I. NATURE OF BUSINESS ORGANIZATIONS.................................................................................................... 8

II. PARTNERSHIP................................................................................................................................................. 13

III. ALTERNATIVE FORMS OF BUSINESS ORGANIZATIONS....................................................................20

IV. CORPORATE FORM....................................................................................................................................... 24

V. CORPORATE STRUCTURE............................................................................................................................ 30

VI. SHAREHOLDER’S RIGHTS........................................................................................................................... 41

VII. CLOSE CORPORATIONS.............................................................................................................................. 49

VIII. DUTY OF CARE............................................................................................................................................ 60

IX. DUTY OF LOYALTY........................................................................................................................................ 65

X. INSIDER TRADING.......................................................................................................................................... 71

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I. NATURE OF BUSINESS ORGANIZATIONSa. Business Organizations :

i. Sole Proprietorship - a business organization that is owned by a single individual, and is not cast in a special legal form of organization, such as a C, that can be utilized only by filing an organic document with the state pursuant to an authorizing statute

1. Has no separate identity from its owner2. Individual who owns SP has unlimited personal liability for obligations incurred in the conduct

of the business3. May hire employees, keep records, take out loans, etc.; but keep business aspect separate from

personal propertyii. Corporation - a type of legal institution that defines legal relationships between people; it is a

method of organizing business; it is a legally recognized fiction.1. Public (open) – a corporation that is listed on a stock exchange or “over the counter market”

(computerized trading system; means they are publicly held by individual owners, SH, and publicly traded)

2. Close corporation (private) – not listed on an exchange and privately held3. Members of a Corporation:

a. Board Members – oversee the corporationb. Shareholders – are the owners of the corporationc. Bondholders – are people that lend money to the corporationd. Managers – run the corporatione. Hedge Funds – large bodies of privately held capital

iii. General Partnership – any association of two or more people who carry on a business as co-owners; can be established by operation of law w/ no formal papers filed; any partnership is general unless comply with special requirements for limited partnerships

iv. Limited Partnership – can only be created where:1. there is a written agreement among the partners, and2. a formal document is filed with state officials

v. Limited Liability Companies – is neither a corporation or a partnership, but incorporates a little of each

b. Corporations Theories: i. Entity Theory: a corporation may be viewed as an artificial entity used to conduct a business. The

entity can conduct business in its own name (pays taxes, sue, buy land). This entity is formed by a grant of authority by the state. This is done by a document called a certificate of incorporation. Individuals and the state know this corporation as a separate entity. Real people actually conduct the business; these are the corporation’s agents.

ii. Concession Theory: because a corporation is a grant or concession of the state, and therefore the state can impose restriction on corporate behavior. Today this really does not exist because the state has no control over the corporation, no decision making power.

iii. Contract Theory: the charter/certificate of incorporation represents a contract between the state and the corporation or the corporation and the shareholders or a contract between the SH’s of the corporation. This contract theory emerges today in disputes between different classes of shareholders.

iv. The Nexus of Contract Theory: this theory rejects the notion that shareholders are ultimate owners of corps, but rather it views SHs as investors of capital that get periodic returns. A nexus of Ks that come together. Under this theory the corp is not an entity, it is a group of individuals that work together for a goal. The proponents of this theory do not believe in corp regulation because it is just

v. *NOTE - State vs. Federal Law: Traditionally corporations regulated by states; since Depression federal gov’t started to regulate, including issuance & trading of securities.

c. Agency and Authority : If there is authority, the agent has the power to bind the principal to an agreement with a third party.

i. Agency - is the fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests asset or otherwise consents so to act (RS 3rd § 1.01)

1. Elements for an agency relationship:a. Manifestation by the principal that the agent shall act for himb. Agents acceptance of the undertakingc. Understanding of the parties that the principal is to be in control of the undertaking

2. Although agency is a consensual relationship, how parties label any given relationship is not dispositive

ii. Agency Law – this area of law governs:

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1. The relationship between agents and principals2. The relationship between agents and third persons with whom an agent deals, or purports to

deal, on a principal’s behalf3. The relationship between principals and third persons when an agent deals, or purports to deal,

with a third person on the principal’s behalfiii. Agent – Person who by mutual assent acts on behalf and subject to the control of another, the

principal 1. General Agent – an agent who is authorized to conduct a series of transactions involving

continuity of service2. Special Agent – an agent who is authorized to conduct only a single transaction, or only a

series of transactions not involving continuity of serviceiv. Principal – person on whose behalf and subject to whose control an agent acts

1. Disclosed Principal – when an agent and third party interact, and the third party has notice that the agent is acting for a principal and has notice of principal’s identity

2. Partially Disclosed Principal – (or unidentified) when an agent and third party interact, and the third party has notice that the agent is acting for a principal but doesn’t have notice of the principal’s identity (cases split whether principal is liable in this situation)

3. Undisclosed Principal – when agent and third party interact, and third party has not notice that agent is acting for a principal

v. Jensen Farms v. Cargill – 1. P – When a creditor maintains de facto control, the creditor relationship becomes an

agency relationship. Case ex. of how A can be found if P exercises de facto control.2. F – W operated grain elevator and sold grain; C buys grain from W and sells to other

companies; C acts like a bank to W and is given right of first refusal; W owes $2 million to farmers, which means C is jointly liable with Warren and farmers can sue C directly.

3. H – C is liable b/c he manifested consent of agency relationship by directing W to implement his recommendations. *Key – factor was C’s (creditors) ability to control W (debtor). Factors to look at:

a. Nature of businessb. Purpose of relationshipc. Amount of financing, andd. Control of the parties

d. Liability : i. Vicarious Liability of Principal – RS 3d § 7.07(1), (2)

1. An employer is subject to vicarious liability for a tort committed by its employee acting within the scope of employment

2. An employee acts within scope of employment when performing work assigned by the employer or engaging in a course of conduct subject to the employer’s control. An employee’s act is not within the scope of employment when it occurs within an independent course of conduct not intended by the employee to serve any purpose of the employer.

3. RS 2nd (master (p) / servant (a)); RS 3rd (employer (p) / employee (a))ii. Liability of Principal to 3rd Person – a Principal becomes liable to a third person as a result of an act

or transaction by an agent on the principal’s behalf, if the agent had the actual, apparent, or inherent authority to act on the principal’s behalf in the way that he did, or was an agent by estoppel, or if the principal ratified the act or transaction

1. Actual Authority – A has actual authority to act on behalf of P if P’s words or conduct would lead a reasonable person in A’s position to believe that P wishes A so to act.

a. Express / Real – P directs A to perform some actb. Implied – including incidental authority, which is authority to do incidental acts that

are reasonably necessary to accomplish an authorized transaction or that usually accompany that type of work

2. Apparent Authority – if manifestations of P to T would lead a reasonable person in T’s position to believe that the principal had authorized the agent to so act.

a. Power of Position – type of apparent authority that is created by appointing a person to a position (ex. manager) that is generally recognized as having certain duties or authority

3. Agency by Estoppel – person who has not made a manifestation that an actor has authority as A and who is not otherwise liable as a party to a transaction purportedly done by the actor on that person’s account is liable to T who is induced to make a detrimental change in position b/c the transcription is believed to be on the person’s account if

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a. 1 – the person intentionally or carelessly caused such belief, orb. 2 – having notice of such a belief and that it might induce others to change their

positions, the person did not take reasonable steps to notify them of the factsc. *This is very similar to apparent authority

4. Inherent Authority – derives solely from agency relationship and exists for the protection of persons harmed by or dealing with an A; ex. A may bind P in certain cases even when A had neither actual nor apparent authority.

5. Ratification – even if A had neither actual, apparent, or inherent authority, P will be bound to T if A purported to act on P’s behalf, and P, with knowledge of material facts, either:

a. (1) affirms A’s conduct by manifesting an intention to treat A’s conduct as authorized, or

i. Manifesting an intention or Express ratificationb. (2) engages in conduct that is justifiable only if he has such an intention

i. Engaging in conduct or Implied ratificationc. *Ratification doesn’t need to be communicated to T to be effective, it only needs to

be objectively manifested

6. Acquiescence – if A performs a series of acts of a similar nature, the failure of P to object to them is an indication that he consents to the performance of similar acts in the future under similar conditions

7. Termination of Agent’s Authority – G/R P has the power to terminate A’s authority at any time, even if doing so violates a contract between P and A, and even if it had been agreed that A’s authority was irrevocable.

a. Even thought P can terminate A’s authority, A can still sue P for damages for wrongful termination or breach of contract.

iii. Liability of 3rd Person to Principal:1. G/R – if A and T enter into a contract, and A’s principal is liable to T under the contract, then

T is liable to P.2. Exception – T is not liable to an undisclosed principal if A or P knew that T would not have

dealt w/ P if he had known P’s identityiv. Liability of Agent to 3rd Person – where A has entered into a contract with T on P’s behalf, A’s

liability to T depends on whether P is bound under the contract1. Where principal is bound – where A has actual, apparent, or inherent authority, so that P is

bound to T, A’s liability to T depends on whether P was:a. Disclosed Principal – A is not bound to Tb. Undisclosed Principal – A is bound even though P is also bound

i. Majority rule – if T obtains a judgment against either P or A, the other party is dismissed

ii. Minority rule - neither A or P are discharged by T’s judgment against the other

c. Partially Disclosed Principal – A and P are bound to T2. Where principal is not bound – A is liable to T

v. Liability of Agent to Principal – If A takes an action that he has no actual authority to perform but P is still liable b/c A had apparent authority, A is liable to P for any resulting damages to P

1. Liability not clear for when A acts with inherent authority and binds Pvi. Liability of Principal to Agent – If A acts with actual authority, P is under a duty to indemnify A for

payments A made that were authorized or made necessary in executing P’s business. This includes:1. Authorized payments made by A on P’s behalf;2. Payments made by A to T under contracts which A was authorized to make himself liable (P

partially or undisclosed);3. Payments of damages to T that A incurs b/c of an authorized act that constituted a breach of

contract for which A was liable to T; 4. Expenses in defending actions brought against A by T b/c of A’s authorized conduct

vii. Morris Oil v. Rainbow Oilfield Trucking

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1. New Mexico oil delivery case Rainbow (agent) entered into a contract with Morris (no idea Dawn existed) w/o the authority of Dawn = creation of an undisclosed agency, court finds liability – when an undisclosed principal entrusts an agent, the undisclosed principal is bound to agreements made by the agent w/third party, even when agreements are outside the scope of business.

2. Where the undisclosed principal retains the benefit or proceeds of agreements reached by an agent, with knowledge of material fact, it ratifies the agreement made by agent.

3. Dawn could have protected itself by ensuring that Morris knew of Rainbow’s lack of authority.e. Agent’s Duty of Loyalty :

i. RS Agency § 8: Duties of A and P to Each Other1. § 8.01 – General Fiduciary Principle2. § 8.02 – Material Benefit Arising Out of Position3. § 8.03 – Acting as or on Behalf of an Adverse Party4. § 8.04 – Competition5. § 8.05 – Use of Principal’s Property; Use of Confidential Information

ii. Tarnowski v. Resop – 1. P - A has utmost duty of loyalty and if he has been disloyal he must turn over all profits

to P; Agents are fiduciaries and are required to act unselfishly; person is obligated to renounce any personal furtherance or interest.

2. F – P hired D as his agent to investigate and negotiate for the purchase of coin-operated music machines. Agent took commissions from seller and made misrepresentations to principal (buyer).

3. L - All profits made by an agent in the course of an agency belong to the principle, whether they are legit or not. Principal can squeeze all profits out of the transaction even if he suffered no loss (attorney fees consequence of misrepresentation).

4. H - If an agent has received a benefit as a result of violating his duty of loyalty, the principle is entitled to recover from him what he has so received and also the amount of damage thereby caused. The right to recover profits made by the agent in the course of the agency is not affected by the fact that the principle, upon discovering a fraud, has rescinded contract and recovers his $.

iii. Redding v. Attorney General1. General, asked to assist in running of whisky, by riding in his army uniform in the truck,

assuring that the truck would not be hijacked or inspected. Redding received 20,000 pounds. 2. British gov’t received these funds on the grounds that the money was paid to Redding as they

were paid while he was falsely representing the government during military duties. 3. Court – if a servant takes advantage of position that he enjoys, or opportunities that it

provides, agent is responsible to the principal for benefits gained. 4. Even through action was a criminal act, the British army had the right to take his profits.

iv. Tarnoski – tells us that agents are fiduciaries1. Few agencies have the power such as the fiduciary obligation. 2. Obliged to act unselfishly3. Has to act for another, provide skill.4. Black letter – fiduciaries are to avoid self interest5. Duties vary in different context (as does justification for imposing limitiation)6. Is a person who undertakes to act in the interest of another person.

7. Many fiduciary norms are very general. Also many beneficiaries as principals are liable to misconduct to fiduciaries.

8. Courts have a difficulty in applying these norms. f. Introduction to Financial Statements :

i. Fundamental Equation: Assets = Liabilities + Owner’s Equityii. Double-Entry Bookkeeping:

1. Any transaction firm enters into, is going to be entered in two places (assets and liabilities)2. Basis for this is the fundamental equation

iii. Balance Sheet – left side of sheet must always equal right side of sheet1. Doesn’t necessarily reflect real or market values; usually just reflect book value (original cost

of asset – depreciation)2. Depreciation – determined by a formula, such as straight line depreciation where item

decreases 5% from cost for each year in existence3. Debits – left side entry4. Credits – right side entry

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iv. Assets & Liabilities:1. Assets – are resources that are based on past transactions

a. They are listed in the order they can be turned into cashb. Listed at the cost to obtain them, rather then present valuec. When lists assets also lists their sources (balance sheet)

2. Liabilities – debts and obligations owed by the companya. They are the reverse of assets b/c they are claims on firm’s resourcesb. Current liabilities, listed in order they are due – must be reduced to cash w/in a yearc. Long Term Liabilities

v. Net Worth = Assets – Liabilities1. Net worth is the owner’s interest in the enterprise after recognizing the interest of the creditors2. Owner’s Interest includes:

a. Capital paid into the company – original stake in the business; money originally invested in company

b. Accumulated profits or retained earnings – Companies distribute their profits in form of dividends, but some money is kept in treasury to be used by company

vi. Income Statement – a statement for a period of time, giving a summary of earnings between balance sheet dates

1. Also known as Earnings report or Profit and Loss sheet2. The income statement matches the amount received from selling goods vs. costs to operate

company, the result is profit or loss for the year; Any profit rolls over into Retained earnings – any dividends paid out

3. Revenues = Revenues Realized – Expenses Incurred4. *Note – a balance sheet speaks as of a particular date, an income statement covers a period of

time between successive balance sheets5. To figure out financial health of a firm look at 2 to 10 years of income statements

vii. Agency Costs – the sum of:1. Monitoring expenditures by the principal2. Bonding expenditures by Agent3. Residual Loss – dollar equivalent of the reduction in welfare experienced by the principal due

to this divergence

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II. PARTNERSHIPa. Partnership Formation :

i. UPA § 6 – Partnership Definedii. UPA § 7 – Rules for Determining the Existence of a Partnership

iii. General Partnership – any association of 2 or more people who carry on a business as co-owners; can be established by operation of law w/ no formal papers filed;

1. Any partnership is general unless comply with special requirements for limited partnerships2. PN are default relationship3. Businesses must be For-Profit4. Two types of Partnerships:

a. At-Will – ended by the express will of the partners or a specific event; don’t have to give a reason for dissolution

b. For a Term – if dissolve prior to ending of term, can be subject to damagesiv. Limited Partnership –

1. Can only be created where:a. There is a written agreement among the partners, andb. A formal document is filed with state officials

2. Two types of partners:a. One or more “general” partners, who are EACH liable for all the debts of the

partnershipb. One or more “limited” partners, who are NOT liable for the debts of the PN beyond

the amount they have contributedv. Limited Liability Partnership – the liability of partners in a PN depends on whether the PN is

“general” or “limited”1. General – all partners are individually liable for the obligations of the PN2. Limited – general partners are personally liable but limited partners are liable only up to

amount of their capital contribution; but a limited partner will lose this limit on liability if he actively participates in the management of the PN

vi. Formalities:1. General Partnerships – can be organized with no formalities and no filing; whether there is a

PN depends on factual characteristics of relationship between people, not whether they think of themselves as having a PN

2. C, LP, LLP, and LLC – all require certain formalities to be complied with and a filing made with the state

vii. Basic Partnership Law Norms: UPA provides default rules to govern situations PN agreement fails to cover, but allows owners to contract for different rules; these are basic rules absent a contrary agreement (*UPA is law in NY)

1. Internal Governance –a. All partners have equal rights in management and conduct of PN b. Differences among the partners as to ordinary matters connected with the PN are

determined by a majority of the partners, but matters that are outside the scope of the PN, or that would be in conflict with the PN agreement, require unanimous approval

2. Authority – any partner has power to bind PN on a matter in the ordinary course of business; even if partner lacks actual authority under PN agreement, so long as T didn’t know that P lacked actual authority

3. Distributive Shares – PN profits are shared per capita, and no partner is entitled to a salary4. Transferability – no person can become a member of a PN w/o consent of all the partners5. Term – PN are normally created for a limited term – frequently a relatively short term – and

dissolution is easy; a. If PN is not for a specified term (express or implied) any partner may cause

dissolution at any time; b. If PN is for a specified term, dissolution occurs at tend of term

6. Fiduciary Duties – Partners stand in a fiduciary relationship to each other7. Liability – Partners in general PN are individually liable for PN’s obligations

viii. Rules for Determining whether a Partnership:1. Facts and Circumstances Test – to determine whether there was intent to do business as co-

owners for profita. Who makes management decisions – Joint managementb. Intent of Parties – Did they intend a PNc. How did parties hold themselves out to each otherd. Amount of services contributed by each party

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e. Is there the existence of another motive, other than PN, to explain the transactionf. Capital contributionsg. Profit Sharingh. Is there any intent to evade a regulation or tax statutei. Is there any purpose to avoid tort liability

2. PN can be express or implied - Doesn’t matter if parties expressly agree to a PN or whether they specifically deny a PN – facts determine relationship

a. *Note – in a close case, court will respect the agreement / intention of the parties if the agreement / intention is clear

3. Need to distinguish between creditor making loan and lender entering PNix. The 4 Element Test – (departs from UPA § 6 statutory test)

1. An agreement to share profits2. An agreement to share losses3. A mutual right of control or management of the business4. A community of interest in the venture

x. Martin v. Peyton –1. F – Lenders investing in a near bankrupt PN were granted profit sharing and some

management rights until they were repaired. When PN defaulted on debts, a creditor sued the lenders, contending their rights made them partners and personally liable for PN debts.

