B U S I N E S S
O R G A N I Z A T I O N S
O U T L I NE
Agency
Definition of Agency
Agency results from: (1) the manifestation of consent by one person to another (2) that the other shall act
on his behalf and subject to his control, and (3) consent by the other to so act [R. Agency. § 1]
 Once P-A relationship is established, it is as if the P has done what the A has done
 There needs to be some agreement more than passive permission but no contract or
compensation needed
o On the other hand, even if there is a contract saying otherwise, e.g. independent
contractor, P-A is a question of fact to be determined from the totality of circumstances
[Humble Oil v. Martin]
 Question of Control: Critical test is nature and extent of the control agreed upon
[Murphy v. Holiday Inn]
 Element of continuous subjection to the will of the principal
o P-A when Doty told Coach that only he can drive the car [Gorton v.
Doty]
o P-A when Humble furnished station location equipment,
advertising media, products, decided operating hours, could
terminate A at anytime [Humble Oil v. Martin]
o No P-A when Sun had no control over Barone’s day-to-day
operation [Hoover v. Sun Oil]
 Security Holders and Debtors: Do not become P by merely exercising veto power
o Creditor becomes Principal when he assumes de facto control over the conduct of his
debtor [R. Agency § 14]
 If he takes over the management of the business and directs what contracts to
enter, he becomes liable as a principal for the obligations incurred in normal
course of business. Gay Jenson Farms v. Cargill.
 Suppliers and Buyers: Supplier becomes agent only if he agrees that he will act primarily for the
benefit of the buyer and not for himself [R. Agency §14k]
o If supplier has an independent business, he is not an agent. Factors include: (1) he receives
a fixed price from the buyer regardless of what he paid; (2) he acts in his own name and
receives title to the property before he transfers it to buyer; (3) he has an independent
business buying and selling similar property. Gay Jenson Farms v. Cargill.
 Undisclosed Principal: Agent is liable until Principal is disclosed, then no liability
o If Principal is partially disclosed, (third party knows P exists but not his identity,) Agent is
responsible for the contract in that situation
Liability of Principal to Third Parties in Contract
Principal is only liable for contracts if Agent manifested one of the following:
 Actual Authority:
o Principal specifically gives the authority to the agent to act on his behalf
 Implied Authority:
o Actual authority circumstantially proven
o Principal actually intended the agent to possess the authority
o Includes powers that are practically necessary or reasonable to carry out the duties
actually delegated
o Factors to consider [Mill Street Church v. Hogan]
 The agent’s reasonable understanding of his own authority given by P
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Nature of the task or job, whether it necessitates that authority
Specific conduct by the P in the past or present permitting the agent to exercise
similar powers (most important)
Apparent Authority:
o Not actual authority
o Principal literally holds out the agent as his agent
 Needs to be within the usual and proper conduct of business
o Matter of appearances that third parties reasonably expect/ rely on
 Third party cannot know of the lack of P-A relationship [Three-Sventy Leasing v.
Ampex]
Inherent Authority:
o Principal has acted as to enable the agent to hold himself out to the world as the
proprietor of their business while they were undisclosed principals [Watteau v. Fenwick]
 P has notice of the agent’s conduct and that it might induce others to change their
positions but did not take reasonable steps to notify them of the facts
 P places agent in the agency and that in itself signals something to others
o P is liable for contracts A enters into in the normal course of business
o P not liable if third party is on notice of A’s lack of authority
Agency by Estoppel:
o When you induce someone (active behavior or involvement) to reasonably rely on you to
their detriment, you are liable for whatever they lost
 Inducement: Active behavior on the part of the person being charged with the
concept of estoppel, i.e. you induced someone and they reasonably relied on you to
their detriment
o When a proprietor derelicts his duty and enables one who is not his agent to transact
business with a person of ordinary prudence who believes that P-A exists, the proprietor
is liable [Hoddeson v. Koos Bros.]
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Employer Liability in Tort
 P is liable for things that are reasonably foreseeable within the scope of employment
o Conduct of a servant is within the scope of employment only if it is actuated, at least in
part, by a purpose to serve the master [R.2d Agency § 228(1)]
 Policy: Incentive of principal to prevent torts of agents
o P is liable for employee’s assault if the assault was in response to conduct which was
presently interfering with the employee’s ability to perform his duties successfully
[Manning v. Grimsley]
The Coase Theorem – Efficiency v. Fairness
 Where transactions costs are low (where the parties can easily negotiate with each other or
contract out of law) then the efficient arrangement will result irrespective of where the law places
entitlement
o Irrelevant from a business and efficient perspective what the legal rule is, who has the
legal entitlement to who is or isn’t liable
o However in the real world transactions costs are not low. It is very hard for them to
contact each other and to reach an agreement therefore they are likely not to contract out
of a wrong legal rule.
 Therefore it matters very much what the law says and that we as policy makers
should give our attention to that project
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Partnerships
Definition of Partnership
A partnership is an association of two or more people who carry on as co-owners for a business for profit,
whether or not they intended to form a partnership [UPA § 202(a)]
 Both partners work on behalf of the partnership and each other as an agent of the partnership for
the purpose of its business [National Biscuit Company v. Stroud]
 One partner is responsible for all torts, contracts, liability and debts that any one partner
causes/enters into, as long as partners voluntarily dealt with each other and third parties in a way
the law views as partnership
o Same categories of agency authorities apply to partnership law, if a partner has any of
those authorities, same legal consequences will follow
 Factors in determining a partnership [Fenwick v. Unemployment Commission]
o Intention of the Parties
o Right to share in Profits
 Receipt by a person of a share of profits is prima facie evidence that partnership
exists, but this presumption can be overcome by other pertinent facts such as lack
of intent or other factors [Southex v. Rhode Island Builders]
o Obligation to Share in Losses
o Ownership and Control of the Partnership Property and Business
 Ownership includes the rights to occupy, exclude, alienate
 Control is key: All partners should have equal access to the controlling
instrumentality
 Joint property does not itself establish a partnership whether or not they
share profits made by use of the property [UPA §7(2)]
o Community of Power in Administration
o Language in the Agreement
o Conduct of the Parties toward Third Parties
o Rights of the Parties on Dissolution and the Result of Dissolution
 Partnership by Estoppel
o In general, persons who are not partners as to each other are not partners as to third
parties [UPA §7(1)]
o However if you induce C to rely on the fact that you are B’s partner, and C relies on the
inducement to C’s detriment, you are estopped from denying that you are B’s partner [UPA
§ 16(1)]
 Consequences of partnership follow if partnership by estoppel established
 C must reasonably rely on the partnership to be entitled to damages [Young v.
Jones]
 Partners v. Lenders
o When lenders have the right to inspect the firm books and veto any speculative business,
but cannot initiate any transactions themselves, they do not become partners; they are
just taking precautions of their loan as lenders. [Martin v. Peyton]
o Policy: Other people should not gamble with your money for their own profit. Lenders
may ask for certain information on the financials out of ordinary caution, but this does not
imply an association in the business.
