is going
on.
c. Not to be invoked in DEMAND REFUSAL cases – Refusal does not create a
presumption of a conflict.
52
4.
The Role and Purpose of Corporation
1. Capital Structure
a. Shares & Bonds
i. Shares/Stocks – Securities attached to equity capital.
1. Equivalent to “points” in a partnership.
2. Voting rights in a firm.
3. Rights to dividends.
4. Rights to residual assets.
ii. Bonds – Securities attached to debt capital.
1. Rights to payment of interest and principal.
2. Often specify collateral.
3. In some cases, give some rights of control.
b. Rights of Shareholder
i. Dividends
ii. Residual Assets
iii. Voting
c. Types of Shares
i. Authorized – Shares specified in the articles of incorporation.
ii. Outstanding – Shares the corporation has sold and not repurchased.
iii. Authorized but Unissued – Shares authorized by the charter but which have not
been sold by the firm.
iv. Treasury – Shares that were once issued and outstanding, but have been
repurchased by the corporation.
d. Special Types of Securities
i. Preferred Shares – Owners of preferred shares receive a certain amount of
dividends before any dividends can be distributed to the holders of the other
shares.
53
ii. Convertible Bond – May be converted into stock.
iii. Warrants – A security issued by the corporation, giving the holder the right to
purchase, by a certain day, a share for a certain price.
2. Hierarchy of Legal Sources
a.
3. Corporate Powers & Purposes
a. Corporate Powers
i. MBCA § 8.01(b) – “All corporate powers shall be exercised by or under the
authority of, and the business and affairs of the corporation managed by or under
the direction of, its board of directors.”
ii. MBCA § 3.02 – “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: . . . (13) to make
donations for the public welfare or for charitable, scientific, or educational
purposes.”
1. Section 3.02 is a broad grant of power.
iii. MBCA § 8.30(a) – “Each member of the board of directors, when discharging
the duties of a director, shall act: (1) in good faith, and (2) in a manner the
director reasonably believes to be in the best interests of the corporation.”
b. Corporate Goals
i. Stakeholders.
ii. Wealth Maximization – This generally is a corporate goal/duty.
4. Dodge v. Ford Motor Co.
a. Facts – Ford Motor Company made extraordinary profits and its founder, Henry Ford,
intended to use those profits to lower the price of its cars and expand factories’
capabilities by adding a steel plant, but Ford Motor’s shareholders objected to these
policies claiming that the company’s first obligation was to make profits for its
shareholders.
54
b. Directors Authorized to Issue Dividends – “The directors of a corporation, and they
alone, have the power to declare a dividend of the earnings of the corporation, and to
determine its amount.”
i. Judicial Review of Dividend Issuance – “Courts of equity will not interfere in
the management of the directors unless (1) it is clearly made to appear that they
are guilty of fraud or misappropriation of the corporate funds, or (2) refuse to
declare a dividend when the corporation has a surplus of net profits which it can,
without detriment to its business, divide among its stockholders, and when a
refusal to do so would amount to such an abuse of discretion as would constitute
a fraud, or breach of that good faith which they are bound to exercise towards the
stockholders.”
ii.  This case is an outlier on dividends, which usually are accorded an immense
amount of deference.
iii.  Why no deference here? A: Ford was talking in the press saying that he was
not interested in making money for his shareholders. This was after he had told
his shareholders that he would make them money.
c. Purpose of Corporation – “Primarily for the profit of the stockholders.”
i. Limits on Directors’ Powers – “The powers of the directors are to be employed
for that end. The discretion of directors is to be exercised in the choice of means
to attain that end and does not extend to a change in the end itself, to the
reduction of profits or to the nondistribution of profits among stockholders in
order to devote them to other purposes.”
ii. “It is not within the lawful powers of a board of directors to shape and conduct
the affairs of a corporation for the merely incidental benefit of shareholders and
for the primary purpose of benefiting others.”
5. Shlensky v. Wrigley
a. Facts – Shlensky, a Chicago Cubs’ shareholder, brought a derivative suit against the
Chicago Cubs and its directors for negligence and mismanagement and for an order that
the defendant install lights for night baseball games.
b. Business Judgment Deference
i. “It is not [courts’] function to resolve for corporations questions of policy and
business management.”
ii. Presumption of Good Faith/Corporate Interests – “The judgment of the
directors of corporations enjoys the benefit of a presumption that it was formed
in good faith and was designed to promote the best interests of the corporation
they serve.”
iii. “In a purely business corporation the authority of the directors in the conduct of
the business of the corporation must be regarded as absolute when they act within
the law, and the court is without authority to substitute its judgment for that of
the directors.”
iv. Arguments on Both Sides
1. Shareholders bought into Wrigley, and now, they must defer to his
decisions.
2. Wrigley must listen to reasoned input, and listening to reasoned input is
part of acting professionally, which is required under the business
judgment rule. (Similar to following proper corporate procedures.
Entitles one to deference.)
c. Court Intervention – Requires Fraud or Bad Faith
i. “The directors are chosen to pass upon such questions and their judgment unless
shown to be tainted with fraud is accepted as final.”
55
CORPORATIONS
(6250-20)
George Washington University Law School
Professor Kieff – Spring 2012
ii. “It is clear that the [Dodge] court felt that there must be fraud or a breach of that
good faith which directors are bound to exercise toward the stockholders in order
to justify the courts entering into the internal affairs of corporations. This is
Bainbridge,
Abramowicz,
made clearCopyrights:
when the
court refused
toKieff
interfere with the directors’ decision to
expand the business.”
1 of 25
LLCs
[See notes on 1/17/12.]
Comparing LLCs and
Corporations
Limited Liability Company
Corporation
Limited Liability
Yes, but creditors may seek
personal guarantees
Yes, but creditors may seek personal
guarantees
Free
Transferability
Default: No, but may be allowed
Default: Yes, but may be restricted
Longevity
Similar to RUPA rules. (generally
wrap up with member departures)
Default: Indefinite, but can be limited
Centralized
Management
Flexible. Default is like partnership,
but can opt for managers.
Yes, but may want to modify to prevent
freeze-out.
Formation
Filing of Articles of Organization
required, as is preparation of
annual reports. Flexibility as to
other formalities.
Formalities required, including: Articles of
Incorporation, Bylaws, Board of Directors,
Officers, Minutes, Elections, Filings; more
costs
Tax
Single; losses used by members.
Some states have LLC taxes/fees.
Double on dist. earnings
2 of 25
1.
a. Equivalent Terms (Corporation – LLC)
i. Shareholders & Partners – Members
ii. Directors & Officers – Managers
iii. Articles of Incorporation – Articles of Organization
iv. Bylaws & Partnership Agreement – Operating Agreement
b. A lot of the LLC statutes and LLC case law track those for corporations.
2. Best of Corporations & Partnerships – Limited liability, fairly freely transferable setup,
flexibility in management, and pass-through taxation.
3. Personal Liability
a. Advantages of exposing yourself to personal liability.  People see that you have skin in
the game and may be more willing to deal with you.
b. Disadvantage of exposing yourself to personal liability.  Exposing yourself to personal
liability.
Formation
1. File Articles of Organization in the designated state office. ULLCA § 202(a).
a. Required Terms – ULLCA § 203(a)
(1) the name of the company;
56
1
(2) the address of the initial designated office;
(3) the name and street address of the initial agent for service of process;
(4) the name and address of each organizer;
(5) whether the company is to be a term company and, if so, the term specified;
(6) whether the company is to be manager-managed, and, if so, the name and
address of each initial manager; and
(7) whether one or more of the members of the company are to be liable for its
debts and obligations under Section 303(c).
b. Optional Terms – ULLCA § 203(b)
(1) provisions permitted to be set forth in an operating agreement; or
(2) other matters not inconsistent with law.
2. Additional Steps
a. Pay filing fees and franchise tax.
b. Choose and register name
i. ULLCA §105(a): The name of a limited liability company must contain “limited
liability company” or “limited company” or the abbreviation “L.L.C.”, “LLC”,
“L.C.”, or “LC”. “Limited” may be abbreviated as “Ltd.”, and “company” may
be abbreviated as “Co.”.
c. Designate office and agent for service of process.
3. Draft Operating Agreement
a. ULLCA § 203(c) – Articles of organization of a limited liability company may not vary
the nonwaivable provisions of Section 103(b). As to all other matters, if any provision of
an operating agreement is inconsistent with the articles of organization:
(1) the operating agreement controls as to managers, members, and members’
transferees; and
(2) the articles of organization control as to persons, other than managers,
members and their transferees, who reasonably rely on the articles to their
detriment.
4. ULLCA § 902 Conversion of Partnership or Limited Partnership to Limited Liability
Company
(a) A partnership or limited partnership may be converted to a limited liability company
pursuant to this section.
(b) The terms and conditions of a conversion of a partnership or limited partnership to a
limited liability company must be approved by all of the partners or by a number or
percentage of the partners required for conversion in the partnership agreement.
(c) An agreement of conversion must set forth the terms and conditions of the conversion
of the interests of partners of a partnership or of a limited partnership, as the case may be,
into interests in the converted limited liability company or the cash or other consideration
to be paid or delivered as a result of the conversion of the interests of the partners, or a
combination thereof.
(d) After a conversion is approved under subsection (b), the partnership or limited
partnership shall file articles of organization in the office of the [Secretary of State]
which satisfy the requirements of Section 203 and contain:
(1) a statement that the partnership or limited partnership was converted to a
limited liability company from a partnership or limited partnership, as the case
may be;
(2) its former name;
(3) a statement of the number of votes cast by the partners entitled to vote for and
against the conversion and, if the vote is less than unanimous, the number or
percentage required to approve the conversion under subsection (b); and
57
(4) in the case of a limited partnership, a statement that the certificate of limited
partnership is to be canceled as of the date the conversion took effect.
(e) In the case of a limited partnership, the filing of articles of organization under
subsection (d) cancels its certificate of limited partnership as of the date the conversion
took effect.
(f) A conversion takes effect when the articles of organization are filed in the office of the
[Secretary of State] or at any later date specified in the articles of organization.
(g) A general partner who becomes a member of a limited liability company as a result of
a conversion remains liable as a partner for an obligation incurred by the partnership or
limited partnership before the conversion takes effect.
(h) A general partner’s liability for all obligations of the limited liability company
incurred after the conversion takes effect is that of a member of the company. A limited
partner who becomes a member as a result of a conversion remains liable only to the
extent the limited partner was liable for an obligation incurred by the limited partnership
before the conversion takes effect.
5. ULLCA § 903 – Effect of Conversion; Entity Unchanged
(a) A partnership or limited partnership that has been converted pursuant to this [article]
is for all purposes the same entity that existed before the conversion.
(b) When a conversion takes effect:
(1) all property owned by the converting partnership or limited partnership vests
in the limited liability company;
(2) all debts, liabilities, and other obligations of the converting partnership or
limited partnership continue as obligations of the limited liability company;
(3) an action or proceeding pending by or against the converting partnership or
limited partnership may be continued as if the conversion had not occurred;
(4) except as prohibited by other law, all of the rights, privileges, immunities,
powers, and purposes of the converting partnership or limited partnership vest in
the limited liability company; and
(5) except as otherwise provided in the agreement of conversion under Section
902(c), all of the partners of the converting partnership continue as members of
the limited liability company.
6. Corporations – No provision for conversion [Can convert by merging the corporation into a
newly-formed LLC; §904 (merger of entities) would then govern procedure].
a. ULLCA § 904 Merger of Entities
(a) Pursuant to a plan of merger approved under subsection (c), a limited liability
company may be merged with or into one or more limited liability companies,
foreign limited liability companies, corporations, foreign corporations,
partnerships, foreign partnerships, limited partnerships, foreign limited
partnerships, or other domestic or foreign entities.
(b) A plan of merger must set forth:
(1) the name of each entity that is a party to the merger; . . .
(c) A plan of merger must be approved:
(1) in the case of a limited liability company that is a party to the merger,
by all of the members or by a number or percentage of members
specified in the operating agreement;
(2) in the case of a foreign limited liability company that is a party to the
merger, by the vote required for approval of a merger by the law of the
State or foreign jurisdiction in which the foreign limited liability
company is organized;
58
(3) in the case of a partnership or domestic limited partnership that is a
party to the merger, by the vote required for approval of a conversion
under Section 902(b); and
(4) in the case of any other entities that are parties to the merger, by the
vote required for approval of a merger by the law of this State or of the
State or foreign jurisdiction in which the entity is organized and, in the
absence of such a requirement, by all the owners of interests in the entity.
(d) After a plan of merger is approved and before the merger takes effect, the
plan may be amended or abandoned as provided in the plan.
7. Water, Waste & Land, Inc. d/b/a Westec v. Lanham
a. Facts – Westec negotiated with Larry Clark, believing Clark was Lanham’s agent, but
Lanham and Clark were both members of Preferred Income Investors, an LLC.
b. Agency Law – “When a third party sues a manager or member of an LLC under an
agency theory, the principles of agency law apply notwithstanding the LLC Act’s
statutory notice rules.
i. Statutory Notice Provision – Applies only where a third party seeks to impose
liability on an Limited Liability Company’s (LLC) members or managers simply
due to their status as members or managers of the LLC.
1. Does not apply if third party does not know about the LLC.
ii. Fully Disclosed Principal – Agent does not become a party to any contract that
he negotiates.
iii. Partially Disclosed Principal – An agent is liable on a contract entered on
behalf of a principal if the principal is not fully disclosed.
1. LLC Act’s notice provision was not intended to alter the partially
disclosed principal doctrine.  Does not supplant common law.
iv. Fact Question – Whether a principal is partially or completely disclosed is a
question of fact.
v. Avoiding Personal Liability as an Agent – Disclose (1) the fact of your agency
and (2) the identity of your principal. Partial disclosure of either is not sufficient.
c. Clark & Lanham
i. Clark – Westec knew that Clark was Lanham’s agent. Clark was excused from
liability on the contract.
ii. Lanham – Lanham was personally liable on the contract because (1) he had acted
as an agent of the LLC and (2) he had not informed Westec that he was acting on
behalf of the LLC.
d. Two Methods of Attack – (1) Agency law and (2) LLC regulations.
The Operating Agreement
1. ULLCA § 103(b) – The operating agreement may not:
(1) unreasonably restrict a right to information or access to records under Section 408;
(2) eliminate the duty of loyalty under Section 409(b) or 603(b)(3), but the agreement
may:
(i) identify specific types or categories of activities that do not violate the duty of
loyalty, if not manifestly unreasonable; and
(ii) specify the number or percentage of members or disinterested managers that
may authorize or ratify, after full disclosure of all material facts, a specific act or
transaction that otherwise would violate the duty of loyalty;
(3) unreasonably reduce the duty of care under Section 409(c) or 603(b)(3);
59
(4) eliminate the obligation of good faith and fair dealing under Section 409(d), but the
operating agreement may determine the standards by which the performance of the
obligation is to be measured, if the standards are not manifestly unreasonable;
(5) vary the right to expel a member in an event specified in Section 601(6);
(6) vary the requirement to wind up the limited liability company’s business in a case
specified in Section 801(3) or (4); or
(7) restrict rights of a person, other than a manager, member, and transferee of a
member’s distributional interest, under this [Act].
2. Elf Atochem North America, Inc. v. Jaffari
a. Facts - Elf Atochem North America, Inc., engaged in a joint venture with Jaffari, the
president of Malek, Inc., and the two entities formed an LLC, but the company did not
sign its operating agreement. Members signed operating agreement, but LLC did not.
b. Freedom of Contract
i. Definition of LLC Agreement – “Any agreement, written or oral, of the
member or members as to the affairs of a limited liability company and the
conduct of its business.”
ii. RUPLA encourages freedom of contract and enforceability of operating
agreements.
iii. “Only where the agreement is inconsistent with mandatory statutory provisions
will the members’ agreement be invalidated.”
c. Delaware favors ADR mechanisms for policy reasons.
d. Rule – An LLC is bound by the terms of an operating agreement that is signed by some
of its members and that defines the LLC’s governance and operation, even if the LLC did
not execute the agreement.
e. Policy Justifications
i. Delaware favors freedom of contract.
ii. Efficiency – Cost savings of default statutory rules. Idiosyncratic parties can
modify by contrary language.
Piercing the “LLC” Veil
1. Limited Liability
a. LLC is liable for members’ or managers’ conduct if it is in the ordinary course of
business of the LLC or with authority of the LLC. ULLCA § 302.
b. Members’ or managers’ liability is limited to their contributions to the LLC, i.e., no
personal liability. ULLCA § 303(a).
i. Exception – If Articles of Organization allow personal liability and member or
manager consented in writing. ULLCA § 303(c).
2. Piercing the LLC Veil
a. MBCA § 6.22(b) – “Unless otherwise provided in the articles of incorporation, 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.”
b. ULLCA § 303(a) – “A member or manager is not personally liable for a debt, obligation,
or liability of the company solely by reason of being or acting as a member or manager.”
i. No explicit exception that opens the door to veil piercing.
ii. Cf. Minn. Stat. § 322B.302(2) – “Case law that states the conditions and
circumstances under which the corporate veil of a corporation may be pierced
under Minnesota law also applies to limited liability companies.”
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iii. But cf. ULLCA § 303(b) – “The failure of a [LLC] to observe the usual company
formalities . . . is not a ground for imposing personal liability on the members or
managers for liabilities of the company.”
3. Kaycee Land and Livestock v. Flahive
a. Facts – Flahive, through Flahive Oil & Gas, an LLC, leased undeveloped property from
Kaycee Land and Livestock and contaminated the property.
b. Equitable Doctrine – “Piercing the corporate veil is an equitable doctrine. The concept
of piercing the corporate veil is a judicially created remedy for situations where
corporations have not been operated as separate entities as contemplated by statute and,
therefore, are not entitled to be treated as such. The determination of whether the
doctrine applies centers on whether there is an element of injustice, fundamental
unfairness, or inequity.”
c. Limited Liability (General Rule)
i. “Unless otherwise provided in the articles of incorporation, 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.”
ii. “Neither the members of a limited liability company nor the managers of a
limited liability company managed by a manager or managers are liable under a
judgment, decree or order of a court, or in any other manner, for a debt,
obligation or liability of the limited liability company.”
d. Piercing the LLC Veil
i. Statutory Construction
1. Lack of statutory authority for LLC veil piercing should not be a barrier.
2. Veil piercing is applicable in the corporate context, and it should not be
presumed that the legislature had intended to abrogate this common law
doctrine in the LLC context without clear and unambiguous language.
3. Corporate Law as Model – “Every state that has enacted LLC piercing
legislation has chosen to follow corporate law standards and not develop
a separate LLC standard.”
ii. Rule – “We can discern no reason, in either law or policy, to treat LLCs
differently than we treat corporations. If the members and officers of an LLC fail
to treat it as a separate entity as contemplated by statute, they should not enjoy
immunity from individual liability for the LLC’s acts that cause damage to third
parties.”
1. Court declined to specify factors for piercing LLC veil.
2. Same corporate factors apply in LLC context.
3. Less formality in LLCs than corporations  Less formality in LLC veil
piercing. Standard for LLC veil piercing should not emphasize disregard
for operational formalities to the extent that the corporate law version
does. See ULLCA § 303(b).
e. Tom Thumb Food Markets, Inc. v. TLH Properties, LLC
i. Rule – Under the express terms of the Minn. LLC statute, the law relating to
corporate veil piercing applies to LLCs.
Fiduciary Obligations
1. Members’ Interest in LLC
a. Include:
i. Management Rights
ii. Financial Interest (right to distributions and participation in liquidation)
b. LLC Property – No direct rights.
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i. Putnam v. Shoaf – Partner has no possessory interest in partnership property.
ii. ULLCA § 501 Member’s Distributional Interest
(a) A member is not a co-owner of, and has no transferable interest in,
property of a limited liability company.
(b) A distributional interest in a limited liability company is personal
property and, subject to Sections 502 and 503, may be transferred in
whole or in part.
(c) An operating agreement may provide that a distributional interest
may be evidenced by a certificate of the interest issued by the limited
liability company and, subject to Section 503, may also provide for the
transfer of any interest represented by the certificate.
c. Profit & Loss Sharing
i. ULLCA § 405(a) – Equal shares (like a partnership).
ii. Most states allocate profits and losses on the basis of the value of members’
contributions (unless agreed otherwise).
iii. Member may withdraw and demand payment of his interest upon giving notice as
specified in statute or in LLC’s operating agreement.
d. Assignment of LLC Interest – Similar to partnership.
i. Default Rule – Member may assign financial interest; transferee becomes a
member only if Operating Agreement allows it or if all members consent.
2. Management Rights
a. Two Options
i. Member Management
ii. Manager Management
b. Member-Managed – Each member has an equal right in the management of the LLC.
ULLCA § 404(a)(1).
i. Issues decided by majority vote, except for matters specified in ULLCA § 404(c),
which require unanimous consent.
c. Manager-Managed – ULLCA § 404(b)
i. Managers elected/removed by majority vote of members.
ii. Managers decide all matters except those specified in ULLCA §404 (c), which
require unanimous consent of the LLC members.
iii. Members have no management rights except for those retained in Articles of
Organization/Operating Agreement and those specified in ULLCA § 404(c).
d. Cost of flexibility is lack of specificity, so the Articles of Organization and Operating
Agreement need to create detailed arrangements.
3. Fiduciary Duties in LLCs
a. Manager-Managed
i. Managers owe fiduciary duties.
ii. Usually, members do not owe fiduciary duties to the LLC or its members by
reason of being members.
b. Member-Managed
i. All members owe fiduciary duties.
c. Standards for Fiduciary Duties – ULLCA § 409.
i. ULLCA § 103(b)(2) – Operating Agreement may not eliminate the duty of
loyalty, but may “identify specific types or categories of activities that do not
violate the duty of loyalty, if not manifestly unreasonable.”
d. Derivative Actions
i. Members may bring an action on behalf of the LLC to recover a judgment in its
favor if the members with authority to bring the action refuse to do so.
4. McConnell v. Hunt Sports Enterprises
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a. Facts – Several individuals formed an LLC to try to attract an NHL team to Columbus,
OH, but when the company’s principal did not enter into the necessary agreements in
time to be considered by the NHL, a subgroup of the company secured the needed
facilities and was awarded the NHL franchise.
b. Rule – Operating Agreement may limit or define the scope of the fiduciary duties
imposed upon its members.
i. “An operating agreement of a limited liability company may, in essence, limit or
define the scope of the fiduciary duties imposed upon its members.”
ii. “In general terms, members of limited liability companies owe one another the
duty of utmost trust and loyalty. However, such general duty in this case must be
considered in the context of members’ ability, pursuant to operating agreement,
to compete with the company.”
iii. Contract must lead to a NON-ABSURD RESULT.
iv. Lack of clarity or contradiction  Extrinsic evidence.
v. Policy Rationales
1. Freedom of Contract
2. Efficiency
c. Tortious Interference with Business Relationship – “Occurs when a person, without a
privilege to do so, induces or otherwise purposely causes a third person not to enter into
or continue a business relationship with another.”
d. Holding – Because the Operating Agreement allowed members to engage in “any other
business venture of any nature,” McConnell’s group was free to pursue their own bid for
the NHL franchise despite being members of an LLC that had been formed for that same
purpose.
Dissolution
1. LLC dissolution is very similar to partnership wrap up.
2. Dissociation v. Dissolution
a. Dissociation – Results in withdrawal or expulsion of members, but not necessarily the
winding up of LLC. ULLCA § 601.
b. Dissolution – Results in winding up of LLC. ULLCA § 801.
3. Dissociated members’ interest must be purchased by LLC. ULLCA § 701.
a. Judicial appraisal proceeding available. ULLCA § 702.
4. Member’s right to participate in LLC management terminates upon dissociation. ULLCA
§ 603(b)(1).
a. Exception – Participation in a post-dissolution winding up process. ULLCA § 603(b)(2).
5. New Horizons Supply Cooperative v. Haack
a. Facts – Kickapoo Valley Freight LLC obtained a credit card for gasoline purchases from
New Horizons Supply Cooperative’s predecessor, and when Kickapoo was no longer able
to make payments, New Horizons sought payment from Haack.
b. Problem
i. This is a properly formed LLC. Court then corrects the veil-piercing argument.
Finally, it identifies a dissolution problem. It is the distribution-priority problem,
i.e., the order in which parties are to be paid upon the dissolution of an LLC.
1. Creditors are paid first. New Horizons is a creditor. Then the members
are paid.
2. Here, the priorities are backward (i.e., there is improper dissolution), and
that is what the court is sorting out.
ii. Solution – Court pays creditors first, and Haack is personally liable because she
was responsible for the improper dissolution.
63
c. Rules
i. “Although it appears that filing articles of dissolution is optional, the order for
distributing a limited liability company’s assets following dissolution is fixed by
statute, and the company’s creditors enjoy first priority. A dissolved limited
liability company may dispose of known claims against it by filing articles of
dissolution, and then providing written notice to its known creditors containing
information regarding the filing of claims.”
ii. “A claim not barred under [Wisconsin statute] may be enforced under this section
against any of the following: . . . (2) If the dissolved limited liability company’s
assets have been distributed in liquidation, a member of the limited liability
company to the extent of the member’s proportionate share of the claim or to the
extent of the assets of the limited liability company distributed to the member in
liquidation, whichever is less, but a member’s total liability for all claims under
this section may not exceed the total value of assets distributed to the member in
liquidation.”
d. Rule – An LLC member may be responsible for the company’s debts if the member fails
to take the appropriate steps to dissolve the company when it winds up its operations,
e.g., by failing to file dissolution documents.
FIDUCIARY DUTIES OF DIRECTORS, OFFICERS & OTHER INSIDERS
Duty of Good Care
1. BJR & Fiduciary Duties
a. Business Judgment Rule – Absent fraud, illegality, or conflict of interest, a board’s
business judgment is not second-guessed by the court.
i. Process-oriented.
ii. Generally an abstention/hands-off decision-making doctrine.
iii. Liability will only attach to actions that violate the BJR: fraud, self-dealing,
egregious misconduct, etc.
b. Court defers to the board’s business judgment unless:
i. Directors breach their Duty of Loyalty because their decision is tainted by fraud,
illegality, or conflict of interest.
ii. Directors breach their Duty of Care because they do not conduct sufficient
investigation or deliberation to make a business judgment.
c. Shareholder Policing – Shareholders have a more difficult time policing duty of loyalty
violations because such violations often are hidden. With duty of care, if someone does
not show up to work, this is obvious.
2. Announcement of Losses Problem – When a company reports accurate information about bad
news about which the market already knew, there usually is a bump up in the company’s value.
a. Market usually overreacted when the news first hit, and now, it is correcting.
b. Certainty that the company has now given to the market bumps up the company’s value.
c. E.g., Martha Stewart.
3. Kamin v. American Express Company
a. Facts – Stockholders brought a derivative action, asking for a declaration that a certain
dividend in-kind was a waste of corporate assets.
b. Business Judgment Rule – “The directors’ room rather than the courtroom is the
appropriate forum for thrashing out purely business questions which will have an impact
on profits, market prices, competitive situations, or tax advantages.”
i. Issuance of dividends or distributions is a matter of business judgment for board.
c. PREREQUISITES TO COURT INTERVENTION
64
i. Powers have been illegally or unconscientiously executed.
ii. Fraud or collusion.
iii. Destruction of stockholders’ rights or oppression
iv. Bad faith, dishonest purpose, or breach of trust.
v. Arbitrary action.
d. INSUFFICIENT GROUNDS FOR COURT INTERVENTION
i. Mere errors of judgment.
ii. Claim that some course of action other than that pursued by the board of directors
would have been more advantageous.
iii. Claim that action has some impact on (board’s) earnings.
1. “Every action taken by the board has some impact on earnings and may
therefore affect the compensation of those whose earnings are keyed to
profits. That does not disqualify the inside directors, nor does it put
every policy adopted by the board in question. All directors have an
obligation, using sound business judgment, to maximize income for the
benefit of all persons having a stake in the welfare of the corporate
entity.”
e. DUTY OF CARE – Two Components:
i. Investigation; and
ii. Deliberation.
f. Negligence Claim – “[New York law] permits an action against directors for the neglect
of, or failure to perform, or other violation of his duties in the management and
disposition of corporate assets committed to his charge. This does not mean that a
director is chargeable with ordinary negligence for having made an improper decision, or
having acted imprudently. The ‘neglect’ referred to in the statute is neglect of duties (i.e.,
malfeasance or nonfeasance) and not misjudgment.”
g. Duty of Loyalty/Control Group – To show a duty of loyalty violation, you need a
control group. Here the control group (16 directors) shows that this action by the board
was not illegal or fraudulent. Only four directors had a financial incentive to issue these
dividends.
4. Smith v. Van Gorkom
a. Facts – Trans Union’s stockholders brought a class action suit against the company’s
board of directors for negligent decisionmaking.
b. Business Judgment Rule
i. Burden – “The party attacking a board decision as uninformed must rebut the
presumption that its business judgment was an informed one.”
ii. Court only reviews PROCEDURE.
iii. Judgment Must Be Informed
1. Duty of care issue.
2. “Turns on whether the directors have informed themselves prior to
making a business decision of all material information reasonably
available to them.”
3. No protection for unintelligent or unadvised judgments.
4. Board could violate duty of care by spending TOO MUCH TIME
INVESTIGATING A MINOR DEAL. See ALI Principles of Corporate
Governance § 4.01(c)(2) (“A director or officer who makes a business
judgment in good faith fulfills the duty under this Section if the director
or officer: . . . (2) is informed with respect to the subject of the business
judgment to the extent the director or officer reasonably believes to be
appropriate under the circumstances.”)
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5. Standard – Use standard of GROSS NEGLIGENCE for “informed”
judgment.
6.  Board did not conduct the proper procedures to determine whether the
deal was a good one. Only a two-hour meeting. No detailed studies, but
only a twenty-minute oral presentation. Board did not (1) inform itself,
and it did not (2) deliberate.
c. Reports
i. Directors may rely in good faith on reports made by officers.
ii. Includes reports of informal personal investigations by corporate officers.
iii. At a minimum, for a report to enjoy the status conferred by Delaware law, it must
be pertinent to the subject matter upon which a board is called to act, and
otherwise be entitled to good faith, not blind, reliance.
d. Duty of Loyalty – Conflict of interest because Van Gorkom was approaching the age of
mandatory retirement, and he wanted to get as much money as he could.
e. Dissent – These board members are experienced, and it is not likely that they would have
been duped by Pritzker’s fast pitch. Business moves fast, and these board members make
decisions under pressure all the time.
i. More deferential version of BJR.
f. ALI Principles of Corporate Governance § 4.01(c)(2) – “A director or officer who
makes a business judgment in good faith fulfills the duty under this Section if the director
or officer: . . . (2) is informed with respect to the subject of the business judgment to the
extent the director or officer reasonably believes to be appropriate under the
circumstances.”
5. Cinerama, Inc. v. Technicolor, Inc.
a. Entire Fairness Standard – Even if there is a procedural defect impugning the BJR, the
court is willing to rebut the procedural defect if the transaction is found to be “entirely
fair”/satisfies the “entire fairness” rule.
i. Benefit – Everyone makes mistakes, but if the overall substance is entirely fair,
there is some benefit to courts allowing deals to go through. No harm, no foul.
ii. Cost – Before this case, the BJR was based almost entirely on process. After this
case, there may be a separate case over the overall substance of the deal. This
will lead to increased litigation costs/increased procedural costs.
b. Factors to Be Considered – Timing, initiation, negotiation, disclosure to and approval
by the directors, disclosure to and approval by the shareholders, etc.
i. Price is absent as its own independent factor because “entire fairness” is about a
lot more than price.
ii. The entire fairness analysis is focused on what is fair to the corporate
shareholders, not necessarily any other parties, the local community, employees,
etc.