2. H – Creditor/Debtor relationship, NOT a PN; helped bail out co, a loan; they had negative controls to protect their securities, not affirmative decision making authority or ability to initiate a transaction or bind co.

3. R – Even PN creditors who are granted a share of profits and some management control are not necessarily deemed partners if other factors indicate contrary intent.

i. In a close case, courts will respect parties’ intentions, in cases where relationship is clear. ii. Also – look at what are the motives of the parties in favor of or opposed to the

relationship. iii. Is there an attempt to evade or benefit from some statute?

xi. Lupien v. Malsbenden –1. F – A business defaults on a customer’s order, the customer sues its financier, contending

financier managed business himself, thus became a partner.2. I – Is a business creditor involved in managing the business liable as PN?3. H – Yes; did more than a loan, no set payments to repair $, affirmatively involved in decision

making, pooled resources together (capital & auto skills).4. R – A creditor who actively manages its borrower’s business may be liable as the

borrower’s partner; was joint management and profit sharing.5. People can become partners even when facts show that they have no intention of doing

so, intent is not enough. b. Legal Nature of a Partnership :

i. UPA § 6 – Partnership Definedii. Entity v. Aggregate – common law PN was not an entity, but merely an aggregate of its members;

more like a friendship1. PN as an entity means that it can sue, be sued, hold property, etc.; there isn’t much difference

regarding liabilityiii. UPA – defines PN as an association of 2 or more persons to carry on as co-owners a business for

profit; applies a hybrid approachiv. Other Statutes – issues arise as to whether states that adopt UPA, but have other statutes, should

treat PN as an entity or in aggregate; most define as an entityv. RUPA – confers entity status on PN

c. Ongoing Operation of Partnerships :i. UPA § 18 – Rules Determining Rights and Duties of Partners

1. PN Agreement - very important b/c you can draft away most UPA provisions2. Disputes – If partner has dispute against one another can file suit for an accounting under § 21

or can sue for dissolution3. Dissolution § 18 – order of payout under dissolution

a. Creditorsb. Partners Advanced (excess contributions)c. Partners capital contributionsd. Profit (if any left over, according to agreement)

ii. UPA § 19 – Partnership Books (Cannot draft around)

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iii. UPA § 20 – Duty of Partners to Render Information (Cannot draft around) iv. PN Liability – Partners are individually liable to PN creditors for PN obligations, but only liable for

their share which is based on the partners capital contributions 1. Indemnification - each partner is liable for his share of the PN obligations – thus if one pays of

more than his share of the debt, he is entitled to indemnification from the PN for the difference between what he paid and his share in the liability

a. Obligation to indemnify a partner is a Partnership liability2. Contributions – Partnership has a right, if they indemnify a partner, to require contribution

from one or more partners; Contribution can also be required for paying off creditors or equalizing capital losses

a. Obligation to make contribution is a liability of a partnerv. Summers v. Dooley:

1. F – After one partner hires an employee over the other partner’s objection, he demands the PN reimburse him for paying the employee’s wages.

2. H – Not obligated to pay; partners have equal rights to manage PN business, so disagreements must be decided by a majority of partners.

3. R – If a partner incurs expenses for the PN, the PN need not reimburse them unless those expenses were authorized by a majority of partners, absent contrary agreement or later ratification.

4. *Note – under UPA § 18(h) need a majority vote to make such a change; but need to actively object, can’t be silent.

vi. Sanchez v. Saylor:1. F – Were partners and T was considering lending PN $ to restructure PN debt, but wanted

Sanchez’s personal finances; Sanchez refused and Saylor brought suit claiming breach of fiduciary duty.

2. H – Held for Sanchez. Remedy is dissolution under Covalt Rule.3. Covalt Rule – All partners have equal rights in a PN, but neither partner can impose his or her

will on the other partners; matters must be decided by a majority (51%)4. Covalt Remedy - Absent an enforceable agreement covering such circumstances of

disagreement, when both partners in a two-partner partnership disagree it is dissolution, not an action for breach of fiduciary duty, that is the appropriate avenue of relief.

d. Authority of a Partner :i. UPA § 3 – Interpretation of Knowledge and Notice

ii. UPA § 9 – Partner Agent of Partnership as to Partnership Businessiii. UPA § 10 – Conveyance of Real Property of Partnershipiv. UPA § 11 – Partnership Bound by Admission of Partnerv. UPA § 12 – Partnership Charged w/ Knowledge of or Notice to Partner

vi. UPA § 13 – Partnership Bound by Partner’s Wrongful Actvii. UPA § 14 – Partnership Bound by Partner’s Breach of Trust

viii. Partner’s Authority:1. Each partner is an agent of the PN for the purpose of its business2. A partner has authority to bind the PN by any act “for apparently carrying on in the usual way

the business of the PN of which he is a member”a. Not clear whether this means an act w/in the course of business as carried on by the

partner’s firm or the course of business of other firms in the same local engaged in the same line of business

ix. Northmon Investment Co. v. Milford Plaza: 1. F – Milford challenged a long-term lease (99 yr) entered into by partners in its PN2. I – May a partner challenge the actions of another partner as outside the scope of its authority?3. H – Yes; partner may bind PN by transaction made in ordinary course of business, but partners

may object to unauthorized transactions in assertion of their equal rights in the management and conduct of PN business.

4. R – Can bind in ordinary course of business (§9) by a majority vote (§ 18) but this was extraordinary leasing sole asset for longer than PN. Unanimous consent required by §9(2)

5. Application of UPA §9, NY = §20a. §9 is really saying that every general partner has the agency powers of a general

manager, but it is still left to the courts to determine on a case-by-case basis the extent of this power.

e. Liability for Partnership Obligations :i. UPA § 9 – Partner Agent of Partnership as to Partnership Business

ii. UPA § 13 – Partnership Bound by Partner’s Wrongful Act

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iii. UPA § 14 – Partnership Bound by Partner’s Breach of Trustiv. UPA § 15 – Nature of Partner’s Liability

1. All partners are liable jointly and severally for everything chargeable to PN under §§ 13 and 14a. §9, 13, 14 make partners liable, but UPA does not authorize such lawsuits.

2. All partners are liable jointly for all other debts and obligations of PN3. *Note – w/o an agreement otherwise, losses and profits are shared equally

v. UPA § 16 – Partner by Estoppelvi. UPA § 17 – Liability of Incoming Partner

vii. UPA § 36 – Effect of Dissolution on Partner’s Existing Liability1. Dissolution does not of itself discharge existing liability2. A partner is discharged by an agreement between himself, the creditor, and the person

continuing the businessviii. Davis v. Loftus –

1. F – Firm had two different kinds of partners (equity and income); Income partners put in capital that they got back when they left, as well as salary; Action brought against firm for malpractice.

2. I – Whether income partners are liable for the malpractice?3. H – Income partners do NOT qualify as partners under UPA, so they are not liable for the

malpractice; they had not right to vote on the management or conduct of PN, no profits, got separate salary, not likely to have been involved in the decisions that caused the malpractice.

4. TEST – Look at the Substance and not the Form of a business relationship to determine whether the relationship qualifies as a PN.

f. Partnership Interests and Partnership Property :i. UPA § 8 – Partnership Property

ii. UPA § 18 – Rules Determining Rights and Duties of Partnersiii. UPA § 22 – Partner Has a Right to an Accounting

1. Can not be changed by agreementiv. UPA § 24 – Extent of Property Rights of a Partnerv. UPA § 25 – Nature of a Partner’s Right in Specific Partnership Property

vi. UPA § 26 – Nature of Partner’s Interest in the Partnershipvii. UPA § 27 – Assignment of Partner’s Interest

viii. UPA § 28 – Partner’s Interest Subject to Charging Orderix. Partnership Property:

1. Under UPA PN can own Property - sets forth rules that effectively treat PN as if it were an entity

a. G/R – individual partners own the partnership property in theory, but in practice all the incidents of ownership are vested in the PN, so that the “tenancy in partnership” rule of UP has no real-world significance

b. § 8 – real property can be held in PN’s namec. § 25(1) – PN property is owned by partners, as tenancy in partnership, but § 25(2)

takes away individual partners ownership of the property2. Property used by a PN may be either:

a. PN property or i. This property can be transferred by the PN

ii. Upon dissolution this property must be sold or valued along with other PN assets and proceeds of sale or value of asset must be distributed amongst partners

b. Property of a partner that is loaned by the partner to the PNi. This property can NOT be transferred by the PN

ii. Upon dissolution, the property must normally be returned directly to the loaning partner

3. This distinction is important:a. For determining who has the power to transfer the propertyb. If creditors of PN are competing w/ creditors of individual partnerc. If partnership is dissolved

x. Partnership Interests:1. Partner’s Interest in the PN – Partner does own his interest in PN or his share of the PN;

creates a 2-level structure of ownershipa. 1 – Partnership owns the partnership propertyb. 2 – Partner owns his interest in the partnership

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2. Assignment – although a partnership interest is assignable, a partner cannot make an assignment of his PN interest that would substitute the transferee as a partner in the transferor’s place b/c no person can become a partner w/o the consent of all the partners

a. When PN interest is assigned, the assignment is not a full transfer of the interestb. Instead, it is a transfer to secure a debt that the assignor-partner owes to the assignee-

creditorc. Assignee only becomes partner if all the other partners consent and has no right to

information about PN, and no right to inspect booksd. Assignee has a right to receive the distribution which the assigning partner would be

entitled, and upon dissolution has right to recover assigning partner’s intereste. A partner who assigned her PN interest remains a partner, but other partners can

dissolve PN3. PN Creditors – If a partner’s individual creditor gets a judgment, he can get a Charging Order

on partner’s PN interesta. Creditor can get partner’s distributions under PNb. Creditor can foreclose on PN interest under § 28 and cause its sale; Buyer of the

interest has right to compel dissolution if:i. The term of PN has expired, or

ii. The PN is at willc. Creditor may put individual partner into bankruptcy, which results in dissolution of

PN under § 31(5)g. Partner’s Duty of Loyalty :

i. UPA § 20 – Duty of Partners to Render Informationii. UPA § 21 – Partner Accountable as a Fiduciary

iii. Fiduciary –1. Partners are fiduciaries2. Duty of loyalty is fiduciary - partners as fiduciaries owe each other the very highest standard of

loyalty, honesty, and honor.3. Partners have a fiduciary duty to share business opportunities, or at least give notice to partners

of business opportunities in same area.4. *Note – fiduciary rules are default rules in the absence of a PN agreement

iv. Meinhard v. Salmon – 1. F – When a PN is offered a profitable lease, one partner accepts it for himself, prompting the

other to demand participation.2. H – S breached his fiduciary duty; S had a duty to inform M of the lease offer to at least allow

him a chance to compete for it. a. NO fraud in this case, S acted in good faith.b. Holding may be different if opportunity unrelated to S’s position in PN

3. R – Partners’ fiduciary duties of loyalty forbid appropriating opportunities offered to the PN.

4. This decision has helped to enable venture capital due to the high fiduciary duty owed to financers. What is the difference between a venture and a partnership?

a. Distinguishable by the narrowness of purpose. b. Partnership is ongoing, venture = “one night stand”c. Venture is a single undertaking or a short series of undertaking, not expected to

exceed a certain period.d. Dispute as to whether joint venture is covered by partnership law. 18(a) might be

unfairly applied.

h. Dissolution by Rightful Election :i. UPA § 29 – Dissolution Defined

1. A dissolution is merely a change in the relation of the partners, not an end of the relationshipii. UPA § 30 – Partnership not Terminated by Dissolution

1. Says that the relationship changes, but changes scopeiii. UPA § 31(1) – Causes of Dissolution: W/o violating Agreementiv. UPA § 38 (1) – Rights of Partners to Application of Partnership Propertyv. UPA § 40 – Rules for Distribution

vi. Types of Partnerships:1. At will – ended by express will of parties at any time or specific event, but only as long as

ended in good faitha. Wind up – pay off any liabilities and surplus paid to partners

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b. No longer have to liquidate – it is a forced sale where you frequently get less then the real value

2. For term – intended to last for a specified duration or until a specified project is completed; cannot be dissolved at will; can be subject to damages for dissolving early

vii. Three Phases to Terminating a Partnership:1. Dissolution – this is an event which sets the termination in motion

a. It describes a change in the legal status of the partners and PNb. It is NOT an end to the relationship, relationship continues until the winding up of

PN’s affairs is completedc. Upon dissolution very little happens except the PN scope of business narrows; you

don’t take on new business, but PN may be required to continue during dissolution in order to maintain assets

d. Partner liability doesn’t end until winding up is completed2. Winding Up – process of actually terminating partnership’s business

a. Describes economic event of liquidation that follows dissolutionb. Includes paying off debts, settling contracts, selling assets, etc.

3. Termination – consists of completing the wind up and ending PN4. *Note – UPA doesn’t adequately distinguish between a departure that triggers a winding up of

a business and a departure due to a Buyout or a Continuation Agreementviii. Consequences to Dissolution:

1. Consequences Among the Partners – a. G/R - Unless otherwise agreed, PN must sell its assets for cash and distribute

proceeds of sale among partners, OR make a cash payment of the value of a partner’s share of PN or an in-kind distribution

b. Wrongful Dissolution – § 38(2)(b), although dissolved the remaining partners can continue PN business by

i. Pay X value of his PN interest – any damages cause by the dissolution, ORii. Put up a bond to secure such a payment and indemnify X against present

and future PN liabilitiesc. Continuation Agreement – can enter into an agreement whereby remaining partners

can continue PN’s business after dissolution; these agreements usually include terms of dissolution and amount of compensation to leaving partner

2. Effect of Dissolution on Relationship between PN and 3rd Parties – a. If PN dissolved and deemed a new partnership for legal purposes, still have to transfer

leases, licenses, franchises, etc. to new PNb. Can’t draft away dissolution - § 31 expressly states that dissolution is caused by

w/drawl of a partner 3. Tax Consequences –

a. IRC § 708 – PN”s existence doesn’t terminate for tax purposes until:i. A – no part of any business, financial operation, or venture of PN

continues to be carried on by any partners in PN, ORii. B – within a 12 month period there is a sale or exchange of 50% or more

of the total interest in PN capital and profitsb. Dissolution generally a non-event for tax purposes

ix. Girard Bank v. Haley –1. F – General PN / at-will; partner sought to dissolve PN by sending a letter to 3 partners.2. Lower court - partner didn’t dissolve PN b/c she didn’t give a reason.3. H – REVERSED; this was an at-will PN and you don’t have to give a reasons for dissolving.

If this was a PN for a term, you would have to give a reason and could possibly be subject to damages.

4. Establishes that a partnership at will does not require justification to dissolve the partnership, even if it is in contravention of the agreement, a partnership can be dissolved under the UPA.

x. Creel v. Lilly – 1. F – After the death of a partner, widow sued the surviving partners for liquidation of PN assets.

Wife claims that instead of winding up PN, they continued PN under another name. 2. H – This was a new PN / successor PN; surviving partners did wind up old business, did an

accounting, and gave $ to estate; Winding up does NOT mean to liquidate – you just have to be able to pay estate what is owed.

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3. R – When remaining partners wind up PN in good faith and provide an accurate accounting of PN’s value, the departing partner has no right to compel liquidation b/c PN”s value can be determined w/o liquidation.

4. *Note – Should have had a PN agreement with a continuation clause for PN to continue even if one partner dies.

5. This case contributes to the development of the RUPA. Avoids the harshness of the UPA where there is a fire sale. It allows the remaining partners to buy out the leaving partner’s estate. Valuation is taken on the date of the partner’s death.

xi. McCormick v. Brevig -1. I – When dissolution is ordered by judicial degree, is liquidation required?2. H – when a partnership dissolution is court ordered, the partnership assets must be reduced to

cash in order to satisfy the partnership obligation, and any additional funds are dispersed to the partners

3. *Fishman thinks that this is a bad result – Clark may not have the ability to pay for the entire share. Or Joan would get less than she would have if the property was sold on the market.

xii. Page v. Page – 1. F – P and D entered into an oral partnership agreement w/ each contributing $43k for purchase

of land, machinery, and linen to start business. Major creditor of business was a corporation owned by P. P claimed business was losing $ and wanted to dissolve; D claims P was acting in bad faith by using his superior financial position and now that business was doing better.

2. I – Whether PN was at will or for a term, and can partners dissolve, what were PN terms?3. H – This was an at-will PN, but can’t be dissolve if in Bad Faith; case was remanded to

determine if done in Bad Faith. i. Dissolution by Judicial Decree & Wrongful Dissolution :

i. UPA § 31(2) – Causes of Dissolution: In contravention w/ Agreementii. UPA § 32 – Dissolution by Decree of Court

iii. UPA § 38 – Rights of Partners to Application of Partnership Propertyiv. Drashner v. Sorenson –

1. F – After an irresponsible partner wrongfully dissolved the PN, he demanded a share of the PN’s good will.

2. H – When a partner causes the PN’s dissolution wrongfully by making it impracticable to remain in the PN, the other partners may continue PN and the wrongfully dissolving partner is not entitled to share in PN’s good will, § 38(2).

v. Wrongful Dissolution – (Illustrated by Drashner) 1. A partner that wrongfully dissolves PN can be subject to:

a. Damages; b. A valuation of his interest that does not reflect the real value of the interest b/c

goodwill is not taken into account; andc. A continuation of the business w/o him

2. Consequences- There is risk to dissolving a partnership at will since, if you are wrong about whether PN is a term or at-will and you proceed with dissolution, you can suffer these consequences.