Fiduciary Obligations of Partners
 Fiduciary obligations are very broad
 Must act in accordance with the obligation of good faith and fair dealing
 Partners owe expansive duties to each other as long as it is related to the partnership venture, for
the lifetime of the partners or the undertaking
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Do not owe everything to each other in their personal lives although the law will
determine if the partnership exists outside of the business venture
Duty of Care: Refraining from grossly negligent or reckless conduct, intentional misconduct, or
knowing violation of the law [§404(c)]
Duty of Loyalty: [§404(b)]
o (1) Account to the partnership and hold as trustee for it any property, profit, benefit
derived from partnership or partnership property, including partnership opportunities,
 Partner must consider other partners’ welfare and refrain from acting for purely
private gain [Meehan v. Shaughnessy]
 Meinhard breaches duty of loyalty by appropriating an opportunity incidental of
the joint enterprise to himself in secrecy and silence
o (2) Refrain from dealing with the partnership as a party having an adverse interest to the
partnership
 Partners cannot use their position of trust and confidence to the disadvantage of
the partnership [Meehan v. Shaughnessy]
o (3) Refrain from competing with the partnership before dissolution
 “Joint adventurers owe to one another, while the enterprise continues, the duty of
finest loyalty. Not honestly alone, but the punctilio of an honor the most sensitive,
is the standard of behavior.” [Meinhard v. Salmons]
Partners May:
o Engage in conduct that furthers his own interest without violating fiduciary duties
o Lend money or transact other business with the partnership, where the rights and
obligations of the partners are same as those of a person who is not a partner
o Plan to compete without violating fiduciary duties, including actually competing
 Facts that pointed towards breach in Meehan v. Shaughnessy:
 Unfairly removing properties from the partnership
 Failure to answer accurately and honestly when directly asked about
leaving
 Failed to give the clients an option to stay
o
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Rights and Obligations 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 [UPA § 18]
 Parties may contract out of the implied obligations and rights in law below
 Sharing of Profits and Losses, Two Approaches:
o Under UPA/Common Law: Irrespective of contribution, you share in profits and losses
50/50 unless specified otherwise
 Each partner shall be repaid his contributions and share equally in the profits and
surplus remaining after all liabilities, including those to partners; and must
contribute towards the losses according to his share in profits [UPA §18(a)]
 Ordinarily, the default rule is that partners share in profits but do not receive
salary, but lots of partners contract out of this and set up salary
o Under RUPA/CA Law: Each party shares in profits and losses in proportion to his
contribution
 Each partner is entitled to an equal share of the partnership profits and is
chargeable with a share of partnership losses in proportion to the partner’s share
of profits [RUPA § 401(a)]
 Although each partner shares equally in all debts (jointly and severally liable) with
respect to third parties, they share profits and losses among themselves in
proportion to the partner’s contribution (whether money or service or specified in
partnership agreement)
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Where one party contributes capital and other his skill and labor, neither party is
liable to the other for any loss sustained since each lost his own capital, one cash
and the other labor hours [Kovacik v. Reed]
 Minority Rule in CA, expressly rejected by RUPA
Rights in Management: All partners have equal rights in the management and conduct of the
partnership business [UPA § 18 (e)]
o The right of each partner to participate in some way will be an implicit term
o Otherwise has equal rights in the management and conduct of the business
Disagreement in Management:
o If there is disagreement in ordinary matters connected with the partnership, the decision
is made by a majority of the partners. [UPA §18(h)]
 In a two-person partnership:
 No majority vote to deprive either party the authority to act for
partnership.
 Where one partner continually voices objections and does not sit idly by
and acquiesce in the actions of his partner, he cannot be held liable since
the expense was incurred individually for the benefit of one partner and
not for the benefit of the partnership [Summers v. Dooley]
o When there is an actual agreement among partners, no act in contravention of the
agreement may be done without the consent of all partners [National Biscuit Company v.
Stroud]
o What either partner does with a third person is binding on the partnership, unless the
acting partner (1) in fact had no authority to act and (2) the third party knew of the lack of
authority [National Biscuit Company v. Stroud]
o However if both partners have the authority, no restriction can be placed up on the
partner’s power to act and the acting partner binds the partnership even if the third party
knew of disagreement [National Biscuit Company v. Stroud]
 Partnership must be a going concern
 Activities should be within the scope of business
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Majoritarian Default v. Penalty Default
 Majoritarian: Choose the rule that most of the parties in the situation would want to have – in the
case of Kovacik, this depends on which partner you are and there is no clear preference as a
society
 Penalty default: opposite of above approach, this default is something most parties would dislike
and never accept on their own, so it forces the parties to speak and make arrangements explicitly
o Introduced in areas where controversy is likely to arise
o In CA, the penalty is on the contributor of financial capital because that partner is more
likely to have access to lawyers and insist on different arrangements
Partnership Dissolution
On dissolution, the partnership is not terminated but continues until the partnership affairs are
completed, such as the settling of debts. [UPA § 30-32]
 Fiduciary obligations continue until affairs are done
 Lawful Dissolution (no violation of agreement) is caused by:
o Termination of the definite term or particular undertaking specified in agreement
 All partnerships hope that they will be profitable but that does not make it a
partnership for a term obligating the partners to continue until all the losses are
recovered [Page v. Page]
 Implied Definite Terms:
 Partner advances sum of money with the understanding that the
contribution was to be repaid as soon as feasible
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Partnership will continue for the term reasonably required to
repay loan
 Partner may impliedly agree (must be supported by factual evidence) to
continue business until:
o Certain amount of money earned
o Partners recoup investments
o Certain debts are paid
o Certain property could be disposed of
o Express will of any partner when no definite term or undertaking specified
 Must be exercised in good faith e.g. cannot freeze out a co-partner and appropriate
the business to his own use unless he fully compensates his co-partner for the
share of the prospective opportunity [Page v. Page]
 If exercised in bad faith  wrongful dissolution consequences
o Express will of all partners
o Expulsion of any partner in accordance with a power conferred by agreement
Wrongful Dissolution is caused by:
o Express will of partner at any time in contravention of the partnership agreement
 This does not necessarily dissolve partnership, see dissociation below
o Event which makes the enterprise illegal
o Death or bankruptcy of any partner
o Decree of court which will be granted under UPA §32 when:
 On application by a partner:
 If party asking for dissolution is at right, he owes no damages
 If it is wrongful dissolution, party owes contractual damages
 Note that the filing of the complaint alone does not constitute dissolution
[G&S v. Belman]
 Partner has been shown to have unsound mind
 Partner becomes incapable of performing his part
 Partner’s conduct prejudicially affects carrying on business
 Partner willfully or persistently commits a breach of partnership agreement that it
is not reasonably practicable to carry on the business with him any longer
 Minor differences and grievances insufficient
 The disagreement needs to be of such a nature and extent that all
confidence and cooperation between the parties have been destroyed or
one of the parties materially hinders a proper conduct of the business
[Owen v. Cohen]
 Business of partnership can only be carried at a loss/economic purpose frustrated
 Other circumstances which make it equitable
 Note: Filing of complaint alone does not constitute dissolution. [G&S v. Belman]
Consequences to Dissolution:
o Exposure to immense liability that the partnership creates
o Partners in a partnership are all individually completely liable for the debts of the
partnership, including debts in contract or tort
 Must first pay creditors other than partners, then what is owed to partners in this
order: (1) other than capital and profits, (2) capital, (3) profits [UPA §40(b)]
o When a partner retires, the old partnership is dissolved by the retirement of any partner
and when the remaining partners continue their practice a new partnership is formed.