66
The BJR and the Duty of Care
BJR Applies: Court abstains
No
The BJR and the Duty of Care
No
Fraud?
Yes
BJR
rebutted
Fraud?
Federal or state
Fraud claims
Yes
BJR rebutted
Federal or state
Fraud claims
No
BJR Applies: Court abstains
Illegality
No
Nodecision
No
Conflict of
Egregious decision
Interest?
Uninformed decision
Yes
Waste
Illegality
No decision
No
Conflict of
Egregious
decision
BJR rebutted
Interest?
Uninformed
decision
Duty of Loyalty
Yes
Waste
BJR rebutted
Duty of Loyalty
Yes
Yes
17 of 33
17 of 33
6.
The Business Judgment Rule and the
Duty of Care
The Business Judgment Rule
BJR
Duty of Care
Illegality
Egregious decision
Yes
Uninformed decision
Waste
No
Decision
Illegality
Egregious decision
Yes
Uninformed decision
Waste
No Decision
Rebutted:
Did
defendant
BJR
violate
Rebutted:
DoC?
Did
defendantNo
violate
DoC?
Calculate
damages
and
the
see Van
Gorkom
Calculate
damages
YesVan
see
Gorkom
Yes
Defendants
Win
No
18 of 33
Defendants
7.
8. Francis v. United Jersey Bank
Win
a. Facts – The bankruptcy trustee of various creditors brought suit against Pritchard’s estate
to recover misappropriated funds. Pritchard was the director of the company but did not
pay attention to it after her husband died. She was grief-stricken18and
an alcoholic. The
of 33
company fell into shambles, and her two sons robbed it by making fraudulent loans.
b. Duty of Care to Shareholders – “In general, the relationship of a corporate director to
the corporation and its stockholders is that of a fiduciary. Shareholders have a right to
expect that directors will exercise reasonable supervision and control over the policies
67
9
9
and practices of a corporation. The institutional integrity of a corporation depends upon
the proper discharge by directors of those duties.”
c. Duty to Creditors – “While directors may owe a fiduciary duty to creditors also, that
obligation generally has not been recognized in the absence of insolvency. With certain
corporations, however, directors are seemed to owe a duty to creditors and other third
parties even when the corporation is solvent. Although depositors of a bank are
considered in some respects to be creditors, courts have recognized that directors may
owe them a fiduciary duty. Directors of nonbanking corporations may owe a similar duty
when the corporation holds funds of others in trust.”
i. Why the bank owed a duty of care to creditors  see pp. 331–32.
d. Oversight Rules – Duty of Care
i. “As a general rule, a director should acquire at least a rudimentary understanding
of the business of the corporation. Accordingly, a director should become
familiar with the fundamentals of the business in which the corporation is
engaged.”
ii. “Because corporate directors are bound to exercise ordinary care, they cannot set
up as a defense lack of the knowledge needed to exercise the requisite degree of
care. If one feels that he has not had sufficient business experience to qualify
him to perform the duties of a director, he should either acquire the knowledge
by inquiry, or refuse to act.”
iii. “Directors are under a continuing obligation to keep informed about the activities
of the corporation.”
iv. “Directors may not shut their eyes to corporate misconduct and then claim that
because they did not see the misconduct, they did not have a duty to look.”
v. “Directorial management does not require a detailed inspection of day-to-day
activities, but rather a general monitoring of corporate affairs and policies.”
vi. “While directors are not required to audit corporate books, they should maintain
familiarity with the financial status of the corporation by a regular review of
financial statements.”
vii. “Upon discovery of an illegal course of action, a director has a duty to object
and, if the corporation does not correct the conduct, to resign.”
viii. “In certain circumstances, the fulfillment of the duty of a director may call for
more than mere objection and resignation. Sometimes a director may be required
to seek the advice of counsel. . . . A director may have a duty to take reasonable
means to prevent illegal conduct by co-directors; in an appropriate case, this may
include threat of suit.”
e. Director Liability
i. “A director who votes for or concurs in certain actions may be liable to the
corporation for the benefit of its creditors or shareholders, to the extent of any
injuries suffered by such persons, respectively, as a result of any such action.”
f. Director Immunity
i. “Usually a director can absolve himself from liability by informing the other
directors of the impropriety and voting for a proper course of action.”
ii. Dissenting – “A director who is present at a board meeting is presumed to concur
in corporate action taken at the meeting unless his dissent is entered in the
minutes of the meeting or filed promptly after adjournment. In many, if not
most, instances an objecting director whose dissent is noted in accordance with
[New Jersey law] would be absolved after attempting to persuade fellow
directors to follow a different course of action.”
9. [Corporate Crime?]
68
Duty of Loyalty
Directors & Managers
1. Direct Interest v. Indirect Interest
a. Direct – “I am a member of the GW Governing Board, and I vote to hire me.”
b. Indirect – A director that has an interest in two companies doing business with each
other.
2. Bayer v. Beran
a. Facts – Shareholders brought a derivative suit against the Celanese Corp. of America’s
directors for breach of fiduciary duty for approving and extending a $1 million per year
radio advertising program.
b. Business Judgment Rule – “The business judgment rule provides questions of policy of
management, expediency of contracts or action, adequacy of consideration, lawful
appropriation of corporate funds to advance corporate interests, are left solely to
directors’ honest and unselfish decision, for their powers therein are without limitation
and free from restraint, and the exercise of them for the common and general interests of
the corporation may not be questioned, although the results show that what they did was
unwise or inexpedient.”
i. BJR applies to duty of care, NOT duty of loyalty.
c. Duty of Loyalty
i. “The business judgment rule yields to the rule of undivided loyalty.”
ii. ENTIRE FAIRNESS – “Such personal transactions of directors with their
corporations, such transactions as may tend to produce a conflict between selfinterest and fiduciary obligation, are, when challenged, examined with the most
scrupulous care, and if there is any evidence of improvidence or oppression, any
indication of unfairness or undue advantage, the transactions are voided.”
iii. Burden of Proof
1. Heightened scrutiny.
2. Examine individual conflicted directors, not the board collectively.
3. “The burden is on the director not only to prove the good faith of the
transaction but also to show its inherent fairness from the viewpoint of
the corporation and those interested therein.”
iv. Close Relative Involved – Motives of directors are likely to be questioned.
Potential conflict of interest. “The entire transaction, if challenged in the courts,
must be subjected to the most rigorous scrutiny to determine whether the action
of the directors was intended or calculated to subserve some outside purpose,
regardless of the consequences to the company, and in a manner inconsistent
with its interests.”
d. Conflict by Minority Board Member – Ask whether the minority controls and thereby
foists the conflict onto the un-conflicted board members?
e. Avoiding Duty of Loyalty Problems
i. Recusal.
ii. Disclose & Manage – Conflicted directors may disclose all of the relevant
information giving rise to the conflict.
1. Better Option – Recusal leaves fewer people in the room, and it often
excludes those that know the most about the transaction.
iii. Delegate duty to a non-interested third party, e.g., outside company.
f. Ratification – Contract is fair, but court enforces it without ratification. Excises
ratification step.
3. Benihana of Tokyo, Inc. v. Benihana, Inc.
69
a. Facts – A board member of Benihana arranged a stock sale between Benihana and BFC,
another company for which he served on the board, and the majority shareholder of
Benihana contested the deal.
b. Rule – “[Delaware law] provides a SAFE HARBOR for interested transactions if the
material facts as to a director’s relationship or interest and as to the contract or
transaction are disclosed or are known to the board of directors, and the board in good
faith authorizes the contract or transaction by the affirmative votes of a majority of the
disinterested directors.”
i.  Disclose & Manage
ii. Elements
1. Disclosed to board.
2. Board (1) in good faith (2) authorizes by majority vote of disinterested
directors.
3.  If met, BJR.
iii. BJR Review – “After approval by disinterested directors, courts review an
interested transaction under the business judgment rule.”
iv. “Corporate action may not be taken for the sole or primary purpose of
entrenchment.”
4. Avoiding Duty of Loyalty Problems
a. Directors are conflicted  Entire fairness analysis.
b. Defensive Steps
i. (1) Seek a fairness analysis beforehand, e.g., send directors’ proposed salaries to
an outside agency for fairness analysis.
ii. (2) Seek shareholder approval of board’s actions.
c. No duty of loyalty problem  Duty of care analysis/BJR.
Corporate Opportunities
1. Corporate Opportunities Problems
a. Delaware Test
b. ALI Test
c. Agency Law
2. Corporate Opportunity Doctrine
a. Subset of duty of loyalty. Different analysis.
b. Delaware Test (Guth v. Loft, Inc.) – An officer/director violates duty of loyalty by
embracing a business opportunity if:
i. Corporation is financially able to take the opportunity;
ii. Opportunity is in the corporation’s line of business;
iii. Corporation has an interest or expectancy in the opportunity; and
iv. By embracing the opportunity the officer/director would create a conflict
between his/her self-interest and that of the corporation.
v.  No factor is dispositive; all must be considered. Beam.
vi.  Ex Ante Analysis – “Director or officer must analyze the situation ex ante to
determine whether the opportunity is one rightfully belonging to the corporation.
If the director or officer believes, based on one of the factors articulated above,
that the corporation is not entitled to the opportunity, then he may take it for
himself.” Broz.
c. ALI Test – Two-Part Test - § 5.05 Taking of Corporate Opportunities by Directors or
Senior Executives
(a) General Rule. A director or senior executive may not take advantage of a
corporate opportunity unless:
70
(1) The director or senior executive first offers the corporate opportunity
to the corporation and makes disclosure concerning the conflict of
interest and the corporate opportunity;
(2) The corporate opportunity is rejected by the corporation; and
(3) Either:
(A) The rejection of the opportunity is fair to the corporation;
(B) The opportunity is rejected in advance, following such
disclosure, by disinterested directors, or, in the case of a senior
executive who is not a director, by a disinterested superior, in a
manner that satisfies the standards of the business judgment rule;
or
(C) The rejection is authorized in advance or ratified, following
such disclosure, by disinterested shareholders, and the rejection
is not equivalent to a waste of corporate assets.
(b) Definition of a Corporate Opportunity. For purposes of this Section, a
corporate opportunity means:
(1) Any opportunity to engage in a business activity of which a director
or senior executive becomes aware, either:
(A) In connection with the performance of functions as a director
or senior executive, or under circumstances that should
reasonably lead the director or senior executive to believe that
the person offering the opportunity expects it to be offered to the
corporation; or
(B) Through the use of corporate information or property, if the
resulting opportunity is one that the director or senior executive
should reasonably be expected to believe would be of interest to
the corporation; or
(2) Any opportunity to engage in a business activity of which a senior
executive becomes aware and knows is closely related to a business in
which the corporation is engaged or expects to engage.
3. Relevant Agency Law
a. Rest. (2d) of Agency § 387 General Principle – “Unless otherwise agreed, an agent is
subject to a duty to his principal to act solely for the benefit of the principal in all matters
connected with his agency.”
b. Rest. (2d) of Agency § 388 Duty to Account for Profits Arising out of Employment –
“Unless otherwise agreed, an agent who makes a profit in connection with transactions
conducted by him on behalf of the principal is under a duty to give such profit to the
principal.”
4. Broz v. Cellular Information Systems, Inc.
a. Facts – Cellular Information Systems, Inc. filed suit against Broz for breach of fiduciary
duty, alleging he put his own interests before that of the corporation.
b. Uses Delaware/Guth Test
i. Impermissible – “A corporate officer or director may not take a business
opportunity for his own if: (1) the corporation is financially able to exploit the
opportunity; (2) the opportunity is within the corporation's line of business; (3)
the corporation has an interest or expectancy in the opportunity; and (4) by taking
the opportunity for his own, the corporate fiduciary will thereby be placed in a
position inimicable to his duties to the corporation.”
ii. Permissible – “A director or officer may take a corporate opportunity if: (1) the
opportunity is presented to the director or officer in his individual and not his
corporate capacity; (2) the opportunity is not essential to the corporation; (3) the
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corporation holds no interest or expectancy in the opportunity; and (4) the
director or officer has not wrongfully employed the resources of the corporation
in pursuing or exploiting the opportunity.”
iii.  No violation of duty of loyalty because first and third factors were not met.
5. In re eBay, Inc. Shareholders Litigation
a. Facts – Individual eBay directors and officers accepted high-profit IPO investments from
Goldman Sachs as an incentive for maintaining a future business relationship.
b. First Argument – eBay insiders took a corporate opportunity.
i. Court held that eBay was in the business of buying stocks, and this is what the
eBay insiders were doing. Therefore, buying stock would have been a corporate
opportunity.
c. Second Argument – Goldman Sachs aided and abetted the taking of this corporate
opportunity.
i. Goldman Sachs knew that eBay was a big stock buyer.
ii. eBay insiders responded that Goldman Sachs was helping them out because they
were rich fat cats, not because they were eBay insiders.
d. Agency Law – Even if this was not a corporate opportunity, does not an agent have to
hand over any benefit that he has earned to his principal? A: Yes.
e. Ethics – Some people say that anything not expressly illegal is ethical, but Kieff thinks
that some things that are legal are not necessarily ethical.
f. If independent members of eBay’s board had authorized defendants to accept the
allocated shares  Possible liability for insider trading under the misappropriation
theory. See United States v. O’Hagan.
6. Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart
a. Rule – Must balance all factors in Delaware test. None is dispositive.
b. Rule – Opportunity is within a corporation’s line of business when it is “an activity as to
which the corporation has fundamental knowledge, practical experience and ability to
pursue.”
i. How active in trading stock must a corporation be before it becomes its line of
business? eBay was very active, but Stewart’s corporation was not.
Dominant Shareholders
1. Sinclair Oil Corp. v. Levien
a. Facts – Shareholders brought a derivative action against Sinclair Oil Corp. to require an
accounting for damages sustained by its subsidiary, Sinclair Venezuelan Oil Company.
b. Intrinsic Fairness Standard
i. Burden of Proof – “On the parent company to prove, subject to careful judicial
scrutiny, that its transactions with the subsidiary were objectively fair.”
ii. “When the situation involves a parent and a subsidiary, with the parent
controlling the transaction and fixing the terms, the test of intrinsic fairness, with
its shifting of the burden of proof, is applied. The rule applies when the parent
has received a benefit to the exclusion and at the expense of the subsidiary.”
iii. “A parent owes a fiduciary duty to its subsidiary when there are parent-subsidiary
dealings, but this alone will not evoke the intrinsic fairness standard.”
iv. “This standard will be applied only when the fiduciary duty is accompanied by
self-dealing, when a parent is on both sides of a transaction with its subsidiary.
Self-dealing occurs when the parent, by virtue of its domination of the subsidiary,
causes the subsidiary to act in such a way that the parent receives something from
the subsidiary to the exclusion of, and detriment to, the MINORITY
STOCKHOLDERS of the subsidiary.”
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1. If subsidiary is wholly owned by parent, there are no minority SH. If
there are no minority SH, transaction may be self-dealing, but not subject
to fairness review.
c. Declaring Dividends
i. “A dividend declaration by a dominated board will not inevitably demand the
application of the intrinsic fairness standard.”
ii. “If such a dividend is in essence self-dealing by the parent, then the intrinsic
fairness standard is the proper standard.”
iii. “Where a proportionate share of dividend money is received by the minority
shareholders of the subsidiary, these dividends are not self-dealing and the
business judgment standard should be applied.”
iv. “The motives for causing the declaration of dividends are immaterial unless the
plaintiff can show that the dividend payments resulted from improper motives
and amounted to waste.”
v.  Here: Not self-dealing because the dividends were paid to all shareholders,
including the minority.  BJR
d. Blocking Sinven’s Opportunities – No reason to think that Sinven was interested in
opportunities outside Venezuela.  BJR
e. Breach of Contract
i. Self-dealing  Intrinsic fairness.
ii. Sinclair Oil Corp. got 100% of the benefits of breaching and paid 97% of the
costs of breaching.
2. Pepper v. Litton
a. “A director is a fiduciary. So is a dominant or controlling stockholder or group of
stockholders. Their powers are powers in trust. Their dealings with the corporation are
subjected to rigorous scrutiny and where any of their contracts or engagements with the
corporation is challenged the burden is on the director or stockholder not only to prove
the good faith of the transaction but also to show its inherent fairness from the viewpoint
of the corporation and those interested therein.”
i. Corporate fiduciary duties.
ii. Same as Sinclair Oil Corp.
3. Zahn Transamerica Corporation
a. Facts – Stockholders of the Axton-Fisher Tobacco Company sued Transamerica
Corporation claiming Transamerica caused Axton-Fisher to redeem its Class A stock at
$80.80 per share, instead of allowing them to participate in the liquidation of company
assets, in which case they contend they would have received $240 per share.
b. Majority’s Duty to Minority – “The majority has the right to control; but when it does
so, it occupies a fiduciary relation toward the minority, as much so as the corporation
itself or its officers and directors.”
c. Stockholder Voting v. Director Voting – Radically different. “When voting as a
stockholder he has the legal right to vote with a view of his own benefits and is
representing himself only; but, a director represents all the stockholders in the capacity of
trustee for them and cannot use his office as director for his personal benefit at the
expense of the stockholders.”
d. Dividends – “Directors may not declare or withhold the declaration of dividends for the
purpose of personal profit or, by analogy, take any corporate action for such a purpose.”
e. Redeeming without disclosing is not fair.
i. Controlling shareholder can (1) disclose and then use the information himself or
(2) abstain and not disclose.
4. Dominant Shareholder Problems
a. First – Do a control analysis.
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Ratification
1. Quorum
a. DGCL § 141(b)
i. “A majority of the total number of directors shall constitute a quorum for the
transaction of business unless the certificate of incorporation or the bylaws
require a greater number.”
ii. “Unless the certificate of incorporation provides otherwise, the bylaws may
provide that a number less than a majority shall constitute a quorum which in no
case shall be less than 1/3 of the total number of directors except that when a
board of 1 director is authorized under this section, then 1 director shall
constitute a quorum.”
b. DGCL § 144(b) – “Common or interested directors may be counted in determining the
presence of a quorum at a meeting of the board of directors or of a committee which
authorizes the contract or transaction.”
2. Vote – NOTE DIFFERENCES BETWEEN STATUTES.
a. DGCL § 141(b) – “The vote of the MAJORITY OF THE DIRECTORS PRESENT at a
meeting at which a quorum is present shall be the act of the board of directors unless the
certificate of incorporation or the bylaws shall require a vote of a greater number.”
b. DGCL § 144(a)(1) – “No contract or transaction between a corporation and 1 or more of
its directors or officers, or between a corporation and any other corporation, partnership,
association, or other organization in which 1 or more of its directors or officers, are
directors or officers, or have a financial interest, shall be void or voidable solely for this
reason, or solely because the director or officer is present at or participates in the meeting
of the board or committee which authorizes the contract or transaction, or solely because
any such director's or officer’s votes are counted for such purpose, if: (1) The material
facts as to the director’s or officer’s relationship or interest and as to the contract or
transaction are disclosed or are known to the board of directors or the committee, and the
board or committee in good faith authorizes the contract or transaction by the affirmative
votes of A MAJORITY OF THE DISINTERESTED DIRECTORS, even though the
disinterested directors be less than a quorum.”
3. Effect of Ratification
a. DGCL § 144(a) – “No contract or transaction between a corporation and 1 or more of its
directors or officers, or between a corporation and any other corporation, partnership,
association, or other organization in which 1 or more of its directors or officers, are
directors or officers, or have a financial interest, shall be void or voidable solely for this
reason, or solely because the director or officer is present at or participates in the meeting
of the board or committee which authorizes the contract or transaction, or solely because
any such director’s or officer’s votes are counted for such purpose, if:”
(1): with disclosure of material facts, it is approved by a majority of the
disinterested directors;
(2): with disclosure of material facts, it is approved by a majority of the
shareholders; or
 “Section 144(a)(2) merely removes an ‘interested director’ cloud from
an agreement between a corporation and one or more of its directors or
officers when its terms are met and provides against invalidation of an
agreement ‘solely’ because such a director or officer is involved.
Nothing in the statute sanctions unfairness to the corporation or removes
the transaction from judicial scrutiny.” Fliegler.
(3): contract is fair to corporation at time it is authorized, approved, or ratified.
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b.  Properly ratified contract between corp. and one of its directors is not necessarily
“void or voidable” because of the conflict of interest/not void or voidable “solely”
because of the conflict.
4. Fliegler v. Lawrence
a. Facts – A shareholder brought a derivative action against the officers and directors of
Agau Mines, Inc. and the United States Antimony Corp. to recover 800,000 shares of
Agau stock transferred to USAC.
b. Rule – “Shareholder ratification of an ‘interested transaction’ (a transaction between a
director or officer of the corporation and the corporation), although less than unanimous,
shifts the burden of proof to an objecting shareholder to demonstrate that the terms are so
unequal as to amount to a gift or waste of corporate assets.”
i. Here: burden does not shift. Majority of the shares that had voted in favor of the
transaction had been cast by interested defendants in their capacities as Agau
shareholders.
ii. Only votes by disinterested shareholders, and only a majority of those votes, shift
the burden.
c. DGCL § 144 is NOT immune from judicial scrutiny.  Without ratification, you must
show intrinsic fairness at the time of the transaction.
5. In re Wheelabrator Technologies, Inc. v. Shareholders Litigation
a. Facts – The shareholders of Wheelabrator Technologies, Inc. sued the company’s
directors for breach of fiduciary duty, alleging the proxy statement issue din connection
with its merger was misleading.
b. Disclosure – “[Board has] the fiduciary duty to disclose fully and fairly all material facts
within its control that would have a significant effect upon a stockholder vote.”
c. Duty of Care
i. Failure of board to reach an informed business judgment constitutes a voidable,
rather than a void, act.
ii. Sustained if its approval by majority vote of the shareholders is found to be based
on an informed electorate.
d. Duty of Loyalty
i. “Approval by fully informed, disinterested shareholders pursuant to § 144(a)(2)
invokes the business judgment rule and limits judicial review to issues of gift or
waste with the burden of proof upon the party attacking the transaction.”
1. “The result is the same in interested transaction cases not decided under
§ 144. Where there is independent shareholder ratification of interested
director actions, the objecting stockholder has the burden of showing that
no person of ordinary sound business judgment would say that the
consideration received for the options is a fair exchange for the options
granted.”
ii. “In a parent-subsidiary merger, the standard of review is ordinarily entire
fairness, with the directors having the burden of proving that the merger is
entirely fair.”
1. Majority of Minority Approval/Burden Shifting – “However, where
the merger is conditioned upon approval by a majority of the minority
stockholder vote, and such approval is granted, the standard of review
remains entire fairness, but the burden of demonstrating that the merger
is unfair shifts to the plaintiff.”
2. “That burden-shifting effect of ratification is held applicable in cases
involving mergers with a de facto controlling stockholder, and in a case
involving a transaction other than a merger.”
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e. Claim against directors  fully informed vote shifts burden to plaintiff. Business
judgment rule applies.
f. Claim against controlling shareholder  fully informed vote shifts burden to plaintiff.
Unfairness test applies.
Duty of Good Faith
Introduction
1. Duty of Good Faith – First appearance in Technicolor (Del. 1993).
a. Triad of directors’ fiduciary duties: good faith, loyalty, and due care.
2. Corporate Contracts – Good faith is mentioned in many corporate cases involving contracts.
Duty of good faith is used to restrain parties so that contracts are not illusory and consideration is
real.
a. Duty of good faith is a formality used to save contracts that would fall for lack of
consideration.
3. No Formal Recognition/Only Informal Recognition – Delaware has rejected the duty of good
faith as a separate duty beyond the sense in which Cardozo used it, which was in the context of
contracts.
a. This does not mean that it may be ignored. It applies in a less formal sense and is similar
to the other duties in ways.
b. Winding such claims through duty of care and loyalty frameworks is likely to be more
successful.
Compensation
4. Shareholder’s Challenges to Executive Compensation
a. Directors failed to become informed (about comparable pay scales in the industry).
b. Directors failed to act in good faith (by consciously disregarding comparable pay scales
in the industry).
c. Dominated by interested director. Very fact-specific.
d. Compensation was wasteful.
5. In re Walt Disney Co. Derivative Litigation
a. Facts – Disney shareholders brought a derivative suit against the directors and officers of
the company, claiming breaches of fiduciary duty and waste in connection with the hiring
and firing of, and payment of a $130 million severance package to, the new company
president.
b. Duty of Care
i. Rebutting Presumption & Burden Shifting – “Delaware law presumes that in
making a business decision the directors of a corporation acted on an informed
basis, in good faith, and in the honest belief that the action taken was in the best
interests of the company. Those presumptions can be rebutted if a plaintiff
shows that the directors breached their fiduciary duty of care or of loyalty or
acted in bad faith. If that is shown, the burden then shifts to the director
defendants to demonstrate that the challenged act or transaction was entirely fair
to the corporation and its shareholders.”
1. BJR presumptions rebutted by showing of bad faith.
c. Delegation of Decision Making to Comm. – “Delaware General Corporation Law
(DGCL) expressly empowers a board of directors to appoint committees and to delegate
to them a broad range of responsibilities, which may include setting executive
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compensation. Nothing in the DGCL mandates that the entire board must make those
decisions.”
i. Committee owes you a duty of care, and its actions are subject to BJR.
1. BJR requires (1) information and (2) deliberation.
2. Before the board may defer to the committee, it must ensure that its
procedures measured up to the BJR.
3. No “substantive due care” analysis. Brehm v. Eisner.
ii. Its actions cannot be an inherently wasteful decision.
1. If independent, disinterested committee approves compensation decision,
it is reviewable only under corporate waste standard.
iii.  Large compensation was rational. Lured Ovitz away from his already
lucrative position.
d. Duty of Good Faith
i. Three Kinds of Bad Faith
1. Subjective Bad Faith – Fiduciary conduct motivated by an actual intent
to do harm.
2. Lack of Due Care – Fiduciary action taken solely by reason of gross
negligence and without any malevolent intent.
3. Statutory Bad Faith – Intentional dereliction of duty; a conscious
disregard for one’s responsibilities.
4.  First and third could be bad faith, but not the second.
5.  Duty of good faith addresses conduct worse than gross negligence,
but not constitution disloyalty.
e. Corporate Waste
i. “To recover on a claim of corporate waste, the plaintiffs must shoulder the
burden of proving that the exchange was so one sided that no business person of
ordinary, sound judgment could conclude that the corporation has received
adequate consideration.”
ii. “A claim of waste will arise only in the rare, unconscionable case where directors
irrationally squander or give away corporate assets. This onerous standard for
waste is a corollary of the proposition that where business judgment
presumptions are applicable, the board’s decision will be upheld unless it cannot
be attributed to any rational business purpose.”
iii. “The payment of a contractually obligated amount cannot constitute waste,
unless the contractual obligation is itself wasteful. Accordingly, the proper focus
of a waste analysis must be whether the amounts required to be paid in the event
of an NFT were wasteful ex ante.”
f. Court rejects argument that Ovitz had breached a fiduciary duty to Disney by asking for
so much money during negotiations. Their interests were adverse at the time.
g. Board could have kept Ovitz and simply downgraded his duties. It would have had to
maintain his pay though.
i. Problem: this probably would have amounted to a CONSTRUCTIVE FIRING.
h. Avoiding Liability
i. Most Important Step – Take good board of director and committee minutes that
clearly show what topics the directors discussed, what factors the directors
considered, whether questions were ask and answered, etc.
6. Jones v. Harris Associates LP
a. Facts – Investors objected that the compensation paid to their investment adviser was
unreasonably high in violation of federal law, but the trial court found in favor of the
adviser and the plaintiffs appealed.
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b. Rule – “A trustee owes an obligation of candor in negotiation, and honesty in
performance, but may negotiate in his own interest and accept what the settlor or
governance institution agrees to pay.”
c. Judicial Review
i. No judicial review of reasonableness of directors’ salary, bonus, and stock option
decisions.
ii. These decisions are constrained by market competition.
iii. “The existence of the fiduciary duty does not imply judicial review for
reasonableness; the question a court will ask, if the fee is contested, is whether
the client made a voluntary choice ex ante with the benefit of adequate
information. Competition rather than litigation determines the fee—and, when
judges must set fees, they try to follow the market rather than demand that
attorneys’ compensation conform to the judges' preferences.”
d. Supreme Court reverses. Says to follow Gartenberg:
i. In the context of § 36(b), the test is essentially whether the fee schedule
represents a charge within the range of what would have been negotiated at
arm’s-length in the light of all of the surrounding circumstances; and
ii. To be guilty of a violation of § 36(b), the adviser-manager must charge a fee that
is so disproportionately large that it bears no reasonable relationship to the
services rendered and could not have been the product of arm’s-length
bargaining.
Oversight
1. Caremark Int’l Inc. Deriv. Litig.
a. Facts – Caremark is a managed care provider. It is subject to the anti-referral payments
law. Caremark is sued by the government for violating the law. It pays damages to the
government. Its shareholders then bring a derivative suit against it, arguing that it did not
fulfill its duty of care.
b. Rule – “A director’s obligation includes a duty to attempt in good faith to assure [1] that
a corporate information and reporting system, which the board concludes is adequate,
exists, and [2] that failure to do so under some circumstances may, in theory at least,
render a director liable for losses caused by non-compliance with applicable legal
standards.”
i. Board’s duty to take affirmative compliance measures.
c. Rule – “Generally where a claim of directorial liability for corporate loss is predicated
upon ignorance of liability creating activities within the corporation . . . 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 exits—will establish the
lack of good faith that is a necessary condition to liability.”
d. Business Judgment Rule
i. Violating the law is not subject to BJR protection.
ii. If the BJR is not applied, there is not necessarily an automatic violation of the
duty of care. A director will have had to have notice than an officer was acting
improperly or that there was a conflict of interest or a lack of oversight, etc.
2. Stone v. Ritter
a. Facts – After the corporation’s banks were assessed significant fines for employee
misconduct, shareholders initiated a derivative action but failed to make a demand on the
board prior to filing suit.
b. Demand Futility Test – “To excuse demand under Rales, a court must determine
whether or not the particularized factual allegations of a derivative stockholder complaint
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create a reasonable doubt that, as of the time the complaint is filed, the board of directors
could have properly exercised its independent and disinterested business judgment in
responding to a demand.”
i. Insistence on particularized factual allegations.
ii. Focus on judgment in responding to the demand rather than the original
judgment.
iii.  See Grimes v. Donald for Delaware’s three-prong demand futility test. BJR is
inapplicable where board did not exercise business judgment.
c. Duty of Good Faith
i. “A failure to act in good faith requires conduct that is qualitatively different
from, and more culpable than, the conduct giving rise to a violation of the
fiduciary duty of care (i.e., gross negligence).”
1. E.g., (1) the fiduciary intentionally acts with a purpose other than that of
advancing the best interests of the corporation; (2) the fiduciary acts with
the intent to violate applicable positive law; or (3) the fiduciary
intentionally fails to act in the face of a known duty to act, demonstrating
a conscious disregard for his duties.