3. Options for innocent partners:a. Wind up and seek damages against wrongful dissolverb. Continue PN and bring in another partnerc. Continue PN and seek damages against wrongful dissolver

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III. ALTERNATIVE FORMS OF BUSINESS ORGANIZATIONSa. Taxation :

i. Taxation is a major issue in choosing a business formii. 2 Basic Patterns of Taxation under IRC:

1. Firm Taxation or Double Taxation:a. Firm is taxed on its incomeb. If firm has income or expenses, gains or losses, those go into firm’s taxable income,

not the taxable income of the ownersc. If firm makes distributions to its owners from after-tax income, the owners pay taxes

on those distributions2. Flow-Through Taxation:

a. Firms is not subject to taxationb. All of firm’s income and expenses, gains and losses, are taxable directly to the firm’s

ownersc. Distributions are not taxed, so there is no double-tax effectd. If firm has losses, owners can use them to offset other income

iii. Selecting Taxation - IRS has adopted a “check the box” method whereby any domestic unincorporated business that constitutes an eligible entity can elect either flow-through or firm (corporate) taxation;

1. *Note - If there is only one owner, the entity’s income, etc. will be attributed to that owneriv. Eligible Entity – is any business entity other than (1) a corporation, or (2) a business entity that is

specifically made taxable as a corporation under IRC1. Generally publicly traded limited partnerships are taxed as corporations

b. Limited Partnerships :i. ULPA § 101 – Definitions

ii. ULPA § 201 – Certificate of Limited Partnershipiii. ULPA § 303 – Liability to Third Parties iv. ULPA § 403 – General Powers & Liabilitiesv. Basics:

1. Generally- is a statutory creature and must comply with ULPA; LP may only be created by filing a certificate w/ SOS; There also must be a written agreement between the partners; LP’s serve an economic function by financing assets used in someone else’s business

a. Issue – should LP be taxed as a PN or Corp2. Two types of partners –

a. General Partner – each liable for all debts of PNi. Corporations can be general partners; whether officers of Corp as general

partners may be liable depends on their role and actions in PN and whether they fail to maintain their corporate identity in conducting PN affairs

b. Limited Partner – one or more partners who are NOT liable for the debts of the PN beyond the amount that they have contributed to the PN

3. Compensation – they have no role in the conduct of the business and their profits are stipulated under their agreement w/ general partners; have lots of options in how profits and losses can be allocated

a. GP – may have insignificant interest in LP, but has exclusive right to manage and control business interest

4. Liability – liability is only up to the value of his investment, but can’t participate actively in the management of PN

a. *Key – is determining how much say LP can have in the business before they lose their limited liability

5. LP Classification – characterized as securities under state and federal securities regs and must be registered under SEA

6. Fiduciary Relationship – generally there is a duty of LP and GP to have fiduciary duties and fairness, and in most states can’t contract around that

a. DE – court said LP agreement can eliminate, expand, or constrict fiduciary dutiesvi. Gateway Potato Sales v. GB Investment:

1. F – When a limited PN defaults, its unpaid supplier sues a limited partner, contending it actually controlled the PN.

2. H – Court applies the “substantially the same” test and finds that if they can show at trial that the limited partner controlled the PN, the limited partner can be personally liable for PN debts; court found it was enough that E told G that LP was controlling the business.

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3. TEST – Is LP’s control of the business is substantially the same as the exercise of the powers of a GP, if so then liability applies even if not dealing with 3rd parties. (Actually - The LP’s participation in the control of the business is not substantially the same as GP, he is liable only to persons who transaction business with the LP with actual knowledge of his position and control)

4. *NOTE – In NY it is NOT enough for creditor to be told by someone that LP is in control of business; Creditor has to be in direct contact with LP

vii. Gotham Partners – no longer good law in Del. 1. F – LP sued GP, directors, parent C, for breach of fiduciary duty and partnership agrmt, and

consummating series of T that increased their control of LP2. I – whether there are same kinds of fiduciary duties that are found in a C3. H – SC Del – T subject to GP’s contractual obligation of entire fairness to LPs. Joint & several

liability for parent & directors (with LP) due to aid & abetting of breach of fiduciary duty. 4. R – LP may provide for contractually created fiduciary duties that are substantially the same

found in C law. Here LP agreement provided this. Under Del. State parties to a LP do have the power to draft around normal rules. Any claim of fiduciary duties must be analyzed in light of the LP agreement.

c. Limited Liability Companies :i. ULLCA § 101 - Definitions

ii. ULLCA § 103 – Effect of Operating Agreement: Non-waivable Provisionsiii. ULLCA § 201 – LLC as Legal Entityiv. ULLCA § 202 - Organizationv. ULLCA § 203 – Articles of Organization

vi. ULLCA § 301 – Agency of Members vii. ULLCA § 302 – LLC Liable for Member’s Actionable Conduct

viii. ULLCA § 303 – Liability of Membersix. ULLCA § 404 – Management of LLCx. ULLCA § 405 – Sharing of & Right to Distributions

xi. ULLCA § 408 – Member’s Right to Informationxii. ULLCA § 409 – General Standards of Member’s Conduct

xiii. Basics – 1. LLCs – are noncorporate entities that are created under special statutes that combine elements

of corporation and PN law; a. No limit on # of SH – but usually establish by family business w/ few investors,

accounts, doctors, lawyers, etc.; Not practical for corp with many SH or ownersb. Benefits - can adopt PN style management and control but maintain corp liability, and

have contract-based flexibility that corps don’t havec. Like Corp law –

i. Owners of LLCs have limited liabilityii. LLC is an entity, so it can hold property and sue and be sued

d. Like PN law – i. LLC has freedom to structure internal governance by agreement

ii. Can be taxed as PN or Corp (check box)2. 2 Types of LLCs –

a. Member-Managed LLC – managed by their members (default)b. Manager-Managed LLC – managed by managers who may or may not be membersc. *Can have non-resident alien shareholders

3. Formation –a. Formed by filing articles of organization w/ SOSb. All statues allow LLCs to be formed by a single personc. Articles include: name of LLC, address of principal place of business or office in

state, name and address of registered agentd. Some states require:

i. Purpose of LLCii. If LLC is manager-managed, names of initial managers; If member-

managed, names of initial membersiii. Duration of LLC or latest date on which it is to dissolve

4. Operating Agreements – an agreement among members concerning the LLCs affairs; typically provides for governance of LLC, its capitalization, admission and w/drawl of members, and distributions

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5. Management – almost all LLC statutes provide as a default rule, that an LLC is to be managed by its members (so members cannot bind LLC with third party agreements)

6. Voting by Members – voting is per capita (one vote per member) unless otherwise agreed7. Agency Powers –

a. Member-managed LLC – each member has power to bind LLC for any act that is for apparently carrying on the business of the LLC in the usual way or ordinary course

b. Manager-managed LLC – typically only managers have apparent authority to bind firm; members have no apparent authority to bind

c. DE statute – § 18-402 of DE LLC Act provides “unless otherwise provided in a LLC agreement, each member and manager has authority to bind the LLC”; But DE also has a rule that you are bound by GF and fair dealing, so not clear if can actually contract out of (but is harder to prove BF then breach of fiduciary duty)

8. Inspection of Books and Records – members are entitled to access books and records9. Fiduciary Duties – fiduciary duties of managers and members are largely unspecified in

statutes; probably like corporate statutes10. Derivative Actions – members of LLC can bring derivative actions on LLC behalf based on a

breach of fiduciary duty11. Distributions – in the absence of an agreement to contrary, distributions to members are to be

made pro rata according to members’ financial contributions12. Members’ Interests – member can have both:

a. Financial rights – i. Right to receive distributions

ii. Member can transfer rights by transferring interest in LLCb. Governance rights –

i. Right to participate in management, to vote on certain issues, and to be supplied with information

ii. Generally member can only transfer rights with unanimous consent of members, unless agreement says otherwise

iii. *Not clear whether if you assign financial rights, you still retain governance rights

13. Liability – every members’ liability is limited to their investment; members and managers are not liable for LLC’s debts, obligations and other liabilities; but members may become liable if conditions for piercing veil are satisfied (use corporate piercing standards)

14. Dissociation – is termination of a member’s interest in an LLC other than by member’s voluntary transfer of her interest; statutes differ on requirements for this (pay out $, don’t need notice, by judicial decree)

xiv. Zolus v. Wolf1. F – P owns 25% of membership in LLC, claim individual and on behalf of LLC that those in

control arranged to lease LLC’s principle asset (building) for below mkt value, that lease unlawfully assigned, company fiduciaries benefitted personally from the sale

2. I – is a derivative suite allowed on behalf of LLCs, statute does not address. 3. H – directors analogized to be a trustee of a trust, SH are a trustee. There is an equitable right

to bring a derivate suit on behalf of LLC where GP is fiduciary and LP is beneficiaries. xv. Salm v. Feldstein –

1. F – P and D were members of LLC, w/ D as managing member. D purchased P’s membership interest in LLC and later sold it for 4X more to a 3rd party. P brought action for breach of fiduciary duty and fraud, claiming that D misrepresented the value of the company and failed to disclose that T had made a firm offer to purchase business for $16million.

2. H – As managing member of LLC and as co-member with P, D owed P a fiduciary duty to make full disclosure of all material facts.

xvi. Phelpstien1. F – D, managing member bought out LLC for 3.7m then sells for 16m, Summary judmt

granted by lower ct.2. Ct finds that there is a fiduciary duty for LLCs, most jurisdictions have adopted corporate

model for LLC. xvii. Matter of 1545 ocean ave

1. F - 2 member LLC, member managed. Ocean Suffolk, crown royal. Reached agreement to solicit bids to perform demolition and construction work to complete project. Managers disagreed on construction work and hiring of manager owned construction business to complete the work, There were no management meetings held.

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2. I - Two managers have a dispute, one, King, wants LLC dissolved. But court allows LLC to continue, as the dispute did not hamper the ability of the LLC to continue.

3. H – Court says the LLC can be dissolved when it is no longer reasonably possibly to carry out the business in accordance with the organization agreement.

a. Management has become dysfunctional (each could make independent decisions)b. Voting deadlock

4. Test to dissolve LLC – whether it is reasonably practicable to carry on the business of the LLC (not whether it is impossible)

a. Court looks at operating agreement, then looks to see if it is reasonably possible to carry on the business, essentially a contract based analysis.

xviii. S Corporations – enables owners of corporation to elect a special tax status under which corp and its SH receive flow-through taxation that is comparable to PN tax; taxable income of S corp is computed as if corp were an individual;

1. To Qualify as S Corp:a. Corp may not have > 100 shareholdersb. Corp may not have > 1 class of stockc. All shareholders must be individuals or qualified estates or trustsd. No shareholder may be a nonresident aliene. Has a max of 80% of another corporations stock that it can holdf. Must have at least one general partner with unlimited liability (may get around this by

having general partner be a corporationd. Limited Liability Partnerships :

i. LLPs - allows a general partnership to adopt some form of limited liability1. Core difference – the liability of general partners of a LLP is less extensive than the liability of

a general partner2. Ancillary difference – LLPs must be registered with the designated state office3. *Note – NY and CA only permit professional firms to be LLPs4. Neither ownership or control determines how profits are distributed, that is K.

ii. Liability under LLP: 1. Limited liability:

a. Extends to all creditors, debts and obligations of PN; b. Partners are not liable for wrongful acts or negligence of other partners or employees,

2. Liability:a. Liable for negligence that YOU have engaged inb. Can be liable for acts that people you supervise have engaged inc. Most jurisdictions you are still liable for contractual obligations of LLPd. Partnership is still vicariously liable for partners acts

iii. New York LLP Statute – 1. Broadest LLP statute in country2. LLP status only available to professionals practicing as a general partnership 3. Not liable for contractual obligations of LLP4. BCL §303(b) (p.760-761) – variety of safe harbors that allow LP to engage in aspects of

business w/o being classified as a GP.iv. LLLP – Limited Liability Limited Partnership, which the liability of the general partners in a limited

partnership is limitedv. Ederer v. Verstien. (2007)

a. Law firm collapses, (LLP later took on new partners, alleged not party to the earlier agreements) Withdrawal agreement - 1 partner would stay on for term of one case, be compensated, then would have access to his cases and books/records following his withdrawal. Two initial partners failed to draft a written partnership agreement amongst themselves. P demands an accounting, alleging breach of k

b. I - §15 deals with joint and several liability for partners charged – says that partners are jointly and severably liable of the debts and obligations of the partnership. (torts and breaches of trust)

a. Court reiterates – partnership is based upon the law of principal and agent, each partner is personally liable for the acts of other partners in the ordinary course of business. (acting in this capacity each partner has authority to bind the P)

b. §26(b) (UPA15)– partner no longer liable for the acts of his fellow partners, no requirement for indemnification or contribution from other partners who did not cause the liability. Does this apply?

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c. H - P is entitled to an accounting. §26(b) does not shield partners from liability to each other, only to third parties. Not to any debts among the partners

vi. Megadyne Information Systems v. Rosner, Owens & Nunziato, LLP1. P has a claim, but the statute of limitations has expired, served one year after SOL has run. P

claims that D has breached duty, paid for worthless services2. I – if it had been shown if the other partners had discussed this re: the handling of the matter,

then issue of fact, meaning the other partners could be sued.3. H - This is sufficient to create a triable issue of fact – whether the firms partners were

personally involved in the firm’s breach of fiduciary dutiesIV. CORPORATE FORM

a. Introduction and Characteristics of Corporation :i. BCL § 201 – Corporate Purposes

ii. BCL § 401 – Formation: Incorporatorsiii. BCL § 402 – Formation: Contents of Certificate of Incorporation (Required Elements)iv. BCL § 403 – Formation: Effect of Certificate of Incorporationv. BCL § 404 – Formation: Organization Meeting

vi. BCL § 601 – Shareholders: Bylawsvii. BCL § 615 (c) – Shareholders: Written consent w/o a Meeting

viii. BCL § 1317 – FN: Liabilities of Directors and Officersix. BCL § 1318 – FN: Liability for failure to disclose required informationx. BCL § 1319 – FN: Applicability of other provisions

xi. BCL § 1320 – FN: Exemption from certain provisionsxii. Publicly held Enterprises – corporate form traditionally preferred by publicly held business

enterprises 1. Limited Liability –

a. SH have limited liability and are not personally liable for C obligationsb. Mangers are normally not personally liable for C obligations, as long as act on C’s

behalf and w/in their authority, they are treated as agents2. Free Transferability of Ownership Interests – ownership / equity interests are represented by

shares of stock and are freely transferable; rapid liquiditya. PN – can’t transfer w/o approval by all partnersb. Close Corp – usually have shareholder agreement that prohibits transfer of shares w/o

consent of other SH3. Continuity of Existence – legal existence of C is perpetual, unless shorter term stated in COI4. Centralized Management – normally managed by or under direction of a board of directors;

SH have no right to participate in management; set up facilitates specialization of roles b/c investors and managers don’t mix

a. Hierarchical structure of authority. Management is in charge, shareholders have very little say. Board members have at best observation.

5. Entity Status – C is a “legal person” or “legal entity”; C can exercise power and have rights in its own name (sue, be sued, hold property) Also must pay taxes.

xiii. Privately held Enterprises – if enterprise is privately held, may prefer to be a close corporation, general PN, LLP, limited partnership, or LLC

b. Selecting State of Incorporation & Organizing Corporation : If choosing to incorporate:i. Selecting a State of Incorporation – firm can incorporate wherever it chooses and C’s internal

affairs are governed by law of its state of incorporation, even if C has no business contacts w/ that state

1. Close corporation – usually incorporate locally in state where it has its principal place of business, often has restriction on the transfer of shares.

2. Public corporation – usually incorporate in DE b/c the law of the state of incorporation normally governs internal corporate affairs

3. Doing Business Tax – tax for states you do business in 4. Franchise Tax / Incorporation Tax – tax for state where you are incorporated, even if C

doesn’t do business in that state 5. Note Elements of both taxes may overlap, may benefit corporations incorporated and operating

in the same state (reducing taxes)ii. Organizing a Corporation –

1. Select a Corporate Name

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a. Name has to be reserved with the secretary of state, can use own name, unless it might confuse people. Cannot use if it is not personal name. Corporation can file in one name, then can file as a DBA.

2. Draft Purposes Clauses of Corporation – usually any lawful purpose is oka. Corporate Power – devices used to effectuate corporate purposes; not put in bylawsb. Corporate Purposes – reasons for which corporation are organized; put in certificatec. Draft bylaws – internal rules for the corporation (not public); these guide management

and board of directors for what they need to do; Directors can amend bylaws w/o shareholder approval (NY)

3. Subscription Agreement – contract with participants thru a promoter to buy shares of C once it is incorporated; this raises $ for C

4. File w/ SOS - Once SOS accepts COI you are incorporateda. NY – Certificate of Incorporationb. Other States – Articles of Incorporation or Charter

5. Hold an organization meeting to elect directors, adopt corp. seal, set salaries, issue shares. 6. Managers are different than the owners, but bylaws provide for maximum indemnification

out of corporate assets. Confers as many powers as the laws allow on the record. Shareholders as owners have a very limited power.

iii. Corporate Finance – 1. Ownership of C described in 3 different ways:

a. 1 – power to exercise control over managementb. 2 – right to receive income from operations of Cc. 3 – right to share in the assets at some rate upon dissolution of C

2. Common Stock – ownership or equity interests in Ca. Greatest Risk - if C goes bankrupt SH is last to receive $ if any leftb. Greatest Gain - have potential for greatest gainc. Benefits - have voting rights; Elect the directorsd. *In NY, BCL § 501, all C’s have to have one class of common stock

3. Bonds – generic term for all long term debt securities, which are typically obtained from public investors

a. Least Risk – in case of bankruptcy you have first claim in liquidationb. Normal Gain – Right to receive fixed interest payments, but no more; right to receive

a return on principal, but no morec. Few Benefits – NOT an owner; you are a creditor, so you don’t get a right to vote

4. 2 Types of Securities:a. Debt – a fixed obligation to repay principal amount of the security, as well as interest

i. Trade debt – amounts C owes for goods and services at any point in time; payment usually not due for 30, 60, 90 days; Accounts Payable

ii. Bank debt – bank loans; Loans Payableiii. Notes – may be long term or short term, but often issued pursuant to

indentures as unsecured long term obligations; tend to be for less time them debentures

b. Equity – rights of the common stock holder are to the residual income and assets after everything is paid to the bond holder

5. NY - §501 All corporations in NY must have a class of common stock.a. Can be dived into classes that have varying voting rights. b. One class of common stock must have a right to vote.c. Participation takes the form of dividends that the corporation has been earned, but can

only be paid after obligations have been paid off. Remainder belongs entirely to common stock class.

d. If declaring dividends tend not to declare all that could, retains some in order to invest in corporate activities.

e. Shareholders hope that values of shares go up, then will make money on sale.iv. Authorized / Issued Stock –

1. COI designates the classes of stock and number of shares of each class that C is authorized to issue; If want to issue more shares, have to amend the COI

a. Seniority of shareholders arises out of provisions in the COI. Typically will be in a dollar amount.