 Some Partnership Agreements may contain a continuation agreement, obligating
the remaining partners to continue to associate with one another as partners
under the existing agreement
o If one partner caused wrongful dissolution, he owes the partnership damages for breach
of the agreement but is also owed the value of his interest in the partnership if the
o
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business continues, not including the goodwill of the business. He is also released from all
liabilities of the partnership. [UPA §38(2)]
 Damages for breach of the agreement may include liquidated damages as long as
they are not a penalty [Pav-Saver v. Vasso]
 In continuing the business, other aspects of the agreement still hold; Vasso may
use IP to continue the company since Dale contractually receives his patents back
upon expiration but the partnership has not yet expired [Pav-Saver v. Vasso]
 Wrongful partner was dissociated so the business may continue
 Court here privileges the right of the business to continue in dissociation
OVER the partnership agreement stating that Dale gets his IP back when
partnership expires
Dissociation Rather than Dissolution Occurs When:
o A partner retires pursuant to an appropriate provision in the partnership agreement
o A partner willfully or persistently commits a material breach of the partnership or a duty
owed [RUPA § 601(5)]
o Consequences to Dissociation:
 When one partner is dissociated, the partnership continues as to the remaining
partners and they must purchase the interest of the retiring partner [Article 19]
Buy-Out Agreement: Before dissolution, partners may take advantage of any buyout provisions
under the agreement allowing the leaving partner to end his relationship and receive a cash
payment in return for his interest
o Buy-Out Formula [Article 19(e)(2)]: Capital Account of Partner + average of prior three
years’ profits actually paid to partner, or other agreed upon sum. [G&S v. Belman]
 Capital Account [§ 401]: Partner’s share of Partnership Profits + Money &
Property Partner Contributed – Liabilities Partner Contributed
Limited Partnerships
 Subspecies of partnership which limits the liability as far as partnership status
o Limited partners don’t have liability to third parties
 Both general and limited partners are considered “corporations”
 Every limited partnership has to have a general partner and one or more limited partner
o Formed upon the parties agreeing to the relationship
o Limited partner has less control as to the operations of the business
 A limited partner will not be 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 [Holzman v. De Escamilla]
o If a limited partner starts actually controlling the business, they lose the limited status and
are liable to third parties regardless of the third party’s knowledge of his role. Limited
partner may even be liable for exercising less than a general partner’s power if third party
knew he acted as more than a limited partner. [Mount Vernon v. Patridge]
 CA has adopted the modern rule which alters this rule
 A limited partner does not participate in control solely by consulting with
and advising a general partner with respect to the business by giving
general business guidance [RUPA 303(b)]
o Must distinguish between control of the operation and mere
guidance
 Even if the limited partner takes control the instrumentality, they are only
liable to third parties that they actually deal with themselves, and only if
the third party reasonably relies on their general partner status due to the
limited partner’s conduct [RUPA 303(a)]
7
Corporations
The Certificate of Incorporation
 This document must contain the corporation’s name, address, and nature of business, number of
shares of stock and par value, and the contact information of the incorporators/directors.
[§102(a)]
 This document may also contain: (1) any provision for the management of the business, create,
define and limit the regulating powers of the corporation, directors and stockholders; (3) any
other provisions desired by stockholders and any preemptive rights of security holders; (4)
provision for actions requiring corporate action or stockholder vote; (5) provision limiting the
duration of the corporation’s existence; (6) provision imposing personal liability for the debts of
the corporation on its stockholders under specified conditions; if not stated, stockholders or
members will not be held personally liable for the corporate debts unless it was due to their own
conduct; (7) a provision limiting or eliminating the personal liability of a director of the
corporation or its stockholders for monetary damages for breach of fiduciary duty, but not for
breach of the duty of loyalty, good faith, or for any transaction from which the director derived an
improper personal benefit. [§102(b)]
o Exculpation Clause (b)(7): No personal liability for the directors’ breach of the duty of
due care as long as it is stated in the articles of incorporation
The Corporate Entity and Limited Liability
 Corporations are run primarily for the good of its shareholders
 Corporations are run by the board of directors unless otherwise provided [Del. § 141(a)]
o Courts will not interfere with the management of directors unless there is a clear showing
of fraud, misappropriation of corporate funds/power, or breach of duty of care or loyalty
 The Law permits the incorporation of a business for the very purpose of enabling its proprietors
to escape personal liability [Walkovszky v. Carlton]
 In determining liability, courts may look to principles of agency [Walkovszky v. Carlton]
o Whenever anyone uses control of the corporation to further his own ends rather than the
corporation’s business, he will be personally liable for the corporation’s acts upon the
principle of respondeat superior
 Liability extends not only to commercial dealings but also to negligent acts
 Piercing the Corporate Veil:
o The equitable owner of a corporation is liable for actions of the corporation where there is
an abuse of the corporate privilege of limited liability
o A corporate entity will be disregarded and the veil of limited liability pierced when BOTH
requirements below are met [Sea-Land, Inc. v. Pepper Source]
o (1) Alter Ego: Such unity of interest and ownership that the separate personalities of the
corporation and the individual or other corporation no longer exist
 Factors for consideration: (1) failure to maintain adequate corporate records or to
comply with corporate formalities; (2) commingling of funds or assets; (3)
undercapitalization; (4) one corporation treating the assets of another corporation
as its own
 Parent-Subsidiary: If corporation is a fragment of a larger corporate combine
which actually conducts the business, only the larger entity is held financially
liable [Walkovszky v. Carlton]
 This set-up is legal as long as it’s not used to further personal ends
 Requires a showing of substantial domination between Parent and
Subsidiary. [In re Silicone Gel Breast Implants] Factors include:
o Common directors/officers
o Common business departments
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Consolidated financial statements
Parent finances subsidiary
P caused incorporation of S
S operates with grossly inadequate capital
P pays the salaries and other expenses of S
S receives no business except given to it by P
P uses S’s property as its own
Daily operations of the two are not separate
S does not observe basic corporate formalities such as keeping
separate books and records and holding shareholder and board
meetings
 However this does not mean that where a parent controls several
subsidiaries, each subsidiary then becomes liable for the actions of other
subsidiaries, for there is no respondeat superior among sub-agents [Roman
Catholic Archbishop of SF v. Sheffield]
(2) Injustice: Circumstances must be such that adherence to the fiction of separate
corporate existence would allow fraud or promote injustice
 The wrong must be beyond a creditor’s inability to collect [Sea-Land Inc.]
 Unfairness is something akin to fraud or deception or the existence of a compelling
public interest, such as using corporate facades to avoid creditors;
 E.g. one person unjustly enriched; intentional scheme to squirrel assets
o
o
o
o
o
o
o
o
o
o
Duties of Corporate Directors to the Corporation
 The Delaware Court of Chancery is a court of Equity, not crunching numbers but deciding fairness
o Decides whether a duty was breached or whether business judgment rule attaches
o Settlements are reviewed for reasonableness
 Ordinary shareholders do not owe fiduciary duties to other shareholders or to the corporation
 But if you are a director, officer, controlling or dominant shareholder, than you do owe fiduciary
duties to the corporation and other shareholders
 The Triad of Fiduciary Duties
o Duty of Care
 Duty to care for the business, be informed, deliberate, disinterested and lawful
 Business Judgment Rule:
o Tremendous deference to directors’ decisions, which are accepted
as final. Mere errors in judgment are insufficient for court
interference. [Kamin v. American Express]
 Judicial review OK when there is fraud, oppression,
arbitrary action, breach of trust, self-dealing, destruction of
rights or neglect of duties
o Directors will not be held liable for the business consequences of
their decisions so long as they were legal, not self-dealing, or
fraudulent. [Shlensky v. Wrigley]
 Policy: If directors knew that they would be evaluated on
negligence standard or that the substance of their choices
would be reviewed, they would be highly conservative. We
as a society want corporations to take risks.