2. Failure to act in good faith = Violation of duty of loyalty.
ii. Breach of duty of good faith does not result in direct liability, as breaches of the
duties of care and loyalty do.
iii. Duty of loyalty encompasses duty of good faith.
iv. “Caremark articulates the necessary conditions predicate for director oversight
liability: (a) the directors utterly failed to implement any reporting or information
system or controls; or (b) having implemented such a system or controls,
consciously failed to monitor or oversee its operations thus disabling themselves
from being informed of risks or problems requiring their attention. In either
case, imposition of liability requires a showing that the directors knew that they
were not discharging their fiduciary obligations. 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.”
v. “In the absence of red flags, good faith in the context of oversight must be
measured by the directors' actions to assure a reasonable information and
reporting system exists and not by second-guessing after the occurrence of
employee conduct that results in an unintended adverse outcome.”
d. Discharging Duty of Good Faith
i. Start by considering whether to implement an action.
ii. Act in good faith: hold meetings, take minutes, etc.
iii. Going forward, directors should continually revisit the decision to implement.
Monitor and reconsider it on an ongoing basis.
3. Traditional Remedy – Strip the benefit from the defendant.
SECURITIES REGULATION
Definition & Registration
Definition of a Security
1. Capital Market – Market that trades in securities.
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a. Security – A bundle of rights connected to debt or equity capital provided to a
corporation.
b. Primary Market – Transactions to which the corporation is a party. E.g., issuing or
repurchasing shares; IPO (Initial Public Offering).
i. Primary markets allow firms to raise capital for their operations.
c. Secondary Market – Transactions in which corporation is not a party. E.g., A sells to B
shares in X Corp.
i. Public Secondary Market – E.g., stock exchange: NYSE or NASDAQ.
2. Assessing the Value of a Company
a. Based on Value of Assets
i. Sum of value of all of the company’s assets.
ii. For each asset, use either book value, actual value, or replacement cost, i.e., how
much it costs to get a new asset.
b. Based on Multiple of Current Sales/Earnings
i. Look at transactions of shares in other, similar companies.
ii. Divide the price by that company’s earnings and multiply by the earnings of the
company whose value you are trying to assess.
c. Discounted Cash Flow Method
i. Net present value of future cash flow, which is the money coming into the
company, less money coming out of the company.
ii. Method – Estimate future income and expenses of the company, year by year
until the company ceases to operate. For each year, subtract expenses from
income, and find present value of the result. Then add all the present values,
from year 1 to the last year of operation.
iii.
3. Efficient Capital Markets Hypothesis
a. Thesis – In an efficient market, current prices always fully reflect all relevant information
about the goods traded.
b. Three Forms
i. Weak Form Efficiency – Current price reflects all information on historical
prices.
1. If this is true, previous price changes have no effect on future prices, i.e.,
how much a stock has gone up/down in the past doesn’t matter.
ii. Semi-Strong Form Efficiency – Current price reflects not only historical
information, but all current public information.
1. If this is true, an investor cannot profit from studying available
information, because the market already incorporates this information,
i.e., “experts” can’t earn higher returns than the market average (unless
they have access to private information).
iii. Strong Form Efficiency – Current price reflects all information, whether publicly
available or not.
1. If this is true, no one can systematically earn higher returns than the
market average—not even people with inside information.
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2. Also, prices don’t change when the company announces new
information.
4. Blue Sky Laws
a. Protect investors from “speculative schemes which have no more basis than so many feet
of ‘blue sky.’” Hall v. Geiger-Jones Co. (U.S. 1917).
b. Origin of modern securities law.
5. Federal Securities Regulation
a. Uniform Securities Act – Originally promulgated in 1956. A revised version came out
in 1985. The Uniform Securities Act was intended to achieve uniformity among the
states, but has not had a high degree of success.
b. Securities Act of 1933
i. Principally concerned with the primary market.
ii. Congress rejected merit review
1. Merit review means a substantive assessment of the security’s risk;
prohibition of very risky stock offers.
2. Some state security regulation includes merit review.
iii. Two goals:
1. Mandating disclosure of material information to investors;
2. Prevention of fraud.
iv. Regulation methods: Merit vs. Disclosure
1. This reminds of substantive vs. procedural review by courts in DoC/DoL
c. Securities Exchange Act of 1934
i. Principally concerned with the secondary market.
ii. Regulates various activities, including:
1. Insider trading and other forms of security fraud [§10(b) and Rule 10b5];
2. Short swing-profits by corporate insiders [§16(b)];
3. SH voting via proxy solicitations [§14];
4. Tender offers.
iii. Creates the Securities and Exchange Commission (SEC)
1. Enforces securities laws;
2. Promulgates rules and regulations to implement securities laws.
a. Practice of securities laws involves elaborate rules/regulations.
iv. Mandates periodic disclosure.
1. If companies reveal information about themselves, investors will be able
to make wise investment choices. If a company looks really good, this
will make investors more likely to invest.
2. If some companies start to display transparency, then it soon will become
an industry norm. Investors will think that companies that do not
disclose information are hiding something.
d. Sarbanes-Oxley Act – Effects on Corporate Governance:
i. National security exchanges required to adopt listing standards mandating that
companies have an audit committee comprised solely of independent directors,
and that at least 1 member is a “financial expert”.
ii. Shifts authority from BoD to audit committee:
1. In establishing a “whistle blowing” system;
2. In appointment, compensation & oversight of independent auditor;
3. In retaining legal and financial advisers.
iii. SEC allowed to remove officers and directors and bar them from serving in other
public corporations for reasons of “unfitness”.
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iv. Prohibition on a corporation from making or arranging for loans to directors/
officers (with a few exceptions).
v. “Therapeutic disclosure” – e.g.: corporation must disclose whether it adopted a
code of ethics; must issue an annual internal control report.
e. Dodd Frank
f.
6. Definition of “Security”
a. Securities Act § 2(a)(1) – “The term ‘security’ means any note, stock, treasury stock,
bond, debenture, evidence of indebtedness, certificate of interest or participation in any
profit-sharing agreement, ... investment contract, voting trust certificate, ... any put, call,
straddle, option, or privilege on any security, certificate of deposit, or group or index of
securities... or, in general, any interest or instrument commonly known as a “security”...”
i. Defined in accordance with various provisions of § 2 “unless the context
otherwise requires.”
ii. Definition in § 2(a)(1) includes:
1. Specific instruments: note, stock, bond, etc.
2. Catch-All Phrases – Investment contract, evidence of indebtedness, any
interest or instrument commonly known as a “security,” etc.
3. Escape Hatch – “Unless the context otherwise requires.”
iii. “Commonly Known as a Security”
1. Is the instrument called a security?
2. Have the parties invoked federal securities laws?
3. Forman – Same as “investment contract.” The Howey test embodies the
central attributes.
4. Note the focus on substance rather than form. Arguably, § 2(a)(1) means
that if something is called a “security,” that should suffice.
7. Robinson v. Glynn
a. Facts – Robinson sued Glynn for securities fraud when Robinson purchased a
membership interest in Glynn’s corporation after Glynn intentionally misrepresented key
investment facts.
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b. Investment Contract – “A contract, transaction or scheme whereby a person invests his
money in a common enterprise and is led to expect profits solely from the efforts of the
promoter or a third party.” S.E.C. v. W.J. Howey Co.
i. Old rule.
ii. Modern innovations:
1. Relaxation of the requirement that an investor rely only on others’
efforts.
2. Focus on Economic Reality – “Congress intended catch-all terms like
investment contract to encompass the range of novel and unusual
instruments whose economic realities invite application of the securities
laws.”
a. Key Question – Whether an investor, as a result of the
investment agreement itself or the factual circumstances, is left
unable to exercise meaningful control over his investment?
c. Economic Reality Test – “Just as agreements cannot evade the securities laws by
reserving powers to members unable to exercise them, neither can agreements invoke
those same laws simply by labeling commercial ventures as securities. It is the economic
reality of a particular instrument, rather than the label attached to it, that ultimately
determines whether it falls within the reach of the securities laws.”
d. Stock – “The term stock refers to a narrower set of instruments with a common name and
characteristics. Thus, the securities laws apply when an instrument is both called stock
and bears stock’s usual characteristics.”
i. Characteristics of Common Stock – “(1) the right to receive dividends
contingent upon an apportionment of profits; (2) negotiability; (3) the ability to
be pledged or hypothecated; (4) the conferring of voting rights in proportion to
the number of shares owned; and (5) the capacity to appreciate in value.”
e. LLC Investments – Court struggled with these.
i. Interest in LLC is not a stock. Great Lakes.
8. Great Lakes Chemical v. Monsanto
a. Howey Test – An interest in an enterprise is an “investment contract” if:
i. “An investment of money”;
1. Anything constituting legal consideration should satisfy the first prong.
ii. “in a common enterprise”;
1. Horizontal Commonality – Relationship between the investors.
Requires pooling of contributions and distribution of profits and losses
on pro-rata basis among investors.
a. Always satisfies the “common enterprise” prong.
2. Vertical Commonality – Relationship between investor and promoter of
the scheme. Requires that the “fortunes of the investors [be] linked with
those of the promoters.” No need for pooling of interests by investors.
a. Split among courts as to whether it satisfies the “common
enterprise” prong.
b. Ninth Circuit accepts vertical commonality as sufficient but
defines it as a direct correlation between the promoter’s returns
and the investors’ returns.
iii. “with profits to come solely from the efforts of others.”
1. Interest in General Partnership – Split among courts as to whether this
is sufficient.
a. Goodwin v. Elkins (3rd Cir.) – No. Partners have right to control
partnership.
b. Williamson v. Tucker (5th Cir.) – Possible when:
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i. Partnership agreement deprives partner of control rights;
ii. Investor so inexperienced/unknowledgeable as to be
incapable of exercising control;
iii. Investor so dependent on unique entrepreneurial
managerial ability of promoter that investor can’t
exercise meaningful control.
2. Interest in Limited Partnership – Maybe, depending on control rights
of the limited partner. Some courts have per se rule that a limited
partnership interest is not a security. Others look at amount of control.
But even if limited partners don’t have control initially, they may assert
control later (e.g., Holzman v. de Escamilla). Once they have control,
their interest ceases to be a security.
9. Forman
a. Stock Test – Instrument called “stock” is considered stock if it has the following:
i. The right to receive dividends contingent upon an apportionment of profits;
ii. Negotiability;
iii. The ability to be pledged or hypothecated;
iv. Voting rights in proportion to the number of shares owned; and
v. The ability to appreciate in value.
10. Landreth
a. If stock satisfies the Forman criteria, its sale is always governed by securities laws, and
Howey test does not apply (so, it is a security even when 100% of business purchased,
and buyer controls company).
b. Howey should thus be used only to determine when an instrument is an “investment
contract,” given that it isn’t stock.
11. Keith/Parkersburg Wireless/Shreveport Wireless
a. Clarified in Great Lakes:
i. If instrument is not traditional stock (e.g., if it’s an interest in an LLC), Landreth
does not apply even if criteria in Forman are met.
ii. But the LLC interest might still be a security if it satisfies the Howey test.
The Registration Process
1. Selling Securities
a. Securities Act
i. Prior to filing a registration statement with SEC.
1. No offering of securities for sale through the mails or by use of interstate
commerce.
ii. From time of filing until the statement becomes effective
1. SEC reviews – examines adequacy of disclosure, not merits.
2. Offers permitted but no sales.
3. Interim period is 20 days after filing unless SEC issues an order halting
the process, but price cannot be determined 20 days in advance, so issuer
gets advance approval of incomplete statement (w/o price), then adds
price and asks to approve statement again, effective immediately.
Because it’s hard to know price 20 days in advance, very few
companies will file a registration statement with a price and then just
begin sales 20 days later.
iii. From time registration statement becomes effective (§ 5 of Act)
1. Selling allowed.
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2. Prospectus must be delivered to people offered the securities before the
sale.
2. Private offerings are the big exception to the registration process.
a. E.g., Facebook wanted to do a private offering rather than a public offering. Private
offerings are much less regulated because we assume that the investors are all
sophisticated actors.
3. Doran v. Petroleum Management Corp.
a. Facts – Doran sued Petroleum Management Corp. for breach of contract and rescission of
contract based on violations of the Securities Acts of 1933 and 1934.
b. Four Factors for Registration Exemption – “The court has identified four factors
relevant to whether an offering qualifies for the registration exemption. The
consideration of these factors, along with the policies embodied in the Securities Act of
1933, structure the inquiry of whether an offering is public or private. The relevant
factors include:
i. The number of offerees and their relationship to each other and the issuer;
1. The number of offerees is not itself a decisive factor in determining the
availability of the private offering exemption.
2. The more offerees, the more likelihood that the offering is public.
a. Rule of Thumb – 25 offerees.
3. Relationship Between Offerees and Issuer
a. Focused on the information available to the offerees by virtue of
that relationship.
b. Investment Sophistication
i. Must be sufficient basis of accurate information upon
which sophisticated investor may exercise his skills.
ii. For an investor to be invested with exemptive status, he
must have the required data for judgment.
iii.  Information that would have been in disclosure is
key. Sophistication itself is not enough.
c. “The ‘availability’ of information means either disclosure of or
effective access to the relevant information. The relationship
between issuer and offeree is most critical when the issuer relies
on the latter route.”
ii. The number of units offered;
iii. The size of the offering; and
iv. The manner of the offering.
c. Private Offering – “The term ‘private offering’ is not defined in the Securities Act of
1933. The scope of the § 4(2) private offering exemption must therefore be determined
by reference to the legislative purposes of the Act. Since exempt transactions are those as
to which there is no practical need for the bill’s application, the applicability of § 4(2)
should turn on whether the particular class of persons affected needs the protection of the
Act. An offering to those who are shown to be able to fend for themselves is a
transaction not involving any public offering.”
4. Most Exemptions - § 4 of Securities Act
a. Private Placements under § 4(2) – Doran.
i. Imprecise definition  Most rely on SEC’s Regulation D (Rules 501–06).
1. Regulation D provides a safe harbor for private offerings, elaborating the
§ 4(2) exemption:
a. If amount raised is under $1M, offer can be directed to an
unlimited number of people [Rule 504].
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b. If amount raised is under $5M, offer can be made to up to 35
offerees [Rule 505].
c. If amount raised is above $5M, offer can be made to up to 35
offerees who pass certain tests of financial sophistication [Rule
506].
2. In all of these cases, issuer can’t advertise publicly, and must file a notice
of the sale with the SEC shortly after it issues the securities.
3. Exemptions
a. Regulation D and § 4(2) exempt only the initial sale, so buyers
can resell only if they find another exemption.
i. § 4(1) – “Transactions by any person other than an
issuer, underwriter, or dealer.”
ii. But § 2(11) defines “underwriter” as someone who buys
a security “with a view to” reselling it.
iii. A resale by someone who counts as an “underwriter” is
sometimes counted by courts as part of the initial
offering, thus affecting the numbers for the purpose of
Regulation D.
iv. To avoid this, issuers should make “reasonable inquiry”
into the buyer’s plans, informing the buyers of resale
restrictions (and placing those restrictions on the stock).
v. Rule 144 also provides a partial safe harbor, where stock
acquired in a Regulation D offering is held for two years
and then sold in limited volumes.
b. Transactions by any person other than an issuer, underwriter, or dealer. § 4(1).
5. Civil Liabilities
a. Common Law Fraud (under normal state laws) – Elements:
i. Misrepresentation of a material fact;
ii. Reliance;
iii. Causation – Differentiate between loss due to fraud and loss due to market
conditions;
iv. Scienter; and
v. Injury.
b. SEC Power
i. Securities Act § 20(b). SEC can bring a civil action or can suspend or bar
brokers, underwriters, and dealers.
ii. Securities Act § 24. SEC can bring criminal charges (up to $10,000 fine and five
years imprisonment).
1. Potentially larger fines for violating the 1934 Act.
c. Express Private Rights of Action
i. Securities Act §11 – Misrepresentations in the registration statement.
1. Does not apply to exempt offering.
ii. Securities Act § 12(a)(1) – Strict liability for offers & sales (e.g., failure to
deliver prospectus, violation of gun-jumping rules) in violation of § 5.
1. Main remedy: rescission (or comparable remedies if plaintiff no longer
owns securities)
iii. Securities Act § 12(a)(2) – Misrepresentations in prospectus/oral sales
communication.
d. Implied Private Rights of Action
i. Exchange Act §10(b) & SEC rule 10b-5.
ii. Exchange Act §14(a) and proxy rules.
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6.
a. Principal express cause of action directed at fraud committed in connection with the sale
of securities through the use of a registration statement.
b. Burden of Proof – Defendant must prove that its misconduct did not cause plaintiff’s
damages.
c. No privity requirement  Wide list of potential defendants.
d. Defense – Due diligence is the only viable defense.
i. Issuer is strictly liable—may not claim due diligence defense. Escott.
ii. Lawyer – May not be able to rely on a due diligence defense because she should
know her obligations. Escott.
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7.
a. Section 12(a)(1) – YOU DON’T REGISTER PROPERLY.
i. Strict liability on sellers of securities for offers or sales made in violation of § 5.
Arises when seller improperly fails to register security.
ii. No scienter requirement for issuer.
iii. Negligence standard for defendants other than issuer.
iv. Main Remedy – Rescission: buyer can recover consideration paid, plus interest,
less income received on the security.
b. Section 12(a)(2) – YOU DON’T REGISTER AT ALL.
i. Private civil liability on any person who offers or sells a security in interstate
commerce, who makes a material misrepresentation or omission in connection
with the offer or sale, and cannot prove he did not know of the misrepresentation
or omission and could not have known even with the exercise of reasonable care.
ii. Prima Facie Case
1. Sale of a security;
2. Through instruments of interstate commerce or the mails;
3. By means of a prospectus or oral communication;
4. Containing an untrue statement or omission of a material fact;
5. By a defendant who offered or sold the security; and
6. Which defendant knew or should have known of the untrue statement (if
plaintiff pleads defendant’s knowledge, the burden of proving otherwise
shifts to the defendant).
iii. Liability only w/r/t public offerings. Gustafson.
1. No § 12(a)(2) liability in the secondary market or private placements.
iv. Due diligence can help defendants avoid liability.
8. Escott v. BarChris Construction Corp.
a. Facts – Purchasers of convertible, subordinated debentures of BarChris Construction
Corp. sued BarChris, claiming that filed registration statement contained material false
statements and omissions.
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b. Prerequisite to § 11 Liability – A false statement of fact in a registration statement or an
omission of fact that should have been provided be material.
i. “The term ‘material,’ when used to qualify a requirement to furnish information,
limits the information required to those matters about which an average prudent
investor ought reasonably to be informed before purchasing the security.”
ii. “A material fact is a fact that, had it been correctly stated or disclosed would
have deterred or tended to deter the average prudent investor from purchasing the
securities in question.”
c. New Director Liability – “Section 11 imposes liability upon a director, no matter how
new he is, for he is presumed to know his responsibility when he becomes a director. He
can escape liability only by using that reasonable care to investigate the facts that a
prudent man would employ in the management of his own property.”
d. Standard – A reasonable person, as if her own money were at stake.
i. Sliding scale standard based on how attentive an ordinary person would be if her
own interests were at stake, based on expertise.
e. Even if you are not an expert, you have a duty to try to read the reports and understand
them.
f. Lawyers-directors must satisfy a higher burden.
g. Good Defenses in Such Cases
i. If plaintiff’s claim is about fraud, e.g., lying (intentionally misrepresenting; Rule
9(b) special pleading-with-particularity requirements), rather than omission,
argue that the plaintiff has not pled her claim with particularity, based on Rule
9(b). Fraud allegations always must be pled with particularity.
ii. Argue that the claim is being made outside of relevant time period.
iii.  Both of the above defenses are grounds for dismissal on Rule 12(b)(6). This
will cut off the case before expensive discovery and save a lot of money.
iv. If you get to the Rule 56 summary judgment stage, argue that you consulted the
expert and did all of the proper procedures, and this is a good ground for
dismissal at summary judgment.
v. If the plaintiff has proved fraud, etc., argue that the plaintiff’s damages were
caused by something other than your material act or omission. You want to show
some alternative reason for the move in the stock price, and proving this will
require a trial. A defendant may not want to go to trial on this.
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h.
[Accounting slides TBD.]
Rule 10b-5
1. State Law Claims
a. Common-law fraud.
b. State blue-sky law. Elements are not as burdensome as Rule 10b-5.
2. Filing Under the Securities Act
a. Regulation S-K: Provides substantive disclosure requirements (for both Acts).
b. Form S-1: Basic registration statement form. Requires detailed information about the
transaction and the issuer
c. Form S-3: Only requires info about the transaction, with other information incorporated
by reference from the last 10-K and other Exchange Act documents.
d. To use S-3 instead of S-1, a company must be large and have been a reporting company
for several years.
3. Filing Under the Exchange Act – Form 10:
a. Covered corporations must register with the SEC by filing an initial Form 10. This form
only needs to be filed once with respect to a particular class of securities-the first time the
issuer registers that class under the Act.
b. Contains exhaustive disclosures similar to those required in a Securities Act registration
statement. The corporation thereafter must annually file a Form 10-K, which contains
audited financial statements and management’s report of the previous year’s activities
and usually also incorporates the annual report sent to shareholders.
c. The company must also files a Form 10-Q for each of first three quarters of the year. It
will contain unaudited financial statements and management’s report on material recent
developments.
d. Finally, the corporation must file a Form 8-K within 15 days after certain important
events affecting the company’s operations or financial condition. In other words, if a
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major event happens, the company must report it immediately instead of waiting for the
next quarterly or annual report. The Form specifies events that are considered sufficient
assets or a change in control of the company.
4. Two Separate Disclosure Regimes
a. Securities Act of 1933 – New issuance.
b. Exchange Act of 1934 – Periodic disclosures.
5. Exchange Act § 10(b) – “It shall be unlawful for any person, directly or indirectly, by the use of
any means or instrumentality of interstate commerce or of the mails, or of any facility of any
national securities exchange . . . To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security not so registered . . . any
manipulative or deceptive device or contrivance in contravention of such rules and regulations as
the Commission may prescribe as necessary or appropriate in the public interest or for the
protection of investors.”
a. Broad – Applies to any security (registered or unregistered), including those of close
corporations, transactions in government securities, etc.
b. Not self-executing.  Requires rules, particularly Rule 10b-5, to implement.
6. Rule 10b-5 – “It shall be unlawful for any person, directly or indirectly, by the use of any means
or instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under
which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate
as a fraud or deceit upon any person, in connection with the purchase or sale of any
security.”
a. Standing – Must be an actual purchaser or seller of a security. Deutschman.
b.  Elements
i. Jurisdictional Nexus – Commerce clause. Mail, wire, national exchanges:
means of interstate commerce. It is difficult for any business not to implicate
interstate commerce. This usually is easy to satisfy, but you still must cover it.
ii. Transactional Nexus – Activity must be in connection with the purchase or sale
of any security. Very broad meaning. Must “touch and concern” a purchase or a
sale.
1. Purchase or Sale – People who actually buy or sell because of a
misstatement. Blue Chip Stamps.
2. What about people who did not buy or sell because of a
misrepresentation? A: Not encompassed under the transactional nexus;
the class would be far too large. Shows that actual buying and selling are
required.
3. People who sold too soon are able to sue. They have a transactional
nexus.
4. No Privity Requirement – Party sued need not be a party to the
transaction.
a. No CoA for Aiding & Abetting – No implied private right of
action against those that aid and abet violations of Rule 10b-5,
e.g., lawyer preparing fraudulent disclosure documents. Central
Bank of Denver.
iii. Materiality – “Material” is stated twice in Rule 10b-5. Basic Inc. v. Levinson
illustrates this.
1. Check out two highlights in Basic.
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iv. Reliance
1. Presumed in OMISSION cases if undisclosed facts were material.
a. Basic is not an omission case, and thus, there is no presumption
based on an omission.
b. But there is a presumption in Basic for other reasons.
2. Common law fraud requires a showing of reliance.
a. Most people trade stocks because they believe that the present
market has it wrong because of incomplete information.
b. Direct reliance is required in face-to-face transactions.
3. Fraud-on-the-Market Theory – Allows plaintiff to satisfy reliance
element by showing that she relied on the market price to reflect truthful
information (rather than showing she relied specifically on the overstated
profits).
a. Applies in exchange-based transactions.
v. Causation – Both are required.
1. Transactional Causation – But for the misrepresentation, the plaintiff
would not have bought or sold the security or would have done so under
different terms.
a. Restated reliance requirement.
b. Presumed in Fraud-on-the-Market settings.
2. Loss Causation – You not only cause me to do something, but your
misrepresentation also causes me to lose. I have traded, and not only
that, I have traded and lost.
a. Proximate-cause requirement.
b. Courts do not presume loss causation.
c. Factors that undermine loss causation:
i. Market does not believe the misrepresentation.
ii. Things would have fallen apart anyway.
iii. There was another intervening and superseding cause
causing the change in the stock price.
iv.  These are empirical claims about what has happened
to the price. Expert witness economists debate about
possible worlds and price fluctuations at trial.
d. Typical Showing – Change in stock price when
misrepresentation was made; opposite change when corrective
information was disclosed.
3. Can be shown by reliance. Basic.
vi. Scienter
1. Scienter required by Ernst & Ernst v. Hochfelder.
a. Recklessness suffices.
2. Look at the state of mind of the person making the misrepresentation.
3. Intention is sufficient, but reckless disregard may be enough.
4. Difficult to show if there is no room for personal gain.
5. Required both in fraud and Securities Act litigation. (?)
6. Scienter must be pled with particularity. You need some evidence.
7. Post-PSLRA Decisions (PSLRA required showing of scienter for
recovery.)
a. Second Circuit continues to require proof that either:
i. Defendant had motive and opportunity to commit fraud;
or
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ii. Strong circumstantial evidence of conscious misbehavior
or recklessness.
b. Third Circuit has similar standard: Extreme departure from the
standards of ordinary care that may mislead buyers and is either
known to defendant or so obvious that defendant must have been
aware of it.
c. Sixth and Ninth Circuits allows only the latter prong (showing
motive and opportunity is insufficient; must show conscious
misbehavior or recklessness). Though this is technically only for
purposes of pleading, there is a substantive effect if you get
thrown out of court.
vii. Manipulation or Deception
1. See Santa Fe Industries.
2. Requires misrepresentation or omission.
3. Rule 10b-5 reaches not all breaches of fiduciary duty, but only those
involving manipulation or deception.
4. Rule 10b-5 does not reach “internal corporate management.”
c.  No implied right of action against those that aid and abet violations of Rule 10b-5.
Central Bank of Denver.
d. Traditional Remedy – Recessionary damages.
7. Basic Inc. v. Levinson
a. Facts – Former Basic Inc. shareholders brought a class action against Basic Inc. and its
directors, claiming the directors issued three false statements and forced the former
shareholders to sell their shares at depressed prices based on their reliance on Basic’s
statements that it was not engaged in merger discussions.
b. Silence – “No comment” is tantamount to silence. Silence is not actionable under Rule
10b-5, even when the company has highly material information.
c. Materiality – “An omitted fact is material if there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding how to vote.” TSC
Industries.
i. “To fulfill the materiality requirement there must be a substantial likelihood that
the disclosure of the omitted fact would have been viewed by the reasonable
investor as having significantly altered the total mix of information made
available.”
ii. “Materiality depends on the significance the reasonable investor would place on
the withheld or misrepresented information.”
iii. Materiality depends on a balance between probability and magnitude [Basic, Inc.
v. Levinson]. Even if you know with certainty that the laser printer in Building
26 got jammed, you don’t need to report that.
iv. Inside information about mergers can become material to close corporations very
early in the process.
v. Factors for Materiality of Merger Discussions (None Are Dispositive)
1. KEY  “Indicia of interest in the transaction at the highest corporate
levels.”
2. Board resolutions,
3. Instructions to investment bankers,
4. Actual negotiations between principals or their intermediaries
5. Size of the two corporate entities and of the potential premiums over
market value.
vi. Reliance Presumed – Plaintiffs need not show how they would have acted if
material omission had been disclosed.
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1. “Where materially misleading statements have been disseminated into an
impersonal, well-developed market for securities, the reliance of
individual plaintiffs on the integrity of the market price may be
presumed.”
2. “An investor who buys or sells stock at the price set by the market does
so in reliance on the integrity of that price. Because most publicly
available information is reflected in market price, an investor’s reliance
on any public material misrepresentations, therefore, may be presumed
for purposes of a rule 10b-5 action.”
3.  Rebutting Presumption of Reliance – “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.”
d. Fraud on the Market Theory – “The fraud on the market theory is based on the
hypothesis that, in an open and developed securities market, the price of a company’s
stock is determined by the available material information regarding the company and its
business. Misleading statements will therefore defraud purchasers of stock even if the
purchasers do not directly rely on the misstatements. The causal connection between the
defendants’ fraud and the plaintiffs’ purchase of stock in such a case is no less significant
than in a case of direct reliance on misrepresentations.”
i. Prerequisite – Requires a market in the security.
ii. Rejects Agreement-in-Principle Theory. See p. 441.
iii. Premised on the semi-strong form efficient market.
iv. “The basis of the fraud-on-the-market doctrine is that public information reaches
professional investors, whose evaluations of that information and trades quickly
influence securities prices.” West.
v. Rebutting Fraud-on-the-Market Presumption of Reliance
1. Show that trading market was not efficient, e.g., challenged
misrepresentation did not affect stock price.
2. Plaintiff would have traded regardless of misrepresentation.
vi. Policy
1. For all the fancy economics cited in its favor, there is a straightforward
problem:
a. Corporate statements are often technical. Ordinary investors do
not read them, and would not understand them if they tried.
Were they required to show that they relied on the statements to
sue, they would lose.
b. Nonetheless, sophisticated stock analysts do read such
statements, and do trade on the basis of the information they
acquire through them. Because they control large financial
resources, they help set the price of the stock through their
trades, and unsophisticated investors buy and sell in the market
these sophisticated investors have created.
c. Although the unsophisticated investors do not directly rely on
the corporate statements, in other words, they buy and sell stock
at prices determined in part by people who do read and rely on
them.
d. Under the traditional approach, unsophisticated investors would
never be able to show reliance, and thus would never recover
under Rule 10b-5. They have, however, been damaged just as
certainly as if they had read and relied on the statements.
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2. And the theory is a simple solution:
a. The FOM theory is but a fancy justification for the courts’
response—to eliminate the reliance requirement by presuming it.
If defendants want to avoid liability, they must now show that
their misrepresentation did not affect the market price.
b. As the Court states, regardless of whether the ECMH is right (fn.
24), “we need only believe that market professionals generally
consider most publicly announced material statements about
companies.” Some nonetheless have criticized the Court found
focusing too much on market efficiency.
8. Duty to Update Information
a. Depends on what you’ve been saying. If what you’ve been saying has suggested
continuance, then you may have duty to update or correct.
b. Depends on if one officer has said something false and you (another officer) know that it
is false.
c. People with no duty to speak have no duty to correct, and people with a duty to speak
(i.e., spokespersons) have a duty to correct.
d. Circumstances with a Duty to Speak
i. Corporation is buying and selling its own shares.
ii. Aware of insider trading by others.
iii. Duty to update an earlier statement that had become inaccurate and was still
“alive” in trading market.
iv. Fiduciary duty to SH requiring update.