2. Common Stock – have right to vote, receive dividends, and if C dissolved and profitable, you have right to receive a pro rata share of assets (Greatest Risk)

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3. Preferred Stock – usually cumulative, stock that carries a preference as to dividends, on liquidation, or both, over common stock; normally don’t have right to vote (unless on changes that effect preferred shareholder rights or if haven’t declared dividends in > 2 years); COI must either

a. Designate terms of each class, orb. Authorize the board to issue portions of authorized class in series from time to time

and to designate the terms of each series as it is issued4. Convertible Stock – contract between preferred SH and C, gave preferred SH right to convert

into common stock; might want to do this if the amount of your dividend for preferred stock (which is set) is less then the amount of dividends for common stock

5. Issuance of Stock – sale of stock by C; only stock that has been authorized in COI can be issued

a. Authorized but Unissued - Stock that is authorized but unissuedb. Issued Stock or Outstanding stock – authorized and issued stockc. Treasury Stock or Authorized & Issued but not outstanding stock – stock that C

repurchases that has previously been issued6. Board decides whether to authorize stock and what price to issue it

a. Use to have preemptive rights – at common law each existing SH had right to subscribe to her proportionate part of a new issue of stock of the class she held; no longer do this

b. Quasi-preemptive right – right to prohibit a non-pro-rata stock issuance for an improper purpose, such as for purpose of reallocating or perpetuating control; board can’t issue stock to directors at an unfairly low price b/c breach of fiduciary duty

v. Bonds – 1. Bond holders generally receive semi-annual interest payments. Holders are third party

beneficiaries – cannot bring suit (left to trustee, to oversee the corp, and interests of the bondholder), have no voting rights (usually), traditionally secured by a mortgage

a. Debentures – used interchangeably.b. If a bond is issued, an indenture will also be issued

2. Complex contract that fixes the term of the security (bond), All issues determined by contract.3. If bonds are sold to the public, they take the form of a trust agreement with the corp issuing the

bond and the public. Distinction between bonds and indenture.4. Trust agreement between corp and bondholders, as well as corp and an indentured trustee

(usually a bank – essentially administers the bond issued, pays the interest) a. If corp misses an interest payment, the whole thing is due, and then is in default on

the loan and may be thrown into bankruptcy. 5. Covenants or negative covenants – company agrees not to issue dividends or repurchase shares

unless meeting certain conditions (usually of solvency) 6. Collectable at the option of the company at a fixed price.

a. Sometimes bonds are convertible into common stock. vi. Initial Directors –

1. Problem - When C established its Board of Directors is elected by SH, but C has no SH until stock is issued, and function of issuing stock is job of Board

2. NY – C’s incorporators have powers of SH until stock is issued, and powers of directors until directors are elected

3. DE – initial directors can be named in C’s COI and the functions of the incorporators pass to directors when COI is filed

vii. Subscription for Shares – 1. Normally – stock issued by C in a simultaneous exchange for cash or property2. Subscription Agreement – would be SH enter into agreement to purchase C’s stock when it is

issued to him at some future date3. Pre-Incorporation Subscription Agreements – those made prior to C being incorporated;

a. DE law – these are irrevocable for a specified period of time unless all subscribers consent to a revocation, or the agreement otherwise provides

viii. VantagePoint Venture Partners v. Examen – 1. F – VP is seeking a class vote of preferred stock SH so that it can have an opportunity to block

E’s merger. If C is CA (or NY) then preferred SH could vote as a class and block merger; if C is DE then preferred are lumped with general SH and wouldn’t be able to block.

a. CA Law – creates a quasi-CA corporation even if incorporated elsewhere b/c C has significant contacts with CA and > half of voting shares are held by CA residents

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b. Internal Affairs Doctrine – chose of law principle that recognizes that only one state should have authority to regulate internal affairs of C and that is the state of incorporation

2. I – Whether this is a DE or CA corporation?3. H – DE corporation; Problem w/ CA law is as amount of CA SH change, so would what state

law governs your C; You need uniformity for intra-C matters and matters regarding right to vote fall within internal affairs doctrine; If you incorporate in a state, should expect that state’s laws to apply.

ix. Friese v. Superior Court – 1. F – Case involving insider trading in which C changed their accounting method so that D could

begin selling C’s stock at an artificially inflated price; their product was flawed and wasn’t selling so C had to file for bankruptcy. Statute at issue is a CA insider trading law; C is a DE corporation.

2. I – Whether CA statute applies to a non-CA corporation.3. H – CA law applies and internal affairs doctrine doesn’t; a statute regulating securities (sale or

transfer) is not part of the internal affairs of the C; a foreign corporation must conform to the securities regs of CA.

4. P – State securities regulations do NOT have to give way to the internal affairs doctrine; these matters are outside the scope of internal affairs doctrine.

c. Pre-Incorporation Transactions by Promoters :i. Promoter – person who transforms an idea into a business by bringing together the needed persons

and assets, and superintending the various steps required to bring the new business into existence1. Liability of the Promoter – G/R is that when a promoter makes a contract for the benefit of a

contemplated C, the promoter is personally liable on the contract and remains liable even after C is formed

a. Exception – if the party who contracted w/ promoter knew that C was not in existence at time of contracting, and nevertheless agreed to look solely to C for performance; can be expressed or implied (novation)

2. Liability of the Corporation –a C that is formed after promoter has entered into a contract on its behalf is not bound by the contract, without more; reason is that C wasn’t in existence when contract made and couldn’t have authorized it; Once C is formed, it may be bound

a. P and C can be jointly and severally liable for contractii. Goodman v. Darden

1. F – Darden knew that C did not exist entered into contract with promoter (Goodman)2. I – Is the promoter, a party to pre incorporation agreement, have to take part in an arbitration,

was he liable for putting his signature on agreement.3. GR – promoter is bound unless the contracting party knows that C is not in existence but

nevertheless agreed to look only to C for payment. 4. H –evidence did not show that DDS intended to contract only with the corporation.

iii. Company Stores Development v. Pottery Warehouse, Inc.1. F – Lease to Potter Warehouse for 5 years, not yet incorporated, president did not sign in

individual capacity, but as president of a future C to be formed. 2. H – No liability to promoter as Plaintiff knew that C was not yet formed, but intended to look

solely for the corporation for satisfaction of the agreement. K identified C as a C to be formed.iv. Generally courts have held that if a promoter is liable under a contract, the mere formation of the

corporation is still left on the hook. If the corp is not formed, promoter still not off the hook, the only way is through a novation, through which all parties agree that the corporation assumes the liability. (or the agreement is like Pottery Warehouse, stating that the agreement is with a corporation to be formed)

v.d. Consequences of Defective Incorporation :

i. De Jure Corporation – a C organized in compliance with the requirements of the state of incorporation; C’s status can’t be attacked by either private parties or the state

1. Must have substantial compliance with statutory requirements, which is determined on a case-by-case basis

2. Some states say must have exact compliance with all Mandatory requirements but failure to comply with Directory requirements is okay; the distinction in the requirements is subject to statutory interpretation

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ii. De Facto Corporation – a C that is said to exist when there is insufficient compliance to constitute de jure C if challenged by the state, but steps taken toward forming C are sufficient to treat it as a C with respect to 3rd Parties (almost unimportant today due to ease of incorporation)

1. 3 Requirements – a. A statute in existence by which incorporation was legally possibleb. A colorable attempt to comply with the statute, ANDc. Some actual use or exercise of corporate privileges

2. State can invalidate C, but creditors or other persons dealing with C can’tiii. Estoppel – if neither a de jure or de factor C has been formed, courts have still held that a party who

has dealt with an enterprise on the basis that it is a C is estopped from denying the enterprises corporate status; Examples of cases:

1. Denial of corporate status by would-be shareholders – true estoppel case where T relied on initial claim of corporate status

2. Technical contexts –cases where question of corporate status is raised in a technical or procedural context; ex. a would-be C sues P and P claims not a C

3. Liability of would-be shareholders – cases where T has dealt with an enterprise on the basis that it is a C, seeks to impose personal liability on would-be SH, who in turn raise estoppel as a defense. Issue becomes whether as a matter of equity, the claimant having dealt with enterprise as if it were a c, should be prevented from treating it as anything else

iv. Who May be Held Liable – if C is none of the three, courts are divided on whether would-be SH may be held personally liable for debts incurred in C’s name

1. Old cases - did impose liability on theory that if not a C, than it was a PN2. New cases - imposes personal liability only against those owners who actively participated in

the management of the business, and are held liable as if they were partners 3. MBC Act § 2.04 – only persons acting as or on behalf of C who know there was no

incorporation are jointly and severally liable for C’s liabilitiese. Classical Ultra Vires Doctrine : has almost become unimportant.

i. Ultra Vires Doctrine – C is regarded as a fictitious person, endowed with life and capacity only insofar as provided in its charter, which sets forth what activities C can permissibly engage; Transactions outside that sphere were characterized by courts as Ultra Vires (beyond C’s power) and unenforceable (against C and by C)

1. Today – doctrine exists only to protect SH from C’s activities that are beyond the scope of C’s charter; also affords state some limited control over C by knowing what C’s purpose clause has designed it to do

2. BCL § 203 – Ultra Vires Statute; only applies to actions between C and SH, cannot otherwise be applied to actions of a party in contract.

a. If ultra vires for other purpose today it is probably grounds for malpractice.ii. Powers & Purposes – UV doctrine applicable in two different situations:

1. Where C acted beyond its purposes; did it engage in a type of business activity not permitted under its certificate

2. Where C exercised a power not specified in its certificate iii. Recurring Problems – under UV doctrine several recurring problems

1. Power of C to guarantee a third party’s debts; today C’s can make guarantees2. Power of a C to be a general partners; today C’s can become partners

iv. Limitations on Ultra Vires Doctrine –many thought doctrine was unsound1. Courts view C’s powers as both implied as well as explicit, and incidental2. UV doctrine didn’t apply to corporate tort, criminal liability, or reverse completed transactions;

only really effected executory contracts3. Didn’t always work as a defense when partial performance or one party had already performed4. Unanimous SH approval barred UV defense unless creditors would be injured5. COI has decreased in its significance as a limit on C’s purpose and power; many COI’s today

state that C can engage in any lawful business and setting forth a laundry list of powers6. Several states passed statutes that almost abolish doctrine, including DE

v. Goodman v. Ladd Estate – 1. F – A C’s ultra vires guaranty agreement was held enforceable.2. R – SH who participated in an ultra vires act can’t later attack it as ultra vires.

f. Objective & Conduct of Corporation :i. BCL § 202(a)(12) – Corporate Purposes: General Powers

ii. BCL § 717 – Directors: Duty of Directorsiii. ALI §§ 2.01, 6.02 (*NOT law – these are persuasive authority only!)

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iv. Generally:1. Corporate Principle - is that a Corporation is to be primarily run for the pecuniary benefit of

its shareholders; Profit motivated.

a. Test for Issuance of Dividends – Bad Faith; company has right to decide whether or not to declare dividends

2. Common Law – C couldn’t expend C $ for philanthropic purposes unless it benefited C3. Today – C contributions have very important role and impact on society4. NY Law – specifically says C contributions don’t have to benefit the C

v. Dodge v. Ford – 1. F – Ford decided not to declare dividends, but to put $ back into company; Dodge brothers

were SH and brought suit to compel the issuance of dividends.2. H – Court ordered Ford to declare dividends b/c purpose of a business is primarily for the

profit of SH and decision by Ford appears to be arbitrary.3. R – Director’s responsibility is to increase earnings and benefit SH and powers of

directors are employed to that end. The object of a corporation is to make money and cannot be run for the incidental benefit of the shareholders

vi. A.P. Smith Co. v. Barlow – 1. F – Stockholders challenged a donation by C to Princeton University.2. I – Can a C make a charitable donation that is not expressly authorized by its COI?3. H – Yes. President thought contribution was a sound investment that would create good will

for the company and a favorable environment for the C. Court found donation was for a modest amount and no evidence it was inappropriate, for President’s pet charity, or his own benefit; donation was w/in C’s implied and incidental powers..

4. R – Reasonable charitable donations can be made by a corporation even if not expressly authorized by its articles of incorporation.

5. NY B.C.L. §202(a)(12) is applicable. vii. Charitable Contributions by Corporations – Virtually all states have adopted statutes relating to

corporate contributions (like DE law) that carry an implied limit of reasonableness1. G/R – donations should be reasonable in amount in the light of the corporation’s financial

condition, bear some reasonable relation to the corporation’s interest, and not be so “remote and fanciful” as to excite the opposition of shareholders whose property is being used. Direct corporate benefit is no longer necessary, but corporate interest remains as a motive.

2. C’s contributions cannot exceed 1% of capital and surplus, institution receiving the money cannot own more than 10% of company stock

3. C’s don’t have to disclose their charitable contributions unless they start another C for a specific charitable purpose

viii. Constituency Statutes – provides that a board must consider the impact of C’s decision on other constituencies, not just SH

1. G/R – Directors owe a fiduciary duty to C and its SH, so SH’s interests are its primary responsibility when making a C decision

2. These statutes enable directors to consider other factors when making a decision, w/o being subject to a lawsuit by SH

3. NY Constituency Statute 17(7)(c) – provides that a board must consider the impact of C decision on other constituencies, not just SH; typically this is applied when C is changing control

4. DE – does NOT have a constituency statute; SH interest is paramountix. Philanthropy –

1. What happens when it has no benefit or relation to shareholders, but management is interested in?

a. Basically a business decision and the shareholders have no rights. b. Fear that the corporations would be held hostage to special interest groups rather than

endure bad publicityc. Donations should be reviewed with ALI test should be the reasonableness of the

institution. This is a hard test to apply as it assumes that Cs are comparable.

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V. CORPORATE STRUCTUREa. Basic Structure of a Corporation:

i. Corporation - a type of legal institution that defines legal relationships between people; it is a method of organizing business; it is a legally recognized fiction.

1. Public (open) – a corporation that is listed on a stock exchange or “over the counter market” (computerized trading system; means they are publicly held by individual owners, SH, and publicly traded)

2. Close corporation (private) – not listed on an exchange and privately held; similar to a partnership

3. Members of a Corporation:a. Board Members – oversee the corporationb. Shareholders – are the owners of the corporationc. Bondholders – are people that lend money to the corporationd. Managers – run the corporatione. Hedge Funds – large bodies of privately held capital

b. Shareholders in Publicly Held Corporations :i. Traditional Model – inverted pyramid w/ SH at top who owned C, elected board of directors, and

whose approval required for major or fundamental C actionsii. Modern Corporation – separates ownership and control, but creates conflicts

1. SH owning tiny amount of stock is rationally apathetic b/c not cost effective to spend a lot of time on C’s affairs; if all SH own few shares, all are apathetic

2. When SH all over country, voting must be done by proxy rather than in person; hard to organize and coordinate efforts; dissatisfied SH will usually exit or sell instead of fight management; when C has great # of SH that are highly dispersed, management will normally control

iii. Institutional Shareholders – frequently there are conflicts of interest between these SH and management and SH tend to vote in accordance with management.

a. Private Pension Plansb. Public Pension Plansc. Banksd. Investment Companiese. Insurance Companiesf. Foundations

2. Can meaningfully assess corporate governance structures, playing an important role in kicking out poorly performing management where individual shareholders could not

3. They can consult with management and share concerns, can vote and will count (due to holding so many shares)

iv. Forms that Institutional SH in Corporate Governance may take:1. Simplest –Take an active posture in voting on management or SH proposals2. More Aggressive – Not only vote on SH proposals, but make SH proposals3. Consultation – consult management on matters; usually more done this way

c. Allocation of Power between Management and Shareholders :i. BCL § 601 – Shareholders: Bylaws

ii. BCL § 602(b) – Shareholders: Meetingsiii. BCL § 615(b) – Shareholders: Quorum & Voteiv. BCL §616(b) – Shareholders: Supermajority Provisionv. BCL § 701 – Directors: Board

1. Power granted to directors except as otherwise indicated in the Certificate of Incorporation.vi. BCL § 702 – Directors: Number of Directors

vii. BCL § 703 – Directors: Election and Termsviii. BCL § 704 – Directors: Classification

ix. BCL § 705 – Directors: Newly created Directors & Vacanciesx. BCL § 706 – Directors: Removal

xi. BCL § 712 – Directors: Committeesxii. BCL § 801 – Amendments: Right to Amend COI

xiii. BCL § 803 – Amendments: Authorization to Amendxiv. BCL § 804 – Amendment: Class Votingxv. BCL § 903 – Merger: Authorization by Shareholders

xvi. BCL § 909 – Merger: Disposition of Assetsxvii. Power of Shareholders –

1. SH have passive role –

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a. Own C, but don’t manage itb. SH can NOT control directors in exercise of their official judgmentc. BUT SH can influence C – can’t bind C by their own direct actions, they must act

thru their control of the boardi. Elect and Remove Directors

ii. COI and By-laws – SH can approve / disapprove of changes to these documents and thereby influence the allocation of power among themselves, directors, and officers

iii. Fundamental Changes – SH have right to approve / disapprove of fundamental changes not in the ordinary course of business

iv. Void or Voidable Transactions – some transactions by officers or Directors are void/voidable unless ratified by SH vote

1. Ex. Transactions between C and Director or Officer are voidable on grounds of self-dealing unless SH ratify transaction by voting to approve it

2. Duties – a. Elect Directorsb. Amend by-laws (Recognized by BCL §601)

i. By-laws – internal operating rules of Cii. This is a contract between those that own C

iii. *Even if power to amend is given to Directors, SH still maintain right to amend them

c. Can take action at SH meeting if there is consent 3. SH Meeting –

a. Main purpose of meeting is to elect Directorsb. Date of annual meeting is set forth in C by-lawsc. Proxy can allow written consent for action. BCL §615 requires unanimity for any

action taken absent a meeting, but can be drafted around. d. Failure to hold shareholder meeting doesn’t void actions taken by directors, who

remain in office after the expiration of their terms per BCL §602(b)4. SH Primary Protections against Poor Performance –

a. Sell their Stock (“Wall Street Walk”)b. Vote to replace the Boardc. Derivative Suit - Difficult to sue C for breach of fiduciary duty b/c of procedural

hurdlesi. Must make a demand request

ii. If board says no, there denial is subject to judicial review under BJR; the demand will be dismissed if futile

5. Key to corporate governance – “an effective board”, assumed for good corporate performance. xviii. Power of Officers – Most C statutes provide that the officers are essentially the agents of the board

of directorsxix. Power of Directors –

1. Two Types of Directors:a. Inside Directors – employees of corporations (full-time employees)b. Outside Directors – not full time employees, but not necessarily independent