 Duty breached when directors are disinterested or fail to do what they should
have under the circumstances
 Standard of breach of duty of care is gross negligence
 Corporation did not breach duty when it donated to Princeton University
since it was made indiscriminately, not in furtherance of directors’
personal ends, modest in amount, and voluntarily made in the reasonable
9
o
o
belief that it would advance the interests of the private corporation in the
community. [A.P Smith v. Barlow]
 Corporation breached duty when the directors did not adequately inform
themselves of material information reasonably available to them related to
the transaction and failed to disclose all material information that a
reasonable stockholder would believe important in deciding whether to
approve the sale. [Smith v. Van Gorkom]
Duty of Loyalty
 Duty to serve the interests of the principal and to limit their own interests for the
interest of the company and its shareholders
 When you have a personal interest or are standing on both sides of the transaction
(not disinterested as required by BJR), then BJR yields to this doctrine
 The Rule of Undivided Loyalty:
o Rigorous scrutiny applied when directors have a particularized
interest in the transaction or are standing on both sides of the
transaction
o Director has an affirmative obligation to demonstrate that the deal
was entirely fair to the corporation and its shareholders
o Breached when defendants took advantage of a favorable market
situation and siphoned off corporate advantages (selling
controlling shares) for personal gain [Perlman v. Feldman]
 Personal Interest does not automatically make the transaction
voidable
o No transaction is voidable solely for this reason if (1) material facts
as to the director’s relationship or interest to the transaction are
disclosed and known to the board and (2) the board in good faith
authorizes the transaction through a majority of disinterested
directors. [Del. Corp. Code §144]
 If the directors know about the conflict and vote to still
allow the transaction, protected by BJR [Benihana v.
Benihana]
o If the contract is fair, it is valid even though disinterested directors
did not formally ratify the decision [Bayer v. Beran]
 Breach of duty of loyalty includes:
 Refusal to declare a dividend when corporation has a surplus of net profits
and the dividend would not cause detriment to business [Dodge v. Ford]
 Corporate Opportunity Doctrine:
o Guth Test: If the opportunity is (1) in the line of business of the
company you serve, (2) the company can financially undertake that
opportunity, and (3) the company has a reasonable expectancy or
practical advantage in the opportunity, you have a responsibility to
turn that opportunity over to the corporation
o Presenting the opportunity to the board is not required but creates
a “safe harbor” removing the specter that the director improperly
usurped a corporate opportunity [Broz v. Cellular]
o If the corporation is first given the opportunity to turn down the
opportunity for themselves, directors are not liable [eBay v.
Shareholders]
Obligation of Good Faith
 Breach of the duties of care and loyalty may directly result in liability, whereas a
failure to act in good faith may only result in indirect liability by breaching the
duty of loyalty [Stone v. Ritter]
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Without a duty to act, there could be no rise of bad faith conduct [In re Walt Disney
Co. v. Deriv Litigation]
Three forms of bad faith conduct:
 (1) Subjective Bad Faith: Actual intent to do harm or violate applicable law
 (2) Lack of due care, gross negligence without malevolent intent
o Breaches both the duty of due care and the duty to act in good faith,
although gross negligence on its own does not constitute bad faith
o Failure of Oversight will result in director liability [Stone v. Ritter]
 A sustained or systematic failure to assure that a
reasonable information and reporting system exists will
establish lack of good faith [In re Caremark]
 (3) Intentional dereliction of duty or conscious disregard of one’s
responsibilities to advance best interests of corporation
o In the transactional context, an extreme set of facts is required to
sustain a disloyalty claim premised on the notion that directors
were intentionally disregarding their duties [Lyondell v. Ryan]
 *Don’t need to break down into these three forms: Focus on whether
the director is consciously disregarding his duties
The Mechanics of Derivative Actions
 Burden Shifting Analysis
o P has the burden to rebut the BJR presumption that the directors, in reaching their
challenged decision, breached one of the triads of their fiduciary duty
 If P fails to meet this evidentiary burden, BJR attaches to corporate officers and
directors unless P can prove other claims such as waste or abdication
 Waste Claim: P must show that no business person of ordinary, sound
judgment could conclude that the corporation received adequate
consideration
o Rare case where directors irrationally squander or give away
corporate assets
 Abdication Claim: The board wrongfully delegates a task or their
authority to another [Grimes v. Donald]
o Litigation Committee: When a board is interested, it may delegate
its authority to a committee of two disinterested directors. The
committee can exercise all of the authority of the board to the
extent provided in the resolution of the corporation, including
investigating the need for continuation of derivative suit. [Zapata
Corp. v. Maldonado]
 Two-Step Inquiry:
 (1) Independence and good faith of the committee
in the basis of supporting it conclusions
o Independence: whether the director is, for
any substantial reason, incapable of making
a decision with only the best interests of the
corporation in mind [In re Oracle]
 Focus on impartiality and objectivity
 (2) Court’s own judgment on whether MSJ should
be granted
o If P succeeds, burden then shifts to defendant directors to prove the “entire fairness” of
the transaction to the Plaintiff stockholder
 The Demand Requirement
11
o
o
o
§ 141 does not speak directly to demand but states that directors have the first instance to
decide for the corporation
Therefore, a shareholder must first demand that the directors act before he is able to file a
derivative suit
 Derivative Suit: The shareholder brings the suit against director on behalf of the
corporation and all other shareholders for monetary damages
 Any winnings will get put back into corporate treasury to be divided
among millions of shareholders to the corporation
 Leads to under-enforcement since shareholder gains no personal wins
while bearing the costs of litigation
 Therefore attorneys are the ones who truly care about bringing these suits,
since they may claim attorney fees from the losing side
 Director Indemnification in Incorporation Clauses
 May state that it will pay for the legal damages of directors as long as they
acted in good faith in the interests of the corporation [§ 145(b)]
 May also state that it will maintain insurance on behalf of a director against
liability incurred by such person whether or not he can be indemnified
o Legally possible to insure directors even in cases of bad faith/not
acting in best interests of corporation
o In reality, this type of insurance hard to obtain
Demand Procedure
 When P makes a demand for director action, he is entitled to know promptly what
action the board has taken in response to the demand [Grimes v. Donald]
 A stockholder filing derivative suit must allege with particular facts either:
 Claim of Wrongful Refusal:
o Demand was made and rejected
o Board entitled to BJR
 P has burden of showing reasonable doubt that board acted
independently or with due care in response to demand
o If demand is refused, P may not go back and claim that demand was
excused [Grimes v. Donald]
 Claim of Demand Excused:
o P claims he was justified in not having made the effort to obtain
board action
o If P fails this burden, he cannot go back and make a demand after
o Futile Demand: Reasonable doubt that board was capable of
making independent decision to assert claim
 P bears burden of showing directors would not be
independent because:
 The board has a material financial, familial, control
or personal interest in transaction
 Board would not exercise BJR: make an informed
decision or choose the terms of the transaction with
due care
 If P succeeds, the court substitutes its judgment for that of
the directors in the conduct of business it should have
chosen if not for fraud or bad faith [Marx v. Akers]
o To establish a claim of Excessive Director Compensation, P must
prove that some wrong resulted to the corporation due to: rates
excessive on their face, unfair compensation rates, lack of good
faith in setting rates, invalid BJR
12
Dodd-Frank Act
 Dodd-frank requires every board to have a compensation committee of independent directors that is
authorized to set compensation for the board and high ranking executives
 Independent Directors do not work for company
 Inside directors do and may be motivated to give executives what they want
 The more independent, the less conflict of interest
 Say on Pay: shareholders’ advisory vote on executive compensation every three years
 However the outcome of vote is binding on board
Limited Liability Companies
 Members typically contribute capital to start the business
o Contribution may be cash, property, services rendered, a promissory note, or other