9. West v. Prudential Securities, Inc.
a. Facts – West brought a class action suit against Prudential Securities, Inc. for securities
fraud, alleging that a stockbroker had falsely told several clients that a corporation’s stock
was certain to be acquired at a premium, artificially inflating the price.
b. Oral Frauds – “Oral frauds are not allowed to proceed as class actions, for the details of
the deceit differ from victim to victim, and the nature of the loss also may be statementspecific.”
i. No presumption of reliance. Fraud-on-the-Market theory does NOT apply here.
ii. Court says that it is hard to imagine how a private lie changes the price of a stock
unless you tell it to a lot of people or the people you tell it to tell it to a lot of
people.
c. What if Hofman had told this private lie to a professional investor with billions of
dollars?
i. First, the professional investor will investigate Hofman’s claim. He is right to be
skeptical.
ii. The professional investor may have conveyed the information to the market
through his actions.
iii. A good professional investor will do two things:
1. Aggressively corroborate information.
2. Diversify.
10. Santa Fe Industries, Inc. v. Green
a. Facts – Kirby Lumber Co.’s minority shareholders sued Santa Fe Industries, Inc., which
was Kirby’s majority shareholder, seeking to set aside the merger of Kirby with Santa Fe
and alleging that their stock was worth more than they were offered when the companies
merged.
b. Rule – “The claim of fraud and fiduciary breach in a complaint states a cause of action
under any part of rule 10b-5 only if the conduct alleged can be fairly viewed as
‘manipulative or deceptive’ within the meaning of the statute.”
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i. Manipulation – “The term refers generally to practices, such as wash sales,
matched orders, or rigged prices, that are intended to mislead investors by
artificially affecting market activity.”
ii. Manipulation means artificially affecting market activity for the purpose of
misleading investors. For example:
1. Wash sales: Manipulator enters a purchase order and a sale order at the
same time through the same stock broker. Ownership of stock does not
change, and price of deal does not matter to manipulator (he is paying
himself), but deal creates appearance that a willing buyer and seller
valued the stock at that price.
2. Matched sales: Manipulator enters a purchase order with one broker,
and a sale order, at the same time and same price, with another broker.
3. Cross-sales: Collaborating manipulators buy and sell to/from each other
at an agreed price.
i.
Rule 10b-5 does not encompass all breaches of fiduciary duty—only manipulation or
deception.
ii.
 Plaintiff are not claiming that they were lied to; they are claiming that the deal is
unfair. This, however, is not a rule 10b-5 violation.
a. RULE 10B-5 DOES NOT REVIEW SUBSTANTIVE FAIRNESS OF A
TRANSACTION, BUT ONLY DISCLOSURE.
c. Deference to State Law
i. Corporate law is traditionally state law.
ii. “Absent a clear indication of congressional intent, the United States Supreme
Court is reluctant to federalize the substantial portion of the law of corporations
that deals with transactions in securities, particularly where established state
policies of corporate regulation would be overridden. Corporations are creatures
of state law, and investors commit their funds to corporate directors on the
understanding that, except where federal law expressly requires certain
responsibilities of directors with respect to stockholders, state law will govern the
internal affairs of the corporation.”
iii. “Congress by § 10(b) did not seek to regulate transactions which constitute no
more than internal corporate mismanagement.”
iv. For a Federal Cause of Action – You have to argue that management knew of
the defective nature of the product and did not disclose it. You also have to show
that the stock price was artificially at the wrong spot and that you bought stock at
that point.
11. Deutschman v. Beneficial Corp.
a. Facts – Deutschman sued Beneficial Corporation and two of its directors for breach of
fiduciary duty, alleging a violation of the Exchange Act and claiming that he suffered
losses when call options he purchases on Beneficial’s stock in reliance on the market
price became worthless.
b. Basics
i. Options – A put is a right to sell, a call is a right to buy; the issuer of the option
need not be the issuer or even a holder of the stock itself (obligates itself to act
later).
1. Put – Suppose you have the right to sell stock at $25 on June 1 and you
don’t own the stock. You have a naked put. You make money if the
market price goes to $20, since you could then buy at the market price
and immediately resell under the put and pocket a $5 gain. If the market
price is above $25 on June 1, you lose the amount you paid for the put. If
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you own the stock, the put merely protects you from a decline in the
value of the stock below $25. It is like an insurance policy.
2. Call – Suppose you have the right to buy stock at $25 on June 1. You
make money if the market price goes to $30, since you could then buy
under the call and immediately resell at the market price and pocket a $5
gain. If the market price is under $25 on June 1, you lose the amount you
paid for the call.
ii. Short Sale – The current market price of a share is $25. You don’t own any
shares. You borrow 100 shares and agree to replace them two months from now.
You then sell the 100 borrowed shares. You are betting that the price will be
lower than $25 two months from now. Suppose the price falls to $20. You have
sold the borrowed shares for $2,500 and now buy shares to replace them for
$2,000. So you have a gain of $500. But suppose the price rises to $75. You lose
$5,000. With a short sale, the duration is indefinite. You borrow for as long as
you are willing to pay for the privilege. Your broker borrows the shares from its
customers (generally, its margin customers will sign agreements allowing it to do
this) and lends them to you. Rarely, the broker will call in the shares and, in
effect, you will be required to close out your position. This might occur, for
example, if all the broker’s customers from whom it borrowed the shares decide
to sell. Then there can be a serious squeeze.
c. Two Types of Deceptive Practices Targeting Holders of Option Contracts
i. Insider Trading
ii. Affirmative Misrepresentation
d. Standing Requirement – “The only standing limitation recognized by the Supreme
Court with respect to § 10(b) damage actions is the requirement that the plaintiff be a
purchaser or seller of a security.”
i. Do you have to own stock to have standing? A: No. You have standing as long
as you buy or sell a security, and options are securities even though they are only
related to stock—and not stock themselves.
Inside Information
[Look up Treaty of Gent information.]
1. Insider Trading Generally
a. ILLEGAL UNDER RULE 10B-5.
b. Not a prohibition on insiders trading at all. Rather, insiders cannot trade based on inside
information.
i. Outsiders also cannot trade on the basis of inside information.
c. Classic Scenario – Tipping. Outsider receives information from an insider and trades on
that basis.
d. Difficulty in Prosecuting – Insider trading is hard to identify, detect, and prosecute.
Congress has kicked up the punishment to make up for the infrequency with which they
are caught.
e. No Duty to Share All Information – There is no duty for parties to a transaction to
share all information. In fact, one only ever buys or sells securities because she believes
that she knows something that the other side doesn’t know.
2. Insider Trading: Good or Bad?
a. Reasons for Banning
i. Preventing Incentives for Bad Management – Insider trading creates a perverse
incentive for insiders to publicize bad news about the company.
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ii. Fairness – Traders cannot see each other when they are buying and selling on the
market.
1. However, if traders cannot see each other, then there may be less
opportunity for deception.
iii. Property Rights – Information is valuable. It is owned by the corporation.
1. But  If it is the firm’s property, why not let it trade on it as the firm
sees fit? Let it allow or prohibit insider trading. An argument could be
that society can reduce the cost of policing insider trading by regulating
it at the level of government.
iv. Level the Playing Field – Only allow trading based on public information.
1. Problem – Less efficient market. Stock prices will not reflect relevant,
but private, information.
2. Problem – Taken to its logical end, this rationale does not allow traders
to act on any private information, even their predictions about the
market. Sweeps too broadly.
b. Reasons for Allowing
i. Market Efficiency – The more trading there is, the more efficient the market is.
The more efficient the market is, the more information the public has. This will
lead to more informed decision making all around.
ii. Executive Compensation – It provides incentives for insiders to do good for the
corporation because then they can trade on that news.
1. But  Coal Fusion makes people wary of relying on the executive
compensation theory.
3. State Law on Insider Trading
a. Majority Rule – Officers and directors may trade with shareholders without disclosing
material information [Carpenter v. Danforth (N.Y. 1868)].
b. Special Circumstances Rule – Duty to disclose might be imposed when there are special
circumstances [Strong v. Repide (U.S. 1909)].
i. Highly material information;
ii. Concealment of identity of insider, or other active fraud;
iii. Especially vulnerable plaintiff.
c. Minority Rule – Insiders have a duty to fully disclose material information whenever
they purchase shares from shareholders [Oliver v. Oliver (Ga. 1903)].
d.  Today, more states follow the special circumstances rule or minority rule than the
majority rule.
4. Federal Law on Insider Trading
a. Insider trading may be considered an omission of a material fact (the inside information)
in connection with a purchase or sale of a security, thus violating Rule 10b-5.
b. Rule 10b-5(a)(1) – “It shall be unlawful for any person, directly or indirectly, by the use
of any means or instrumentality of interstate commerce, or of the mails or of any facility
of any national securities exchange, (a) To employ any device, scheme, or artifice to
defraud . . . .”
i. The “manipulative and deceptive devices” prohibited by Section 10(b) of the Act
and Rule 10b-5 thereunder include, among other things, the purchase or sale of a
security of any issuer, on the basis of material nonpublic information about that
security or issuer, in breach of a duty of trust or confidence that is owed directly,
indirectly, or derivatively, to the issuer of that security or the shareholders of that
issuer, or to any other person who is the source of the material nonpublic
information.
c. Exchange Act § 14(e) – “It shall be unlawful... to make any untrue [statement or
omission] or to engage in any fraudulent, deceptive or manipulative acts... in connection
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with any tender offer... The Commission shall [promulgate rules to fill prohibition with
content].”
d. Rule 14e-3
i. (a) – When a tender offer has commenced or is about to be commenced, it is a
violation of § 14(e) for a person other than the offering person to trade in the
relevant securities, if that person has material non-public information relating to
the tender offer, which the person knows or has reason to know was acquired
(directly or indirectly) from:
1. the offering person,
2. the target company, or
3. any officer, director, employee or other person acting on behalf of either
the offering person or the target company.
ii. (b) – A “Chinese wall” defense for business associations, allowing exemption
where someone didn’t know and there is some procedure for preventing the
person from obtaining the information or from trading on it.
iii. (c) – Exception allowing the offering person to purchase the securities
(remember Van Gorkom).
iv. (d) – It is a violation of § 14(e) for the following persons to communicate
material private information to others if it is reasonably foreseeable that this
communication will result in a violation of §14(e):
1. The offering person;
2. The target company;
3. Their officers/directors/employees/advisors;
4. Anyone working on their behalf; and
5. Anyone possessing material non-public information which she knows or
has reason to know was acquired from any of the above.
e. Rule 10b5-2 (Adopted in Response to Chairella & Dirks) (TEMPORARY INSIDERS) –
The rule provides a non-exclusive list of three situations in which a person has a duty of
trust or confidence for the purpose of the misappropriation theory:
i. Whenever a person agrees to maintain info in confidence;
ii. Whenever the person communicating info and the person to whom it is
communicated have a history, pattern or practice of sharing confidences, such
that the recipient of the info knows or reasonably should know that the person
communicating the info expects the recipient to maintain confidentiality; or
iii. Whenever the info is obtained from a spouse, parent, child or sibling, unless
recipient shows that history, pattern or practice indicates no expectation of
confidentiality.
f. Liability for an omission exists only if there is a duty to disclose.
i. State law usually does not create a duty to disclose in exchange transactions.
5. Goodwin v. Agassiz
a. Facts – Goodwin, a shareholder in Cliff Mining Co., filed suit against Agassiz for
damages suffered during the sale of his stock.
b. Directors’ Fiduciary Duty – “The directors of a commercial corporation stand in a
relation of trust to the corporation and are bound to exercise the strictest good faith in
respect to its property and business.”
c. Directors’ Peculiar Knowledge/Heightened Duty – “The knowledge naturally in the
possession of a director as to the condition of a corporation places upon him a peculiar
obligation to observe every requirement of fair dealing when directly buying or selling its
stock.”
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d. Directors’ Duty to Disclose – “Mere silence does not usually amount to a breach of
duty, but parties may stand in such relation to each other that an equitable responsibility
arises to communicate facts.”
e. Insider Trading Rule for Face-to-Face Trades – “Where a director personally [face-toface] seeks a stockholder for the purpose of buying his shares without making disclosure
of material facts within his peculiar knowledge and not within reach of the stockholder,
the transaction will be closely scrutinized and relief may be granted in appropriate
instances.”
f. Court held that directors bore no liability here.
i. No fraud or conspiracy.
ii. Theory was early in development; nebulous; and did not indicate any specific
spot. Not fact yet. Not certain.
iii. Directors owed a duty to the corporation, not to the shareholders. Maybe it was
best to keep the information private.
iv. Company was not harmed by the nondisclosure. Another company that the
defendants were working for may have been harmed if the information had been
disclosed.
v. There was no face-to-face transaction.
g. Rule for Stock-Exchange-Based (Rather than Face-Based) Trades – No duty on part
of directors to make disclosure. Justification:
i. Specific disclosure to a particular buyer or seller across an open market is hard to
do. How is the corporation supposed to know which buyer or seller to make
disclosure to in these impersonal transactions?
ii. Causation is a problem in open exchanges. What you know about the outsider is
that she wanted to trade that day. That helps to show that she was not coerced.
6. Securities & Exchange Commission v. Texas Gulf Sulfur Co.
a. Facts – The SEC filed suit against Texas Gulf Sulfur Co. for violation of the insider
trading provisions of Rule 10b-5.
b. Disclose or Abstain Rule – “Anyone in possession of material inside information must
either disclose it to the investing public, or, if he is disabled from disclosing it in order to
protect a corporate confidence, or he chooses not to do so, must abstain from trading in or
recommending the securities concerned while such inside information remains
undisclosed.”
i. Required Only in Extraordinary Situations – “An insider’s duty to disclose
information or his duty to abstain from dealing in his company’s securities arises
only in those situations which are essentially extraordinary in nature and which
are reasonably certain to have a substantial effect on the market price of the
security if the extraordinary situation is disclosed.”
1. Information must be material.
2. Material – “The basic test of materiality is whether a reasonable man
would attach importance in determining his choice of action in the
transaction in question. This, of course, encompasses any fact that in
reasonable and objective contemplation might affect the value of the
corporation’s stock or securities. . . . Thus, material facts include not
only information disclosing the earnings and distributions of a company
but also those facts which affect the probable future of the company and
those which may affect the desire of investors to buy, sell, or hold the
company’s securities.”
ii. Timing of Disclosure – “The timing of disclosure is a matter for the business
judgment of the corporate officers entrusted with the management of the
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corporation within the affirmative disclosure requirements promulgated by the
exchanges and by the SEC.”
iii. Waiting for Public Dissemination (Media of Widest Circulation) – “Where
the news is of a sort which is not readily translatable into investment action,
insiders may not take advantage of their advance opportunity to evaluate the
information by acting immediately upon dissemination.”
c. More on Materiality
i. SEC v. Adler (11th Cir.): Trading while possessing private information raises a
strong inference that private information was material to trading, but such
inference can be rebutted.
1. E.g., if costs of a medical emergency forced insider to sell securities.
ii. U.S. v. Smith (9th Cir.): Argues that burden of proof regarding this inference is
on government, not defendant.
iii. Rule 10b-5
1. Part (a) basically adopts misappropriation theory of O’Hagan.
2. Part (b) basically treats possession of the inside info as same as trading
on the basis of the info (so presumption is in favor of the government).
3. Part (c) basically provides affirmative defense “designed to cover
situations in which a person can demonstrate that the material nonpublic
information was not a factor in the trading decision,” such as when the
trade was made pursuant to a contract, instructions given to another, or a
written plan that “[d]id not permit the person to exercise any subsequent
influence over how, when, or whether to effect purchases or sales.”
7. Chiarella v. United States
a. Facts – Employee at printing company that gleaned inside information from the corporate
documents that he was preparing traded on the basis of that information. He was not
employed at any corporation in whose stocks he traded. He was discovered, fired, and
criminally prosecuted for violating § 10b and Rule 10b-5 even though he disgorged his
profits.
b. Traditional Theory – Duty to abstain arises from relationship of trust between a
corporation’s shareholders and its employees. Duty to shareholders not to profit at their
expense.
i. No violation of Rule 10b-5 because Chiarella was not an “insider” of the
corporation in whose shares he had traded.
c. Misappropriation Theory – Duty of confidentiality owed to the source of the
information (not necessarily the security issuer).
i. Court did not apply, but Chiarella may have been liable under this theory.
8. Dirks v. Securities & Exchange Commission
a. Facts – The SEC accused Dirks of violating anti-fraud provisions of the federal securities
laws for disclosing to investors material nonpublic information that he received from
insiders.
b. Affirming Chiarella.
i. Requirements for Rule 10b-5 Violation – “In order to establish a violation of
Rule 10b-5, (1) the existence of a relationship affording access to inside
information intended to be available only for a corporate purpose, and (2) the
unfairness of allowing a corporate insider to take advantage of that information
by trading without disclosure must be shown.”
ii. “There is no general duty to disclose before trading on material nonpublic
information, and a duty to disclose under Rule 10b-5 does not arise from the
mere possession of nonpublic market information. Such a duty arises rather from
the existence of a fiduciary relationship.”
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c. Rule 10b-5 Liability Requires Non-Disclosure & “Secret Profits”
i. Rule 10b-5 liability requires manipulation or deception.
ii. “In an inside-trading case this fraud derives from the inherent unfairness
involved where one takes advantage of information intended to be available only
for a corporate purpose and not for the personal benefit of anyone. Thus, an
insider will be liable under Rule 10b-5 for inside trading only where he fails to
disclose material nonpublic information before trading on it and thus makes
secret profits.”
d. Temporary Insiders – “Under certain circumstances, such as where corporate
information is revealed legitimately to an underwriter, accountant, lawyer, or consultant
working for the corporation, these outsiders may become fiduciaries of the shareholders.
The basis for recognizing this fiduciary duty is not simply that such persons acquired
nonpublic corporate information, but rather that they have entered into a special
confidential relationship in the conduct of the business of the enterprise and are given
access to information solely for corporate purposes. For such a duty to be imposed,
however, the corporation must expect the outsider to keep the disclosed nonpublic
information confidential, and the relationship at least must imply such a duty.”
e. Tippee Liability
i. Derivative Liability – “The transactions of those who knowingly participate
with the fiduciary in such a breach are as forbidden as transactions on behalf of
the trustee himself. Thus, the tippee’s duty to disclose or abstain is derivative
from that of the insider’s duty.”
ii. Test – “A tippee assumes a fiduciary duty to the shareholders of a corporation
not to trade on material nonpublic information only when (1) the insider has
breached his fiduciary duty to the shareholders by disclosing the information to
the tippee and (2) the tippee knows or should know that there has been a breach.”
iii. Key  Information has been made available to tippee IMPROPERLY.
iv. Tipper’s Duty/Personal Gain Required – “In determining whether a tippee is
under an obligation to disclose or abstain from using inside information, the test
is whether the insider personally will benefit, directly or indirectly, from his
disclosure. Absent some personal gain, there has been no breach of duty to
stockholders. And absent a breach by the insider, there is no derivative breach.”
f. SEC Regulation FD
i. Mandates that when someone acting on behalf of a public corporation discloses
private information to securities market professionals (e.g., analysts) or “holders
of issuer’s securities who may well trade on the basis of the information,” the
same information must also be disclosed to the general public.
ii. Applies whether initial disclosure was intentional or unintentional, with
broadcasting of inadvertently disclosed information required “promptly.”
iii. A great way to disclose is to flood the market with information, as on the
Internet. This means that you do not have to abstain.
9. United States v. O’Hagan
a. Facts – The SEC indicted O’Hagan, an attorney, on fifty-seven counts, including
seventeen counts of securities fraud and seventeen counts of fraudulent trading in
connection with a tender offer, for his trading on nonpublic information in breach of the
duty of trust and confidence he owed to his law firm and its clients.
b. Traditional Theory – “Under the traditional or classical theory of insider trading
liability, § 10(b) and Rule 10b-5 are violated when a corporate insider trades in the
securities of his corporation on the basis of material, nonpublic information. Trading on
such information qualifies as a deceptive device under § 10(b) because a relationship of
trust and confidence exists between the shareholders of a corporation and the corporate
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insiders. That relationship gives rise to a duty to disclose or to abstain from trading. The
classical theory applies not only to officers, directors, and other permanent insiders of a
corporation, but also to attorneys, accountants, consultants, and others who temporarily
become fiduciaries of a corporation.”
c. Misappropriation Theory – “The misappropriation theory holds that a person commits
fraud in connection with a securities transaction, and thereby violates § 10(b) and Rule
10b-5 when he misappropriates confidential information for securities trading purposes,
in breach of a duty owed to the source of the information. Under this theory, a
fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell
securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the
exclusive use of that information.”
i. “Satisfies § 10(b)’s requirement that chargeable conduct involve a ‘deceptive
device or contrivance’ used ‘in connection with’ the purchase or sale of
securities.”
ii. Full Disclosure Forecloses Liability – “Full disclosure forecloses liability under
the misappropriation theory: Because the deception essential to the
misappropriation theory involves feigning fidelity to the source of information, if
the fiduciary discloses to the source that he plans to trade on the nonpublic
information, there is no ‘deceptive device’ and thus no § 10(b) violation—
although the fiduciary-turned-trader may remain liable under state law for
breach of a duty of loyalty.”
10. United States v. Carpenter
a. Facts – R. Foster Winans wrote a widely read column in The Wall Street Journal. Stocks
mentioned in the column would be affected by it. Winans disclosed the content of the
column to friends prior to publication, and the friends traded based on this information.
b. Court in Carpenter (which was decided a decade before O’Hagan) was equally divided
(4-4) with respect to the misappropriation theory.
c. Upheld convictions based on the mail and wire fraud statutes (18 U.S.C. § § 1341, 1343),
which ban using the mails and wires for any “scheme or artifice to defraud.” These
protect property rights, but confidential business information is a property right. Here,
the WSJ had a property right and was the victim of the fraud.
d. Result – These statutes will be very close in insider cases to the scope of the
misappropriation theory, perhaps entirely coextensive.
11. United States v. Chestman
a. Rule – A person violates Rule 10b-5 when he misappropriates material nonpublic
information in breach of a fiduciary duty or similar relationship of trust and confidence
and uses that information in a securities transaction.
b. Absent evidence that Keith (relative that obtained insider info through familial
relationships) regularly participated in confidential business discussions, the familial
relationship in itself did not create a fiduciary duty. Thus, telling Chestman (Keith’s
stockbroker) the information did not breach any fiduciary duty, and therefore Rule 10b-5
was not violated.
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12.
13.
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14.
Short-Swing Profits, Indemnification & Insurance
Short-Swing Profits
1. Exchange Act § 16(a) – “Every person who is directly or indirectly the beneficial owner of more
than 10 per centum of any class of any equity security . . . or who is a director or an officer of the
issuer of such security . . . within ten days after the close of each calendar month . . . shall file
with the Commission . . . a statement indicating his ownership at the close of the calendar month
and such changes in his ownership as have occurred during such calendar month.”
a. Three Magic Classes – 10% owners, directors, and officers.
i. Officers & Directors – Funds can be matched with any that occur after
employee ceases to be an officer or director.
b. Only applies to companies that have to register under the Exchange Act. E.g., companies
traded on a national exchange, assets of $10 million, and 500 or more shareholders.
c. Under § 16(a), members of these classes are required to make some filings (below).
2. Forms – Required of § 16(a) classes.
a. Form 3: Insiders must file no later than the effective date of the registration statement,
or, if the issuer is already registered, within ten days of becoming an officer, director, or
beneficial owner.
b. Form 4: Changes in ownership must be reported within two business days. Limited
categories of transactions are not subject to the two-day reporting requirement.
c. Form 5: Insiders use this form to report any transactions that should have been reported
earlier on a Form 4 or were eligible for deferred reporting. If a Form must be filed, it is
due 45 days after the end of the company's fiscal year.
3. Exchange Act § 16(b) – “Any profit realized by [such beneficial owner, director, or officer] from
any purchase and sale, or any sale and purchase, of any equity security of such issuer . . . within
any period of less than six months . . . shall inure to and be recoverable by the issuer.”
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a. Key Language – “This subsection shall not be construed to cover any transaction where
such beneficial owner was not such both at the time of the purchase and sale, or the sale
and purchase, of the security involved.”
b. If you are a member of a § 16(a) class and you trade stock, then any profit that you make
will inure to the corporation.
c. Timeframe – Six months or less.
d. Any Class of Stock – Need only own 10% of one class of stock, not all classes and not
10% of total stock.
e. Covers convertible debt, but not other bonds or debentures.
f. Recovery – Any recovery inures to the company, but shareholders may sue derivatively,
and lawyers may collect fees from the violating party.
g. Accounting – The same analysis always applies. Whatever makes the short-swing sale
the most profitable, i.e., whatever makes the defendant lose the most/allows the company
to recover the most. Lowest-priced purchase and highest-priced sales. It is rather
punitive in this way.
h. Unconventional Transactions – Not sales for § 16(b). Three-Factor Test:
i. Whether the transaction is volitional;
ii. Whether the transaction is one over which the beneficial owner has any
influence; and
iii. Whether the beneficial owner had access to confidential information about the
transaction or issuer.
i. Examples
i. January 1 – Purchases 200,000 shares @ $10; May 1 – Sells 200,000 shares @
$50; Bill owes $800,000 to company.
ii. January 1 – Sells 200,000 shares @ $50; May 1 – Buys 200,000 shares @ $10;
Bill owes $800,000 to company.
1. Here, the order of purchase and sale does not matter, i.e., sales are
fungible. The purchase and sale of particular shares does not matter.
iii. January 1 – Buys 200,000 shares @ $10; May 1 – Sells 110,000 shares @ $50;
May 2 – Sells 90,000 @ $50; Bill owes $800,000 to company.
4. Reliance Electric Co. v. Emerson Electric Co.
a. Facts – Emerson Electric Co., which acquired 13.2% of the outstanding stock of Dodge
Manufacturing Co. (which later merged with Reliance Electric Co.) and was faced with
the failure of its takeover attempt, disposed of enough shares to bring its holdings below
10% in order to avoid liability under § 16(b).
b. Legislative History – “The history and purpose of § 16(b) have been exhaustively
reviewed by federal courts on several occasions since its enactment in 1934. Those
courts have recognized that the only method Congress deemed effective to curb the evils
of insider trading was a flat rule taking the profits out of a class of transactions in which
the possibility of abuse was believed to be intolerably great.”
c. Objective Standards – “In order to achieve its goals, Congress chose a relatively
arbitrary rule capable of easy administration. The objective standard of § 16(b) imposes
strict liability upon substantially all transactions occurring within the statutory time
period, regardless of the intent of the insider or the existence of actual speculation. This
approach maximized the ability of the rule to eradicate speculative abuses by reducing
difficulties in proof. Such arbitrary and sweeping coverage was deemed necessary to
insure the optimum prophylactic effect.”
d. Rule – “A ‘plan’ to sell that is conceived within six months of purchase clearly would not
fall within § 16 (b) if the sale were made after the six months had expired, and we see no
basis in the statute for a different result where the 10% requirement is involved rather
than the six-month limitation.”
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5. Foremost-McKesson, Inc. v. Provident Securities Co.
a. Facts – Foremost-McKesson, Inc. sued Provident Securities Co. to recover profits
realized on the sale of debentures to the underwriters.
b. Rule – “In a purchase-sale sequence, a beneficial owner must account for profits only if
he was a beneficial owner ‘before the purchase.’”
i. The transaction crossing the 10% threshold is not the one that makes you count
as crossing the threshold. Only later transactions are match-able to a later sale.
ii. You are not within § 16(b) status when you take on your 10% shares, but once
you have, then you are within § 16(b) status.
iii. For purposes of accountability under § 16(b), the Court distinguished between
the position of a more than 10% beneficial owner who purchases and sells
corporate securities within six months of purchase and that of a less than 10%
owner who increases his or her corporate holdings to above the 10% level and
sells the securities within six months of the purchase. While the 10% owner had
achieved the “insider” status prior to the purchase in the purchase-sale sequence
and therefore could reap profits at the expense of less well informed investors,
the person who owned less than 10% became an “insider” only upon purchase of
the securities within the purchase-sale sequence. Section 16(b) is intended to
reach only those who bought and sold on the basis of inside information, which
was presumptively available to them only after they had become statutory
insiders, i.e., beneficial owners of 10% of corporate securities.
Indemnification & Insurance
1. Indemnification & Insurance Generally
a. Roughly designed to do the same thing, at least with respect to the person being
indemnified.
b. Purpose – Imagine that an individual sues a corporate agent, employee, officer, or
director in her official, but individual, capacity. You, as that employee, would want the
corporation to cover your liability and legal fees.
c. Reactions
i. Such corporate indemnification/insurance is terrible because it will encourage
corporate negligence or recklessness.
ii. If there is no corporate coverage, this may cause corporate employees to proceed
exceedingly cautiously, and this may not be good for the corporation. Some
amount of boldness may be desirable.
2. Liability Limitation Statutes – DGCL § 102(b)(7) – A corporation’s Articles of Incorporation
may (but need not) contain:
a. A provision eliminating or limiting the personal liability of a director to the corporation
or its stockholders for monetary damages for breach of fiduciary duty as a director,
provided that such provision shall not eliminate or limit the liability of a director:
(i) For any breach of the director’s duty of loyalty to the corporation or its
stockholders;
(ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
(iii) under § 174 of this title [relating to liability for unlawful dividends]; or
(iv) for any transaction from which the director derived an improper personal
benefit.
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b.
c. Allows a corporation to provide insurance or indemnification to its officers or directors.
d. Attracting Talent – Such statutes enable corporations to attract director talent. Who
would become a director if doing so exposed her to liability and legal fees that she would
have to bear personally? Corporate indemnification/insurance mitigates this concern.
e. Applies only to directors, not officers.
i. It does not limit the ability to sue a director. Equitable remedies still are
possible.
ii. Section 102(b)(7) limits the amount of money that a director will be forced to
pay.
iii. Section 102(b)(7) is an affirmative defense.
3. DGCL § 145
a. Coverage – Good faith required.
i. Direct Suit Indemnification – As to suits by shareholders or third parties,
§145(a) authorizes the corporation – “a corporation shall have power” – to
indemnify the director or officer for expenses plus “judgments, fines, and
amounts paid in settlement” of both civil and criminal proceedings.
1. “if the person acted in GOOD FAITH and in a manner the person
reasonably believed to be in or not opposed to the best interests of the
corporation, and, with respect to any criminal action or proceeding, had
no reasonable cause to believe the person’s conduct was unlawful”
ii. Derivative Suit Indemnification – As to suits brought by or on behalf of the
corporation, §145(b) authorizes – “a corporation shall have power” –
indemnification only for expenses, albeit including attorney’s expenses.
1. “if the person acted in GOOD FAITH and in a manner the person
reasonably believed to be in or not opposed to the best interests of the
corporation”
2. If the director or officer was held liable to the corporation, he may only
be indemnified with court approval.
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b. Mandatory v. Permissive Indemnification – Under §145(c), the corporation must
indemnify a director or officer who “has been successful on the merits or otherwise.”
i. As for directors and officers who are unsuccessful, check whether
indemnification is allowed by §145(a) or (b).
ii. If so, the corporation may – but need not – indemnify the director or officer.
c. Advancement of Expenses – Under §145(e), the corporation may advance expenses to
the officer or director provided the latter undertakes to repay any such amount if it turns
out he is not entitled to indemnification.
i. Sarbanes-Oxley prohibits loans by corporation to officers and directors. Some
think this provision may affect advancement of expenses.