2. Directors are fiduciaries of C – a. They are not like employees, more like public officials; they are elected for a period

of time and have a fiduciary duty to C / SH as a wholeb. Bound to use ordinary care and diligence in the management of Cc. Today they are at best answerable for gross negligenced. Usually don’t get involved in day-to-day affairs; that is the job of senior management

i. Senior management will call the real shots for a corporation (Directors often cannot oversee top management)

3. D have control over officers and agents -a. Hire / Fire officers

i. BCL §705(a) –Vacancies occurring in the directors term of office may be filled for the unexpired term by the remaining directors. This does not preclude SH from filling vacancies, depends on C bylaws.

b. Set Compensationc. Must meet regularly

4. Business Judgment Rule –

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a. Most Lenient Standard for judging conduct of Directors & Officersb. If Director exercises due care, is informed about the decision, has no interest, and acts

in good faith – court won’t second guess that decisionc. If certain conditions are satisfied, a director or officer will not be liable for the

consequences of a decision unless the decision was irrationald. Rule does NOT apply in cases dealing with the allocation of power between Board

and SHxx. Organic Fundamental Change –

1. Special events that if C is going to do it, SH must participate in procedure to approve these types of changes

2. Standard Procedure:a. Board adopts proposed changeb. Proposal submitted to SH at annual or special meeting (All jurisdictions, but most

states allow C to amend COI in any way “so long as its COI as amended would contain only such provisions as would be lawful and proper to insert in an original COI if filed at the time of the filing of the amendment”)

c. Proposal will have to be approved by a requisite # of shares, and subsequently the acts of such action will be filed with SOS w/ supporting documents stating what has occurred

d. *NY – today need 51% of vote to approve an organic change (Except under BCL §905 i.e. C owns 90% of sub & seeks to merge into parent, SH vote not required)

3. Ex. Merger, Dissolution, Disposition, Sale of Assets; Most states require SH approval for amending COI

xxi. Removal of Directors – 1. Removed by SH –

a. Cause - SH can remove a director for cause, even w/o a statute b. Without Cause – SH can NOT remove a director w/o cause unless it is permitted in a

statute, COI, or by-lawsc. NY BCL § 706(b) – Only SH can remove director w/o cause if COI or by-laws

provide for it (Cause – dishonest, not attending meetings, etc) 2. Removal by Board –

a. Unless there is a statute, board cannot remove a director with OR without causeb. Some states say board can do it for cause if in COI

3. Removal by Court – a. Cases split whether Court can remove directors for causeb. Some statutes permit Court to remove a director for specified reasons, ex. fraudulent

or dishonest actsxxii. Takeovers –

1. Old Way – hard to oust incumbent management of a publicly held C; had to wage a proxy fight to get rid of them

2. Hostile Takeovers – mid 1960s this became a way to oust incumbent management and effect acquisitions

a. A makes a public offer – bid or tender offer – to purchase stock of B up to a stated amount and subject to certain conditions

b. Tender offer is made to B’s shareholders, not to B; the price of the tender offer is usually well above the market price for B’s stock

c. Because offer made to B’s SH, rather than to B, the approval of B’s board is not required; despite this, management tends to fight it

d. Unocal Test – (applied for hostile takeovers) if board wants to take defensive actions against takeover, it must satisfy enhanced business judgment rule (or intermediate standard of review).

i. Intermediate Standard of Review – greater than BJR standard and less then the high standard under duty of loyalty

ii. 1st – Board must show that it had reasonable grounds for believing that the tender offer presented a danger to corporate policy and effectiveness

1. Burden met by showing Good faith and reasonablenessiii. 2nd – Board must then satisfy a proportionality test: the defensive action

must be reasonable in relation to the threat posed1. Board’s defensive action must not be either preclusive or coercive

(draconian in nature), and

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2. Must be within a range of reasonable responses to the threat posed by the tender offer

xxiii. Weighted Voting in Publicly Held Corporations – 1. Only common SH have voting rights; each share of stock carries 1 vote2. Voting rights can be conferred on Preferred Stock or Bonds3. Dual Common Stock – when there is more than one class of common stock, one of which has

a greater weight than the other; usually stock with greater weight given to directors or managers

a. DE Law – one share = one vote, unless COI provides otherwiseb. G/R – difference between classes of stock will normally be upheld b/c when you buy

stock you know what you are getting into and if it is allowed, then it is legalxxiv. Charlestown Boot & Shoe v. Dunsmore –

1. F – SH of CBS brought suit against its directors claiming the directors should have done what the SH wanted them to do.

2. I – May SH of C force directors to take certain actions on behalf of C?3. H – No; C structure provides that business of C is managed by directors subject only to the by-

laws and votes of C; SH are not authorized to compel directors to act a certain way; Court sets boundary between SH and D.

4. R – SH have no power over the management of C and cannot order the directors to take particular actions in managing the business of C. Old rule, now directors are only held liable for gross negligence. SH can vote out the board, but cannot give instructions.

xxv. People ex rel Manice v. Powell1. I - Is the board board the agent of the shareholders?2. H – Board members are more than just agents, relationship is like that of a trustee and

beneficiary. Powers of the board are original and un-delegated. 3. R - Shareholders as a group own the property, but directors in the course of their duty

direct it and act as if they own it for the term of their position. Directors are not at the beck and call of the voters of individual things.

xxvi. Schnell v. Chris-Craft Industries – 1. F – Directors advanced the date of the annual SH meeting in an attempt to stifle a proxy fight.2. H – By-laws of C set the date for the annual meeting; Management can’t advance the date to

gain an advantage; this was an inequitable purpose. Inequitable action does not become permissible simply because it is legally possible

3. R – Even if authorized by statute, Directors of a C can NOT advance the date of SH meeting when this action would effectively eliminate the chances of a successful proxy fight. Can’t use corporate machinery to thwart corporate democracy.

4. *Note – this action was legal under DE law; court said an inequitable action or decision doesn’t become permissible just because it is legally permissible

xxvii. Blasius Industries v. Atlas Corp – 1. F – The incumbent board of Atlas sought to prevent Blasius from gaining control of C by

increasing the number of board members. 2. H – Board may not interfere with SH vote; BJR doesn’t apply b/c dealing with allocation of

power between Board and SH.3. TEST – (“Compelling Justification” standard) Once a showing has been made that a board

acted for the primary purpose of thwarting a SH vote, Board bears the heavy burden of demonstrating a compelling justification for its action. (quite onerous and rarely applied)

4. R – Actions by Directors made for the primary purpose of interfering with a SH vote are improper, even if made in good faith. Improper actions not defended by BJR.

5. *Note – usually by-laws will provide that directors can expand number of directors in between the annual meeting.

6. Staggered board – makes it more difficult to oust incumbent management & board. May not be a sufficient defensive tactic to prevent hostile removal of board members. Will also need provisions preventing the by laws to be amended to increase the number of directors as this undermines the tactic of staggering.

7. Fishman details 13-d filing – tender offers regulated under SEC act – whenever a person or corporation acquires 5% of the stock of a public company, within 10 days of that acquisition, it must send to the issuer (the corporation) and the SEC certain information.

a. Facts about the identity and background of purchaserb. # Of shares heldc. Where the funds were sourced fromd. If the purchaser intends to take control, must disclose plans.

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8. In most cases, the question of whether the board’s actions are preclusive is hotly contested.a. The line between board actions which influence in legitimate dates vs. actions that

preclude shareholder action are not always clear.b. The way a court looks at board’s actions may influence the standard of review that

will be applied to itc. Later cases says that the invocation of the Blasius standard usually indicates the board

action will be invalidated, failure to invoke Blasius indicates that the board action will survive review.

9. If management opposes tender offer, how far can they go? Delaware follows Unocal case, with an intermediate standard of review. Board must show that they had reasonable grounds for believing the tender offer was harmful to the company.

a. Must show it was reasonableb. Defensive action by management must be proportional to threat. Must be within a

range of reasonable responses.10. There has been some erosion of this rule. Here Atlas was too ‘ham fisted’ in attempting to

thwart the Blasius plan.d. Legal Structure of Management:

i. BCL § 707 – Directors: Quorum ii. BCL § 708 – Directors: Actions by Board

iii. BCL § 709 – Directors: Greater Requirement for Voteiv. BCL § 712 – Directors: Committeesv. BCL § 715 – Directors: Officers

vi. BCL § 716 – Directors: Removal of Officersvii. ALI § 3A.01 to § 3A.05

viii. Modern Corporate Practice – traditionally the board managed the business of C; today the board still has central legal role in C, but today the management function is ordinarily role of executives and CEO; Board’s role is limited due to constraints:

1. Constraints of Time2. Constraints of Information 3. Constraints of Composition

ix. Monitoring Board – recently there has been a shift to having the board act as a monitor, rather than manager; this model recognizes that senior management runs C and recognizes that Board sets compensation, replaces senior executives, monitors conduct of business, and reviews major corporate plans and policies; for this model to be effective the Directors of the board need to be more independent form senior execs

1. CEO – Chief Executive Officer / President2. COO – Chief Operating Officer / Vice President

x. Committees1. Bylaws - may authorize directors to appoint committees. C should generally operate through a

committee structure.a. Executive committee – important when there is a large board composed of non

management personnelb. Finance committee – typically principle financial officers of the corpc. Compensation committee –determines the compensation of sr. management.d. NY a committee can have one or more members. 712(a) – a committee has no

authority to submit to the shareholders a motion that must come from the full board. Cannot amend the bylaws.

e. Delaware – no such restrictions, BUT cannot authorize a dividend or issue stock, UNLESS bylaws authorize

2. Delegation of Authoritya. Boards may override any committee decision, but can delegate authority to

committeesb. Boards can delegate authority to outside companies to manage certain facet of

business, frequently used by smaller companies. These contracts must be approved annually by the board of directors, and can be ended at any time.

xi. Authority of an officer to act on a corporations behalf – depends on the title1. Apparent authority – third party assumes customarily vested authority by person holding

position (title)2. Modern rule – Lee v. Jenkins – President only has the authority to bind his company by

acts arising in the usual and normal terms of business. a. Courts all over the line on this issue, depends on facts case and attitude of the court.

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3. Declaration of dividends - can only be done by the board of directors.4. Elements to consider if things are extraordinary (thereby outside of apparent authority)

a. Economic magnitude of the decision in relation to earningsb. Amount of risk involvedc. Time spent on the result of the actionsd. What is the cost of reversing the action

5. Courts look at the significance of the decision on the structure of the business6. An officer can have certain authority if the board gives specific permission. It is good to ask

if the person has the authority to speak/act on behalf of the corporation. xii. Sarbanes-Oxley Act (“SOX”) - establishes the framework for a new requirement of accountability

by public companies in the areas of financial reporting, disclosure, auditing, conflicts of interest, and governance; Statute primarily about disclosure

Public Accounting Oversight Board – regulates the accounting profession and overseas the audit of public companies to protect public interest and board is subject to SEC oversight; establishes rules for audits and can adopt standards suggested by professional accounting orgs;

Key aspect is Auditor Independence – an important part of an audit is to test the reliability of company information systems; problem with Enron is that auditors were setting up the system, and then the same auditors were saying that the system was great – these companies were not independent, but rather were consulting too;

SOX – prohibits auditors from providing most auditing services Something – must change every 5 years, to avoid the look that the head auditor’s alliance

is with the company and not independent; These auditors can’t accept any type of compensation or perform consulting; they do have a salary, but can’t have other kinds of compensation

Audit committee – establishes procedures for receipt and retention of complaints, provide a channel where confidential and anonymous submissions by employees can be rec’d and employee won’t be fired for being a whistleblower. Committee has ability to retain independent counsel.

o One person on audit committee has to have financial experience, such as accounting

o Officers of corporation can’t try and influence audit committee X – must say they investigated internal financial information and are confident that figures

are accurate; and then the head of each department has to also sign off on this – this way all heads are on the line

SEC sets out what they want to know about different corporate controls Result of SOX – was a slew of restatements of accounting and financial results; tons of companies

after SOX’s had to re-state their financial results b/c they were cooking the books SOX requires that if the restatement of financial results was b/c of misconduct by

mismanagement, the CEO and COO or CFO have to reimburse company for differenceo CEO & CFO required to certify the accuracy of financial statements

Companies – have to have code of ethics, policy on conflicts of interest, can’t give loans to directors of corporation

Act requires lawyers to report evidence of material violations of security laws, to appropriate enforcement agencies

Material Changes have to be disclosed very rapidly under SOX, off balance transaction sheets must be mentioned, and there are whistleblower protections under SOX as well

*Smaller firms with less than $75 million in corporate assets – have more time to comply with SOX

SOX – only applies to publicly traded companies Audit Committee is sub-committee of board of directors and are suppose to be

independent members of the board; Job of audit committee is to ensure that there are financial controls in place and that the numbers that go up to the board are accurate – they can hire independent accountants and lawyers to ensure that these controls are working

Criticism of SOX is that it is overkill – now every company that is listed has to comply with SOX, as opposed to # of companies actually involved. Problems still exist.

e. Formalities Required for Action by the Board :i. BCL § 708 – Directors: Actions by Board

ii. BCL § 709 – Directors: Greater Requirement for Voteiii. BCL § 710 – Directors: Place & Time of Meetingsiv. BCL § 711 – Directors: Notice of Meetings - during a regular meeting of the board, specific items

to be discussed do not need to be disclosed.

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v. Governing Rules:1. Meetings –

a. A single D normally has no power; instead Ds can only act as a bodyb. Usually must act at a meeting where quorum present; c. Can conduct meetings via conference calld. Can act w/o a meeting if unanimous written consent

2. Notice – a. Regular Meeting - formal notice not required b/c already on noticeb. Special Meeting – every D must be given notice of date, time, and place; don’t have

to state purpose unless COI providesc. Waiver – notice can be waived in writing before or after meeting

3. Quorum – a. Quorum of a board consists of a majority of the Full Board (the authorized number of

directors); not just majority of # in office b/c there could be vacancies on the boardb. COI or Bylaws can allow for a lesser amount, but usually no less 1/3

4. Voting –a. The affirmative vote of a majority of those present (not simply a majority of those

voting) is required for actionb. COI or bylaws can require a greater-than-majority vote for board action

vi. Consequences of Non-Compliance – for publicly held C failure to comply will render board action ineffective

1. Unanimous explicit, but informal, approval – for close corps, most courts would hold that explicit but informal approval by all the directors is effective where a person who has contracted with a corporate officer has been led to regard his transaction with the corporations as valid an all SH either are directors or have acquiesced in the transaction or in past practice of informal board action

2. Explicit approval by a majority coupled with acquiescence by remaining directors – when majority of directors explicitly approve transaction and the rest know of the transaction but take no action, most courts will uphold the transaction

3. Majority approval or acquiescence – if majority of directors approve a transaction, but the remaining lack knowledge of the transaction, some courts have refused to uphold the transaction; others will hold C liable if the SH acquiesced

vii. Committees – Boards of Publicly held C do most of their work thru committees1. Committees can be advisory, or board can delegate decision making power to a Committee on

a specific matter or range of matters2. Some statutes list matters that can NOT be delegated to a committee3. C can delegate authority to outside corporations, such as corporations w/ specific expertise;

problem is lack of accountability4. Rules governing board procedures (notice, quorum, voting) are applicable to committees5. Compensation Committee – determines salaries and hire a consultant to tell them who should

be paid what6. § 712 – NY Committees

a. Committee can have one memberb. Have no authority to submit matters to SH for signaturec. Board can override any cmt decision

7. DE Committees – no restrictions, in DE committees can run whole corporationf. Authority of Corporate Officers :

i. BCL § 715 – Directors: Officersii. President –

1. Apparent Authority – P has apparent authority to bind company to contracts in the usual and regular course of business, but NOT contracts of an extraordinary nature

a. Extraordinary Matters - decisions that would make a significant change in the structure of the business enterprise, or in the structure of control over the enterprise

b. P can NOT bind C – i. In declaration of dividends b/c must be decided by Board

ii. On matters that need Board and SH approval2. Actual Authority – P’s actual authority is in COI, by-laws, or Board resolutions, or may derive

from a pattern of past acquiescence by the Board, or from Board’s ratification of a specific transaction

iii. CEO – Chief Executive Officer; usually holds a second title of either Chairman of the Board, President, or Both; COO or Chief Operating Officer is usually also President

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iv. Chairman of the Board – frequently held by CEOv. Vice President – has little or no apparent authority

vi. Secretary –has apparent authority to certify records of C, including resolutions of the board; no apparent authority for matters other than certification

vii. Treasurer – has no apparent authorityviii. Closely Held Corporations – if P has been exercising absolute authority over C’s affairs, and board

has never questioned, altered, or rejected his decisions, P will have extremely wide actual and apparent authority

ix. Ratification – 1. Even if an officer lacks both actual and apparent authority, C may be bound by officer’s act in

entering into a contract or other transaction on its behalf, if the board later ratifies the officer’s act

2. Ratification may occur where C, knowing all of the facts, accepts and uses the proceeds of an unauthorized contract executed on its behalf

g. Formalities Required for Shareholders Action – Cumulative Voting :i. BCL § 602 – Shareholders: Meetings – requires annual meetings, 602(c) re: who can call special

meetings and procedure to do so. ii. BCL § 603 – Shareholders: Special meeting for elections

iii. BCL § 604 – Shareholders: Fixing Record Dateiv. BCL § 605 – Shareholders: Notice of Meetingsv. BCL § 606 – Shareholders: Waivers of Notice

vi. BCL § 607 – Shareholders: List of Shareholders at Meetingsvii. BCL § 608 – Shareholders: Quorum

viii. BCL § 609 – Shareholders: Proxiesix. BCL § 612 – Shareholders: Qualification of votersx. BCL § 613 – Shareholders: Limitations on right to vote

xi. BCL § 614 – Shareholders: Votexii. BCL § 615 – Shareholders: Written consent w/o a meeting

xiii. BCL § 616 – Shareholders: Greater requirement for votexiv. BCL § 617 – Shareholders: Voting by Classxv. BCL § 618 – Shareholders: Cumulative Voting

xvi. BCL § 704 – Directors: Classificationxvii. BCL § 706(c) – Directors: Removal

xviii. Formalities Required for Shareholder Action:1. Meeting and Notice –

a. Annual Meeting – must provide notice of place, time, and datei. Federal Proxy Rules and some State Laws – require a description of

purpose in the annual meetingii. Date is set by the by-laws

b. Special Meeting – must provide notice of place, time, and date; must describe the purpose for which the meeting is called

i. ONLY business that can be transacted at a special meeting is that which is set froth in the notice of the meeting

c. Who Notices are Sent to :i. Notice of a Meeting is given to those persons who are SH of record on a

designated record date prior to the meeting1. Record Owners – persons who are listed as shareholders on C’s

records - BCL § 604a. This is NOT necessarily the same as those persons who are

owners of the stock on the date of the meetingb. Only persons who were record holders on the record date

have right to Notice of meeting and are entitled to vote at the meeting

2. Beneficial Owners – persons who actually own C’s shares3. Notice of meeting usually given a month before the meeting

ii. Record Date – normally fixed in the by-laws, or by the board; or if date not fixed, statutes usually provide that it be the day of or day preceding the day on which the meeting notice is sent; date is used to determine SH entitled to vote at the meeting

iii. Waiver – SH can waive notice by showing up at meeting

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2. Quorum – a majority of shares entitled to vote is necessary for a quorum, unless COI sets a higher or lower number - BCL § 608

a. Some laws - quorum can’t be lower than 1/3 of shares entitled to voteb. Other laws – set no minimum