obligation to contribute cash, property or to perform services
 LLC combines corporate-type limited liability with partnership-type flexibility and tax advantages
o Members have only limited liability: they may lose their capital contributions but their
personal assets will not attach to debt obligations
o LLC generally permits private ordering with substantial freedom of contract to govern
their relationship [Elf Atochem v. Jaffari]
 Partners have broad discretion in drafting partnership agreements
 Policy: Give maximum effects to the freedom of contract and enforceability of the
LLC Agreements
 Member Rights and Obligations
o Profit and loss sharing are based on the value of members’ contributions, similar to
partnership agreements
o Member may withdraw and demand payment of his interest upon giving the notice
specified in the statute or the LLC’s operating agreement
o Absent contrary agreement, each member has equal rights in the management of the LLC
 Most matters decided by majority vote
 Significant matters require unanimous consent
 E.g. merger, admission of new member, dissolution, etc
o Manager-managed LLC option available
o Can be structured as a board of directors, a CEO or both
o Must be specified in articles of organization
 Fiduciary duties
o All members of a member-managed LLC have a duty of care and loyalty
o The managers of a manager-managed LLC have a duty of care and loyalty
 However, members of a manager-managed LLC have no duties to the LLC or other
members by reason of being members
o Ability to Compete
 In corporations, direct competition between directors and company breaches
fiduciary duty
 However, an operating agreement that by its very terms allows members to
compete will be upheld under the private order justification [McConnell v. Hunt
Sports Enterprises]
 However provisions still cannot exculpate duty of good faith or misconduct
such as theft
 Liability of LLC Directors/Members
o Derivative actions allowed
 Member 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
o Principles of Agency apply to third-party liability [Westec v. Lanham]
13
Principal not fully disclosed: Agent liable for contract
Principal partially disclosed: Agent party to the contract
Principal’s existence and identity fully disclosed: Only Principal is a party to the
contract
Equitable doctrine of piercing the corporate veil applies to LLC’s
 If the members and officers of an LLC fail to treat it as a separate entity and cause
harm to third party by reason of his own acts, they are individually liable for the
LLC’s acts that cause damage to third parties [Kaycee and Livestock v. Flahive]



o
The Federal Securities Laws
The Securities Act of 1933
 Concerned with the primary market, where the issuer of securities sells them to investors
 Purpose of Act is to protect investors by promoting full disclosure of the information necessary to
make informed investment decisions
 Meant to protect passive investors that will not be active in managing their investments
 Registration Requirement
o § 5 requires in connection with any public sale of a security:
 (1) Registration statement filed with SEC
 (2) No sale until the registration statement becomes effective
 (3) Prospectus (principal disclosure statement) distributed to investors before a
sale
o §12(a)(1) Imposes strict liability on sellers in violation of § 5
 Main remedy is rescission: buyer can recover price paid plus interest less income
received on the security
o §12(a)(2) imposes civil liability if Plaintiff can prove prima facie case elements of:
 (1) Sale of a security; (2) using instruments of interstate commerce or mail; (3)
through prospectus or oral communication; (4) untrue statement or omission of
material fact; (5) D offered or sold security; (6) and knew or should have known of
untrue statement
 Burden on D to prove that he did not know of the misrepresentation/could
not have known even with the exercise of reasonable care
 No reliance requirement for P
 Broader than § 11 since it applies not only to fraudulent registration
statements but also to material misrepresentations in written or oral
communications
 Liability under this section does not arise in secondary market
transactions or private placements [Gustafon v. Alloyd Co, U.S.]
o Two exemptions to the registration requirement
 Exempt securities, where the buyer is not an issuer, underwriter (someone with a
view to reselling the security), or dealer, do not need to be registered, either when
initially sold or in any subsequent transaction §4(1)
 Exempt transactions, where the issuer is not involving any public offering, are onetime exemptions only §4(2)
 The Private Offering Exemption [SEC Regulation D]
o Issuer cannot widely advertise the security
o Must still provide information essential to investment judgment as
would have been disclosed in a registration statement
o Must file notice of sale with SEC
o Generally exempts only the initial sale
14
Limits on numbers:
 If an issuer raises no more than $1 million through
securities, may sell to unlimited number of buyers
 If it raises no more than $5 million, may sell to no more
than 35 buyers
 Limits on number of buyers do not apply to
accredited investors such as banks, brokers and
other financial institutions/wealthy buyers
o Proving the Affirmative Defense of Exemption [Doran v. Petro
Management Corp.]
 D has burden of proving that the sale was private not public
 Factors for consideration:
 (1) Number of offerees (not purchasers) and their
relationship to each other and issuer
o Most important factor
o The more offerees, more likely public
o Every single offeree must be provided
with sufficient information
o Relationship matters; focus on the
information available (given or effective
access/realistic opportunity) to the offeree
as a result of the relationship
 (2) Number of units offered
 (3) Size of the offering
 (4) Manner of the offering
Disclosure and Fairness Requirements
o Mandates disclosure of material information to investors and the prevention of fraud
o Securities fraud laws are better to sue under than common law fraud
 Procedural advantages
 Easier elements to prove than common law, which requires (1) material
misstatement, (2) scienter (intent), (3) reliance/causation, (4) damages
o § 11 is the principal express cause of action for fraud
 Cannot sue under this in relation to private offering
 Material misrepresentation or omission must be in the registration statement
 Material: matters an average prudent investor ought reasonably to be
informed of before making an intelligent, informed decision on buying the
security; facts which would deter an investor from buying security
 No reliance or causation requirements
 D has burden of proving that misconduct did not cause P’s damages
 D may reduce damages if it can prove that reduction in value was caused
by some other factor e.g. market factors [§11(e)]
 No privity requirement
 P may sue everyone who signed the registration statement, such as issuer,
executive officers, majority of board of directors, every director at the time
registration became effective, every person named in the registration as
someone about to become director, every expert having prepared or
certified any part of the statement and every underwriter involved in the
transaction, regardless of whether they read or understood it before
signing
o § 11(b)(3) Affirmative Defense of Due Diligence (if proven no fraud):
 No person, other than the issuer, shall be liable if he can prove that:
o

15


(A) He is a non-expert who had reasonable ground to believe and did
believe that the statements were true
 (B) He is an expert, who, after reasonable investigation, had reasonable
grounds to believe that there was no need to make the statements not
misleading or that the registration statement did not fairly represent his
statement of valuation as an expert
 (C) As regards to the statements made by other experts, he did not believe
that the statements were untrue or that there was an omission of a
material fact
Reasonableness: the standard is that required of a prudent man in the
management of his own property, more than simply asking questions and
believing the answers you hear without verification
 Even if you fail to detect errors, the question is whether a reasonable effort
was made to that end [Escott v. BarChris Construction]
The Securities Exchange Act of 1934
 Concerned with secondary market transactions in which investors trade securities among
themselves without significant participant by the issuer
o Regulates insider trading, securities fraud, short-swing profits by corporate insiders,
shareholder voting via proxy solicitations, tender offers
 Recognizes that there may be a difference between what is good for the public v. shareholders
 Registered Corporations must file:
o Form 10 (once)
o Form 10-K (annual)
o Form 10-Q (quarterly)
o Form 8-K (episodic)
 Exchange Act § 10 confers powers to SEC to promulgate rules on securities fraud
 SEC Rule 10b-5 is a really broad rule prohibiting fraud, the making of untrue statement or
omission of material fact, in connection with the purchase or sale of securities
o Policy: Justifiable expectation of the securities marketplace that all investors trading on
impersonal exchanges have relatively equal access to material information
o Unclear whether there is a private cause of action
o Protection only applies to actual not potential purchasers and sellers of a corporation’s
securities [Blue Stamps v. Manor Drug Stores, U.S.]