1. Majority View – No effect on state law.
d. Indemnification by Agreement – § 145(f) authorizes the corporation to enter into
written indemnification agreements with officers and directors that go beyond the statute:
statutory indemnification rights “shall not be deemed exclusive of any other rights” to
indemnification created by “bylaw, agreement, vote of the stockholders or disinterested
directors or otherwise.”
4. Waltuch v. Conticommodity Services, Inc.
a. Facts – Waltuch sued his employer for indemnification of the legal expenses he incurred
in defending himself from numerous civil lawsuits and an enforcement proceeding
brought by the Commodity Futures Trading Commission.
b. Rule – “Under § 145(f), a corporation may provide indemnification rights that go
‘beyond’ the rights provided by § 145(a) and the other substantive subsections of § 145.
At the same time, any such indemnification rights provided by a corporation must be
‘consistent with’ the substantive provisions of § 145, including § 145(a).”
i. “Indemnification rights granted by a corporation may be broader than those set
out in § 145(a), but they cannot be inconsistent with the scope of the
corporation’s power to indemnify, as delineated in the statute’s substantive
provisions.”
c. Section 145(c) & Vindication – “Success is sufficient to constitute vindication for the
purposes of § 145(c).”
i. Does not man moral exoneration.
ii. Court asks only what the result was, not why.
d. Fees for Fees – Issue: If an officer or director is obliged to sue the corporation seeking
indemnification, is a prevailing officer or director entitled not only to indemnification of
attorneys’ fees incurred in the underlying litigation but also those fees incurred in the
indemnification suit?
i. Baker v. Health Management Systems, Inc. (N.Y.) – No. N.Y. indemnification
statute bars recovery of “fees for fees.”
1.  But the N.Y. statute authorizes corporations “to provide
indemnification of fees on fees in bylaws, employment contracts or
through insurance.”
ii.  But see Stifel Financial Corp. v. Cochran (Del.) – No “fees for fees” is
inimical to interests of former director and contrary to express purpose of § 145.
“The indemnification statute should be broadly interpreted to further the goals it
was enacted to achieve.”
5. Citadel Holding Corporation v. Roven
a. Facts – Roven, a former director of Citadel Holding Corp., sued Citadel for
indemnification of sums he paid to defend a federal court action Citadel brought against
him.
b. Advance Payments to Director – “The General Corporation Law of Delaware expressly
allows a corporation to advance the costs of defending a suit to a director. § 145(e). The
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authority conferred is permissive. The corporation ‘may’ pay an officer or director’s
expenses in advance.”
i. § 145(e).
ii. Permissive, not mandatory.
iii. Reasonableness Requirement – Corporation need not advance unreasonable
expenses but must advance reasonable ones.
1. It is reasonable to cover expenses incurred under § 16(b) litigation
because there is little incentive for potential plaintiffs to think twice
about bringing § 16(b) suits. If they win, they win. If they lose, they do
not lose much unless they are sanctioned. The defendant, however, must
finance the other side of every one of those cases. So it is reasonable for
an individual to demand that those expenses be fronted.
CONTROL
Proxy Fights
Introduction
1. Role of Shareholder
a. Do not manage corporation. Keep board, which does manage, accountable.
b. Right to vote on certain issues:
i. Election of Directors – MBCA §§8.03–.04
1. Slate Voting v. Cumulative Voting (MBCA §7.28(a) vs. (c))
a. Slate Voting: Everyone gets one vote per slot, and candidates
with largest number of votes wins. E.g., how Americans elect a
President.
b. Cumulative Voting: Voters can use their votes more than once
per candidate; allows minority shareholders to assure themselves
of some representation.
i. E.g., if there are 80 elected positions, you get 80 votes,
and you may assign them as you wish, e.g., 80 votes for
the same presidential candidate and no votes for senator.
ii. Amendments to Articles of Incorporation and bylaws – MBCA §10.03, .20
iii. Fundamental Transactions. E.g.,
1. Mergers – MBCA §11.04
2. Major Asset Sales – MBCA §12.02
iv. Miscellaneous issues, such as approval of independent auditors.
2. Shareholder Meetings
a. Annual – Required. MBCA §7.01
b. Special
i. MBCA § 7.02 – Called by board or authorized officer, or by shareholders owning
together a 10% interest (AoI/bylaws may modify this percentage up or down, but
it may not exceed 25%).
ii. DGCL § 211(d) – No right for shareholders to call meeting unless AoI/ bylaws
specify such right.
c. Procedural Rules
i. Quorum – MBCA § 7.25–.27
1. Default: A majority of shares are entitled to vote. MBCA § 7.25(a)
ii. Voting
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1. MBCA § 7.25(c): Approved if number of votes cast in favor > number
cast against.
2. DGCL § 216: Must be approved by the vote of a majority of shares
present.
iii. Group Voting – MBCA § 10.04; DGCL § 242(b)(2)
1. Where share classes or rights would be changed, all holders of
outstanding shares of a class may vote as a separate voting group, so that
a majority of these shares controls all the votes.
iv. Notice – MBCA § 7.05
1. Eligibility, based on the “record date,” which is usually specified by the
bylaws. MBCA § 7.07.
d. Actions Without Meetings (i.e., by Written Consent)
i. MBCA § 7.04 – Require unanimity.
ii. DGCL § 228(a) – Allowed if consents come from same number of shares as
would be needed to take action at a meeting.
3. Seizing Control of Corporation – Options
a. Tender Offer – Buy enough shares from the other shareholders. Investor says to
shareholders, “If X% of the popular stock tenders their shares to me, I will buy the shares
at Y price above market value.” If enough shareholders tender their shares, the investor
will fulfill her obligation and buy them.
b. Shareholder Proposal – Propose that shareholders vote that Board is no good. Like a
referendum.
c. Proxy Solicitation – Convince the masses of individual shareholders to allow you to vote
for them. You vote their proxy. Proxy usually argues, “Showing up and voting is
expensive for you. Let me take care of it.” Shareholders must trust proxy.
i. Different Kinds of Proxies
1. General (voting generally) or specific (voting on specific issues).
2. Revocable or irrevocable.
ii. Congruent with the principles behind corporate law. Shareholders are supposed
to be passive and let other people, i.e., the board, run things.
4. Regulation of Proxy Voting
a. Applies to companies whose securities are registered under Exchange Act § 12.
b. Unlawful to solicit proxies in contravention of §§ 10(b), 14a.
c. Exchange Act § 14(a) – “It shall be unlawful for any person...in contravention of such
rules and regulations as the Commission may prescribe... to solicit or to permit the use of
his name to solicit any proxy or consent or authorization in respect of any security (other
than an exempted security) registered pursuant to section 12.”
i. Like § 10(b), § 14(a) is not self-enforcing, but relies on SEC rules to provide it
with content.
ii. Applies only to registered securities.
iii. “Solicitation” is construed very broadly under § 14(a). Gittlin.
d. Rule 14a-3(a) – Anyone (usually, a board) soliciting a proxy must first provide a written
proxy statement (following a prescribed form).
i. Must disclose information that may be relevant to the decision that the
shareholder must make. E.g., background of director nominees, board’s
compensation, matters being voted on, conflicts of interest, etc.
ii. Rule 14a-6: Preliminary copy of proxy statement must be filed with SEC at least
10 days before being sent to SH. Final copies must be filed with SEC before or
at time of sending.
e. Rule 14a-3(b) – Incumbent directors must provide an annual report before soliciting
proxies for the annual meeting.
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i. For many companies, this is the only requirement for periodic corporate
communications to SH.
f.
g. Rule 14a-1(l)(1) – The terms “solicit” and “solicitation” include:
i. Any request for a proxy whether or not accompanied by or included in a form of
proxy;
ii. Any request to execute or not to execute, or to revoke, a proxy; or
iii. The furnishing of a form of proxy or other communication to security holders
under circumstances reasonably calculated to result in the procurement,
withholding or revocation of a proxy.
h. Rules 14a-1(l)(2) & 14a-2 exempt certain activities, including:
i. Public statements as to how a SH plans to vote and her reasons for doing so [14a1(l)(2)(iv)(A)];
ii. Solicitations by a person who doesn’t seek (for herself or for others) the power to
act as proxy, subject to many exceptions [14a-2(b)(1)];
iii. Solicitations (other than by incumbents) to 10 or fewer people [(b)(2)].
i. Rule 14a-7 – When an INSURGENT GROUP challenges management, management
may either (1) mail insurgent group’s materials to shareholders directly and charge
insurgents or the cost or (2) give insurgent group a copy of its SH list and let it distribute
its materials on its own.
i. Management opts for former, but insurgent group always wants the latter.
j. Rule 14a-8 – SH Proposals.
k. Rule 14a-9 – “SEC Rule 14a–9 prohibits solicitation of a proxy by a statement
containing either (1) a false or misleading declaration of material fact or (2) an omission
of material fact that makes any portion of the statement false or misleading.”
Strategic Uses of Proxies
1. Levin v. Metro-Goldwyn-Mayer, Inc.
a. Facts – Levin and five other shareholders of MGM, Inc. brought an action against its
directors, arguing the management was using illegal and unfair methods of
communicating with stockholders and had forced the corporation to bear the expenses of
a proxy solicitation.
b. Stockholders Decide Management – “The decision as to the continuance of the present
corporate management rests entirely with the stockholders. A court may not override or
dictate on a matter of this nature to stockholders.”
i. Importance of Being Informed – “In such a situation the right of an
independent stockholder to be fully informed is of supreme importance.”
c. Rule – Incumbent management may make reasonable use of corporate assets to inform
shareholders of its position in a proxy contest involving corporate policy issues.
i. Held that expenses in ensuring that shareholders were informed were reasonable.
ii. AS LONG AS EXPENSES ARE REASONABLE, COURT WILL NOT
DISALLOW THEM. E.g., incumbent management could hire a PR firm to
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inform its shareholders, and a court probably would uphold this expenditure as
reasonable.
Reimbursement Costs
1. Rosenfeld v. Fairchild Engine & Airplane Corp.
a. Facts – Stockholders brought a derivative action arising out of money paid by the
corporation to defray rival factions’ expenses in a proxy fight.
b. Policy Contest – Rival factions within corporation each argues that it could run the
corporation better.
c. Rule – “Management may look to the corporate treasury for the reasonable expenses of
soliciting proxies to defend its position in a bona fide policy contest.”
i. “When the directors act in good faith in a contest over policy, they have the right
to incur reasonable and proper expenses for solicitation of proxies and in defense
of their corporate policies, and are not obliged to sit idly by.”
ii. Good Faith in Policy Questions – Duty of care. If directors think their expenses
are in the best interest of the corporation, the court should allow them to do it.
1. Not in good faith if undertaken for purely personal reasons.
2. Rule that action must be in the interests of the corporation has NO
TEETH because anything can be framed as in the interests of the
corporation.
a. E.g., “she’s doing this for her ego, not in the interests of the
corporation.” Response: If she acts that way and is not
successful for the corporation, she will tarnish her own
reputation. It is in her interest that the corporation does well.
iii. Reasonableness - Must be outrageously unreasonable to be impermissible. BJR.
1. Justification – Shareholders picked board to run the corporation, and
they should not interfere with how the board decides to run the
corporation.
2. E.g., hiring lawyers, PR firms, entertaining people, etc.
d. Reimbursement for Insurgents – “The members of the so-called new group could be
reimbursed by the corporation for their expenditures in this contest by AFFIRMATIVE
VOTE OF THE STOCKHOLDERS.”
i. Same rules apply, i.e., good faith, policy-driven, reasonable.
ii. Additional Requirement – Insurgents must prevail.
1. Not a legal requirement, but a practical one. Incumbent management, if
it prevails, will not take kindly to a insurgent group’s reimbursement
request.
iii. Insurgent group may investigate many firms. NO COMPENSATION for
(1) firms that it discovers are properly managed or (2) proxy fights that it loses.
2. Economics of Proxy Fights
a. Fell out of favor for economic reasons.
i. If insurgent group organized a proxy fight and lost, it bore the entire cost of
soliciting the proxies.
ii. If it won and made the business more profitable, it gained only a fraction of that
increased profitability.
b. Preference for tender offers, which allow insurgent group to buy all corporate stock.
i. In contrast, in proxy fights, insurgent group must share the value of the corporate
stock with other shareholders.
Private Actions for Proxy Rule Violations
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1. Rule 14a-9 – “SEC Rule 14a–9 prohibits solicitation of a proxy by a statement containing either
(1) a false or misleading declaration of material fact or (2) an omission of material fact that makes
any portion of the statement false or misleading.”
2. ELEMENTS
a. Misrepresentation or omission.
b. Materiality – Mills; TSC.
c. Defendant’s State of Mind – Rule 14a-9 does not mention. Scienter is not required.
Negligence will suffice.
d. Reliance – Rule 14a-9 is silent. Not required. Materiality suffices. Mills.
e. Causation – Rule 14a-9 is silent. Use liberal “essential link” standard in Mills.
3. Remedies
a. Forbidding SH meeting until soliciting party provides a new, corrected proxy statement
and re-solicits proxies.
b. Retrospective Relief – Available if a loss is shown. Violation itself is not enough.
c. Setting Aside/Undoing Transaction – Drastic and rare.
d. Attorneys’ Fees – Mills.
4. J.I. Case Co. v. Borak
a. Facts – Borak and other shareholders found that the proxy materials used by J.I. Case Co.
used their names as part of the company’s efforts to obtain approval of a merger with
American Tractor Corp., and Borak sued to have the merger declared void.
b. Direct & Derivative – Proxy claims under § 14(a) are both direct and derivative in
nature.
i. Derivative – Management may sue insurgents in corporation’s name. May use
firm’s resources to pay litigation expenses.
ii. Direct – Management may sue insurgents in their individual capacity as
shareholders. Cannot use firm’s resources to finance litigation.
c. Implied Private Right of Action
i. Purpose of § 14(a) – “The purpose of § 14(a) is to prevent management or others
from obtaining authorization for corporate action by means of deceptive or
inadequate disclosure in proxy solicitation.”
ii. “While the language makes no specific reference to a private right of action,
among its chief purposes is ‘the protection of investors,’ which certainly implies
the availability of judicial relief where necessary to achieve that result.”
1. Section 27 – Court looks to § 27 to interpret § 14(a). Section 27
provides for private rights of action. Creates a federal right of action, but
it does not explicitly create a private right of action.
2. Courts have jurisdiction over § 27 actions. The power to enforce this
provision implies the power to make effective right of recovery afforded
by the Act.
iii. Court created private right of action by judicial fiat.
iv. Shareholders are in a better position than the SEC to detect proxy violations.
1.  Not true. Shareholders are rationally apathetic.
2. Court wanted to encourage fraud detection from plaintiffs’ bar.
5. Mills v. Electric Auto-Lite Co.
a. Facts – Plaintiffs brought suit to undo a merger because the proxy materials submitted to
the shareholders before the merger’s vote failed to disclose that the board members
endorsing the merger were nominees of the targeting company who had held a majority
interest in the targeted company years before the merger was proposed.
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b. Attorneys’ Fees – Shareholder-plaintiffs “who have established a violation of the
securities laws by their corporation and its officials, should be reimbursed by the
corporation or its survivor for the costs of establishing the violation.”
i. Entitled to attorneys’ fees for finding a violation.
ii. No requirement that plaintiff ultimately prevail.
iii.  Powerful incentive for lawyers to find violations even where no injury has
occurred.
c. Materiality – Statement or omission is material when “it might have been considered
important by a reasonable shareholder who was in the process of deciding how to vote.”
Must have “a significant propensity to affect the voting process.”
i. TSC Industries Standard – “There is a substantial likelihood that a reasonable
shareholder would consider it important in deciding how to vote.”
1. Supplanted Mills standard.
d. Causation/”Essential Link” – “Where there has been a finding of materiality, a
shareholder has made a sufficient showing of causal relationship between the violation
and the injury for which he seeks redress if he proves that the proxy solicitation itself,
rather than the particular defect in the solicitation materials, is an ESSENTIAL LINK in
the accomplishment of the transaction.”
i. Plaintiff proves causation by showing that proxy solicitation (rather than the
defect) was an “essential link” in the accomplishment of the transaction.
1. Almost any violation “causes” an injury.
2. Proxy solicitation usually satisfies. It is necessary to obtain requisite
shareholder vote.
ii. No Need to Prove Affected Votes – “This objective test will avoid the
impracticalities of determining how many votes were affected, and, by resolving
doubts in favor of those the statute is designed to protect, will effectuate the
congressional policy of ensuring that the shareholders are able to make an
informed choice when they are consulted on corporate transactions.”
e. Damages
i. Damages must be proven.
ii. If the merger is fair, then there would be no damages.
iii. Equity courts have discretion to unscramble a merger, but courts are reluctant to
do this. It is very messy.
iv. Money Damages – Must show unfairness.
v. Attorneys’ Fees – See above.
6. Seinfeld v. Bartz
a. Facts – Cisco Systems, Inc. issued proxy statements that failed to value the stock options
granted its directors as part of their compensation.
b. Rule 14a-9 – “SEC Rule 14a–9 prohibits solicitation of a proxy by a statement
containing either (1) a false or misleading declaration of material fact or (2) an omission
of material fact that makes any portion of the statement false or misleading.”
c. Materiality – “An omitted fact is ‘material’ if ‘there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding how to vote.’ TSC
Industries, Inc.”
i. Totality of Information – “A plaintiff does not have to demonstrate that
disclosure of the fact in question would have caused a reasonable shareholder to
change his or her vote. Instead, it is sufficient to establish a substantial
likelihood that, ‘under all of the circumstances, the omitted fact would have
assumed actual significance in the deliberations of the reasonable shareholder.’
In other words, ‘there must be a substantial likelihood that the disclosure of the
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omitted fact would have been viewed by the reasonable investor as having
significantly altered the “total mix” of information made available.’”
ii. Not important whether fact would have caused SH to change her vote.
d. Rule – Company’s failure to disclose in its proxy statements the value of the stock
options granted to its directors does not constitute a materially false and misleading
statement under Rule 14a-9.
i. Four other courts had ruled that it was not material.
Shareholder Proposals
1.
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2.
3. Lovenheim v. Iroquois Brands, Ltd.
a. Facts – Lovenheim asked to have information about a resolution he proposed to make at
an upcoming shareholders’ meeting included in the company’s proxy materials, but the
company refused.
b. Rule 14a-8 – “If any security holder of an issuer notifies the issuer of his intention to
present a proposal for action at a forthcoming meeting of the issuer’s security holders, the
issuer shall set forth the proposal in its proxy statement and identify it in its form of
proxy and provide means by which security holders [presenting a proposal may present in
the proxy statement a statement of not more than 200 words in support of the proposal].”
c. Exception – “An issuer of securities ‘may omit a proposal and any statement in support
thereof’ from its proxy statement and form of proxy ‘if the proposal relates to operations
which account for less than 5 percent of the issuer’s total assets at the end of its most
recent fiscal year, and for less than 5 percent of its net earnings and gross sales for its
most recent fiscal year, and IS NOT OTHERWISE SIGNIFICANTLY RELATED TO
THE ISSUER'S BUSINESS.’” Rule 14a-8(i)(5).
i. If exception is met, issuer need not include SH proposal in proxy statement.
ii. “Otherwise Significantly Related”
1. Not limited to economic significance.
2. Ethical and social significance can be considered.
3.  This essentially means that every topic can be made “significant.”
Kieff thinks that the court’s holding here means that Rule 14a-8(i)(5) no
longer functions to exclude anything from Rule 14a-8.
4. AFSCME v. AIG, Inc.
a. Facts – AIG shareholders made a proposal relating to the publication of board of director
candidates’ names and asked that the proposal be included in AIG’s proxy materials, but
AIG objected, arguing that the proposal need not be included because it related to an
election and therefore fell within an exclusion from the requirement that shareholder
proposals be included in proxy materials.
b. Rules – Deference to Agency Interpretation
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i. “An agency’s interpretation of an ambiguous regulation made at the time the
regulation was implemented or revised should control unless that agency has
offered sufficient reasons for its changed interpretation.”
ii. “When the language of a regulation is ambiguous, courts typically look for
guidance in any interpretation made by the agency that promulgated the
regulation in question.”
iii. “While agency interpretations that lack the force of law do not warrant deference
when they interpret ambiguous statutes, they do normally warrant deference
when they interpret ambiguous regulations.”
iv. “An agency’s interpretation of a regulation that conflicts with a prior
interpretation is entitled to considerably less deference than a consistently held
agency view.”
v. Amending Interpretation – “An agency may alter its interpretation of a statute
so long as the new rule is consistent with the statute, applies to all litigants, and is
supported by a ‘reasoned analysis.’”
Shareholder Inspection Rights
1. Generally
a. Rule 14a-7 – When an insurgent group challenges management, management may either
(1) mail insurgent group’s materials to shareholders directly and charge insurgents or the
cost or (2) give insurgent group a copy of its SH list and let it distribute its materials on
its own.
i. Management opts for former, but insurgent group always wants the latter.
ii. These cases fall under state law.
b. DGCL § 220(b) – SH must make a written demand and articulate a proper purpose.
i. Proper Purpose – Reasonably related to interest as shareholder.
1. Presumptively Proper
a. Request for shareholder list.
b. Stock splits.
c. Social activism concerns. A link usually can be drawn between
the bad act and the overall value of the corporation, i.e., tarnish
to the corporation’s name.
2. Any other request – Not presumptively proper.
ii. Delaware law gives shareholders inspection rights, but it tries to strike a balance.
2. Crane Co. v. Anaconda Co.
a. Facts – Crane Co. sought to acquire 20% of Anaconda Co.’s shares and asked to have
access to Anaconda’s shareholder list to distribute information on the tender offer directly
to Anaconda’s shareholders.
b. Tender Offers Are Proper – Tender offer stated a proper purpose in desiring to inform
other shareholders of the pending offer and soliciting tenders from them.
i. “A shareholder desiring to discuss relevant aspects of a tender offer should be
granted access to the shareholder list unless it is sought for a purpose inimical to
the corporation or its stockholders—and the manner of communication selected
should be within the judgment of the shareholder.”
ii. Takeovers/tender offers are a way of disciplining the board.
iii. Crane may have multiple motives, but included in those is some nontrivial,
legitimate motive.
c. Applying New York law.
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i. Internal Affairs Doctrine – Generally, apply the law of the state of
incorporation to govern issues of internal corporate governance. This would
suggest that Montana law should apply.
ii. Exception to Doctrine – Each state may have shareholders living in its territory
investing in corporations. Applying New York law because this is a New York
court and the corporation is doing business with New York shareholders.
Voting Control & Close Corporations
Shareholder Voting Control
1. Closely Held Corporations Generally
a. No secondary market.
b. Usually have a small number of shareholders, which all usually are actively involved in
managing the firm.
i. Very similar to partnerships.
c. Shareholders may elect closed-corporation status. (Delaware law requires there to me
less than 30 shareholders.) Allows the shareholders, rather than the board, to manage the
business of the corporation. Limited liability still is available to shareholders.
i. Taxed under federal law as ordinary corporations. May be eligible for Scorporation status.
d. Cannot assume that total passivity will play out well for you as a shareholder. You want
to participate or closely monitor management.
i. Difficult to exit, i.e., sell shares of, closed corporation. There is no market for
these shares. If you can’t get out quickly, you want to pay attention.
ii. People running closed corporations are paying themselves a lot rather than rather
than taking dividends. Helps to avoid double taxation.
iii. Disagreements – Because it is difficult to exit a close corporation, it becomes
important to fight for your views and resolve your differences. This gives
shareholders incentive to exercise control or oversight.
2. Packing Rights (Stock Class Issuance)
a. Two Kinds of Stock Rights
i. Financial
1. Right to receive dividends.
2. Residual claim on assets when corporation is round up.
ii. Voting
1. Right to elect the board.
2. Right to vote on some extraordinary matters.
b. MBCA § 6.01(b) – “The articles of incorporation must authorize (1) one or more classes
of shares that together have unlimited voting rights, and (2) one or more classes of shares
(which may be the same class or classes as those with voting rights) that together are
entitled to receive the net assets of the corporation upon dissolution.”
i. May be the same class of shares, but need not be.
c. MBCA § 6.01(c) – “The articles of incorporation may authorize one or more classes or
series of shares that: [are nonvoting stock or other variants on one-share-one-vote].”
d.  MBCA is very liberal. Some states are more restrictive.
3. Voting Rights – Meetings
a. Meetings
i. Two Types
1. Annual
2. Special
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ii. Who can call?
1. Compare MBCA § 7.02(a)(2) (allowing those with 10% of votes to call a
meeting, though charter may change that to up to 25%),
2. With DGCL § 211(d) (allowing only the directors or others authorized
by Articles of Incorporation or bylaws to call meetings)
b. Action Without Meeting (Written Consents)
i. Must be unanimous in MBCA.
1. Compare DGCL § 228(a) – Action by consents okay if same number of
shares consent as would be needed at a meeting.
2. Difference may reflect different views on value of deliberation.
c. Quorum
i. In order for shareholders to take action, there must be a quorum at the meeting.
ii. Default Rule – A majority of the shares entitled to vote. See MBCA § 7.25(a).
d. Voting Outcomes
i. MBCA § 7.25(c) – A matter is approved if votes cast in favor > votes cast
against.
ii. DGCL § 216 – Decisions must be approved by the vote of a majority of the
shares present.
4. Stroh v. Blackhawk Holding Corp.
a. Facts – Stroh purchases shares of Blackhawk Holding Corp.’s Class B stock, which
permitted voting rights in corporate matters, but did not receive dividends or other
corporate assets.
b. Rule – “The proprietary rights conferred by the ownership of stock may consist of one or
more of the rights to participate ‘in the control of the corporation, in its surplus or
profits, or in the distribution of its assets.’ The use of the disjunctive conjunction
‘or,’ indicates that one or more of the three named rights may inure to a stockholder by
virtue of his stock ownership.”
i. Three Pieces – Control, earnings, and residual claim.
1. Statute used the disjunctive and not the conjunctive. Thus, a share gives
you A or B or C, i.e., some piece but not all three.
2. Dissent – Stock should have all three.
c. Rule – “These rights and powers granted by the legislature to the corporation to make the
terms of its contract with its shareholders are limited only by the proviso that the articles
may not limit or deny the voting power of any share. This section of the Act expressly
confers the right to prefer a class of shares over another with regard to dividends and
assets.”
d. Rule – “The rights to earnings and the rights to assets—the ‘economic’ rights—may be
removed and eliminated from the other attributes of a share of stock. Only the
management incident of ownership may not be removed.”
i. Illinois constitution forbade issuance of nonvoting stock.
ii. OK for corp. to issue Class B shares with voting power—but no economic rights.
5. Providence and Worcester Co. v. Baker
a. DGCL § 151(a) – Allows corporations to issue various classes of shares with various
voting powers.
b. Court says that it is OK for different shares within the same class to have different voting
power.
Control in Closely Held Corporations
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1.
2. Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling
a. Facts – Edith Ringling agreed to vote her stock in agreement with Galey, but then refused
to do so.
b. Contractual Voting Agreements Are Permissible/Enforceable – “Generally speaking,
under Delaware law a shareholder may exercise wide liberality of judgment in the matter
of voting, and it is not objectionable that his motives may be for personal profit, or
determined by whims or caprice, so long as he violates no duty owed his fellow
shareholders. The ownership of voting stock imposes no legal duty to vote at all. A
group of shareholders may, without impropriety, vote their respective shares so as to
obtain advantages of concerted action. They may lawfully contract with each other to
vote in the future in such way as they, or a majority of their group, from time to time
determine.”
i. “Reasonable provisions for cases of failure of the group to reach a determination
because of an even division in their ranks seem unobjectionable.”
ii. The remedy for violating the shareholder voting agreement is that your votes
are not counted.
c. Proxies
i. No implied proxy here, i.e., no party is empowered to exercise the voting rights
of another party.
ii. Loos (arbitrator) could have gotten written proxies and made them irrevocable.
This would have allowed him to enforce the decisions that he reached.
1. To have someone cast a deciding vote, give her an irrevocable proxy.
3. McQuade v. Stoneham
a. Facts – McQuade, who was employed as corporate treasurer pursuant to a shareholders’
agreement, was discharged.
b. Agreements to Limit Directors’ Judgment Are Void – Directors must exercise their
independent business judgment on behalf of all shareholders. If directors agree in
advance to limit that judgment, shareholders do not receive the benefit of their
independence, and the agreement is therefore void as against public policy.
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i. “Although it has been held that an agreement among stockholders whereby it is
attempted to divest the directors of their power to discharge an unfaithful
employee of the corporation is illegal as against public policy, it must be equally
true that the stockholders may not, by agreement among themselves, control the
directors in the exercise of the judgment vested in them by virtue of their office
to elect officers and fix salaries. Their motives may not be questioned so long as
their acts are legal. The bad faith or the improper motives of the parties does not
change the rule. Directors may not by agreements entered into as stockholders
abrogate their independent judgment.”
c. Stockholders’ Power to Unite – “Stockholders may, of course, combine to elect
directors. That rule is well settled. If stockholders want to make their power felt, they
must unite. There is no reason why a majority should not agree to keep together. The
power to unite is, however, limited to the election of directors and is not extended to
contracts whereby limitations are placed on the power of directors to manage the business
of the corporation by the selection of agents at defined salaries.”
4. Clark v. Dodge
a. Facts – Clark, who was employed as treasurer and general manager of a corporation
pursuant to a shareholders’ agreement, was discharged. Clark has ideas, and Dodge has
money. They will run two drug companies in which Clark promises to disclose the secret
formula and Dodge promises to vote for Clark as director and general manager
(contingent upon his remaining loyal, competent, etc.). Clark discloses the secret
formula, and then Dodge fires Clark.
b. Rule – McQuade is intended to protect minority shareholders not party to the agreement.
Where the corporation has no minority shareholders, the prohibition is unnecessary.
Absent potential harm “to bona fide purchasers of stock or to creditors or to stockholding
minorities,” i.e., externalities, there is no justification for invalidating a contract about
whom to elect as directors and officers of a firm even though it “impinges slightly” on the
principle of director primacy.
c. Shareholder agreements are allowed even if they restrict discretion, govern payout
distributions, create officers or directors, etc.
i. Only Limitations – (1) Relieving directors from fiduciary duties or (2) give nondirectors the power of directors.
ii. Must be in articles of incorporation or bylaws or another written instrument so
that people know of them.
iii. Third-party innocent purchases are not bound.
5. MBCA on Shareholder Agreements
a. MBCA § 7.32(a): Allows SH agreements on even if they:
i. Eliminate the BoD or restricts the discretion or powers of the BoD;
ii. Governs the authorization or making of distributions (subject to limitations);
iii. Establishes who shall be directors or officers of the corporation;
iv. Governs exercise or division of voting power by/between SH/directors;
v. Transfers to someone the authority to exercise corporate powers or manage the
business and affairs of the corporation.
b. MBCA § 7.32(e)
i. Limitations on BoD discretion/powers relieves directors from fiduciary duties in
that area.
ii. Vesting in a non-director discretion/powers otherwise belonging to the BoD
imposes a fiduciary duty on that person as if she were a director.
c. Validity
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i. MBCA §7.32(b): Such agreements must be set in AoI/bylaws and approved by
all SHs of that time, or in a written agreement signed by all SHs of that time and
made known to the corp.
ii. MBCA §7.32(d): SH agreement ceases to be effective when shares are
listed/traded.
d. Third Parties
i. MBCA §7.32(c): Purchaser of shares who didn’t know of agreement at time of
purchase is entitled to rescission.
ii. Corp. can create constructive knowledge: Print reference to SH agreement on
share certificates/information statements given to buyer.