3. Voting - a. Ordinary Matters – affirmative vote of a majority of shares represented at a meeting is

required i. If need affirmative vote of majority present, then an abstention counts as a

negative voteii. Requirements can be changed by COI

b. Fundamental Changes – often require approval by a majority or 2/3 of the outstanding voting shares, rather than a majority of those present or voting at the meeting

c. Election of Directors – need a plurality vote, the candidates who receive the highest number of votes are elected

d. Written Consent – generally SH are permitted to act by written consent in lieu of a meeting

xix. Cumulative Voting:1. Straight Voting – a SH can cast for each candidate for election to the board, a # of votes equal

to her number of sharesa. Ex. S owns 100 shares and 7 directors are up for election; S can cast a total of 700

votes, but no more than 100 per candidateb. Under this method, a minority SH can never elect a director to the Board over the

opposition of the majority2. Cumulative Voting – a SH can cast for any candidate a number of votes equal to the number of

shares she holds X the number of directors to be electeda. Ex. S owns 100 shares and 7 directors are up for election; S can cast 700 votes for one

candidate, or 350 votes for 2, or 300 for 2 and 100 for a third candidate, etc.b. Under this method, minority or majority can vote in a candidate; it protects the

interests of minority SH3. Mandatory Cumulative Voting – % of stock that minority SH must hold to elect at least 1

director under cumulative voting varies inversely w/ the # of directors to be elected; problem is that SH or Boards can undermine it

a. In NY and DE – cumulative voting is permissible, but it can be ignored. Some states are mandatory. (then the issue is can steps be taken to dilute the effects)

i. Board can be classified – stagger the election of directors. (board size can also be decreased to achieve same result)

ii. Replace board meetings with informal discussions. iii. Use of committees by which the minority issues are not on the table.

1. States that are mandatory have gone both ways whether these actions can be taken to mitigate the effect of cumulative voting.

iv. Classification of stock in NY – Can be in the bylaws § 707. 1. Can have up to four classes, and each need to be as close to each

other as possible. v. Removal of directors elected by cumulative voting requires the same # of

votes used to elect them. vi. Most corporations do not like to use it since it gives up some control

4. Mathematics of Cumulative Voting – a. Minimum # of shares needed to elect a particular number of Directors :

i. X = (S x N) + 2 D + 1

ii. X = minimum number of shares needediii. S = total number of shares that will be voted at meetingiv. N = number of directors desired to electv. D = total number of directors to be elected

b. How many Directors can be elected by a group controlling a particular number of shares:

i. N = (X) x (D+1) S

ii. N = number of directors that can be electediii. X = number of shares controllediv. D = total number of directors to be elected

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v. S = total number of shares that will be voted at meetingh. Limited Liability :

i. Limited Liability – 1. No-Liability Rule: SH ordinarily have NO liability for corporate obligations2. SH’s risk is ordinarily limited to her investment – the most a SH stands to lose if C fails, is the

amount that she paid for her shares3. Corporate managers and SH are ordinarily not liable for C obligations

a. SH – are not liable by statuteb. Managers – are not liable under agency principles; but they are liable for their own

tortious acts or those that they direct to be donec. Vicarious Liability – a tort by a corporate employee that injures a 3rd party, normally

will not cause a manger to be vicarious liable, even if employee was a subordinate to the manager

4. Exception – Piercing the Corporate Veilii. Piercing-The-Veil Doctrine –

1. This is an equitable concept, courts will pierce corporate veil whenever necessary to prevent fraud or achieve equity

2. Doctrine is applied to all corporations, but primarily close corporation or a parent corporation and subsidiary; no case has held SH of public C liable

a. If veil has been pierced, only those that have been personally involved in the management of the C are usually held liable

b. Courts have generally held that PV doctrine can be applied to LLCsc. BCL §630 – Unlimited liability survives, 10 largest shareholders of a close

corporations are liable personally for the wages of employees if a corporation becomes insolvent

d. Agency law will impose liability on parent corporations – because it is a principal, not a corporation whose veil has been pierced.

i. Did the party deal with the corporation voluntarily, or was it imposed (tort situation = involuntary creditor)

ii. As a creditor a due diligence investigation should be done, additional guarantees can be required.

3. Typically veil will be pierced when:a. (1st prong) There has been some disregard of corporate formalities, orb. (2nd prong) If the facts are treated as of the C alone and an equitable result would

follow (It would be unfair/unjust to acknowledge corporate form.)4. Even if a corporation is pierced, generally only hold liable those who are active in managing

the corporation are held liable. iii. Alter Ego Theory – basically arguing that the alter ego virtually ignored the corporate form, and

operated the subsidiary corporation as if it were the parent, and that it would be unfair to not pierce the corporate veil of the sub

1. 1st Prong - P must show that the parent and the subsidiary “operated as a single economic entity” and

a. A parent C approving major decisions of sub doesn’t mean two Cs are a single economic entity

2. 2nd Prong - that an element of injustice or unfairness is presenta. It is not necessary that their be a showing of fraud

3. Factors for court to consider:a. Whether C was adequately capitalizedb. Whether C was solventc. Whether C records were kept and other formalities observedd. Whether a dominant SH siphoned corporate fundse. Whether, in general C simply functioned as a facade for dominant SHf. *Note – courts generally refuse to find alter ego liability where a cash management

system is usediv. Equitable Subordination –

1. Under this doctrine, when a C is in bankruptcy, debt claims that a controlling SH has against the C may be subordinated to the claims of other persons, including the claims of preferred shareholders, on various equitable grounds

a. Also referred to as the “Deep Rock” doctrine (Taylor v. Standard Gas & Electric)

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2. This is NOT piercing; you are knocking down some of the creditors to a less preferred status; this is much less drastic than piercing veil which undermines the essential premise of limited liability - that a SH risk is limited to the amount of his investment

3. This usually happens where there is not enough capitalization, usually must more common thatn piercing.

v. Corporate subs or divisions - A parent corporation may operate a business either as a sub or a division within the corporation itself.

1. Parent is usually liable for the operations of the division, there is no separation2. If operated as sub, parent is normally not obligated for sub’s liabilities. 3. Limitation of parent liability is not the dominant factor in choosing between sub/division,

usually it is an operational choice. (management decision) 4. Parent may make use of the assets of a sub, to get better interest rates, to ensure that the sub is

not wasting money. i. Fletcher v. Atex –

i. F – F was allegedly injure by an Atex keyboard and sought to pierce corporate veil to hold Atex’s parent company, Kodak, liable.

ii. H – P failed to satisfy either prong of the alter ego theory test.iii. R – Corporate veil can be pierced if the Corporation and the SH operated as a single economic

entity and there was an overall element of unfairness present.j. Walkovszky v. Carlton –

i. F – W hit by a taxicab and sought to hold SH personally liable for his injuries. The cab companies were intentionally undercapitalized by Carlton by providing the bare minimum liability insurance.

ii. H – Case dismissed for failure to state a claim; P failed to show that the corporation was a dummy for its SH who were actually carrying on the business in their personal capacity for personal rather than C ends.

iii. R – For personal liability to attach to SH, it must be shown that the SH were actually carrying on the business in their individual capacity for personal rather than corporate ends.

iv. Note – When case was dismissed for failure to state a claim, W re-filed case and alleged that Carlton conducted the business in their individual capacities.

v. **Court views that holding minimum insurance as not fraudulent. Corporate form will not be discarded just because corporate assets are insufficient to make P whole.

k. Minton v. Cavaney – Outer limits of piercing doctrinei. F – M’s daughter drowned in a pool owned by S. M sought to hold S’s director liable for her death.

ii. H – Corporate veil should be pierced b/c there was no attempt to adequately capitalize C; but S can’t be held liable since not a party to original action so need to re-litigate.

iii. Factors for when SH should be held personally liable:1. When they treat the assets of the C as their own2. When they hold themselves out as personally liable, OR3. When they provide inadequate capitalization and actively participate in the conduct of

corporate affairs4. Here the basis for piercing is –

a. Inadequate capitalization – trivial to the business to be done and the risks involved. b. Ignorance of corporate formalities –

i. Amount of directors (was only one)ii. Corporate records kept in personal office

iii. Shares never dispersed. iv. R – Corporate veil can be pierced where SH undercapitalize the corporation and actively

participate in the conduct of corporate affairs.. 1. BUT undercapitalization alone is still not sufficient to pierce. 2. Corporate formalities must be followed

l. Arnold v. Browne – “Evidence of inadequate capitalization is, at best, merely a factor to be considered by the trial court in deciding whether or not to pierce the corporate veil”

m. Slottow Fidelity Federal Bank v. American Casualty Co – piercing in a parent/ sub organization holds the parents liable, but not the shareholders of the parent company.

n. Radaszewski v. Telecom Corp. – Subsidiary was adequately capitalized due to insurance policy, even if undercapitalized.

o. Sea-Land Services v. Pepper Source – i. F – After losing on remand, D appealed the court’s finding that injustice would result if the corporate

form was respected. ii. H – S satisfied the 2nd prong of the test by showing that in addition to the inability to collect on a

judgment, D was unjustly enriched and manipulated the corporations to avoid creditors. D had used

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C funds to pay personal expenses and expenses of his other Cs; he left C with insufficient funds to pay its creditors causing bankruptcy; he violated lots of tax laws.

iii. R – Unjust Enrichment and Manipulating corporate funds are sufficient “wrongs” to pierce the corporate veil of (here ofalter ego corporations)

iv. When will the corporate veil be pierced? 1. Failure to maintain adequate corporate records or comply with corporate formalities2. Commingling of funds or assets3. Undercapitalization4. One corporation treating the assets of another corporation as its own.

v. The nexus of fraud was that he knew he would be unwilling/unable to pay. D was found personally liable, and all corporations were pierced (reverse pierced) D was the dominant force behind all the corporations. D and all his subsidiaries were held liable.

1. Fraud is still an independent basis for liability, but must prove reliance on fraud. Some cases hold that reliance does not need to be shown.

p. US v. Bestfoods and Direct Liability – case stresses formalities of corporate formality. i. I – Whether the Parent CPC was liable as the owner/operator of a plant owner by a subsidiary for a

toxic cleanup under CERCLA.ii. Cases in which parent is sought to be held liable w/o piercing the subsidiary’s veil, on the ground that

the parent directed the subsidiary’s operations, or some relevant portion of those operations, and is therefore directly liable as a primary wrongdoer for wrongs that were committed in the course of those operations

iii. Key Question (TEST) – Whether in degree and detail, actions directed to the facility by an agent of the parent alone are eccentric under accepted norms of parental oversight of a subsidiary facility.

iv. Under CERCLA a parent may be liable under traditional piercing situations, but also for directly participating where agents participate or directly operate a hazardous waste site. The fact that there are employees of parent present is not sufficient to pierce, parent must conduct activities specifically related to pollution for liability

q. Kinney Shoe v. Polan – Court set forth a 3rd prong to corporate veil test, apply to contract creditors only:i. When it would be reasonable for a creditor entering a contract with C, to conduct an investigation of

the credit of C prior to entering into the contract, the creditor will be assumed to have knowledge that a reasonable credit investigation would disclose.

1. If the investigation would disclose that C is grossly undercapitalized, the creditor will be deemed to have assumed the risk of gross under capitalization and will not be permitted to pierce corporate veil.

ii. Basically – Incorporates who actively participate in the operation of the business are not entitled to personal immunity, when they fail to provide the quid pro quo for such immunity, specifically, a reasonably adequate capital fund to which creditors may resort

iii. Poland was pierced because if they wanted the protection of formalities, proper corporate formalities should have been followed. Nothing invested in corporation therefore no protection to owner.

1. Fishman thinks case allowed Kenny to be reckless and do no due diligence. But court says that it would be inequitable to allow Poland to walk away from sublease. Not a normal result.

VI. SHAREHOLDER’S RIGHTSa. Shareholder Information Rights under State Law :

i. Rights to Inspect Books and Records:1. BCL § 624 – Shareholders: Inspect Books2. BCL § 1315 – FN: Record of Shareholders3. Common Law – SH acting in good faith for purpose of advancing the interest of C and

protecting his own interest as a SH has a right to examine the corporate books and records at reasonable times

a. Burden of Proof – SH bears burden of alleging and proving good faith and proper purpose

4. Statutory Limitations on Inspection – a. Only certain kinds of SH; ex. SH of at least 5% of stockb. Only certain kinds of books or records

5. Today – Statutes supplement the common law, so that a suit for inspection that does not fall within the relevant statute can still be brought under common law

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a. Derivative suit – where a shareholder or director brings suit on behalf of a corporation, where the recovery goes to the corp.

b. Direct suit – where shareholder sues on behalf, and recovery goes to plaintiff (& other shareholders)

c. Request cannot be too sweeping, cannot cover preliminary profit/loss statements, monthly profit analysis, detailed balance sheets, or other confidential information.

6. Proper Purpose – courts have held that proper purposes for SH to exercise right of inspection are: To determine the financial condition of the corporation; and To ascertain the value of the petitioner’s shares

a. Purpose reasonably related to such person’s interest as a shareholder.b. Once establishing a proper purpose, secondary improper purposes will not defeat

accessc. Access limited to books needed to establish proper purpose, right to inspect does not

allow a mere fishing expedition. 7. Stockholder Lists –

a. Easy to get other stockholder lists and basic informationb. Harder to get internal data or contracts; Have to show the court a “specific and

plausible reasons why the information is needed”8. Reporting Laws:

a. C with 500 or > shareholders = SEA requires C to report certain information to all SH without specific SH requests

b. C with < 500 shareholders = Model Business C Act and some state statutes, require C to furnish its SH annual financial statements, including a balance sheet and income statement

i. *DE – doesn’t require C to furnish financial statements to SH even on written request

9. Director’s Intent:a. NY –director’s intent is irrelevant; director needs unqualified access to information to

perform his dutiesb. DE – director’s intent is relevant on theory that his right to information presupposes

that he is not hostile to Cii. Saito v. McKesson HBOC –

1. F – S as a SH sought to inspect books and records of HBOC to determine whether C was engaged in any wrongdoing. S was seeking inspection of both parent and subsidiaries books, including for the time before he was a SH.

2. I – Is a SH right to inspect C records and books limited by the date of the records or their sources?

3. H – No; right of inspection is limited to review of those records necessary and essential to accomplish stated purpose.

a. P in a derivative suit must be a SH at the time the transaction complained of occurs

b. Books and records can pre-date P’s stock ownership, as long as they are reasonably related to P’s interest as SH

c. If activities that occurred before stock purchase date are reasonably related to SH’s interest as SH, then the SH should be given access to records necessary to an understanding of those activities

d. 3rd party documents – must be reasonably related to SH’s interest and necessary to establish SH’s proper purpose justifying inspection

e. A SH of a parent corporation ordinarily does not have a right of inspection of the books and records of a subsidiary of which he is not a stockholder

4. R – SH has broad right to inspect corporate books and records; SH has right to make a written demand to inspect corporate books and records for a purpose reasonably related to such person’s interest as SH.

iii. Seinfeld v. Verizon – 1. F – S brought suit under § 220 DE law to inspect the books and records of V relating to the

compensation of their 3 highest corporate officers. S claimed their compensation was excessive and wasteful (corporate waste) but lower court said he didn’t meet his burden of establishing a credible basis for waste.

2. I – Should a SH seeking inspection under §220 be entitled to relief w/o being required to show some evidence to suggest a credible basis for wrongdoing?

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3. H – No; A SH seeking inspection must present a preponderance of evidence to suggest a credible basis from which a court can infer that mismanagement, waste or wrongdoing have occurred; S failed to meet the credible basis standard to justify additional investigation.

a. “Credible Basis” standard – provides SH with access to records; and protects C from requests based on suspicion or curiosity

b. Shareholder Information Rights under Federal Law & Stock Exchange Rules: i. Stock Markets:

1. Financial Market – is a way of bringing buyers and sellers together; debt and equity securities are bought and sold

a. Equity Securities – issued solely by the corporationsb. Debt Securities – issued by both governments and corporations

2. Primary Market – refers to the original sale of securities by governments and corporationsa. C is the seller and transaction raises $ for Cb. C engages in 2 types of transactions:

i. Public Offering – selling securities to general public1. SEC requires public offerings of debt and equity to be registered

with the SEC, which requires C to disclose a great deal of information before selling any securities

ii. Private Placement – negotiated sale with a specific buyer1. These sales do not have to be registered w/ SEC

3. Secondary Market – those in which these securities are bought and sold after the original salea. Involves one owner or creditor selling to anotherb. This market provides means for transferring ownership of C securitiesc. 2 Kinds of Secondary Markets :

i. Over the Counter / Dealer Markets – dealers buy and sell for themselves at their own risk; most trading takes place OTC

1. Ex. National Association of Securities Dealers (NASD)ii. Auction Markets – brokers and agents match buyers and sellers; this takes

place at a physical location (like Wall ST.)1. Ex. New York Stock Exchange (NYSE); American Stock Exchange

(AMEX); and Pacific Stock Exchange2. Street Name – stock frequently held in the name of a broker or a

bank, rather than the individual shareholder3. Nominee Name – stock registered in the name of a bank nominee

account4. *Note - Problem arises when C soliciting proxy votes b/c when

stock registered in street or nominee name, they don’t have a beneficial interest in the vote, they are merely custodians of the securities

d. Listing – stocks traded on an organized exchange are “listed” on that exchange; To be listed firms must meet certain minimum criteria for asset size and # SH

i. NYSE – has most stringent requirements; must have a market value of at least $100 million and a total of at least 2,000 SH with at least 100 shares each

ii. SEC & Securities Exchange Act:1. SEA § 12(a), (b), (g) – Registration Requirements for Securities2. Securities Exchange Act: Rule 12g-1. Exemption From Section 12(g) - An issuer shall be

exempt from the requirement to register any class of equity securities pursuant to section 12(g)(1) if on the last day of its most recent fiscal year the issuer had total assets not exceeding $10 million and, with respect to a foreign private issuer, such securities were not quoted in an automated inter-dealer quotation system.