o Materiality Requirement: substantial likelihood that the disclosure of the omitted fact
would have been viewed by the reasonable investor has having significantly altered the
“total mix” of information made available
 Liability for issuance of a false or misleading statement requires proof of scienter –
intent to deceive, manipulate, or defraud. Later opinions also count recklessness as
sufficient. [Ernst v. Hochfelder, U.S.]
 Policy: A fundamental purpose of the securities act was to substitute a
philosophy of full disclosure for the philosophy of caveat emptor (buyer
beware) and thus to achieve a high standard of business ethics in the
securities industry
 Materiality in preliminary merger negotiations [Basic v. Levinson]:
 Materiality depends on balancing (1) indicated probability that the event
will occur and (2) anticipated magnitude of the event in total company
activity
o Facts pointing towards materiality: board resolutions, instructions
to investment bankers, actual negotiation between principals
16

o
Since a merger is one of the most important events that could occur in a
small company’s life, inside information regarding a merger can become
material at an earlier stage than would lesser transactions
Rebuttable Presumption of Reliance
 Reliance is an element of a Rule 10b-5 cause of action
 Fraud-on-the-Market Theory
 Reliance is different in an open and developed securities market than in
face-to-face transactions since the market performs a substantial part of
the valuation process performed by an investor in f-t-f transaction
 Market is the unpaid agent of the investor, informing him that given all the
information available to it, the value of the stock = fair market price
 Therefore, where a materially misleading statement has been disseminated into an
impersonal, well-developed market, D must rebut the presumption by showing
facts that sever the link between the alleged misrepresentation and P’s decision to
purchase [Basic v. Levinson]
 E.g. misrepresentation did not in fact distort the market price, or individual
would have purchased despite knowing the statement was false
 Where the misleading statements were made to a few clients in private rather than
disseminated in the market, the efficient market hypothesis does not apply
because there was no way the securities buyer could have heard of the lies; no
presumption of reliance. [West v. Prudential Securities]
Definition of a Security
 The term “security” includes stock, notes, bonds, evidence of indebtedness, investment contracts,
or, in general, any interest or instrument commonly known as “security,” unless the context
otherwise requires. [§2(a)(1)]
 Litigation often turns on what constitutes “investment contract.” SCOTUS defines it as a contract
or transaction where a person invests his money in a common enterprise and is led to expect
profits solely from the efforts of the promoter or third party
o Requirement of “solely” now loosened
 Policy: Requiring investors to rely wholly on the efforts of others excludes the
protection of the securities laws whenever investors make the slightest efforts
o Look to the economic reality of the investment contract: f the investor is unable to exercise
meaningful control over the investment, it is a security
 In Robinson v. Glynn, Robinson’s interest was not a security but an ordinary
commercial venture since he was an active and knowledgeable executive, not a
passive investor, in the company
 Characteristics typically associated with common stock in company:
 Right to receive dividends contingent on profits; negotiability; voting
rights proportionate to shares owned; capacity to appreciate in value
 Note: The underlying risk and return on stock does not change regardless of the sale of stock price
Insider Trading
 Insiders may not trade by reliance on material, nonpublic information intended for corporate
purposes only and not for the personal benefit of anyone [SEC v. Texas Gulf]
o Insiders include the officers, directors, permanent insiders of a corporation, as well as the
attorneys, accountants, consultants and others who temporarily become fiduciaries of a
corporation [Dirks v. SEC, U.S.]
o Material facts include:
 Any fact which might affect the value of the corporation’s securities
 Facts disclosing earnings and distributions of company
17
Fact that affect the desire of investors to buy, sell, or hold securities
 If those who knew the information trade on it, it compels the inference that
other investors would be influenced by the information too
o Insider has duty to disclose information or abstain from trading or recommending
securities concerned while information is undisclosed [SEC v. Texas Gulf]
 However the insider is not always foreclosed from investing in his own company,
the duty to disclose or abstain rises only in those situations where disclosure is
reasonably certain to have a substantial effect on the market price of the security
 Reasonableness standard
 Insider will always know a bit more than the outsider because of implicit
knowledge in the strengths, weaknesses and operations of the business
 Reiterating the point that insider duties only attach to material information
o Once information is disclosed, insiders should wait until the news could reasonably
circulate widely [SEC v. Texas Gulf]
o Policy:
 Insider-trading benefits are a form of secret corporate compensation derived at
the expense of the uninformed investing public and not at the expense of the
corporation, which receives the sole benefit from insider incentives
 All investors should have equal access to the risks and rewards of participating in
securities transactions
Classical Theory
o Liability under §10(b) and Rule 10b-5 when corporate insider trades in the securities of
his corporation on the basis of material, nonpublic information
 Deceptive device since a relationship of trust and confidence exists between the
shareholders of a corporation and those insiders who obtained the confidential
information in their capacities as corporate officers [Chiarella v. United States, U.S.]
 There is a manipulation or deception element of breaches of fiduciary duty in
connection with a securities transaction [Dirks v. SEC]
 The manipulation 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
Tipper/Tippee Liability
o A tippee assumes fiduciary duty to the shareholders of a corporation not to trade on
material nonpublic information when the tippee knows or should know that the insider
has breached his fiduciary duty to the shareholders by disclosing to tippee [Dirks v. SEC]
o Test is whether the insider will benefit, directly or indirectly, from his disclosure
 Absent some personal gain, there has been no breach of duty to stockholders
 Absent breach by the insider, there is no derivative breach by the tippee
 In SEC v. Switzer, the eavesdropper trading on inside information was not guilty of
insider trading because the director whom he overheard did not personally benefit
from passing along this information
Piggyback trading
o Not on the basis of information but on following someone else’s trades
o Would most likely liable only if piggy backer knew that the other person was trading on
insider information
Misappropriation Theory
o Person violates §10(b) and Rule 10b-5 when he misappropriates confidential information
for securities trading purpose in breach of a duty owed to the source of the information
 Liability of corporate outsider premised on the deception of those who entrusted
him with the information [United States v. O’Hagan]
 If the trader discloses to the source that he plans to trade on the nonpublic
info, there is no deceptive device and thus no violation





18
In practice, you wouldn’t disclose because you are still breaching a
fiduciary duty to the discloser
Policy: protects the integrity of the securities markets against abuses by
outsiders who have access to confidential information that will affect the
securities price when revealed but who owe no fiduciary or other duty to
that corporation’s shareholders
o

Control Issues among Shareholders
 Short-Swing Prohibition: The Exchange Act states that when a 10% owner, director, or officer
gains profit or avoids loss in connection with the sale of a security, the issuer can recover that
profit within six months [§ 16(b)]
o Purchase of stock falls under this when the purchaser becomes 10% by virtue of the
purchase; likewise, when someone becomes less than a 10% owner by virtue of sale, 16(b)
no longer applies [Reliance Electric v. Emerson Electric]
 Shareholder Democracy/Proxy Fights:
o Shareholders have a right to vote on corporate matters or may appoint an agent to vote on
their behalf
 Agent is the proxy-holder, the document which appoints the agent
 The incumbent managers of a large firm will solicit proxies from shareholders
directly by asking them to sign and return the proxy card authorizing the
management representative to vote on their behalf
 It is lawful for present management to utilize corporate funds to solicit
proxies from shareholders [Levin v. MGM] when informing stockholders of
management’s views on policy questions related to reelection [Cheff v.