Abuse of Control
1. Normally, no fiduciary duties among SHs
a. major exception is duty of majority to minority (Sinclair)
i. essence of exception is a decision that tanks everybody's interest as SH (but
works for the person for some other reason)
ii. veto like the one in Atlantic is effective control -, where there is such effective
control, duty is to act in the best interests of the corporation
1. best/strongest version of that argument: person acting in a way that
favors herself/themselves at expense of others and not generally in the
best interests of the corp.
2. Wilkes v. Springside Nursing Home, Inc. (Mass.) (Does Delaware follow?)
a. Donahue – Earlier Mass. case. SH of close corporation owe each other fiduciary duties
like in a partnership. Recall Meinhard. Duty of inest loyalty,
i. Cut back in this case.
b. Rule
i. Controlling group must first demonstrate some legitimate business purpose for its
action.
ii. If such a showing is made, the burden then shifts to the minority SH to show that
the legitimate purpose could have been achieved through an alternative less
harmful to the minority’s interest.
1. If minority shareholder cannot come up with an alternative, court will
defer to controlling group.
iii. Court must then attempt to balance the legitimate business purpose against the
practicability of the proposed less harmful alternative.
iv.  Gives majority “some room to maneuver” in setting policy.
c. How could parties have structured this deal to avoid this lawsuit?
i. buy out agreement: agmt to buy out the interest of a SH whose employment
ends/is terminated
ii. SH agmt to keep each other in office: problem-->not clear you can constrain
directors to not act in best interest of the corp
1. actually seemed to have that agmt in this case and it didn't do much
iii. employment agreement: constraining the corporation rather than the Bd
(anything other than at-will employment)
3. Ingle v. Glamore Motor Sales, Inc. (NEW YORK)
a. Employment at-Will – “A minority shareholder in a close corporation, by that status
alone, who contractually agrees to the repurchase of his shares upon termination of his
employment for any reason, acquires no right from the corporation or majority
shareholders against at-will discharge.
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i. Distinction in Capacities – “It is necessary to appreciate and keep distinct the
duty a corporation owes to a minority shareholder as a shareholder from any duty
it might owe him as an employee.”
ii. No Implied Duty of Good Faith – “There is no implied obligation of good faith
and fair dealing in an employment at will, because that would be incongruous to
the legally recognized jural relationship in that kind of employment relationship.”
b. Rule – “No duty of loyalty and good faith akin to that between partners, precluding
termination except for cause, arises among those operating a business in the corporate
form who have only the rights, duties, and obligations of stockholders and not those of
partners.”
i. Contrast with Wilkes.
ii. Arguably stands for the proposition that you can contract around fiduciary duties.
iii. See Gallagher v. Lambert – Shareholder “agreements define the scope of the
relevant fiduciary duty and supply certainty of obligation to each side,” and such
agreements “should not be undone simply upon an allegation of unfairness.”
iv. See Blank – Court says that a shareholder gets what he bargained for and nothing
more.
v. Bottom Line - The more you're involved in crafting agreement, the more you're
stuck with it.
c. Dissent – Cites unfairness, but that is not good enough.
4. Brodie v. Jordan (Mass.)
a. Stockholders’ Fiduciary Duty – “Stockholders in a close corporation owe one another
substantially the same fiduciary duty in the operation of the enterprise that partners owe
to one another, that is, a duty of utmost good faith and loyalty.”
i. Freeze Out Violates – “Majority shareholders in a close corporation violate this
duty when they act to ‘freeze out’ the minority.”
b. Remedy for Freeze Out – “The proper remedy for a freeze-out is to restore the minority
shareholder as nearly as possible to the position she would have been in had there been
no wrongdoing. Because the wrongdoing in a freeze-out is the denial by the majority of
the minority’s reasonable expectations of benefit, it follows that the remedy should, to the
extent possible, restore to the minority shareholder those benefits which she reasonably
expected, but has not received because of the fiduciary breach.”
i. Courts have broad equitable powers to fashion remedies.
1. Reviewed only for abuse of discretion.
ii. “The remedy for a freeze-out should neither grant the minority a windfall nor
excessively penalize the majority. Rather, it should attempt to reset the proper
balance between the majority’s conceded rights to what has been termed selfish
ownership, and the minority’s reasonable expectations of benefit from its shares.”
c. Lawyers for person w/ 2 relationships with corp: employee and SH, then one of those
relationships severed and we're marshalling args on her behalf
i. if there's a contract, argue about it-->straightforward contractual argument
1. employment K: anything other than at-will
2. SH K
ii. Special duty other SHs owe this SH like the duty to a minority SH in Sinclair Oil
1. weakest where status as minority SH is merely incidental to real
relationship, which was employee - either given or bought some
company stock
2. if shares carry with them particular DoL, like controlling SHs won't take
advantage of minority, then decent argument
iii. Non DoL SH arg: DoC argument
1. not that you fired SH, but that you fired a good employee
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2. problem: as a DoC arg, BJR applies
5. Smith v. Atlantic Properties, Inc. (MASSACHUSETTS)
a. Shareholders’ Fiduciary Duty – “Stockholders in the close corporation owe one another
substantially the same fiduciary duty in the operation of the enterprise that partners owe
to one another. That standard of duty is the utmost good faith and loyalty. Such
stockholders may not act out of avarice, expediency or self-interest in derogation of their
duty of loyalty to the other stockholders and to the corporation.”
b. Minority Shareholders’ Fiduciary Duty– Minority shareholders, at least where they
have a veto power over corporate action, are subject to the same fiduciary duties as those
imposed by Donahue and Wilkes.
i. Minority shouldn’t be able to take corporation hostage.
ii. “The majority may not exercise their corporate powers in a manner which is
clearly intended to be and is in fact inimical to the corporate interest, or which is
intended to deprive the minority of its pro rata share of the present or future gains
accruing to the enterprise. A minority shareholder whose conduct is controlling
on a particular issue should be bound by no different standard.”
6. Merner v. Merner (9th Cir. 2005)
a. California follows Delaware approach.
b. Carl (the majority shareholder) sought to enjoin the minority shareholder, from selling his
shares, because the sale would result in the corporation losing its Subchapter S tax status
c. Plaintiff relied on a partner-like fiduciary duty of the minority shareholder
d. one minority SH threatenting to act in a way that affects everyone else's taxes negatively;
majority brings suit
e. Ct sensitive to fact that one can harm everyone else-->fiduciary duty in that setting
f. opposite of Sinclair in factual position (minority abusing majority), but same in that it is
showing that action favored group exercising control at the expense of the corp and other
SH
7. Jordan v. Duff and Phelps, Inc.
a. Debate between Easterbrook and Posner about what at-will employment protects against.
b. Easterbrook (Majority)
i. “Close corporations that purchase their own stock must disclose to the sellers all
information that meets the standard of materiality. The special price and
structure rule, under which public corporations need not disclose impending
negotiations for their merger, does not apply to close corporations.”
1. TSC Industries standard of materiality.
2. Why information is material:
a. at time, expected to succeed at higher than book value
b. even if deal eventually failed, attempt suggested more suitors,
one of whom would eventually exceed present book value
c. all of that would have impacted J's decision-making at the time
3. Disclose or Abstain – Normal rule. Generally, under 10b-5, if insider
trades on inside info, have to disclose; if no one trades, then don't have to
disclose.
ii. “Employment at will is still a contractual relation, one in which a particular
duration (‘at will’) is implied in the absence of a contrary expression. One term
implied in every written contract and therefore, we suppose, every unwritten one,
is that neither party will try to take opportunistic advantage of the other.”
iii. “The rationale of finding a securities violation -- if there was one, a qualification
we will not repeat -- is that Jordan sold his stock in ignorance of facts that would
have established a higher value. The relevance of the fact does not depend on
how things turn out. Just as a lie that overstates a firm's prospects is a violation
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even if, against all odds, every fantasy comes true, so a failure to disclose an
important beneficent event is a violation even if things later go sour.”
iv. “Because a reasonable investor would not conclude that the withdrawal of one
bid implies that there will be no others -- and because Jordan would have known
of the board's decision to sell the firm -- a jury would be entitled to conclude that
Jordan would have stuck around.”
v. Holding
1. Rule 10b-5 violation because Jordan had a choice whether or not to stay
or leave, and disclosure would have affected that choice.
a. Opportunistic firing would breach the employment at will
contractual relation. Implied term.
2. State Law Fiduciary Duty.
c. Posner, Dissenting
i. Abstain & disclose rule does not apply where person can't use it in a way that
will impact his decision making.
Control, Duration & Statutory Dissolution
1. Generally
a. Collective Answer to Fiduciary Duty Problems – The best solution is to plan up front.
b. State Dissolution Statutes
i. Some are fairly liberal/enabling.
ii. If you have a going concern with a high value, its value may be high just because
it is a going concern. “Sharks can only breathe while they’re swimming”
problem.
1. Why might a corporation not be valuable when it stops running? A: No
one really wants to buy the stock of a closed corporation, and stopping
the operations of a closed corporation places it in a setting in which it has
little value.
iii. The minority says, “We’re frozen out. Please order dissolution.” Majority says,
“Please do not order dissolution. It will ruin us.” What is the minority’s
response?
1. For an asset not to be valuable, it must lie fallow.
2. Majority is saying, “If you let us, we have a plan that will allow the
company to make a lot of money.”
3. Proper Response from the Minority – Go ahead with your plan. We will
not dissolve, but you should buy me out.
iv. When might a minority choose to trigger dissolution?
1. When it is most convenient for the minority.
2. When it will give the minority leverage over the majority. We do not
want to make dissolution too easy, however, because this will allow the
minority to blackmail the majority by threatening dissolution. We do not
want a minority to be able to hold the majority hostage.
2. Alaska Plastics, Inc. v. Coppock
a. Four Main Grounds for a Corporation Buying out the Minority
i. First, there may be a provision in the articles of incorporation or by-laws that
provide for the purchase of shares by the corporation, contingent upon the
occurrence of some event, such as the death of a shareholder or transfer of shares.
ii. Second, the shareholder may petition the court for involuntary dissolution of the
corporation.
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1. Requires a showing that the acts of the directors or those in control of the
corporation are illegal, oppressive or fraudulent; or
a. Look to evidence – SH being treated differently? No dividends?
Inequitable dividends? Unacceptable price for shares? Not
notified of SH meetings?
b. Reasonable Expectations – Expectations that the minority SH
“will participate in the management of the business or be
employed by the company,” but limited to “expectations
embodied in understandings, express or implied, among the
participants.” Meiselman.
2. When corporate assets are being misapplied or wasted.
3.  Payout according to SH rights and interests.
iii. Third, upon some significant change in corporate structure, such as a merger, the
shareholder may demand a statutory right of appraisal.
1. E.g., merger, de factor merger, consolidation, sale of substantially all of
the assets.
iv. Finally, in some circumstances, a purchase may be justified as an equitable
remedy upon a finding of a breach of a fiduciary duty between directors and
shareholders and the corporation or other shareholders.
1. Transactions by one group of shareholders that enable it to derive some
special benefit not shared in common by all shareholders.
2. Fiduciary Duty b/w SH in Close Corp. – Like partnership. Utmost
duty and loyalty.
3. Burden Shifting – Defendants must prove that transaction was fair.
b. Remedy for Duty of Loyalty Breaches – Equal treatment of the minority shareholder.
Give the minority shareholder, who had been receiving unequal treatment, the same
treatment as the majority shareholder.
i. “None of the other shareholders of Alaska Plastics have sold their stock to the
corporation so it would not be appropriate to order the corporation to purchase
Muir’s stock.”
c. Two Grounds for Dissolution (Most States)
i. Deadlock Among the Directors – Key Requirements
1. Actual deadlock. Directors must be evenly divided; unable to make
corporate decisions.
2. Shareholders must be unable to break corporate deadlock.
3. Deadlock must be serious enough that it threatens irreparable injury to
the corporation.
ii. Deadlock Among the Shareholders – Key Requirements
1. Actual deadlock. Depending on the voting/quorum rules, no actual vote
can be held/determined.
2. Because of the deadlock, shareholders are unable to elect a board twoyears-running.
3. Haley v. Talcott
a. Judicial Dissolution – “[Delaware law] permits the Delaware Court of Chancery to
decree dissolution of a limited liability company whenever it is not reasonably practicable
to carry on the business in conformity with a limited liability company agreement.”
i. Two LLC Members – Either stockholder may, unless otherwise provided, in a
written agreement, file with the Court of Chancery a petition stating that it
desires to discontinue such joint venture and to dispose of the assets in
accordance with a plan to be agreed on by both stockholders or that the
corporation be dissolved.”
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1. Pulling from DE joint venture law.
ii. Three Requirements – Delaware law “essentially sets forth three pre-requisites
for a judicial order of dissolution: (1) the corporation must have two 50 percent
stockholders, (2) those stockholders must be engaged in a joint venture, and (3)
they must be unable to agree upon whether to discontinue the business or how to
dispose of its assets.”
b. LLC Act encourages freedom of contract, and courts want to respect it.
c. Equitable power to strike down what is seen as inequitable  If Haley followed exit
strategy in agreement, he would be penalized because of his continuing personal guaranty
on the LLC’s mortgage.
i. Exit mechanism is inequitable.
ii. Court orders dissolution.
4. Pedro v. Pedro
a. Fiduciary duty can be breached without decrease in company value.
i. Adopts Meinhard-like partnership interpretation.
ii. Brothers firing another brother for no reason is a breach.
b. Damages
i. “Loss in value of a shareholder’s stock is not the only measure of damages.”
ii. “If the fair value of the shares is greater than the purchase price for the buyout,
the difference is the measure of damage resulting from having been forced to sell
shares in the company.”
iii. Court has broad equitable power/may consider shareholders’ reasonable
expectations:
1. Factors – “The duty which all shareholders in a closely held corporation
owe one another to act in an honest, fair and reasonable manner in the
operation of the corporation and the reasonable expectations of the
shareholders as they exist at the inception and develop during the course
of the shareholders’ relationship with the corporation and with each
other.”
2. Reasonable Expectations – “In addition to an ownership interest, the
reasonable expectations of such a shareholder are a job, salary, a
significant place in management, and economic security for his family.”
a. In close corp.  SH may have reasonable expectation that
employment is not terminable at will.
c. Two Claims
i. Lost Employment – As employee.
ii. Breach of Fiduciary Duty – As SH.
5. Stuparich v. Harbor Furniture Mfg., Inc.
a. Grounds for Court-Ordered Dissolution
i. California Law – “Provides for the involuntary dissolution of a corporation
where, in the case of any corporation with 35 or fewer shareholders, liquidation
is reasonably necessary for the protection of the rights or interests of the
complaining shareholder or shareholders.”
ii. Stumpf – Court may order dissolution “when required to assure fairness to
minority shareholders and at the same time to lessen the danger of minority
abuse.”
iii. Bauer
1. § 1800(b)(4) - persistent fraud, mismanagement, abuse of authority or
persistent unfairness toward shareholders
2. § 1800(b)(5) - dissolution necessary to protect rights or interests of
complaining shareholders
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3.  (b)(5) grounds are broader than (b)(4) grounds.
4.  Insufficient reasons for dissolution:
a. Not necessary to protect minority’s interests
b. nonpayment of corporate dividends was not a basis for granting
dissolution because of evidence that there were no profits from
which dividends could be paid.
c. minority shareholders did not have a reasonable expectation of
receiving either dividends or salaries from West Coast.
b. Rule – Dissolution of close corporation is necessary if plaintiffs show that it is
reasonably necessary to protect their rights.
i. That majority SH can outvote minority is insufficient. This does not
substantially impair their right to control so as to require dissolution.
c. Contrast with Pedro
i. Pedro – Breach of fiduciary duty without financial damage to company.
ii. Stuparich – Plaintiffs had been receiving substantial dividends for shares and
were not injured.
iii. Alaska Plastic – Court was slower to find injury because shares because minority
SH paid nothing for shares. They were a gift.
Transfer of Control
1. Control Generally
a. Control premium associated with control.
i. If you buy a large block of shares, you will pay a premium for that large block,
i.e., more than if you had bought them in smaller blocks or individually.
Question: who should receive the benefit of this premium?
ii. Anyone with a controlling or large block has a controlling premium.
b. Two Choices for Buying Control
i. Buy dominant shareholder’s block.
ii. Offer something to all of the other minority shareholders that will induce them to
tender their shares.
1. Tender Offer – If X percent of shareholders tender their shares to me, I
will buy them at Y premium price.
c. Why would an incumbent not be running a firm well?
i. She’s looting.
ii. The board is running the business into the ground.
iii. The board is not trying very hard. Sounds like a duty of care problem, but if the
board has a preference for leisure, it may be a duty of loyalty problem.
d. Possible Rules
i. Not required to share the control premium with other shareholders.
ii. Must share control premium with other shareholders.
iii. Actual Rule – Somewhere in between. No sharing unless, like in Sinclair Oil
Corp., the minority shareholders are injured by the transaction.
1. Duty of loyalty analysis. Controlling shareholder is benefiting herself at
the expense of minority shareholders.
2. Voluntary Dissolution & Liquidation of a Corporation – MBCA § 14.02:
(b) For a proposal to dissolve to be adopted:
(1) the board of directors must recommend dissolution to the shareholders ...; and
(2) the shareholders entitled to vote must approve the proposal to dissolve as
provided in subsection (e).
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(e) ... adoption of the proposal to dissolve shall require the approval of the shareholders at
a meeting at which a quorum ... exists
3. Frandsen v. Jensen-Sundquist Agency, Inc.
a. Rule – A minority shareholder’s right of first refusal that is triggered by the majority
shareholders’ sale of their stock does not apply to a transaction in which an acquiring
entity purchases the corporation’s principal asset, after which the corporation is
liquidated.
i. Merger has different implications than sale of stock.
ii. Frandsen, an experienced businessman, should have recognized the distinction
and protected himself.
iii.  Declined to give “offer to sell” an expansive construction.
iv.  Narrow construction of right of first refusal: puts a premium on careful ex
ante negotiation and drafting.
v. Differences – “A sale of the majority bloc's shares is not the same thing as a sale
of either all or some of the holding company's assets. The sale of assets does not
result in substituting a new majority bloc, and that is the possibility at which the
protective provisions are aimed.”
vi. Narrow Interpretation – “Rights of first refusal are to be interpreted narrowly.
The right of first refusal is enforceable but only if the contract clearly confers it.”
4. Zetlin v. Hanson Holdings, Inc.
b. No Duty to Share Control Premium – “Recognizing that those who invest the capital
necessary to acquire a dominant position in the ownership of a corporation have the right
of controlling that corporation, it has long been settled law that, absent looting of
corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a
controlling stockholder is free to sell, and a purchaser is free to buy, that controlling
interest at a premium price.”
i. Duty of loyalty problems.
5. Perlman v. Feldmann
c. Facts – Feldmann, a majority shareholder in a steel mill business, sold a controlling
interest in the mill to a company that required steel in the fabrication of its products, and
the minority shareholders brought a derivative action against Feldmann to recover the
amounts he received in excess of the shares’ market price. The company could have
acquired the steel mill business by means of a merger or tender offer in which all
shareholders of the target steel manufacturer would share equally in any premium that
was offered.
i. Three Main Factual Points
1. A unique profit-making opportunity was available to the corporation
only because of government price controls.
2. The value of that profit-making opportunity could be capitalized and
divided between the purchaser and seller of the control block.
3. Minority shareholders thus lost significant sums that otherwise would
have come to them in the ordinary course.
d. Breach of Fiduciary Duty – “Siphoning off for personal gain corporate advantages to be
derived from a favorable market situation” violated Feldmann’s fiduciary duties to the
minority.
e. Rule – Controlling shareholder may not usurp an opportunity that should be available to
all shareholders.
i. NOT  Controlling shareholder must give all other shareholders an equal
opportunity to sell their stock on a pro rata basis.
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ii. General Rule – There is NO GENERAL RULE THAT ONE HAS TO SHARE
A CONTROL PREMIUM unless one somehow has come through the backdoor
in a way that favors oneself.
1. Perlman is exceptional in that the court required that the control premium
be shared.
iii. “When the sale of a controlling block of stock necessarily results in a sacrifice of
the element of corporate good will and consequent unusual profit to the fiduciary
who has caused the sacrifice, he should account for his gains.”
iv. “In a time of market shortage where a call on a corporation’s product commands
an unusually large premium, in one form or another, a fiduciary may not
appropriate to himself the value of this premium.”
f. Sinclair Oil Corp. – Same result. Controlling shareholder received a benefit “to the
exclusion and at the expense” of the minority.
g. Minority Recovery – “Minority shareholders are entitled to a recovery against a selfdealing majority shareholder in their own right, instead of in right of the corporation.”
6. Essex Universal Corporation v. Yates
h. Facts – Yates agreed to sell a controlling block of shares in Republic Pictures to Essex
Universal Corp., and the sale agreement required Yates to deliver a board of directors
filled with members nominated by Essex Universal. Essex Universal arranged to buy
28.3% of the stock from Yates.
i. Issue – Is this contract for sale and control of the board a sale of office? Is it
illegal per se under N.Y. law?
i. Sale of Office – It is impermissible to sell an office without an accompanying sale of
stock. However, one can sell an office as long as there is an accompanying sale of stock.
j. Three Opinions
i. Lumbard, Chief Justice
1. No liability if buyer purchased more than 50% of voting stock because
buyer eventually would get control of board anyway.
2. If buyer purchased less than 50% of voting stock, liability for a sale of
office should be imposed unless the buyer “would as a practical certainty
have been guaranteed of the stock voting power to choose a majority of
the directors of a company in due course.”
3. Because 28.3% of stock is “usually tantamount to majority control,”
burden of proof is on challenger.
ii. Friendly, Judge – Sequential registration plan is voidable as contrary to public
policy except “when it was entirely plain that a new election would be a mere
formality, i.e., when the seller owned more than 50% of the stock.” Purchase of
less than 50% of shares does not make it certain that a particular slate of directors
will be elected.
1. Rejects Lumbard’s “practical certainty” line of analysis.
iii. Clark, Judge – Such arrangements are not per se unlawful. Legality is a
question of fact for trial.
k. Staggered Board – One way to avoid sudden changes of direction. Electing, e.g., only
one-third of the board every year. It therefore takes two election cycles to acquire
majority control.
i. Essex would have had to wait a few years to acquire a majority of the seats on
the board. Thus, the promise to acquire immediate control was very desired.
ii. If you did not want to wait the two years, you would have to remove the existing
board members for cause (if the articles of incorporation so provided).
MERGERS & ACQUISITIONS & TAKEOVERS
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Mergers & Acquisitions
The De Facto Merger Doctrine
1. Means of Acquiring Control of Target Company
a. Proxy contest
b. Tender offer
c. Stock purchases
d. Sale of assets
e. Merger or consolidation (same process; mere difference of terminology)
f. Buyout agreement/Cash-out merger
i. E.g., two shareholders can require a third to sell her shares at a negotiated price.
“Get lost, and we have your back.” Contracting for dissenters’ or appraisal
rights.
ii. Shareholders get cash but lose their ownership rights in the process. Thus, cashout mergers are seen as ways of freezing out minorities.
g. Triangular merger
h.  Factors to Consider: gaining ancillary benefits of control (e.g., prestige  everyone
wants to be CEO); freezing out the minority; combining operations of several
corporations.
2. Statutory Mergers Under Delaware Law
a. Step 1: Board of directors approval of merger agreement [DGCL § 251(b)].
i. Boards of merging entities adopt an agreement of merger/consolidation.
ii. Agreement can modify surviving corporation’s Articles of Incorporation [DGCL
§ 251(b)(3)].
iii. Consideration to SH of merging entities does not have to be shares in the
surviving entity; can also be cash or other securities or property [DGCL
§ 251(b)(5)].
iv.  Required where there is a merger and a sale of assets, and the sale of assets is
large. E.g., if GM sold all or a chunk of its factories, this would require board
approval. Proxy Contests, Tender Offers – Usually no approval required.
b. Step 2: SH approval of merger agreement [DGCL § 251(c)].
i. SH votes in each of the merging entities.
1. Approval by majority of shares entitled to vote.
2. Compare to sale of assets: DGCL § 271 requires approval by board and
SH of target (selling corp.), but requires only board (not SH) approval of
acquiring corporation.
c. Step 3: Filing
i. Merger becomes effective when merger agreement is filed [DGCL § 251 (c)].
d. Step 4: Appraisal rights (DGCL § 262) [sometimes called dissenters’ rights].
i. Certain transactions (usually including mergers & sales of assets) allow SH who
dissented (but lost the vote) to “cash-out,” i.e., have the corporation buy-out their
shares. See MBCA § 13.02 and recall discussion in Alaska Plastics v. Coppock.
ii. No appraisal rights if stock is publicly traded or held by over 2,000 SH
[§ 262(b)(1)], but only if the consideration to the SH is publicly held stock
[§ 262(b)(2)].
iii. To be entitled to appraisal rights (under Delaware law):
1. SH must hold shares continuously through the effective day of the
merger;
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2. SH must perfect his appraisal right by sending a written notice to the
corporation, prior to the SH vote, informing that he intends to exercise
his appraisal rights [§ 262(d)];
3. SH must not vote in favor of the merger nor consent to it in writing.
iv. Compare to sale of assets: No appraisal rights to anyone.
3. Triangular Mergers
a.
b.
4. Appraisal Rights – Dissenting shareholders paid fair value for shares.
a. Why have these rights?
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i. They are important for the same reason that eminent domain is important.
ii. Society determines that some assets should go to a different use, and society is
comfortable paying for that new use.
b. Argument Against – They do not like appraisal rights, so let them sell on the market.
5. Farris v. Glen Alden Corporation (Pa. 1958)
a. Facts – List Industries, which purchased almost 40% of the outstanding shares of Glen
Alden Corp. and characterized its purchase as an asset purchase rather than a merger,
proposed a reorganization whereby List would operate Glen Alden.
b. Choice of Law – List (Del. corp.) selling assets to Glen Alden (Pa. corp.) ensured that,
because of differing state laws, that no shareholders were entitled to appraisal.
c. Appraisal Rights in De Facto Merger – “When a corporation combines with another so
as to lose its essential nature and alter the original fundamental relationships of the
shareholders among themselves and to the corporation, a shareholder who does not wish
to continue his membership therein may treat his membership in the original corporation
as terminated and have the value of his shares paid to him.”
d. Sale of Assets – No Appraisal Rights
i. “The shareholders of a business corporation which acquires by sale, lease or
exchange all or substantially all of the property of another corporation by the
issuance of stock, securities or otherwise shall not be entitled to the rights and
remedies of dissenting shareholders.”
ii. “The right of dissenting shareholders … shall not apply to the purchase by a
corporation of assets whether or not the consideration therefor be money or
property, real or personal, including shares or bonds or other evidences of
indebtedness of such corporation. The shareholders of such corporation shall
have no right to dissent from any such purchase.”
e. Sale of Assets = Merger – “When as part of a transaction between two corporations, one
corporation dissolves, its liabilities are assumed by the survivor, its executives and
directors take over the management and control of the survivor, and, as consideration for
the transfer, its stockholders acquire a majority of the shares of stock of the survivor, then
the transaction is no longer simply a purchase of assets or acquisition of property.”
f. De Facto Merger Doctrine – “If a combination outlined in a ‘reorganization’ agreement
so fundamentally changes the corporate character of the company at issue, and the
interest of the plaintiff as a shareholder therein, that to refuse him the rights and remedies
of a dissenting shareholder would in reality force him to give up his stock in one
corporation and against his will accept shares in another, the combination is a merger
within the meaning of section 908A of the corporation law.”
i. Elevates Substance over Form – Court recognized that the form is a sale of
assets, not a merger. But the substance was a merger, so the court treated it like a
merger.
ii. Counterargument – Why create different forms unless the court will give each
form the same dignity, i.e., respect the form?
iii. Advantages
1. Appraisal rights are supposed to keep the board accountable. Doctrine
helps to execute appraisal rights and keep the board accountable.
iv. Disadvantages
1. When so much of law is about forms, it does not help parties not to
respect the forms that they have chosen.
v. Delaware REJECTED De Facto Merger Doctrine, Hariton, and Third Circuit
eventually pronounced its demise, Terry.
6. Terry v. Penn Central Corp. (3d Cir. 1981)
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a. Based on changes in Pennsylvania law and a preamble expressly denouncing the De
Facto Merger Doctrine, Third Circuit pronounced its demise in Pennsylvania.
b. Disingenuously Distinguishing Farris – But the court distinguished Farris, suggesting
that if the company were sufficiently transformed, with a minnow swallowing a whale,
then “a different result might be reached.” There’s no real justification for that, other
than by application of the de facto merger doctrine.
7. Hariton v. Arco Electronics, Inc. (Del. 1963)
a. Facts – Arco Electronics, Inc. and Loral Electronics Corp. negotiated to integrate their
companies under a reorganization plan that required Arco to sell its assets to Loral in
exchange for shares of Loral stock.
b. Respecting Form/Independent Legal Provisions – “The reorganization here
accomplished through § 271 and a mandatory plan of dissolution and distribution is legal.
This is so because the sale-of-assets statute and the merger statute are independent of
each other. They are, so to speak, of equal dignity, and the framers of a reorganization
plan may resort to either type of corporate mechanics to achieve the desired end.”
i. REJECTION OF DE FACTO MERGER DOCTRINE.
ii. Elevates form over substance.
iii. Legislature has provided multiple ways to achieve the same substantive outcome.
Court will not gainsay the legislative decisions to provide different acquisition
forms carrying different levels of shareholder protection.
8.
Freeze-Out Mergers
1. Freeze-Out Mergers Generally
a. Definition – Controlling shareholder buys out minority shareholders, even if the minority
objects. Usually effectuated through a triangular merger in which the corporation is
merged with a wholly owned subsidiary of the controlling shareholder.
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b. Proxy solicitation, tender offer, stock repurchase: each requires each individual
shareholder to decide to handover or sell her shares. Individual shareholders ultimately
are making the decision.
c. Merger
i. Requires a shareholder vote. Any shareholder may be outvoted by the collective.
A majority of shareholders may bind the minority.
ii. Stock for Stock – Dissenting shareholders will hold stock in a company that they
did not want to be a part of.
iii. Stock for Cash – Dissenting shareholders will have cash when they actually
wanted stock.
iv. Appraisal Rights – Designed to protect minority stockholders that do not like
the majority’s decision.
1. Similar to condemnation in property law.
d. Policy Fights – It is good to freeze out a minority. Provides incentive for the majority to
construct a plan to create new value. Majority gets to extract the full value that it creates,
and it does not have to share that value with the minority. Incentivizes shareholders to be
innovative and find new value.
i. Danger – Majorities will do this even when they do not have a plan for increasing
value, i.e., they will do this simply to oust the minority.
ii. Solution – Let freeze outs happen, but protect the minority by giving it a shot at
fair value.