3. Securities Exchange Act of 1934:a. Created Securities and Exchange Commissionb. Empowers SEC w/ broad authority over all aspects of securities indusc. Powers Include: to register, regulate and oversee brokerage firms, transfer agents, and

clearing agencies as well as the nation’s securities self regulatory organizationsd. Act identifies and prohibits certain types of conduct in the markets and provides SEC

w/ disciplinary powers over regulated entities and persons associated w/ theme. Empowers SEC to require periodic reporting of information by companies w/ publicly

traded securitiesf. Act Regulates :

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i. Corporate recordingii. Proxy statements

iii. Tender off solicitations thru Williams Activ. Insider tradingv. Margin trading – borrowing $ to buy stock

vi. Market surveillance of the exchangesvii. Regulates fraud and manipulation

viii. Regulates stock exchanges / OTCix. Broker / dealer registrationx. Proxy’s

xi. Enforcement4. Corporate Reporting – companies w/ > $10 million in assets whose securities are held by

more than 500 owners must file annual and other periodic reports; reports are available to public thru SEC database EDGAR

5. Proxy Solicitations – Act governs disclose in materials used to solicit SH votes in annual or special meetings held for election of directors and approval of other corporate action

a. Proxy information must be filed with SEC in advance of any solicitation to ensure compliance w/ disclosure rules

b. Solicitations must disclose all important facts concerning the issues on which SH are asked to vote

6. Prospectuses – disclosure reports before a company issues stock; these must be extremely accurate

iii. Periodic Disclosure under Securities Exchange Act:1. SEC imposes periodic reporting requirements on C w/ security registered under § 12; also

known as Structured Disclosurea. Structured Disclosure also required when C makes a public offering

2. SEA § 13 – requires C to file:a. Form 10-K : must be filed annually; must include

i. Audited financial statementsii. Management’s discussion of C’s financial condition and results of

operations, andiii. Disclosure concerning legal proceedings, developments in C’s business,

executive compensation, conflict of interest transactions, and other issuesb. Form 10-Q : must be filed quarterly; must include

i. Quarterly financial data prepared in accordance w/ general accounting principles

ii. Management report, andiii. Disclosures concerning legal proceedings, defaults on senior securities,

and other issuesc. Form 8-K : must be filed w/in 4 business days after the occurrence of certain events:

i. Change in control of C; ii. Acquisition or disposition of significant amount of assets;

iii. Change of accountants; iv. Termination of a material definitive agreement; v. Departure of a director or principal officer;

vi. Amendments to COI or bylaws or code of ethicsvii. Waivers of a provision of C’s code of ethics

3. Proxy Rules – periodic reporting also required in connection w/ C’s annual meeting4. Note – C’s may make voluntary disclosures of material corporate developments whenever they

want; Also, rules of major stock exchanges often require listed Cs to make timely disclosure of material developments

c. Proxy Rules :i. SEA § 14(a): Proxies

ii. SEA Rules 14a-1: Definitionsiii. SEA Rules 14a-2: Proxy Solicitationsiv. SEA Rules 14a-6: Filing Requirementsv. Introduction:

1. Terms:a. Proxy Holder – a person authorized to vote shares on a SH behalfb. Proxy, form of proxy, or proxy form – written instrument in which such an

authorization is embodied (like a power of attorney)

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i. Revocable – every proxy is revocable; can revoked by sending in another vote afterwards or by showing up at the meeting

ii. Valid – proxy is only valid for 11 months, unless otherwise stated; SH cannot sell their vote for S

iii. NY BCL § 609 – every SH entitled to vote, may authorize another person to vote for him; person would be your agent acting pursuant to your instructions

c. Proxy Solicitation – process by which SH are asked to give their proxies; solicitation is defined broadly

d. Proxy Statement – written statement sent to SH as a means of proxy solicitation; SH use this to decide how to vote

e. Proxy Materials – proxy statement and form of proxy2. Overview of Proxy Rules:

a. Background – proxy voting is the dominant mode of SH decision making in publicly held C b/c SH are geographically dispersed and typical shareholding will normally represent only a fraction of SH’s total wealth; C usually bears cost of proxy process

b. Coverage – Rule 14a-2 provides that Proxy Rules apply to every solicitation of a proxy with respect to securities registered pursuant to § 12 of SEA; definitions of Proxy and Solicitation are very broad

i. If you are contacting > 10 people, have to go thru proxy rules; as such virtually everything comes under these rules

ii. Any action brought must be in federal courtiii. Penalties – fine and prison time

c. Focus / Purpose of Proxy Rules – i. Disclosure of Information – material information for SH to vote

ii. Election Contests – apply whenever competition for a board position; ea participant must file a special disclosure statement; this is very different from a general election

iii. Anti-Fraud – filing w/ SEC doesn’t mean information is not misleading; SEC only requires disclosure, info could be wrong

d. Transactional Disclosure – Rule 14a-3; Proxy rules require full disclosure in connection w/ transactions that SH are being asked to approve, such as mergers, certificate amendments, or election of directors; specific information that must be disclosed is listed as well as statement that no solicitation shall contain any statement that is false or misleading with respect to any material fact or omits a material fact

e. Periodic Disclosure – require certain forms of annual disclosure f. Proxy Contests – Rule 14a-11 regulates proxy contests, in which insurgents try to oust

incumbent directorsg. Access to body of SH – Rules 14a-7 and 14a-8 provide mechanisms through which

SH can communicate w/ each otherh. Mechanics of Proxy Voting – Rule 14a-4 governs form of proxy

3. Annual Report to SH:a. C must send an Annual Report to its SH either in advance of or concurrently w/ the

proxy statementb. This Report must be distinguished from Form 10-K annual reportc. Contents of Annual report governed by Rule 14a-3 and includes:

i. C’s financial statementsii. Selected financial data

iii. Management’s discussion and analysis of C’s financial condition and results of operations

vi. Private Actions: 1. SEA Rules 14a-9: False or Misleading Statements2. JJ Case v. Borak – a SH can bring a private action for violation of Proxy Rules, even though

neither SEA or Proxy Rules provide for such an action; court found an implied right of action under § 14 of SEA

3. Wyandotte v. US - Individual is subject to Civil NOT Criminal liability for violating Proxy Rules

4. Gerstle v. Gamble-Skogmo – negligence sufficed to establish liability under Rule 14a-95. Cort v. Ash – in order to bring a private action must:

a. P must be one of the class for whose especial benefit the statute was enacted; that is, does statute create a federal right in favor of P

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b. Is there any indication of legislative intent, explicit or implicit, either to create such a remedy or to deny one

c. Is it consistent with the underlying purposes of the legislative scheme to imply such a remedy for P

d. Is the cause of action one traditionally relegated to state law, so that it would be inappropriate to infer a cause of action based solely on federal law

6. Mills v. Electric Auto-Lite – a. F – C’s minority SH brought a derivative action to set aside a merger between C and

C that was its majority SH by charging that the proxy solicitation for the merger was materially incorrect in that it failed to mention C’s board of directors was controlled by majority SH C.

b. H – SH do not need to prove that the material defect in the proxy caused the injury. Court sets out the test for private action

c. TEST – A private action under § 14(a) of SEA has two elements:i. Materiality of omision, and

ii. A nexus between the proxy and the transaction (that the proxy was necessary to complete the proposed transaction)

d. *Note – the court essentially merged the causation issue into the finding of materiality, so that causation is not a separate element for P to prove; once the two elements are satisfied, the court just needs to determine what remedy to apply.

7. TSC Industries v. Northway, Inc. –a. I – How is “Materiality” to be defined?b. TEST – General Standard of 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.

c. BOP – 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

8. Virginia Bankshares v. Sandberg – a. F – A SH, who w/held her proxy in a merger vote, sought damages from the bank

holding company that acquired her shares, claiming that proxies were solicited by means of materially false or misleading statements b/c the board of directors did not believe their own assertion that the tender price was high. Proxy statement recommended the merger stating it was “fair” and that it gave minority SH an opportunity to receive a “high” value for their stock. But b/c of % owned, VA law didn’t require minority SH approval for the merger.

b. H – SH did state an action, but can’t prove damages.i. Directors’ statements of reasons, opinions, or beliefs are facts that may be

actionable under § 14(a) as misstatements of material factii. Court refuses to extend Mills (don’t have to prove causation) holding to a

situation where minority votes are not necessary to complete the transaction; P can’t prove damages.

c. R – Statements of reasons, opinions, or beliefs may be actionable under § 14(a) of SEA.

vii. Shareholder Proposals:1. SEA Rules 14a-7: Obligations of Registrants (lists, mailings)2. SEA Rules 14a-8: Shareholder Proposals (includes list of reasons why mgmt can exclude)3. No-Action Letters – Rule 14a-8 provides that if management believes SH proposal may be

excluded from C’s proxy statement, it must submit to SEC a statement of reasons why omission is proper

a. If SEC Agrees – it sends management a No Action Letter, stating if the SH proposal is omitted, SEC won’t take any action

b. If SEC Disagrees – it sends a letter stating why proposal should be included; these are also referred to as no-action letters, even though they implicitly threaten legal proceedings if omitted

c. *Note – C can still omit SH proposal but run legal risks w/ SEC4. Roosevelt v. EI Du Pont de Nemours –

a. F – A SH brought suit against C under § 14a claiming C improperly excluded her proposal from the annual proxy materials. C had rec’d a no-action letter from SEC citing the ordinary business exception as basis for excluding the proposal.

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b. I – May C omit SH’s proposal from its annual proxy materials if the proposal relates to the timetable for implementing a C policy?

c. H – Yes; SH proposal may be excluded under “ordinary business” exception if the proposal relates to the timetable for implementing corporate policy; SH sought to move the date up a year, and such a decision is within the “ordinary” business judgment of C.

i. SH does have an implied right of action under § 14a & Rule 14a-8 when C refuses to include SH’s proposal in proxy materials

ii. Ordinary Business Judgment – implementation of a policy; the timing for an agreed-upon action

iii. *Note – the adoption of a corporate policy would probably NOT be w/in ordinary business judgment

5. Shareholder Proposals / Resolutions – usually divided into 2 categoriesa. Social-Policy Resolutions

i. Case by case analysis for employee related shareholder proposals as significant policy proposals

b. Corporate-Governance Resolutionsc. NY – Dressel case – SH can vote on a precatory proposal and it does not interfere

with board authority. d. 14a-8(i)(5) – management can exclude proposals that are not significantly related to

company purposes, it must be related to operations that involve 5% of assets, earnings, or gross sales, or otherwise significantly related to the company’s business.

i. SEC has gone back/forth on this.ii. 13 reasons for mgmt to exclude proposals

1. to preserve state law scheme of centralized decision making in a board of directors

2.e. Should shareholders be able to nominate board members w/o a proxy vote?

i. Dodd-Frank legislation makes it easier to nominate board members w/o proxy vote.

ii. Shareholders can elect to have more liberal rulesiii. Management can exclude;

1. Proposals that directly conflict with management proposals2. Duplicative shareholder proposals. 3. Recidivist proposals (that showed up in the past, but did not get

much support)a. Have to get an increasing amount of votes in order to

submit the same proposal again.4. Illegal proposals that violate any law, including of SEC.5. Proposals based on personal grievances. 6. Proposals that are moot/beyond corporation ability

iv. If proposal passes all these hurdles, management must include for SH vote, if failing to do this, SH can seek SEC declaration that rules are being violated, or bring a private action in court.

f. Annual reports to shareholders are usually very expensive, under current laws proxy cost may be charged to the C for contested and uncontested meeting/proxy fight.

i. Financial burden to the incumbents should not depend on if someone contests their leadership

ii. Basic rules of reimbursement – C may not reimburse either party (management or insurgents) unless the dispute concerns question of policy, for reasonable and proper expenses. Incumbents may be reinforced whether they win or lose. Insurgents may only be compensated if they win, must obtain shareholder approval of reimbursement after disclosure. (nearly impossible if they lose)

iii. (every dispute involves policy and not personnel, or else nobody could get reimbursed)

iv. Computer Associates case – proposal to reimburse the candidates for a proxy fight, re: pension plan.

i. F - Under Del (& NY) law both board and the SH have power to amend bylaws. a. Ct. holds that powers are not coextensive. Giving the SH these

powers have to be read with a statutory section saying that C will be

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managed under the direction of the board. SH don’t have power unless statute says so, or bylaws give such permission to SH.

b. Ct. has to determine scope of power of amendment, appeal, and adoption, and whether the bylaw falls within the allowable type.

c. §109(b) Del. code permits bylaws to contain a provision retaining to the rights of SH, pension plan argues this pertains to the right to electing directors.

d. 102(b)(1) Delaware code – any provision limiting the power of directors must be contained in the COI, and not in the bylaw. (initiative to amend COI, is taken by directors then voted on by SH)

e. Ct. says CA argument is wrong, as it would allow corporation to gut shareholder ability to amend bylaws.

ii. I –Is proposed bylaw intruding upon director’s power to manage C’s business.ii. H – Ct. concludes that this proposal was proper for shareholder vote, as it relates.

a. 2nd part of the court’s analysis – that proposal violates federal law as the issue does not arise from a set of facts, under at least one hypothetical directors could breach fiduciary duties under this proposal

i. Directors could be required to reimburse insurgents who brought proxy fight not relating to any policy issue (personal matters)

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VII. CLOSE CORPORATIONSa. Introduction :

i. Three Class of Corporations:1. Publicly Held – large number of SH and publicly traded2. Private Corporations – small or large # of SH, but not publicly traded3. Close Corporations – a subset of private corporations; similar to partnerships, except that in

PN can dissolve, generally provides limited liability and tax benefits.a. Small # of SH; SH may not have limited liability for many claimsb. Restrictions on Transferability of ownership interests / stock - No ready market for

corporate stockc. Owner-Management Control - Substantial majority SH participation in the

management, direction and operations of Ci. SH participate in management, no separation of ownership/control

1. BCL §715b – COI can provide that SH rather than managers elect board.

d. May not have indefinite or perpetual duration, particularly if major shareholder wants to leave, or runs another business.

e. Every corp. should have shareholder agreement that sets how corp will operate and how shareholders can get out if the chose.

ii. Legislative Strategies re: Close Corporations – 1. Unified Strategies – don’t make any special laws for CC, just modify traditional C laws to fit

CCs2. NY and Model Act Strategies – follow unified approach to a point, then add 1 or 2 provisions

that are applicable only to CCa. BCL § 620(c) – authorizes certain kinds of certificate provisions so long as no shares

of C are listed on a NSE or OTC market3. Statutory Close Corporations –

a. DE – follows unified up to a point, but adds an integrated set of provision explicitly applicable only to CC; Under DE law § 342 a C can qualify for statutory close corp status if its certificate provides:

i. All of C’s issued stock of all classes shall be represented by certificates and be held of record by not > a specified # of ppl, not to exceed 30;

ii. All of issued stock of all classes shall be subject to 1 or > of the restrictions on transfer permitted by § 202 of DE;

iii. C shall make no offering of any of its stock of any class, which would constitute a public offering

iv. *If qualify – can Elect this status by adopting heading in COIb. Significance – very few newly formed C elect to become statutory CC

4. Corporations that do NOT Elect CC status – a. One view is that even if a CC doesn’t elect CC status, the courts can still continue to

apply and develop corporate law in a way that is responsive to the needs of CCb. DE – if you do not elect CC status, then you are NOT subject to CC law, you are

subject to regular corporate lawiii. Donahue v. Rodd Electrotype -

1. F – A minority SH of a CC seeks to rescind C’s purchase of controlling SH’s stock; D claims that C refused to buy her shares at the same price C offered to another SH.

2. H – Controlling SH breached fiduciary duty to D when he refused to offer her the chance to sell a ratable number of shares to C at an identical price.

3. R (1) – SH in a CC owe each other a fiduciary duty of the utmost good faith and loyalty, similar to duty that partners in a PN owe each other.

4. R (2) – SH have an equal opportunity to participate when C is purchasing stock, but SH have NO right to demand C to buy back stock unless there is a buy-back agreement.