Mathes]
o Policy: The right of an independent stockholder to be fully
informed before making the decision on the continuation of
present management is of supreme importance
 It is unlawful to use corporate funds to advance the selfish desires of
directors to perpetuate themselves in office [Cheff v. Mathes]
o Shareholder Proposals: If any security holder notifies the issuer of his intention to
present a proposal for action at the next meeting, issuer must set forth the proposal in its
proxy statement and allow the security holder to present a 500-word statement in
support of the proposal in the proxy [SEC Rule]
 Exception: Issuer may omit a proposal if the proposal:
 Relates to less than 5% of the issuer’s total assets or net earnings and gross
sales at the end of its most recent fiscal year
 Is not otherwise significantly related to the issuer’s business
o Moral, social and ethical questions can be included in the proposal
mechanism even if it doesn’t narrowly relate to the profitability
and operations of the company [Lovenheim v. Iroquois Brands]
o Shareholder Inspection of Corporate Records: A shareholder has the right to inspect
business records upon written demand if the shareholder can state a proper purpose
reasonably related to such person’s interest as a stockholder [Del. § 220]
 Policy: Inspecting a corporation’s shareholder ledger and business records is
merely the act of a concerned owner checking on what is in part his property
 The statute must be liberally construed in favor of the stockholder since
his welfare as a stockholder or the corporation’s welfare may be affected
[Crane v. Anaconda]
 A qualified stockholder may inspect the corporation’s stock register to
directly inform other shareholders on its exchange offer and soliciting
tenders of stock [Crane v. Anaconda]
19

o
A stockholder who buys stock for the sole purpose of using shareholder
democracy to impress his social opinions upon management does not
prove that this is a proper purpose germane to his economic interests as a
shareholder [Pillsbury v. Honeywell]
Shareholder Agreements: When the directors are the sole stockholders, they may limit
their respective rights and powers by agreement even where there is a conflicting
statutory standard, in this case the selection of officers [Clark v. Dodge]
 Policy:
 If the enforcement of a contract damages no one, there is no reason to hold
it unlawful even though it slightly impinges upon a broad statutory
provision stating that the directors of a corporation must manage the
corporation
 Shareholder-Director agreements that technically violate statutes are still
upheld in light of circumstances such as [Galler v. Galler]
o No apparent public injury
o Absence of complaining minority interest
o No apparent prejudice to creditors
o No fraud
o No clearly prohibitory statutory language
 Policy in the context of close corporations: The agreement is the result of
careful deliberation by all initial investors in order to protect those financially
interested in the close corporation [Galler v. Galler]
 Different from a large corporate setting where stockholders’ agreement is
not consciously agreed to by the investors; there, investors have no voice
in the formulation and very few ever read the certificate of incorporation
Control in Closely Held Firms
 In a close corporation, only a few people or families hold stock and the stock is rarely bought or
sold. Shareholders in a close corporation are often also the directors and officers thereof. [Galler v.
Galler]
o A stockholder who bargains for stock in a close corporation can contract and bargain into
his minority position using business judgment [Nixon v. Blackwell]
o A minority shareholder in a close corporation who contractually agrees to the corporation
repurchasing his shares upon at-will termination is an at-will employee, only with the
rights and duties of stockholders, not partners [Ingle v. Glamore Motor Sales]
 Policy: Certainty, predictability and reliability
 Stockholders in close corporations owe each other substantially the same fiduciary duty that
partners owe to one another – one of utmost good faith and loyalty [Wilkes v. Springside]
o Freeze-Outs:
 When a majority freezes out a minority shareholder:
 Majority must articulate a legitimate business purpose
 Minority is entitled to some value since majority has frustrated his purpose
in entering the corporate venture, denying him return on investment
[Wilkes]
 Policy: A guarantee of employment with the corporation is one of the basic
reasons why a minority owner invests capital in a close corporation
 A person such as a lawyer who knowingly aids another in the breach of a fiduciary
duty aided and abetted a tort and is liable for the losses suffered by the harmed
[Granewich v. Harding]
The Transfer of Control
20

Right of First Refusal: Contractual right that gives the option to enter a business transaction
before the owner can enter into the same transaction with a third party
o Should be interpreted narrowly
 In Frandsen, when First Wisconsin acquired J-S, Frandsen did not have the right of
first refusal because First Wisconsin was not interested in becoming a shareholder
of J-S, and the shares of J-S were not bought but extinguished
o Enforceable only if the contract confers it

Sale of Controlling Shares:
o It is illegal to sell corporate office or management control by itself [Del. § 141]
 However it is lawful to give and receive payment for the immediate transfer of
management control to one who achieved majority share control, even if he cannot
convert that into operating control for some time [Essex Universal v. Yates]
o A controlling stockholder may sell his controlling interest at a premium price as long as he
acts in good faith
 Policy: Control shares can have a premium price because the investor is paying
extra for the privilege of directly influencing the corporation’s affairs [Zetlin v.
Hanson Holdings]
o When the sale of a controlling premium results in a sacrifice of corporate good will and
consequent unusually large premium to the fiduciary, he may not appropriate himself the
value of the premium and must account for the corporation [Perlman v. Feldman]
Mergers and Acquisitions
 Conventional Statutory Merger
o Boards and shareholders of both companies must approve the merger
o Lawyers create the new company, usually named after the larger company
o Both companies convey all of its assets to the new company in exchange for stock in the
new company, which goes to the shareholders of the old companies
 Bigger company with more assets will have dominant stock in company
o Old companies dissolve
o Shareholders who did not want to be a part o the new company are entitled to turn in
their shares for cash and receive the appraisal value for stock
 The De Facto Merger Doctrine - Overturned
o A merger takes place when the sale of corporate assets (no shareholder rights) have the
effect of a merger (statutory shareholder rights)
 Look to the “reorganization” document to see if the transaction so fundamentally
changes the corporate character of the smaller company that its shareholder in
reality is forced to give up stock in the smaller company and accept shares in
another [Farris v. Glen Alden Corp.]
 Shareholders should be notified as if merger and should be advised of their
statutory rights of dissent and appraisal
 Policy: Unacceptable since the shareholder would be projected against his will
into a new enterprise under terms not of his own choosing
o However the legislature overturns Farris and the De Facto Merger doctrine
 The reorganization accomplished through § 271 and a mandatory plan of
dissolution and distribution is legal because the sale-of-assets statute and the
merger statute are independent of each other [Hariton v. Arco, Del.]