1. Problem – How do you determine fair value?
e. Why get rid of minority shareholders?
i. Large majority with small minority: majority owes the minority Sinclair Oil
Corp. duties. Get rid of the minority, and there are no more Sinclair Oil Corp.
duties.
ii. Minority shareholders are in the public, i.e., all of the shares are not owned by a
single entity. For this reason, the controlling shareholder is subject to federal
securities regulations.
f. General Remedy for Minority  Appraisal at Fair Value
i. More extreme cases of fraud, misrepresentation, corporate waste 
structural remedies, i.e., behavior, may be available.
ii. Why are minority shareholders not satisfied with appraisal rights (i.e., cash)?
1. The money is taxed by corporate tax provisions.
2. If a minority shareholder can obtain a structural remedy, then a minority
shareholder can threaten to seek a structural remedy. The minority often
would prefer structural remedies if available. Majority does not want to
deliver them.
g. California Law – Under California’s § 1101, a corporation cannot cash out minority
shares by merger except in a short-form merger, where it must start with 90%, except
with the approval of the Commissioner of Corporations of the fairness of the transaction
(§ 1101.1). Either way, appraisal is available. § 1301.
i. Very protective of minorities.
2. Weinberger v. UOP, Inc.
a. Facts – Signal Corp., which wanted to acquire UOP, Inc., offered to buy a majority of
UOP’s shares and then used its nominees on UOP’s board to help it obtain more UOP
stock.
b. ENTIRE FAIRNESS – Freeze-out merger must satisfy an “entire fairness” standard.
(Essentially Sinclair Oil Corp. duties.)
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i. “When directors of a Delaware corporation are on both sides of transaction, they
are required to demonstrate utmost good faith and most scrupulous inherent
fairness of bargain.”
ii. Burden of Proof – Ultimate burden is on majority shareholder.
1. Disinterested shareholders do not approve of merger  plaintiff must
show some evidence of fraud, misconduct, etc. Just a little evidence.
Then, defendant must show that the transaction was fair nevertheless.
2. Disinterested shareholders approve of merger  defendant must show
that all material facts were disclosed. If it does this and the minority
approved the transaction, then plaintiff must show that the transaction
was unfair.
3.  Burden to show entire fairness is on defendant either if (1) plaintiff
meets the minimal requirement of showing some evidence of fraud,
misconduct, etc. or (2) plaintiff is able to show that despite shareholder
ratification, the ratification does not count because there was not
sufficient disclosure to support it (i.e., material facts were withheld).
4.  Burden to show unfairness is on plaintiff (1) if there is proper
ratification with disclosure of all material facts or (2) if there is no
evidence of fraud, misconduct, etc.
iii. Two Basic Aspects – FAIR DEALING & FAIR PRICE
1. Fair Dealing (Process) – “Embraces questions of when a merger
transaction was timed, how it was initiated, structured, negotiated,
disclosed to the directors, and how the approvals of the directors and the
stockholders were obtained.”
a. “Part of fair dealing is the obvious DUTY OF CANDOR. One
possessing superior knowledge may not mislead any stockholder
by use of corporate information to which the latter is not privy.
Delaware imposes this duty even upon persons who are not
corporate officers or directors, but who nonetheless are privy to
matters of interest or significance to their company.”
2. Fair Price (Substance) – “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 a company’s stock.”
a. Valuation Method
i. Rejected exclusive use of “Delaware block” method.
ii. “A more liberal approach must include proof of value by
any techniques or methods which are generally
considered acceptable in the financial community and
otherwise admissible in court, subject only to the court’s
interpretation of [Delaware law].”
b. Factors – “Fair price requires consideration of all relevant
factors involving the value of a company. A stockholder is
entitled to be paid for that which has been taken from him, viz.,
his proportionate interest in a going concern. By value of
stockholder’s proportionate interest in corporate enterprise is
meant true or intrinsic value of his stock which has been taken
by merger. In determining what figure represents this true or
intrinsic value, appraiser and courts must take into consideration
all factors and elements which reasonably might enter into fixing
of value. Thus, market value, asset value, dividends, earning
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prospects, nature of enterprise and any other facts which were
known or which could be ascertained as of date of merger and
which throw any light on future prospects of merged corporation
are not only pertinent to inquiry as to value of dissenting
stockholders’ interest, but must be considered by agency fixing
the value.”
i. May include “elements of future value, including the
nature of the enterprise, which are known or susceptible
of proof as of the date of the merger and not the product
of speculation” and “any damages, resulting from the
taking, which the stockholders sustain as a class.”
ii. EXCLUDED – “Speculative elements of value that may
arise from the accomplishment or expectation of the
merger.”
3.  Deal should be at arms length.
4.  “The test for fairness is not a bifurcated one as between fair dealing
and price. All aspects of the issue must be examined as a whole since the
question is one of entire fairness. However, in a non-fraudulent
transaction, price may be the preponderant consideration outweighing
other features of the merger.”
5.  What could Signal have done to demonstrate entire fairness?
a. Disclose material information.
b. Make sure that the fairness opinion was not rushed. This would
help to demonstrate good procedure.
c. Stop all the sharing of information because this only confuses
directors’ duties of loyalty. People with confidential information
should not be involved in the merger discussions.
c. Rejection of Business Purpose Test
i. Business Purpose Test – Merger cannot be effected for the sole purpose of
freezing out minority shareholders.
ii. “In view of the fairness test which has long been applicable to parent-subsidiary
mergers, the expanded appraisal remedy now available to shareholders, and the
broad discretion of the Chancellor to fashion such relief as the facts of a given
case may dictate, we do not believe that any additional meaningful protection is
afforded minority shareholders by the business purpose requirement.
Accordingly, such requirement shall no longer be of any force or effect.”
1. Rejects Singer.
3. Kahn v. Lynch Community Systems (Del. 1994)
a. Even a decision by an independent committee (regarding cash-out) mergers is subject to
an entire fairness standard.
i. Concern about undetected influence by the majority SH;
ii. Final period problem for the independent directors.
b. Approval of the transaction by an independent committee or an informed majority of
minority SHs shifts the burden of proof on the issue of fairness to the plaintiffs.
i. BoP shifted only if the independent committee had “real bargaining power that it
can exercise with the majority shareholder on an arms length basis” (quoting
Rabkin).
ii. It is, however, up to the corporation (typically in articles of incorporation)
whether to obtain approval in this way.
4. Three Methods of Valuation
a. Net Asset Value
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i. Similar to book value, but including an assessment of the company’s goodwill
(i.e., value as a going concern).
ii. Because it is based on book value, the basis is the historical cost of assets and (an
unrealistic) linear depreciation.
b. Capitalized Earnings
i. Similar to the multiplier (price-to-earnings ratio) method.
ii. Formula: Earnings/Capitalization Rate
iii. Earnings:
1. Massachusetts: “earnings value”  the average earnings for the previous
five years, throwing out extraordinary gains and losses.
2. Pennsylvania: “investment value”  appraiser selects a representative
earnings figure.
iv. Capitalization Rate – Largely at the appraiser’s discretion.
c. Market Value
i. Less useful when a majority SH is present.
ii. Unavailable in close corporation because it only works when there is a market.
d.  Post Weinberger – Court does not set fair value. It reviews the procedure and
substance of a fair-value determination, but this requires that the court conduct its own
independent fair-value determination. It uses all of the above methods, and uses any
relevant evidence. Very sweeping analysis.
5. Coggins v. New England Patriots Football Club, Inc. (Mass. 1986)
a. Facts – The original founder of the New England Patriots, wanting to reclaim full
ownership of the team, structured a merger requiring other shareholders to exchange their
stock for cash, and Coggins challenged the merger.
b. Business Purpose Test – “Holds that controlling stockholders violate their fiduciary
duties when they cause a merger to be made for the sole purpose of eliminating a
minority on a cash-out basis.” Singer.
i.  Court cites to Singer. The is odd for a few reasons.
1. Even Singer-oriented courts would have allowed the merger. These
courts (Delaware) say that any business purpose is enough—even if it is
only the majority’s legitimate business purpose. Like the BJR.
2. Singer courts like there to be clear signaling of the rules so that all of the
parties can act knowingly. NFL had signaled that it preferred private
ownership, and this is a legitimate business purpose.
3. Weinberger rejected Singer.
ii. Massachusetts considers both the Business Purpose Test and the Entire Fairness
Test.
iii. Analysis
1. “Judicial scrutiny should begin with recognition of the basic principle
that the duty of a corporate director must be to further the legitimate
goals of the corporation. The corporate directors who benefit from this
transfer of ownership must demonstrate how the legitimate goals of the
corporation are furthered. A director of a corporation violates his
fiduciary duty when he uses the corporation for his or his family’s
personal benefit in a manner detrimental to the corporation. Because the
danger of abuse of fiduciary duty is especially great in a freeze-out
merger, the court must be satisfied that the freeze-out was for the
advancement of a legitimate corporate purpose.”
2. “If satisfied that elimination of public ownership is in furtherance of a
business purpose, the court should then proceed to determine if the
transaction was fair by examining the totality of the circumstances.”
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iv. Defendant’s Burden of Proof – “A defendant bears the burden of proving that a
merger was for a legitimate business purpose, and, that, considering the totality
of the circumstances, it was fair to the minority.”
v. Damages – “Rescissory damages must be determined based on the present value
of the Patriots, that is, what the stockholders would have if the merger were
rescinded.”
6. Rabkin v. Philip A. Hunt Chemical Corporation
a. Facts – Shareholders brought an action to enjoin a proposed merger, arguing that the
acquiring company, which was already a majority shareholder in the targeted company,
purposely timed the transaction to avoid paying the minority shareholders a fair price.
b. Rule – Appraisal is minority shareholders’ exclusive remedy only when the minority’s
claims go solely to the fairness of the price.
c. Rule – In freeze-out mergers, minority shareholders may form a class and bring a
derivative action, as long as their claims do not go solely to the fairness of the price.
De Facto Non-Merger
1. Rauch v. RCA Corporation
a. Facts – Rauch, an acquired corporation’s shareholder, challenged the propriety of a
merger accomplished through the conversion of shares to cash.
b. Two Independent Legal Rules (Different rights attach to each form.)
i. Conversion of Shares to Cash – DGCL § 251.
ii. Redemption – “Section 151(b) of the Delaware General Corporation Law
provides that a corporation may subject its preferred stock to redemption by the
corporation at its option or at the option of the holders of such stock or upon the
happening of a specified event.”
iii. Legal Rules Are Independent  “Action taken under one section of the
Delaware General Corporation Law is legally independent, and its validity is not
dependent upon, nor to be tested by the requirements of other unrelated sections
under which the same final result might be attained by different means.”
iv.  RESPECTING CORPORATE FORM.
v. Doctrine of Independent Legal Significance is seen in Hariton but rejected in
Farris.
c. Court rejected the De Facto Non-Merger Doctrine.
LLC Mergers
1. VGS, Inc. v. Castiel
a. Facts – LLC members fought over the company’s direction and distrusted the majority
owner’s ability to further the company’s goals, so the remaining members secretly
arranged to merge the company to shut out the majority owner.
b. Rule – Managers that fail to provide notice to all board members of their intent to hold a
meeting or seek consent to a written resolution violate their fiduciary duties to each other,
even if they believe that keeping an individual member from voting at the meeting is in
the company’s best interests.
i. “When Sahagen and Quinn, fully recognizing that this was Castiel’s protection
against actions adverse to his majority interest, acted in secret, without notice,
they failed to discharge their duty of loyalty to him in good faith. They owed
Castiel a duty to give him prior notice even if he would have interfered with a
plan that they conscientiously believed to be in the best interest of the LLC.”
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c. Equity in Form – Court is not open to equity on the substance. It will not evaluate
which party would have been a better manager. It goes with equity on form, i.e., making
sure that the proper procedures were followed.
d. Holding – “Because the two managers acted without notice to the third manager under
circumstances where they knew that with notice that he could have acted to protect his
majority interest, they breached their duty of loyalty to the original member and their
fellow manager by failing to act in good faith. The purported merger must therefore be
declared invalid.”
Takeovers
Introduction
1. Why would a board resist a takeover?
a. Individualized shareholder vote – Merger; sale of substantially all assets.
b. Board wants to protect its own jobs. Not acceptable.
c. Board has a long-term value plan for the company, and it needs time to implement it.
Acceptable.
d. Board wants to wait out for a higher offer. Also acceptable.
2. Advantages to Shareholders of Golden Parachutes – Board has an incentive to sell out. Thus,
the board has an incentive to seek out value.
3. Hostile Takeovers – Several options always are off the table.
a. Proxy solicitation.
b. Merger or consolidation.
c.  Must appeal to the atomized group of shareholders and convince them to sell their
shares.
4. Williams Act – Federal Regulation of Tender Offers & Stock Purchases
a. Amendments to §§ 13–14 of the Exchange Act.
i. Apply only to securities registered under the Exchange Act.
ii. Anyone who acquires 5% of stock of a firm must file a Schedule 13D disclosure
statement within 10 days of acquiring the 5% interest.
iii. Anyone making a tender offer must file a detailed set of disclosure documents,
including the acquirer’s plans for the company [§ 14(d)(1)].
1. This information is important to SH tendering in a stock-for-stock offer,
but not ordinarily in a stock-for-cash offer. (Ironically, the better the
plans for the company, the less likely tender is to occur.)
iv. If the tender is over-subscribed (i.e., more shares are tendered than the acquirer
offered to purchase), acquirer must accept stock on a pro-rata basis [§ 14(d)(6)].
v. Any acquirer who raises his price during the term of the tender offer must raise it
for any stock already tendered [§ 14(d)(7)].
vi. The tender offer must be open for at least 20 business days, and a SH who
tendered may withdraw the tendered stock during the first 15 days [§ 14(e)(1)].
b. Disclosure Rules
i. § 13(d) – A beneficial owner of 5% of a registered security must file a Schedule
13D disclosure statement within 10 days of crossing the 5% threshold
[§ 13(d)(1)]. Prevents “beachhead” (secret) acquisitions.
ii. Schedule 13D requires info on:
1. Identity of acquirer;
a. Aggregate purchases by several people as part of a single plan
[§ 13(d)(3)].
2. Plans/Intentions;
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a. Including an intention to seek control of the issuer.
3. Any contracts, arrangements, understandings, or relationships with
respect to the securities of the issuer.
iii. Rule 13d-2 – Schedule 13D must be amended promptly in the event of any
material change in the facts set forth in the statement.
1. An acquisition or disposition of at least 1% of a class of securities is
considered material.
iv. Target corp. can sue a 5% beneficial owner for failing to file a Schedule 13D or
for filing a misleading statement.
1. Standing to seek equitable relief (injunction, rescission of securities
purchases, divestiture of the securities, suspension of voting rights), but
not damages.
c. Tender Offers
i. § 14(d), 14(e) triggered when a tender offer is made for more than 5% of a
target’s equity securities.
ii. An offer commences when the bidder provides security holders with means to
tender their securities.
1. Transmittal form; or
2. Information regarding how the transmittal form may be obtained.
3. Bidder may communicate intent to acquire shares without commencing
the tender offer if the communication does not include means to tender
the securities, and required disclosure was made prior to the
communication [Rule 14d-2(b)].
iii. By the date the tender offer commences, bidder must file a Schedule 14D-1
disclosure statement. Same info must be disseminated to SH via newspaper
publication or mailing.
iv. Target must then file a Schedule 14D-9 form, in which the management states
whether they support the offer, oppose it, or are unable to take a position.
Reasons for the position must be given.
d.  Kieff thinks that the Williams Act is a net loser for society. It requires disclosure of
all of this information, and competing bidders are able to free ride on it.
5. Corporate Takeover Defenses
a. Greenmail – Cheff
b. Counter-Tender Offers – Unocal; Time
c. Poison Pills – Revlon
i. Flip-over plans
ii. Flip-in plans
iii. Back-end plans
iv. Voting plans
v. Poison debt
d. Lock Ups – Van Gorkom; Revlon; QVC
i. No-shop obligation
ii. Cancellation fee
iii. Stock options
6. Cheff v. Mathes
a. Facts – Stockholders brought a derivative suit against the company’s directors after the
board authorized a series of expensive actions to ward off an outside shareholder’s
attempts to take over the company.
b. Rule – Corporation can buy and sell its own stock.
c. Business Purpose in Buying out Dissident Stockholder Required – “If the actions of
the board are motivated by a sincere belief that the buying out of a dissident stockholder
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is necessary to maintain what the board believes to be proper business practices, the
board will not be held liable for such decision, even though hindsight indicates the
decision not to have been the wisest course. On the other hand, if the board members act
solely or primarily because of the desire to perpetuate themselves in office, the use of
corporate funds for such purpose is improper.”
i. Purpose other than self-perpetuation of board members, which would create duty
of loyalty problems.
ii. Decision to resist takeover must be consistent with the corporation’s long-term
business plan. Such a result is not hard to engineer.
1. Argument – Company will be more profitable if current board retains
control. Bolstered if the individuals making the argument buy into the
corporation; shows confidence.
iii. Only slightly less deferential than BJR review.
d. Burden of Proof
i. Interested Directors – Must “justify such a purchase as one primarily in the
corporate interest.”
1. “The mere fact that a director is a substantial shareholders does not
create a personal pecuniary interest in the decisions made by the board of
directors, since all shareholders presumably share the benefit flowing to
the substantial shareholder.”
2. BJR still applies. Good faith and reasonable investigation.
ii. Non-Interested Directors – Presumption that they acted in good faith, which
“can be overturned only by a conclusive showing by plaintiffs of fraud or other
misconduct.”
1. “The corporate directors satisfy their burden of proof by showing that
they acted in good faith and after reasonable investigation; they will not
be penalized for an honest mistake of judgment if the judgment appeared
reasonable at the time the decision was made.”
e. “If the actions were in fact improper because of a desire to maintain control, then the
presence or absence of a non-corporate alternative is irrelevant, as corporate funds may
not be used to advance an improper purpose even if there is no non-corporate alternative
available. Conversely, if the actions were proper because of a decision by the board
made in good faith that the corporate interest was served thereby, they are not rendered
improper by the fact that some individual directors were willing to advance personal
funds if the corporation did not.”
f. Greenmail – Paying off a potential bidder to go away.
i. May be good because it protects jobs and prevents takeovers.
1. But if a company greenmails actors all the time, more and more bidders
will come forward, try to takeover the company, and demand to be
greenmailed. Greenmail increases threats.
2. However, some of these threats may be real. The threats will scare the
board and trigger an auction, where lots of bidders show up. This could
extract a lot of value from the company.
ii. Section 5881 – SEC rule that tries to identify greenmail and tax it.
Development
1. Rules
a. Basic BJR – Van Gorkom
b. Basic BJR Plus Reasonableness – Unocal
c. Basic Duty of Loyalty – Weinberger
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2. Unocal Corporation v. Mesa Petroleum Co.
a. Facts – Mesa Petroleum Co., a minority shareholder, made a hostile tender offer for
Unocal’s stock and filed a complaint to challenge Unocal’s board’s decision to affect a
self-tender for its own shares because, pursuant to the offer’s terms, Mesa could not
participate.
b. Unocal Duties – Two Steps
i. Initial Burden of Proof – On directors. Must show that they had reasonable
grounds for believing that a danger to corporate policy or effectiveness existed.
1. BJR applies.  Good Faith & Reasonable Investigation
a. Good Faith – Directors acted in response to a perceived threat to
the corporation, and not for the purpose of entrenching
themselves in office.
b. Reasonable Investigation – Board must have been adequately
informed. Relevant standard is gross negligence.
2. Independent Directors – “Such proof is materially enhanced by the
approval of a board comprised of a majority of outside independent
directors who have acted in accordance with the foregoing standards.”
ii. Directors then must show that the defense was reasonable (proportionate) in
relation to the threat posed by the hostile bid.
1. Factors – “This entails an analysis by the directors of the nature of the
takeover bid and its effect on the corporate enterprise. Examples of such
concerns may include: inadequacy of the price offered, nature and timing
of the offer, questions of illegality, the impact on ‘constituencies’ other
than shareholders (i.e., creditors, customers, employees, and perhaps
even the community generally), the risk of nonconsummation, and the
quality of securities being offered in the exchange. While not a
controlling factor, it also seems to us that a board may reasonably
consider the basic stockholder interests at stake, including those of short
term speculators, whose actions may have fueled the coercive aspect of
the offer at the expense of the long term investor.”
a. Will workers be laid off? Will customers or communities suffer?
b. Revlon (below)
i. Directors may consider stakeholder interests only if
doing so would benefit shareholders.
SHAREHOLDERS MUST BENEFIT.
1. No stakeholder consideration once Revlon duties
trigger.
ii. Reasonableness depends on coercion and
proportionality. Depends on the inevitability of the
corporation being sold because this fact changes the
nature of the board’s duty to the corporation. At this
point, the board’s duty is to maximize the cash.
c. Cheff – Significant deference to employees’ concerns.
(Maremount was allegedly going to fire the sales force.)
d. Time – Court considers maintaining the “corporate culture.”
iii.  If two steps are satisfied, BJR/duty of care analysis applies. Plaintiff can
rebut BJR assumptions (good faith and informed decision) only by showing
fraud, misconduct, self-dealing, etc.
1. Preponderance of the evidence.
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iv.  If directors fail to satisfy their initial burden, intrinsic fairness/duty of loyalty
analysis applies. Directors must show entire fairness of the transaction.
Weinberger.
c. No Fiduciary Duty Violation – (1) Coercive nature of Mesa’s bid; (2) bid’s probable
price inadequacy; and (3) Pickens’ reputation as a greenmailer: Unocal was entitled to
take strong measures to defeat the Mesa offer. Excluding Mesa from the self-tender offer
was essential to making the defense work, and so directors could discriminate against
Mesa without violating their fiduciary duties.
3. Poison Pills
a. Definition – Rights the exercise of which makes the takeover less profitable to the
acquirer, typically by lowering the value of the target’s or the acquirer’s shares.
b. Triggering Event – These rights are distributed to someone (usually, SH other than the
acquirer) via a “vehicle,” and cannot be exercised until a triggering event (e.g., a takeover
attempt) takes place. Examples of triggering events:
i. The announcement of a tender offer for more than X% of target’s stock;
ii. The acquisition, in any way, of X% of target’s stock (or of any stock class); and
iii. The execution of a merger to which the target is a party.
c. The rights are initially “stapled” to another security.
i. They are not issued in physical form and cannot be sold separately from the
stock. This ensures that there is no secondary market for the rights.
ii. Upon occurrence of the trigger event, the rights detach from the security and may
be exercised or traded.
d. Flip-Over Plans
i. The first poison pill was adopted in 1983 by Lenox.
1. As the vehicle for the “poison,” it used “blank check preferred stock.”
2. “Blank check preferred stock” is preferred stock whose rights are not set
in the Articles of Incorporation. Rather, the Articles of Incorporation
state that the board will define those rights at the time the securities are
issued.
ii. The “vehicles” (i.e., the preferred shares) were distributed to SH as a special
dividend (of the stock, not of cash).
iii. Upon the occurrence of a trigger event (a merger or other acquisition of Lenox),
the shares became convertible into common stock of the acquiring corporation
(the surviving entity) at well below market price. Result: target SH dilute the
bidder’s pre-existing SH.
1. These poison pills are called “flip-over” plans.
2. The rights were discriminatory; the bidder could not exercise them.
iv. Example – Target, whose 100 outstanding shares sell for $10, executes a flipover poison pill plan. It distributes to its SH a dividend in kind—for each Target
share, the SH receives a dormant right that is triggered when a rival merges with
Target (e.g., the back-end of a two-tier tender offer). To allow friendly mergers,
the board retains the right to redeem the rights for one cent per right.
1. The right allows its owner (other than the acquirer) to buy three of the
shares of the corp. surviving the merger, at 50% of its market price.
2. Acme has 100 shares outstanding, and each shares sells for $10. Acme
launches a tender offer and acquires 60 Target shares (60%). It then
plans to cash out the remaining 40% by merger. But the tender offer
triggered the flip-over rights. All SH owning the remaining 40 Target
shares exercise their rights (since they receive Acme shares at halfprice), and receive 120 Acme shares. Acme SH now owns 100 of 220
shares, or 45%, possibly losing control of the merged Acme/Target.
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v. Defeating Flip-Over Plans
1. The acquirer may condition the tender offer on the redemption of the
plan by target’s board. If the board refuses, SH may be upset.
2. Acquirer may place anti-dilution provisions into its Articles of
Incorporation.
a. For example, provision mandating issuance of shares to the
acquirer’s SH in proportion with the shares issued to the target’s
SH under the poison pill.
b. Or acquirer may give itself a right to recall any shares issued in a
merger at below-market prices.
3. Triggering Without Swallowing – Sir Goldsmith’s takeover of Crown
Zellerbach.
a. Goldsmith acquired control of CZ, triggering CZ’s poison pill,
but declined to continue to stage 2 (the freeze out merger), which
would have diluted the acquirer (i.e., him).
b. Instead, he merely controlled the corporation.
i. He was now immune to a counter-bid—a contender
could only take over CZ via merger, and that would
“poison” the contender.
e. Flip-In Plans
i. Usually adapted together with flip-over plans.
ii. Key Difference from Flip-Over Plans – Same as flip-overs, except that the
right the SHs get (when the pill is triggered) is to purchase at below-market price
shares (and sometimes, bonds) in the target, not in the acquirer. Once again,
the acquirer is excluded.
iii. Example – Target, whose 100 outstanding shares sell for $10, executes a flip-in
poison pill plan. It distributes to its SH a dividend in kind—for each Target
share, the SH receives a dormant right, that if triggered, allows its owner (other
than the acquirer) to buy two Target shares at $5 a share.
1. Acme launches a tender offer and acquires 60 shares (60%). This
triggers the rights. All SH owning the remaining 40 shares exercise their
rights (since they receive the shares at half-price), and receive 80 new
shares. Acme now owns 60 of 180 shares, or 33%. To acquire control, it
needs to buy all those new shares.
iv. Flip-ins are designed to counter partial tender offers/street sweeps. An all-shares
tender offer will mean that no shares will be triggered.
f. Back-End Plans
i. Similar to Flip-Overs and Flip-Ins, except for the type of “poison.” The rights in
back-end plans, when triggered, allow a SH to convert her share into a package
of the target’s securities (typically, debt securities) worth the present fair value of
the target.
1. This results in a minimum takeover price, since SHs that the acquirer
threatens to freeze out in a back-end merger (the second part of a twotier tender offer) can opt for the debt package.
ii. To increase takeover defenses, the debt securities provided in the package
include provisions precluding the acquirer from selling target assets or taking on
additional debt. This prevents the bidder from using the target’s resources to
finance the acquisition (see “poison debt”).
iii. Back-end plans are designed to counter partial-tender offers, coercive two-tier
tender offers, and open-market purchases.
iv. Example
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1. Target has 100 shares outstanding, selling at $10. Acme, and Target’s
BoD, think the real value of a share is $20. Acme launches a tender offer
for 60% of shares at $20, then planning to cash out the remaining 40% at
$10 (assume this would be the appraised value). Acme plans to get the
cash for the purchase ($1600) by selling Target’s widget division.
a. The average price an Acme SH will receive is: $16 (.6x20 +
.4x10).
2. Target executes a back-end plan, under which each SH receives a right to
convert her share to a $20 Target bond. The bond states that until the
debt is satisfied, Target may not sell any major assets or use them as
collateral.
a. After Acme acquires 60 Target shares, it launches a merger at
$10. All remaining SH convert their shares into $20 bonds
(since this is worth more than $10 in cash). Acme now controls
100% of Target, but effectively paid $20 per share. In addition,
until it pays the debt it cannot finance the tender offer using
Target’s assets.
g. Voting Plans
i. Often, voting plans use preferred stock as the “vehicle” to distribute the “poison”
(similar to the first generation pills).
ii. One type of voting plan “poison”: Giving preferred SH the right to vote, except
for bidders owning more than a specified percent of the common or preferred
stock.
1. For a milder version, recall Providence & Worcester Co. v. Baker. One
vote per share for the first 50 shares owned, then one vote per 20 shares
for all shares over 50.
iii. Another type of “poison”: Preferred SH other than the bidder may vote as a
separate class in electing a specified number of directors.
h. Poison Debt
i. Here, the vehicle is DEBT SECURITIES. Target issues bonds or notes with
terms that make a takeover more difficult.
1. Forbidding the acquirer from burdening Target with additional debt;
2. Forbidding the acquirer from selling or mortgaging Target’s major
assets;
3. Make a change in control a default event. This means that upon change
of control, bondholders may force Target to immediately redeem the
bonds, plunging Target into a cash shortage.
ii. Poison debt is designed to counter leveraged buyouts (LBOs).
iii. Example: Acme wants to buy Target, but only has $1M in cash. To succeed,
they must pay at least $5M. They want to borrow $4M from Bank. Acme itself
doesn’t have sufficient unencumbered collateral to back a $4M loan, but it offers
Bank a mortgage on Target’s assets (which are worth $5M).
iv. Target issues $2M of bonds, under the terms mentioned above.
v. Acme now has to find other assets to back the loan from Bank. Furthermore,
when it acquires control it will be a default event for the bonds, so it may have to
immediately get $2M in cash to redeem the bonds. Thus, it needs to borrow not
$4M, but $6M.
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i.
4. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.
a. Facts – Bidder for corporation’s stock brought an action to enjoin certain defensive
actions taken by the target corporation and others.
b. Directors’ Duty Changes
i. Trigger – Recognition that company is for sale/breakup is inevitable/company
will not continue in its current state.
1. Long-term business plan is no longer applicable. No BJR anymore.
ii. Focus – Getting highest bid for shareholders—not keeping company together.
1. Duty of Care – Getting highest value for shareholders.
2. Duty of Loyalty Problem – Directors are trying to perpetuate
themselves in office rather than obtain the highest value for the
corporation.
iii. “The duty of the board had thus changed from the preservation of Revlon as a
corporate entity to the maximization of the company’s value at a sale for the
stockholders’ benefit. This significantly altered the board’s responsibilities under
the Unocal standards. The directors’ role changed from defenders of the
corporate bastion to auctioneers charged with getting the best price for the
stockholders at a sale of the company.”
iv. DUTY OF LOYALTY TO SHAREHOLDERS is key.
v. No-shop and lock-up options are not permissible “when a board’s primary duty
becomes that of an auctioneer responsible for selling the company to the highest
bidder.”
vi. Cannot Favor White Knight – “Favoritism for a white knight to the total
exclusion of a hostile bidder might be justifiable when the latter’s offer adversely
affects shareholder interests, but when bidders make relatively similar offers, or
dissolution of the company becomes inevitable, the directors cannot fulfill their
enhanced Unocal duties by playing favorites with the contending factions.
Market forces must be allowed to operate freely to bring the target’s shareholders
the best price available for their equity.”
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c. Regard for Constituencies in Unocal Step Two – “In a takeover situation, a board may
have regard for various constituencies in discharging its responsibilities, provided there
are rationally related benefits accruing to the stockholders. However, such concern for
non-stockholder interests is inappropriate when an auction among active bidders is in
progress, and the object no longer is to protect or maintain the corporate enterprise but to
sell it to the highest bidder.”
i. Directors may consider stakeholder interests only if doing so would benefit
shareholders. SHAREHOLDERS MUST BENEFIT.
ii. No stakeholder consideration once Revlon duties trigger.
d. Board Composition
i. Because of the conflicts on the board, the court could not conclude that the board
was entitled to the business-judgment-rule, duty-of-care presumptions.
ii. What if it had been an INDEPENDENT BOARD, i.e., without employment
positions and contractual ties? Weinberger: still would not want to do an entire
fairness standard, but would want to do a little more because of the conflict.