 New Policy: The Transfer of Control is desirable
 The Practical Merger
o List offers its shares or cash to the individual shareholders of Glen Alden in return for
their Glen Alden shares
21
Transaction is with individual shareholders, requiring no votes of Glen Alden
directors or shareholders
 No appraisal rights for other shareholders
o Once List has enough shares to gain control (usually 90%), List uses a special procedure
called Short-Form Merger to merge Glen Alden into List
The Cash Out Merger
o Old Acme and Blue Building create a new company called New Acme
o Both companies convey all their assets to New Acme. As consideration, New Acme gives:
 Cash payment to Blue Building
 All of its stock to Old Acme
o New Acme ends up with assets of Blue Building but all the shareholders from BB have
been cashed out; new company consists entirely of Old Acme shareholders
The Freeze-Out Merger
o A concerning twist to the cash out merger
 Difference is dealing between two companies v. one company and minority
stockholders
o Existing Company Pyramid owns 60% of Acme, minority shareholders own 40%
o Pyramid holds a vote in Acme to merge Pyramid and Acme into PyrAcme
 Will obviously win majority vote since it owns 60%
o Pyramid and Acme convey all assets to PyrAcme. As consideration, PyrAcme gives:
 Cash payment to minority shareholders
 All of its stock to Pyramid
o Considered legal as long as the minority shareholders receive a fair price
 Challenging the merger:
 Burden-Shifting
 P must allege specific acts of fraud, misrepresentation or other misconduct
to demonstrate unfairness of the merger terms to the minority
 Majority shareholder must show by preponderance of the evidence that
the transaction was fair
 If the corporate action was approved by an informed vote of majority of
the minority shareholders:
o Burden shifts to P to show that transaction was unfair
o However those relying on the vote carries the burden of proving
disclosure of all relevant material facts
 Fairness has two aspects, fair dealing and fair price, to be looked at as a whole
[Weinberger v. UOP]
 Fair Dealing: timing of transaction, who initiated, structured, negotiated,
disclosed to the directors, how the approvals of the directors and the
stockholders were obtained
o Whether defendants disclosed all information in their possession
germane (that a reasonable stockholder would consider important)
to the transaction
 Fair Price: economic considerations of all relevant factors such as assets,
market value, earnings, future prospects and any other elements that affect
the inherent value of a company’s stock



Takeovers
 Stock Options
o Call Option: right to buy at a certain price on a specified day
 $1 for an option to buy Acme from you at $20 on or before April 10
 On April 10 if Acme is $30, exercise option
 On April 10, if Acme is $15, do not exercise option
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 Want to own if you believe stock will increase in value over long term
Put Option: right to sell sock at a specified price on or before a specified day
 $1 for the right to sell you Acme at $20 on or before April 10
 On April 10 if Acme is $15, put it
 On April 10 if acme is $25, then put is useless
 Want to own if you believe stock will decrease in value
o Short-sale
 Pay $1 to borrow Acme today (trading at $20) return it to you on April 10
 Sell acme today, pocket the $20
 Hope that Acme is $15 on April 10
 Hope that Acme is not $25 of April 10
Tender Offers: A public, open offer by a prospective acquirer made directly to all stockholders
tender their stock for sale at a specified price during a specified time, subject to the tendering of a
minimum and maximum number of shares
o Unlawful to engage in fraudulent, deceptive, or manipulative acts in connection with any
tender offer. SEC will prescribe means reasonably designed to prevent such acts and
practices. [§ 14(e) of Exchange Act]
o Liability for fraud in connection with a tender offer under SEC Rule 14e-3(a) if:
 Someone takes substantial step to commence a tender offer
 D has insider info and knows that the information comes from (a) the tender
offeror, (b) the issuer of securities, or (c) an agent of either and engages in a
transaction related to the tender offer without public disclosure
 Must wait a reasonable time after disclosure to engage in trading
o A corporation may purchase and sell shares of its own stock [Del. § 160 (a)]
 If the Board buys out a dissident stockholder in good faith to maintain proper
business practices, board will not be held liable [Cheff v. Mathes]
 Board may self-tender for its own shares excluding the participation of a
stockholder making a hostile two-tier tender [Unocal v. Mesa]
 Duty of care extends to protecting the corporation and shareholders
whether the threat originates from third parties or other shareholders
 Heightened Scrutiny of BJR in the context of Control Issues:
 Board will not be penalized for an honest mistake of judgment if it
appeared reasonable at the time decision was made [Cheff v. Mathes]
 However there is an enhanced duty upon the board due to the potential
conflict of interest since they will stay in office [Unocal]
o Requirements to satisfy Unocal Duty:
 Directors have burden of proof
 Good faith investigation
 Leading to reasonable grounds for believing danger
to corporate policy and effectiveness
 No dominant motive of self entrenchment or interest
 Proportionality: Decision must be reasonable in relation
to threat posed [Unocal]
o Helps if board is comprised of independent directors
 After Unocal, SEC amends rules to prohibit issuer tender offers unless they’re
made to all shareholders - This particular defense from Unocal is now outlawed
o Lock-up provision is an option granted to a buyer of a corporation’s stock as a prelude to a
takeover; the major or controlling shareholder is effectively “locked up” and may not sell
its stock to anyone else without paying an agreed upon “option” $ to the buyer
 Permitted when there is no director interest or other breaches of fiduciary duty
 Policy: Lock-ups entice other bidders to enter a contest for control,
creating an auction and maximizing shareholder profit since the rest of the
o

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o
market now finds out the value of the company from all the work and
money the buyer put into it, and just needs to bid $1 higher and creating an
auction and maximizing shareholder profit
 Poison Pills: Shareholders receive the right to be bought out by the corporation for
a substantial premium on the occurrence of a specified triggering event
 The Poison Pill from Revlon is a pill that the directors distribute a right to
all the shareholders; the right allows the shareholders to exchange their
share for a debt instrument with a high value requiring the firm to pay
them a high figure by a specified date. Since it will be difficult for the firm
to pay those off, they promise to use assets in a certain way
 Purpose of the pill: threaten to burden the corporation with a heavy debt
to repel buyers
o You hope you never have to swallow the pill; you threaten to burn
the company down
 Concern for various corporate constituents are proper when addressing a
takeover threat, as long as it is rationally related to the benefit accruing to
stockholders; No longer proper once the company is no longer a going concern
[Revlon v. MacAndrews]
 Just rearticulating the rule from Unocal/Ford
Revlon Duty: Once the company is for sale, the duty of the board changes from defenders
of the corporate entity to the maximization of the company’s sale value for the benefit of
the shareholders [Revlon v. MacAndrews]
 Two situations implicate Revlon duties [Paramount v. Time]
 When a corporation initiates an active bidding process seeking to sell or
reorganize itself, involving a clear break up of the company
 When a corporation abandons its long-term strategy seeking to break up
the company in response to a bidder’s offer
 *Focus on whether or not the shareholders will be sticking around:
o If there is no tomorrow for the shareholders and they are just being
cashed out, the only question left for them is the price
o If there is a tomorrow for the shareholders, the continuing viability
of the business plan is relevant
 If board’s reaction is a defensive response and not an abandonment of the
corporation’s continued existence, Revlon duties are not triggered although Unocal
duties attach [Paramount v. Time]
 Directors are not obligated to abandon long-term plans for short-term
shareholder profit unless there is clearly no basis to sustain the corporate
strategy
 There are no legally prescribed steps that directors must follow to satisfy their
Revlon duties [Lyondell v. Ryan]
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