5. Lockups & Termination Fees
a. Lockups – Option granted by a seller to a buyer to purchase a target company’s stock as
a prelude to a takeover. The controlling shareholder is then effectively “locked-up” and
is not free to sell the stocks to a party other than the designated party (potential buyer).
i. It costs a bidder a lot of money to investigate a company to determine whether it
wants to bid on the company; costs incurred in determining a company’s true
value.
1.  A company may compensate a bidder for these costs.
ii. Example
1. A values a company at $100.
2. Market values it at $70.
3. B values it at anything at $95 or below.
4. The target company wants B to be in the bidding because B will drive the
price up at least to $95.
5. However, why would B ever get involved if it knew that A valued the
company more highly? If B already knew that it would be outbid? B has
no reason to bid in the first place.
a. B’s decision not to bid is based on its understanding that A
values the company more highly than it does.
6. What should A do? A should say, “I value the company very highly,”
because this will scare away all of the B companies. If no one is bidding
against A, A can purchase the company for $71 or $72. If A says, “I
value the company at $90,” then it will start a bidding war with B.
a. Some bidders want to develop reputations of being aggressive.
7. Second bidders lose the cost of their bids.
b. Termination Fee – “Come and bid, and if things do not go well, we will compensate
you.” This is why good termination fees only cover bidding costs.
i. Optimal Termination Fee – You want it to increase overall bidding and not,
overall, scare away bidding.
1. Termination fees that cover bidding costs generally are good.
2. Termination fees that go beyond bidding costs generally are bad.
6. Paramount Communications, Inc. v. Time Incorporated
a. Facts – Shortly before a merger between Time Inc. and Warner Communications, Inc.,
was to be put to a shareholder vote, Paramount Communications launched a takeover
effort against Time, and when Paramount’s efforts were rejected, it filed suit seeking a
preliminary injunction to halt the Time-Warner merger.
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b. Board has authority to pursue Warner merger, even though Paramount merger may be
more lucrative and some/many SH might prefer it.
i. Board, not shareholders, is entrusted with managing corporation.
ii. Pursuing Warner merger is part of Time’s long-term business plan, and so
Revlon duties have not been triggered.
1. Helps to show that Time’s defensive measures were reasonable and not
purely defensive w/r/t Paramount. Time’s business strategy had not been
cobbled together to justify its takeover defenses.
2. Board need not abandon long-term plan for short-term SH gain.
c. Two Situations for Revlon Duties – “Under Delaware law there are, generally speaking
and without excluding other possibilities, two circumstances which may implicate duties
under Revlon.”
i. “The first, and clearer one, is when a corporation initiates an active bidding
process seeking to sell itself or to effect a business reorganization involving a
clear break-up of the company.”
ii. “In response to a bidder’s offer, a target abandons its long-term strategy and
seeks an alternative transaction also involving the breakup of the company.”
iii.  Neither applied here.
d. No Revlon Duties (but Unocal Duties)
i. “[Revlon] duties will not be applied to corporate transactions simply because
they might be construed as putting a corporation either ‘in play’ or ‘up for sale.’”
ii. Adoption of structural safety devices alone.
e. Threat Under Unocal
i. First prong of Unocal is open-ended and flexible. Can include threats to
CORPORATE CULTURE.
ii. “In a TWO-TIER, HIGHLY COERCIVE TENDER OFFER, the threat is
obvious: shareholders may be compelled to tender to avoid being treated
adversely in the second stage of the transaction.”
iii. “An ALL-CASH, ALL-SHARES OFFER, falling within a range of values that a
shareholder might reasonably prefer, cannot constitute a legally recognized
‘threat’ to shareholder interests sufficient to withstand a Unocal analysis.”
f. Reasonableness of Defense Under Unocal
i. Prerequisite – “Clear identification of the nature of the threat.”
ii. “This requires an evaluation of the importance of the corporate objective
threatened; alternative methods of protecting that objective; impacts of the
‘defensive’ action, and other relevant factors.”
g. BJR for Board’s Defense in Unocal – Only after both prongs have been satisfied.
7. Paramount Communications, Inc. v. QVC Network Inc.
a. Facts – Viacom Inc. and Paramount Communications, Inc. formed an alliance even
though QVC Network Inc. proposed a more valuable offer.
b. Sale of Control
i. Applies to situations in which a single SH becomes the majority SH.
ii. Change of control triggers Revlon duties.
iii. Falls under the “other possibilities” language in Time.
iv. Shows that more situations can trigger Revlon duties than Time had suggested.
c. Determining Best Value After Revlon Is Triggered – “A board of directors is not
limited to considering only the amount of cash involved, and is not required to ignore
totally its view of the future value of a strategic alliance. Instead, the entire situation
should be analyzed, and the consideration being offered should be evaluated in a
disciplined manner.”
i. Cash is not dispositive.
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ii. Must evaluate entire situation, including future strategic alliances.
d. Sale of Control Circumstances Calling for Enhanced Review
i. The threatened diminution of the current stockholders’ voting power;
ii. The fact that an asset belonging to public stockholders - a control premium - is
being sold and may never be available again: and
iii. The traditional concern of Delaware courts for actions which impair or impede
stockholder voting rights.
e. Enhanced Scrutiny – “The key features of an enhanced scrutiny test are: (a) a judicial
determination regarding the adequacy of the decisionmaking process employed by the
corporate directors, including the information on which the directors based their decision;
and (b) a judicial examination of the reasonableness of the directors’ action in light of the
circumstances then existing.”
i. Burden of Proof – On directors w/r/t both issues. Need not prove that their
decisions were the best, but only that the fell within the range of reasonableness.
1. If board’s decisions are within range of reasonableness, court will not
second guess.
ii. Case-by-case.
iii. A little more searching than BJR.
f. Breakup Not Necessary for Revlon Duties – “It is not required that a corporate ‘breakup’ must be present and inevitable in a sale of control transaction before directors are
subject to enhanced judicial scrutiny and are required to pursue a transaction that is
calculated to produce the best value reasonably available to the stockholders.
8. ALI Principles of Corporate Governance – § 6.02 Action of Directors That Has the
Foreseeable Effect of Blocking Unsolicited Tender Offers
(a) The board of directors may take an action that has the foreseeable effect of blocking
an unsolicited tender offer [§ 1.39], if the action is a reasonable response to the offer.
(b) In considering whether its action is a reasonable response to the offer:
(1) The board may take into account all factors relevant to the best interests of
the corporation and shareholders, including, among other things, questions of
legality and whether the offer, if successful, would threaten the corporation's
essential economic prospects; and
(2) The board may, in addition to the analysis under § 6.02(b)(1), have regard for
interests or groups (other than shareholders) with respect to which the
corporation has a legitimate concern if to do so would not significantly disfavor
the long-term interests of shareholders.
(c) A person who challenges an action of the board on the ground that it fails to satisfy
the standards of Subsection (a) has the burden of proof that the board's action is an
unreasonable response to the offer.
(d) An action that does not meet the standards of Subsection (a) may be enjoined or set
aside, but directors who authorize such an action are not subject to liability for damages if
their conduct meets the standard of the business judgment rule [§ 4.01(c)].
9. Unitrin v. American General Corp.
a. Draconian Defenses – “Draconian” defenses are “coercive” and “preclusive.” They are
invalid.
i. Coercive – Whether the shareholders or directors are given such a strong
incentive to take one approach over another. The stronger the incentive, the
more coercive.
ii. Preclusive – Will the defensive measure in effect prevent a transaction from
taking place? Will it preclude something else?
b. Non-Draconian Defenses – Reviewed under QVC’s “range of reasonableness” standard.
Very broad standard. Gives a lot of deference to board.
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10. Carmody v. Toll Brothers, Inc.
a. Dead Hand Pill – Permit only the corporate directors in office at the time the rights plan
was adopted to redeem their rights; thus, if the continuing directors are ousted from office
in a proxy contest waged by a bidder making a hostile tender offer, the bidder’s newly
elected board nominees could not redeem the rights to permit the bidder to acquire the
stock tendered to it.
b. Dead hand pills violate Delaware law.
i. “Absent express language in the charter, nothing in Delaware law suggests that
some directors of a public corporation may be created less equal than other
directors, and certainly not by unilateral board action.”
ii. Disenfranchised shareholders that wished to elect a board committed to
redeeming the pill by deterring proxy contests by prospective acquirers.
iii. Both coercive and preclusive.
11. Mentor Graphics Corp. v. Quickturn Design Systems, Inc.
a. No Hand Pill – No way for continuing directors to redeem the pill. Makes the pill nonredeemable for six months after a change in control.
b. There is the same worry as in Toll Brothers. We are limiting board authority, and if we
are going to do this, we must do so up front in the articles of incorporation.
i. Structural coercion.
ii. Failed second prong of Unocal.
Extension of the Unocal/Revlon Framework to Negotiated Acquisitions
1. Best Efforts Clauses
a. Each party will do its best to get the deal done. Includes cooperating with each other; not
cooperating with outsiders; making appropriate disclosures to the board; etc.
b. How enforceable are these clauses? Shareholder approval is a prerequisite to merger.
c. Fiduciary Out Clauses – Nothing in the agreement abrogates directors’ fiduciary duties.
2. Exclusive Merger Agreement
a. No-Shop Clause – A clause in an agreement between a seller and a potential buyer that
bars the seller from soliciting a purchase proposal from any other party. In other words,
the seller cannot “shop” the business or asset around once a letter of intent or agreement
in principle is entered into between the seller and the potential buyer.
b. Lockup Agreement – Broad term that covers several categories of clauses. Gives
favored bidder a competitive advantage over non-favored bidders.
i. Two Types
1. Stock Option Lockup – Target gives bidder an option to buy a
percentage of target’s stock. Stock authorized in articles of
incorporation, but not issued to the public, i.e., treasury shares.
2. Asset Lockup – Option to buy a very important asset of the target, i.e., a
crown jewel.
3. Omnicare, Inc. v. NCS Healthcare, Inc.
a. Facts – NCS Healthcare, Inc. agreed to defensive devices in a merger transaction with
Genesis Health Ventures, Inc. that precluded the NCS board’s consideration of Omnicare,
Inc.’s subsequent superior offer.
b. Defensive measures cannot limit or circumscribe directors’ fiduciary duties.
c. Signaling & Fiduciary Duty to Investigate
i. Omnicare is sending signals (calling; leaving messages). Omnicare might make
public statements hoping that they reach the NCS shareholders.
ii. Omnicare hopes that NCS will hear it, listen, and maybe consider what it is
saying.
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iii. Special committee at NCS owes a fiduciary duty to its shareholders to analyze
what Omnicare is saying. If there is a lot of Omnicare information in
public/media, then the NCS board has a fiduciary duty to investigate. Omnicare
could in effect trigger the fiduciary duty.
d. Treats Unocal and Revlon as a SINGLE STANDARD.
i. Change in control is not required for enhanced scrutiny under Unocal.
(“Defensive devices adopted by the board to protect the original merger
transaction must withstand enhanced judicial scrutiny under the Unocal standard
of review, even when that merger transaction does not result in a change of
control.”)
ii. Enhanced Scrutiny in Two Circumstances
1. Unocal
2. Revlon
iii. Numerous other cases treat them as a single standard. Barkan; MacMillan; In re
Lukens; Malpiede.
e. Standard
i. Requires an informed decision by board.
1. Board may become informed by contacting the acquirer’s board or
receiving its signals.
ii. What the board does with this information must be reasonable.
1. If Revlon duties are triggered, board must make a reasonable effort to get
the best price. See Arnold.
2. If Revlon duties are not triggered, then Unocal is in effect.
a. Must identify reasonable grounds for believing that there is a
threat to corporate policy.
i. Good faith and reasonable investigation
b. Response must be (1) not preclusive or coercive and (2) within
the range of reasonableness to the threat perceived.
f. Arnold  When Revlon Duties Are Triggered: The directors of a corporation “have the
obligation of acting reasonably to seek the transaction offering the best value reasonably
available to the stockholders,” in at least the following three scenarios:
(1) “when a corporation initiates an active bidding process seeking to sell itself or
to effect a business reorganization involving a clear break-up of the company”;
(2) “where, in response to a bidder’s offer, a target abandons its long-term
strategy and seeks an alternative transaction involving the break-up of the
company”; or
(3) when approval of a transaction results in a “sale or change of control.” In the
latter situation, there is no “sale or change in control” when “‘[c]ontrol of both
[companies] remain[s] in a large, fluid, changeable and changing market.’”
Extension of the Unocal/Revlon Framework to Shareholder Disenfranchisement
1. Blasius Indus. v. Atlas Corp. – Particular defensive measures interfering with shareholder voting
get enhanced scrutiny.
a. Facts
i. Blasius started buying up shares of Atlas, and ended up with about 9% of the
stock. They suggested that Atlas liquidate most of their assets and give the
shareholders a nice big dividend. Atlas' management was not keen on this idea.
ii. Blasius sent Atlas' management a precatory resolution saying that they should
restructure, double the size of the board of directors, and elect Blasius' candidates
to those positions.
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1. A precatory resolution, is a letter sent to a board of directors from a
powerful shareholder threatening them to acquiesce to a particular policy
or else they would try to get their way through a shareholder vote.
iii. In response, Atlas management held an emergency meeting of the board,
amended the by-laws to add a few more directors, and appointed Atlas-friendly
people to those new directorships. Blasius sued.
b. Board action intended to thwart the free exercise of the SH franchise must satisfy the
“heavy burden” of demonstrating a “compelling justification” for their action.
c. Holding
i. The Trial Court found that Atlas' management was not acting selfishly because
they were worried they might lose their jobs, but acting in what they perceived to
be the best interests of the corporation because they honestly believed that
Blasius' goals would harm the corporation.
ii. However, the Court found that even when an action is taken in good faith, it
could constitute an unintended violation of the duty of loyalty that the directors
owes to the shareholders.
1. The directors are in effect agents of the shareholders. If the purpose of an
action is to obstruct the shareholders' reasonable control over their
business, that is inequitable. Basically, the directors work for the
shareholders, so if there is a disagreement between the shareholders and
the directors, the directors have to defer to the judgment of the
shareholders.
2. Schnell v. Chris-Craft – A Delaware court may invoke its equity powers to invalidate conduct
permissible under the statute.
a. One instance in which a court will do so is where the board interferes with the
shareholder vote for self-dealing reasons. Such actions purportedly are per se invalid.
b. Written consent is OK. Creating new board seats by written consent also is OK.
c. If it looks like that the board is interfering with shareholder voting for reasons to enhance
the board itself, then we might reasonably be skeptical of the board.
3. Stroud v. Grace – Where board action in response to an unsolicited tender offer affects the
shareholder franchise, Unocal does apply.
a. Act that “purposefully disenfranchises the shareholders” is “strongly suspect” and
requires a “compelling justification.”
4. Hilton Hotels Corp. v. ITT Corp.
a. Facts – Hilton Hotels, which sought to acquire ITT Corp., sued to obtain an injunction
precluding implementation of the target company’s comprehensive plan.
b. Choice of Law – NV law is silent on the subject. Court looks to DE case law as
persuasive authority.
c. Heightened Review for SH Disenfranchisement – “A board’s unilateral decision to
adopt a defensive measure touching upon issues of control that purposefully
disenfranchises its shareholders is strongly suspect under the Unocal test, and cannot be
sustained without a compelling justification.”
d. Two Types of Cases
i. Power over the assets of the corporation. BJR analysis.
ii. Power relationship between the board (management) and the shareholders.
Blasius analysis.
e. Unocal Analysis Here – “The Unocal test requires the court to consider the following
two questions: 1) Does the board have reasonable grounds for believing a danger to
corporate policy and effectiveness exists? 2) Is the response reasonable in relation to the
threat? If it is a defensive measure touching on issues of control, the court must examine
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f.
whether the board purposefully disenfranchised its shareholders, an action that cannot be
sustained without a compelling justification.”
Blasius Rule – “Even if an action is normally permissible, and the board adopts it in
good faith and with proper care, a board cannot undertake such action if the primary
purpose is to disenfranchise the shareholders in light of a proxy contest.”
State & Federal Legislation
1. CTS Corporation v. Dynamics Corporation of America
a. Facts – Dynamics offered to purchase CTS and was obligated to fulfill state law
requirements in order to obtain majority shareholder status.
b. Williams Act
i. Congress passed the Williams Act in 1968 in response to the increasing number
of hostile tender offers. Before its passage, these transactions were not covered
by the disclosure requirements of the federal securities laws.
ii. The Williams Act, backed by regulations of the SEC, imposes requirements in
two basic areas. First, it requires the offeror to file a statement disclosing
information about the offer, including: the offeror’s background and identity; the
source and amount of the funds to be used in making the purchase; the purpose of
the purchase, including any plans to liquidate the company or make major
changes in its corporate structure; and the extent of the offeror's holdings in the
target company.
iii. Second, the Williams Act, and the regulations that accompany it, establish
procedural rules to govern tender offers.
c. Conflict Preemption Test – “Absent an explicit indication by Congress of an intent to
pre-empt state law, a state statute is pre-empted only where compliance with both federal
and state regulations is a physical impossibility or where the state law stands as an
obstacle to the accomplishment and execution of the full purposes and objectives of
Congress.”
i. After this case, only if simultaneous compliance is impossible would a state law
be preempted by the Williams Act.
ii. Standard conflict preemption analysis.
d. NOT Preempted by Williams Act – Indiana statute is consistent with the provisions and
purposes of the Williams Act and is not pre-empted by the federal statute, because (a) it
protects independent shareholders against both the offeror and management, thereby
furthering the basic purpose of the Williams Act to place investors on an equal footing
with offerors, and (b) it does not unreasonably delay the consummation of tender offers.
e. Commerce Clause – Indiana statute does not violate the commerce clause, because (a) it
does not discriminate against interstate commerce, (b) it does not create an impermissible
risk of inconsistent regulations by different states, (c) its primary purpose is to protect the
shareholders of Indiana corporations, and (d) even if the statute should decrease the
number of successful tender offers for Indiana corporations, this would not offend
the commerce clause.
2. Edgar v. MITE
a. Court struck down the Illinois Business Takeover Act as preempted by the Williams Act.
b. A majority of the court (per Justice White) was able to agree only one issue—i.e., the
Illinois Act was unconstitutional because the burden it placed on interstate commerce
outweighed the local interests served by the statute.
CORPORATE DEBT
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Introduction
1. Two Components of Equity
a. Vote
b. Residual Claim
c.  We do not think of debt as having either, but this is not always the case.
2. Company can make itself immune from liability by doing debt financing, rather than equity
financing. Debt financing: no assets, and therefore, the business is judgment-proof.
3. Parlance
a. Equity – Common stock and preferred stock.
b. Debt – Debt Instruments: Promise to pay is secured by some property interest.
i. Mortgage – Debt agreement where one gives the bank a contingent property
interest in one’s home. If one does not pay the bank, it can collect by possessing
and selling one’s house. The house is a security interest here.
4. Types of Debt Instruments
a. Bonds – Long-term and secured, i.e., with a security interest. Special Types:
i. Income – Interest is paid only if there is income above a certain level.
ii. Floating-Rate – Interest rate floats. Coupon varies with market interest rates.
iii. Zero-Coupon – No interest rate. (Interest rate actually is priced into the face
value.) Sold at discount from face value; pay no coupon; function like long-term
T-bills.
iv. Split-Coupon – Combination. Zero coupon initially; coupon later.
b. Debentures – Long-term, but not secured.
i. Often called “bonds.” Calling them “bonds” indicates that an individual only is
talking about long-term debt.
c. Notes – Short-term.
d.  Key difference between loaning secured debt and loaning someone unsecured debt:
when you are dealing with a promise only, i.e., unsecured debt, you will want to know
with whom you are dealing.
5. Features
a. Rate
b. Coupon – Interest rate started on a bond when it is issued.
c. Value
i. Bonds
1. Think about relationship between price and interest rate. Usually an
inverse relationship. If prevailing interest rates have risen, the price of
the bond decreases. If prevailing interest rates drop, value of bonds rises.
2. Usually issued in $1000 increments.
d. Risks
i. Bonds
1. Issuer makes two promises:
a. Pay back principal of debt.
b. Pay the going interest rate.
2. Risk is that issuer will not pay/go into default. Default indicates breach
of contract. Creditor now has a contract cause of action, which is
expensive to act on. Even if creditor prevails, debtor may be judgmentproof; may have entered into bankruptcy.
3. Bankruptcy – Stops all flows out of the estate and pays (1) property
owners.
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4. Risk Profile of the Entity – Affects interest rate and causes it to fluctuate.
Amount of interest it is required to pay will be a function of the risk that
the market perceives.
6. Indentures/Control Provisions
a. Redemption – Set of statements setting forth what constitutes default on the debt
instrument. E.g., “If A, B, or C occurs, I can declare that you are in default, and you will
be required to pay me back much sooner.”
b. Call – An option contract giving the owner the right (but not the obligation) to buy a
specified amount of an underlying security at a specified price within a specified time.
Allow an issuer to redeem a bond prior to maturity.
i. Usually, there is a call price. The price at which the bond is cashed out usually is
high.
ii. Calling far in advance is an expensive option. Calling very close to the normal
redemption date is relatively cheap.
iii. Reflects that when people are doing a debt deal, they are locking in interest rates.
Question: who is taking on the risk to get the cash?
c. Restrictive Covenants – Any type of agreement that requires the buyer to either take or
abstain from a specific action. E.g., “If corp. X borrows all of this money, it promises not
to pay too many dividends. We want to make sure that we are paid back, and we do not
want corp. X just giving all of its money to its shareholders.”
i. Limit uses to which corporations may put their income.
ii. Designed to keep corporations, which are ships moving through the water, above
the water line.
d. Negative Pledge Covenants – A negative covenant in an indenture stating that the
corporation will not pledge any of its assets if doing so gives the lenders less security.
Debtor’s Sale of Substantially All Its Assets
1. Sharon Steel Corporation v. Chase Manhattan Bank, N.A.
a. Facts – UV Industries issued bonds to raise corporate capital and then decided to
liquidate operations, selling each of its three divisions in separate sales with the final
buyer, Sharon Steel Corporation, assuming responsibility for the bonds.
b. Successor-Obligor Clauses
i. Boilerplate; standard contractual provisions.
ii. Found in almost all indentures.
iii.  Successor-obligor clause does not apply unless there is a sale of all the assets.
c. Boilerplate
i. Meaning does not depend on relationship between parties or parties’ intentions.
ii. Meaning is a MATTER OF LAW, not a matter of fact.
iii. “Uniformity in interpretation is important to the efficiency of capital markets.”
d. Interpretation of Indenture Provisions – “Interpretation of indenture provisions is a
matter of basic contract law.”
e. Rule – “BOILERPLATE SUCCESSOR OBLIGOR CLAUSES do not permit assignment
of the public debt to another party in the course of a liquidation unless all or substantially
all of the assets of the company at the time the plan of liquidation is determined upon are
transferred to a single purchaser.”
f. Sale of Substantially All Assets v. Liquidation
i. Sale of Substantially All Assets  Surviving company must assume the debt.
ii. Liquidation  Must pay off debt at the call provisions and must pay the call
premium.
g. Substantially All Assets
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i. Court does not indicate how “substantially all assets” is to be measured.
ii. 51% of total book value of assets ≠ “substantially all assets.”
Incurrence of Additional Debt
1. Metropolitan Life Insurance Company v. RJR Nabisco, Inc.
a. Facts – Metropolitan Life Ins. Co. brought an action against Nabisco to recover the loss
in value of the Nabisco bonds the plaintiff held following the KKR group’s LBO of
Nabisco.
b. LBO Definition – “A leveraged buy-out occurs when a group of investors, usually
including members of a company’s management team, buy the company under financial
arrangements that include little equity and significant new debt. The necessary debt
financing typically includes mortgages or high risk/high yield bonds, popularly known as
‘junk bonds.’ Additionally, a portion of this debt is generally secured by the company’s
assets. Some of the acquired company's assets are usually sold after the transaction is
completed in order to reduce the debt incurred in the acquisition.”
c. Express Covenant Violation – “If there has been a violation of an express covenant, the
court need not reach the question of whether or not an implied covenant has been
violated.”
d. Implied Covenant of Good Faith
i. NO IMPLIED DUTY OF GOOD FAITH TO BONDHOLDERS.
1. Contrast: there is an implied duty of good faith to shareholders, and there
is an implied duty of good faith in performance of every contract.
ii. Implied only when necessary to ensure that neither party deprives the other of the
“fruits of the agreement.”
1. Fruits of the bond indenture are LIMITED TO REGULAR PAYMENT
OF INTEREST AND ULTIMATE REPAYMENT OF PRINCIPAL.
2. “The implied covenant will only aid and further the explicit terms of the
agreement and will never impose an obligation which would be
inconsistent with other terms of the contractual relationship.”
a. No extra-contractual rights inconsistent with those set out in the
indenture.
b. Discerned from Context – Discerned in the context of the
actual facts of the deal, i.e., what parties asked and did not ask
for. Must look for intent of parties as reflected in the objective
evidence.
i. Contrast with fiduciary duty. Implied generally, not
from context. Reflects broader legal policy.
iii. Could there be a duty of good faith to a bondholder not because of her status as a
bondholder, but because of another relationship?
1. Perhaps if the bondholder is like a shareholder in some respects. How do
we get a bondholder to look like a shareholder?
a. If BH have some equity in the entity that will emerge postbankruptcy. Bondholders in this way are future shareholders.
b. Rights, control, etc. associated with the debt instrument might be
sufficient for the court to categorize the debt as equity.
e. Implied Covenants Generally – “In contracts like bond indentures, an implied covenant
derives its substance directly from the language of the indenture, and cannot give the
holders of debentures any rights inconsistent with those set out in the indenture. Where
plaintiffs’ contractual rights have not been violated, there can have been no breach of an
implied covenant.”
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i. Finding Implied Covenant – “A promise by the defendant should be implied
only if the court may rightfully assume that the parties would have included it in
their written agreement had their attention been called to it.”
f. Method of Analysis – “The appropriate analysis, then, is first to examine the indentures
to determine ‘the fruits of the agreement’ between the parties, and then to decide whether
those ‘fruits’ have been spoiled-which is to say, whether plaintiffs’ contractual rights
have been violated by defendants.”
2. Geren v. Quantum Chemical Corp. (APPLICATION OF MetLife)
a. The court rejected the bondholdlers’ effort to distinguish MetLife on the ground that they
were not big-time sophisticated investors: “I do not believe Judge Walker contemplated a
cause of action that would lie in favor of ordinary investors but not in favor of market
professionals.”
b. No implied duty of good faith even when bondholders are ordinary, unsophisticated
investors.
Exchange Offers
1. Exchange Offer – An offer to trade one security for another, usually to stockholders of a
company in financial trouble and at less favorable terms. Swapping one type of debt for another
type.
a. Renegotiating debt agreements usually involves exchange offers.
2. Three Key Features of Debt Agreement
a. Principal
b. Interest
c. Due Date
3. Katz v. Oak Industries, Inc.
a. Facts – Bondholder sought to enjoin the consummation of a exchange offer and consent
solicitation made by a corporation to long-term debt holders.
b. Fiduciary Duty to SH, Not BH – “It is the obligation of directors to attempt, within the
law, to maximize the long-run interests of the corporation's stockholders; that they may
sometimes do so at the expense of others does not for that reason constitute a breach of
duty.”
i. Bondholders often must bear greater risk of loss.
ii. Court cannot protect BH without relevant legislation or indenture provisions.
c. Coercion – Court says that the modification is somewhat coercive, but not wrongfully
coercive, which is the only legally actionable kind of coercion.
i. Enough coercion to breach implied duty of good faith? To answer this question,
use the implied duty of good faith analysis below.
d. Implied Duty of Good Faith – Implied duty of good faith is breached when it is clear
from the express terms of the indenture that the parties would have prohibited the
challenged act if they had thought to negotiate about it.
i. “A court is justified in concluding that a party has breached the implied covenant
of good faith if is it clear from what was expressly agreed upon that the parties
who negotiated the express terms of the contract would have agreed to proscribe
the act later complained of as a breach of the covenant had they thought to
negotiate with respect to that matter. [If the parties would have so negotiated], a
court is justified in concluding that such act constitutes a breach of the implied
covenant of good faith.”
ii. Suggests that an implied duty of good faith is part of every contract.
iii. Broader than MetLife
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1. Applies to conduct that does not directly threaten either repayment of
principal or regular payment of interest.
2. Applies to matters that affect the market price of bonds.
3.  Court still requires express terms in the indenture addressing such
matters because only then could the necessary inferences be drawn.
STILL FACT/CONTEXT-SPECIFIC.
Redemption & Call Protection
1. Preferred Stock – A class of ownership in a corporation that has a higher claim on the assets and
earnings than common stock. Preferred stock generally has a dividend that must be paid out
before dividends to common stockholders and the shares usually do not have voting rights. The
precise details as to the structure of preferred stock is specific to each corporation. However, the
best way to think of preferred stock is as a financial instrument that has characteristics of both
debt (fixed dividends) and equity (potential appreciation).
2. Common Stock – A security that represents ownership in a corporation. Holders of common
stock exercise control by electing a board of directors and voting on corporate policy. Common
stockholders are on the bottom of the priority ladder for ownership structure. In the event of
liquidation, common shareholders have rights to a company’s assets only after bondholders,
preferred shareholders, and other debt-holders have been paid in full.
3. Morgan Stanley & Co. v. Archer Daniels Midland Company
a. Facts – Archer Daniels Midland Co. sought to redeem $125 million in debentures, and
Morgan Stanley sought a preliminary injunction against the proposed redemption.
b. Rule – Using the funding obtained with proceeds of common stock issued by a bond
issuer is a lawful means of redeeming outstanding debentures, notwithstanding the fact
that the debtor corporation had also obtained funding that was prohibited from being used
to effect a redemption.
c. Relied on Franklin (S.D. Ill. 1978).
i. Redemption terms contained in an indenture or stock agreement are contractual
and, therefore, courts considering disputes between security holders and security
issuers with respect to redemption provisions generally apply contractual
principles to resolve the disputes.
ii. “Because a court construing a contract must try to give meaning to all of the
contractual terms, the Edison court closely examined the language of the nonrefunding provision which provided that the Company could not redeem the
preferred stock ‘through refunding.’ The court reasoned that this limiting
language prohibited the Company’s preferred stock redemption only if the
Company obtained the funds necessary for the redemption through a refunding
operation by which the Company incurred debt. The Edison court agreed with
the Company’s conclusion that obtaining funds through a sale of common stock
was equity financing, not a refunding operation, and, therefore, redeeming the
preferred stock with the proceeds of a common stock sale did not violate the
preferred stock’s non-refunding provision.”
iii. The stockholder must realize that, as the Edison court emphasized, an issuing
company’s right to redeem outstanding preferred stock depends on the language
of the stock contract’s redemption provision.
iv.  Court basically applied the Franklin holding to this case.
i.
nonrefunding provision.
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