5. Test – must be equal opportunity for each shareholder to participate, subject to being in good faith, to equal creditors and then shareholders. Controlling group cannot use their control to obtain special advantages.

b. Special Voting Arrangements at Shareholder Level :i. BCL § 609 – Shareholders: Proxies

ii. BLC § 620 – Shareholders: Agreements at to Votingiii. Vote Pooling Agreement – a contract in which 2 or more SH of a C agree to vote their stock together

as a unit on one or more corporate issues; this is an alternative to the more formal voting trust, except with VP, each party votes their own shares

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iv. Irrevocable Proxies – 1. Even if a proxy is expressly conferred in connection w/ a voting agreement, problem is that

proxy’s are revocable2. To insure that a proxy will be irrevocable – confer it upon a proxyholder who has an “interest”

in the shares to which the proxy relates; then complies w/ agency laws as well as proxy rulesa. Magic language needed – “power coupled with an interest”b. Power coupled w/ an interest – the agent has an interest in the subject matter to which

vote or power relates and thus doesn’t exercise vote on behalf of principal, but on behalf of agent

c. Interest – in stock or C, or when proxy has a charge, lien, or some other property interest in the shares, or a security interest given to protect proxy holder for $ advanced or obligations incurred

3. Today – most statutes will make such proxies irrevocablea. NY BCL § 609 and DE § 212(e)

i. §212(e) – A duly executed proxy shall be irrevocable if it states that it is irrevocable and if, and only as long as, it is coupled with an interest sufficient in law to support an irrevocable power, a proxy may be made irrevocable regardless of whether the interest with which it is coupled is an interest in the stock itself or an interest in the corporation generally

ii. Not seller’s agent, stock can be voted as wanted, owe nothing to other party, called proxy only because the form is given in traditional matter

iii. Power given by a SH, allowing the proxy holder to vote independently. Seller is still listed as the owner on the company books.

iv. Typical situation is as a means of securing a debt. Company extends funds, and receives irrevocable proxies sufficient to elect members of the board of directors. Holder of the proxy does not have the duty to act for the giver of the power, nor subject to the giver’s control.

v. Another example – one extends credit to a corporation, and can be given irrevocable proxy in order to vote to protect the loan. Here the interest is in the corporation (not in the stock)

vi. Another example – employee can bargain for a proxy (interest is in the corporation)

v. Ringling Bros. V. Ringling – 1. F – SH of CC operating a circus sued to enforce terms of a vote-pooling agreement entered

into w/ another SH who had refused to vote according to terms of the agreement. 2. I – Is a vote-pooling agreement among SH automatically unlawful?3. H – No; SH have broad discretion in voting and in fact don’t even have to vote; this agreement

is lawful, but court didn’t enforce it b/c wouldn’t hold another election. If was an irrevocable proxy would have been enforceable:

a. Interest in stock – right of first refusalb. Interest in C – good management, C run by family; BCL § 609(e)

4. R – SH may enter into an agreement to vote their shares jointly; Vote Pooling agreements are lawful.

5. SCOTUS – arbitrator’s duty was to decide if there was a disagreement between parties, not be a trustee. The agreement contained no protections against Haley shifting allegiance to North, parties only bound to each other, no explicit proxy provision. Here one party could not exercise the voting rights of another, enforcement mechanism was flawed, Haley’s failure to exercise voting rights in accordance with agreement was a breach of K. (SCOTUS doesn’t count Haley’s vote, leaving one vacancy) Power of the arbitrator is not independent of the decision making of the two SH, court finds that the agreement to use an arbitrator is merely a deadlock breaking device. The agreement is legal, but cannot be enforced.

c. Voting Trusts & Classified Stock :i. BCL § 617 – Shareholders: Voting by Class

ii. BCL § 621 – Shareholders: Voting Trust Agreementsiii. Voting Trusts – a legal device in which corporate shareholders transfer legal title and voting rights to

a voting trustee who is authorized to vote on their behalf, but still retain the beneficial right to corporate distributions and stock appreciation

1. In General – voting trust is a device by which SH separate (i) the voting rights in, and the legal title to, their shares from (ii) beneficial ownership of shares

a. Structure of Voting Trust :

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i. Trustees – get voting rights and legal title ii. Shareholders – retain ultimate right to dividends and stock appreciation

iii. Usually VT is 2 or > SH involved, a type of pooling agreementiv. Can be 1 SH; created to satisfy creditors or vest control of business in

managersb. Requirements to create a Voting Trust –

i. 1. Execution of a written trust agreement between participating SH and voting trustees, and

ii. 2. A transfer to trustee for a specified period, of SH’s stock certificates and the legal title to their stock

iii. Voting Trustee registers transfer w/ C’s books so that they are Record owner and thus entitled to voted

iv. Dividends issued to trustee, trustee fwds to beneficial ownerc. Validity – most statues both explicitly validate voting trusts and regulate their

creation and contenti. Max period of time for a voting trust is 10 years (except in Del)

ii. Agreement must be filed w/ C and open to inspectioniii. Must be noted on stock itself that stock is in a voting trustiv. Beneficial owners have right to inspect the books.

d. Termination – i. Trust is not terminated just b/c beneficial owners transfer their stock to

someone else; can sell shares while in a trustii. Term of trust is renewable

iii. When trust is terminated at end of specified time, beneficial owners receive stock certificates that reinstate them as complete owners and are registered on C books

e. Benefits (uses) i. To protect creditors – allows creditors to elect the board until the debt is

paid, allows corporation to get credit in many situations.ii. To preserve control in a shareholders agreement (best way, divorced

ownership from control)iii. To ensure professional management (often used in the publishing industry

where founders did not trust children to run business) iv. To implement a legally required severance of control (divestiture under an

anti-trust agreement)

2. Overlap of Voting Trusts and Shareholders’ Voting Agreements – frequently these overlap so courts apply rules of voting trusts to SH voting agreements

iv. Classified Stock & Weighted Voting – 1. BCL § 703 & 704 – Can establish different classes of stock and give each class a different

level of voting rights or # of directors they can electa. Can be up to 4 classes, if classified directors, any changes in # directors have to be

proportioned among classes so that all classes are nearly as equal. When increased by board there is no classification, SH meeting will elect by class at next SH meeting.

2. This is very useful in ensuring family control of C3. Courts have upheld the creation of a class of stock that has voting rights, but no proprietary

rights4. Statute allows whatever capital structure wanted.

a. Parties to a corporate entity may create whatever restrictions and limitations they may want with regard to their corporate stock by expressing such restrictions and limitations in the articles of incorporation.

5. Very useful in Close C’s where one party contributes capital, other skill and both parties want to be members of the board

d. Agreements Controlling Matters within Board’s Discretion :i. BCL § 620 – Shareholders: Agreements to Voting

1. Shareholder’s Agreements – a. Restrict transferability of sharesb. Limit or control the power of the Board of Directorsc. Dissolution if deadlockd. Voting agreement, where SH agree to combine votes to elect directors

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2. Purpose – to ensure your agreement is enforceable w/o having to go to court to get specific performance under the contract, you need an irrevocable proxy

3. Implementation - Any SH voting can be put into an agreement under § 620, and § 609 is the mechanism to make the § 620 agreement binding

4. § 620(a) – available to anyone, not just CC5. § 620(b) – only available to CC

a. Clark v. Dodge – still good law, not affected by statuteb. Statute expands holding in Clark to allow SH agreements to limit the authority of the

board of directors minimallyc. Restrictions on Board have to be in COI

6. If SH Agreement designates a certain person as officer, can always remove them for cause under § 706; action of 10% of SH can remove an officer by going to court

7. Requirements for § 620(b) – a. Have to be CCb. Must be authorized / approved by all shareholdersc. Shares can be transferred or issued only to ppl who have knowledge of this SH

agreementd. SH agreement has to be noted on stocke. Shares cannot be listed on any stock exchange (Close C - BCL 620(b))

8. How to Strike out Provision in § 620(b) – a. Ex. if C private and wants to go publicb. Prior to 1998 – need 2/3 vote to do away with provisionc. After 1998 – need ½ vote (simple majority)d. Board can authorize an amendment to COI under § 805e. Invalid – agreement will be invalid if injury to other SH or creditors

9. §620 gives matters that would normally be part of the board’s powers to the shareholders.a. So shareholders assume fiduciary liabilityb. They assume liability for results of their control. (no longer on directors)c. 620(a) & (b) (mostly) is used to overrule – provides that management powers of the

board can be restricted, but this provision must be in the certificate.i. (a) Applies to all

ii. (b) Only applies to close corporations. ii. BLC § 715(b) – Directors: Officers

1. D are the exclusive executive representatives of C and are charged w/ management and administration of its assets

2. Have a legal duty to act for C3. D must be free to exercise their independent business judgment4. Limits on SH:

a. SH can’t control the power of Board to elect officers of fix salariesb. SH can unite to elect directors, but can’t unite to limit power of elected directors to

manage businessc. Public Policy – SH can not enter into an agreement to control the directors in the

exercise of their judgment5. Employment Contracts:

a. If D has an employment contract, court will uphold the economic aspects of contract, but D has no right to stay in his position as D

b. Employment contract treated separately for your position / duties; BCL § 716(a) and (b)

iii. McQuade v. Stoneham – 1. F – After being voted off the Board of Directors and removed as an office of CC, a minority

SH sued to enforce an agreement requiring the controlling SH to use their best efforts to keep him in office.

2. H – Refuses to enforce agreement b/c it limits directors from exercising their judgment; A directors fiduciary duty of undivided loyalty to C applies in all circumstances, even in CC.

3. R – An agreement among SH of a C to restrict their discretion as directors of C is invalid and unenforceable as against public policy.

4. *NOTE – this case is no longer law!iv. Clark v. Dodge – Case is LAW in NY

1. F – Two Cs manufactured medicinal preparations under secret formulas; Clark owned 25% of stock and Dodge owned 75% of stock. Both entered into an agreement to provide for certain compensation and to maintain D as director.

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2. H – Court upheld agreement finding that McQuade holding is limited to the facts of that case, and that in this case there was no attempt to sterilize Board

a. Interpreted “net income” as whatever is left so that agreement doesn’t hurt creditors or 3rd parties;

b. Agreement said C in office as long as faithful, efficient, and competent; so didn’t require board to keep him in office if he does something bad

3. Ct. holds that these are essentially chartered partnerships. v. Longpark – Even if all board members agree, if the infringement upon board powers is too great, it

will not be upheld. vi. Galler v. Galler –

1. F – Widow of one of 2 principal SH of CC sued the other principal SH seeking to enforce an agreement prescribing how SH would vote for corporate offices and requiring the declaration of annual dividends and payment of a widow’s pension. When 1 brother died, other brother refused to uphold agreement. Sues for specific performance and an accounting.

2. I – Whether the SH agreement, limiting the discretion of the board of directors of CC, will be upheld?

3. H – Yes; in the case of a CC where they have no market to sell their shares, a SH agreement can protect their interests and be lawful; court upheld agreement b/c no SH not a party to the agreement was injured (only the 2 SH).

4. R – SH agreement limiting discretion of Board of Directors of CC will be upheld where no minority SH is prejudiced, corporate creditors or public are not injured, and no clearly prohibitory statutory language is violated by its enforcement.

5. *Note – should have had a Buy-sell (buyout) agreement that upon one of brothers death, the other side could buy out shares of the other party. Business motives of C driven by personal consideration of SH

a. Careful lawyer should always recommend various ancillary agreements (voting, buy/sell, employment) to serve as shareholder protection.

i. If clients do not want, then lawyer should send a letter acknowledging their choice. (CYA letter)

vii. Adler v. Svingos – 1. F – Entered into a SH agreement that provided that all C operating, including changes in

corporate structure, would require unanimous consent of all 3; A and S sought to sell business and SV objected under the agreement; A and S brought action to strike ¶ of agreement as void under BCL § 620(b) b/c a provision that restricts board in the management of C must be in COI.

2. H – Court upheld provision and reformed COI to reflect the SH agreement.a. Here formalities were ignored, but nobody was injured by it.

3. Possible solution - Put in Berezofhsky clause – ct of appeals case – in the event any provisions of the agreement shall be deemed illegal or against public policy, the legality and validity of the remainder shall not be affected. However if any illegality or validity issue can be solved by amending the certificate it will be done.

e. Supermajority Voting & Quorum Requirements at Shareholder & Board Level :i. BLC § 608 – Shareholders: Quorum

ii. BLC § 616 – Shareholders: Greater Requirement for Votingiii. BLC § 617 – Shareholders: Voting by Classiv. BLC § 705 – Directors: Newly created Directors & Vacanciesv. BLC § 708 – Directors: Action by Board

vi. BLC § 709 – Directors: Grater Requirement for Votingvii. Generally:

1. Supermajority Provision – a provision in a C’s COI requiring more than the usual 50% majority vote to constitute SH approval of a corporate resolution

a. Veto Right comes with a SM provision2. High Quorum Supermajority Provision – business can’t be conducted at a SH or directors

level w/o all members of the body present; this means that a minority SH or director could veto an action just by not showing up

a. Advantage – they are valid in more states than a SM voting provision, which generally require a statute

b. Disadvantage – it discourages parties from getting together in the same room and talk, they can just boycott the meeting

3. Unanimity Provision – a provision in C’s COI requiring the consent of all SH to approve a corporate resolution

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a. If deadlock - § 1104 is a provision for deadlock where you can go to court to get C dissolved

b. In real life – one party will just buy the other out4. Modern statutes provide for these super-majority provisions:

a. BCL § 616 and § 709(a) – expressly permit COI to provide for high votes and high quorums

i. SM provision may be amended by 2/3 vote unless COI specifically says a greater vote is required (§616(b))

ii. SM provision must be noted on stock to give noticeviii. Sutton v. Sutton –

1. F – Controlling SH of a CC sued to compel a minority SH/director of C to sign an amendment to C’s COI striking a provision requiring unanimous SH approval, including for any amendment of certificate.

2. H – NY law provides supermajority provisions in COI may be amended by 2/3 vote unless COI specifically provides otherwise; but in this case the certificate is unambiguous and requires unanimity – it can’t be amended by 2/3 vote.

3. R – A unanimity provision of a C’s COI may not be amended by a less than unanimous vote of SH of C.

f. Fiduciary Obligations of Shareholders :i. Rosenthal v. Rosenthal – fiduciary duties owed by business associates in CC

1. To act with that degree of diligence, care and skill which ordinarily prudent persons would exercise under similar circumstances in like positions

2. To discharge the duties affecting their relationship in good faith with a view to furthering the interest of one another as to matters within the scope of the relationship

3. To disclose and not withhold from one another relevant information affecting the status and affairs of the relationship

4. To not use their position, influence or knowledge respecting the affairs and organization that are subject to the relationship to gain any special privilege or advantage over the other person(s) involved in the relationship

ii. Wilkes v. Springside Nursing Home – 1. F – After being removed as an officer and director of CC and having his weekly salary

discontinued, a founding investor in C sued controlling SH for breach of their fiduciary duty to him as a minority SH.

2. H – Controlling SH failed to demonstrate a legitimate purpose for their actions; they disregarded long-standing policy that each SH shares equally in profits, salary and management of C, and that since C never paid dividends, W would have gotten NO return on his investment.

3. R – In deciding if controlling SH of CC have breached their fiduciary duty to a minority SH, a court must weigh any legitimate business purpose the controlling SH can demonstrate for their action against the feasibility of an alternative course of action that is less harmful to the minority SH.

4. “Legitimate Business Purpose TEST” for Breach of Fiduciary Duty in CC: a. 1st – Minority SH of CC alleges breach of FD by controlling SHb. 2nd – Controlling SH have opportunity to demonstrate that a legitimate business

purpose exists for their actions which affect minority SH (burden shifts to SH if successful)

c. 3rd – If Controlling SH assert a business purpose, Minority SH can rebut this by showing that there are alternate options that are less harmful to minority SH

d. 4th – Court must weigh any legitimate business purpose that they can demonstrate Against the alternative options

e. *Note – this is an intermediate test (for fiduciary duty for SH in Close C, less strict than what partners owe each other, but stricter than BJR) and was criticized;

f. Courts adopted the “Reasonable Expectations of the Parties” Test – look at what are the reasonable expectations of the parties when they entered the relationship and how have they changed over time

5. Narrows Donahue v. Rodd – strict good faith standard owed to minority SH, ct is concerned that strict good faith standard will result in limitations on legitimate actions by a controlling group in a close C. Majority has certain rights of selfish ownership that needs to be balanced against the fiduciary rights of the minority.

iii. Smith v. Atlantic Properties –

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1. F – 3 of 4 equal SH in CC sued to remove the 4th SH from Board of Directors, after 4th SH used a supermajority veto power contained in C’s COI to prevent C from declaring any dividends. He refused for years, even after repeatedly getting hit with a penalty tax by IRS.

2. H – 4th SH breach fiduciary duty to other SH when he recklessly permitted C to be repeatedly assessed a penalty tax.

3. R – A minority SH in a CC, whose conduct is controlling on a particular corporate issue, is held to same fiduciary duty as majority SH.

iv. Merola v. Exergen – 1. F – An at-will employee and minority SH of CC sued C and its majority SH, alleging breach of

fiduciary duty for terminating the minority SH’s employment w/o cause.2. H – Not every discharge of an employee of a CC will gives rise to a breach of fiduciary duty

claim; Here there was no C policy that stock ownership and employment went hand in hand; Also M got a return on his investment in a form other than salary and sold shares at a fair price.

a. Court distinguishes this case from Wilkes, where the termination of a minority SH of CC was terminated to freeze-out SH

b. Wilkes depended on his salary as his principal return on his investment b/c in CC corporate earnings are generally distributed as salaries

c. Ct. separates SH interests from interests as an employee3. R – The mere fact that CC, w/o cause, terminates employment of a minority SH who is an

employee in C will not automatically constitute a breach of fiduciary duty to minority SH. CC has to have ability to maneuver

a. G/R – employees can be terminated at will, w/ or w/o causeb. Exception – minority SH (Wilkes Balancing Test)c. *Note – NOT every termination is a breach of Fid Duty (Merola)

g. Restrictions on Transferability of Shares & Mandatory Sale Provisions :i. Overview – SH of CC have a legitimate interest in limiting transferability of shares to prevent

outsiders from entering and prevent a shift in control among SH1. Restrictions on Transferability – reasonable restrictions are valid and enforceable;

a. Must be Reasonable – determined at time restrictions were adoptedb. Flat / absolute prohibitions are not permitted c. Must have NOTICE of restrictionsd. Must voluntarily agree to restrictionse. Setting purchase price is generally upheld, in absence of fraud

2. Three basic types of restrictions for CC - a. First Refusals – prohibit a sale of stock unless shares have been first offered to C, the

other SH, or both, on the terms offered by Tb. First Options – prohibit a transfer of stock unless shares have been first offered to C,

other SH, or both, at a price fixed under the optionc. Consent Restraints – prohibit a transfer of stock w/o permission of C’s board or SH

3. Mandatory Sales – give C or the remaining SH an option to purchase a SH’s stock upon the occurrence of one or more designated contingencies, even if SH doesn’t want to sell

a. Termination – when employee terminated, C has option to re-purchase stock issued to the employee

b. Buy-Sell or Survivor-Purchase agreement – on death of SH in CC, his estate has an obligation to sell its shares to C or remaining SH at a price fixed under the agreement, and C or remaining SH are obligated to buy

4. Problems of Interpretation – courts often give restrictions on transfer a strict interpretation5. Pricing Provisions – under CC difficult to price shares, so some methods are

a. Book Value – pricing formula based on book value; reflects historical cost of assets, rather than their present value and ignores good will

b. Capitalized Earnings – fix the price on the basis of a multiple of earnings; more fair then book value but lots of drafting problems

c. Periodic Revisions – agree on a price when provision is adopted, subject to periodic revision at agreed-upon intervals

d. Appraisal – appraisal by a third party at the time the option is triggered6. Notes

a. Shareholders have a legitimate interest in controlling the transfer of stocki. Essentially partners and have a vested interest in who they work with.

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b. Stock is personal property of the holder, should have the right to dispose of the personal property as desired

i. Law has reached a compromise situation, reasonable restrictions are permissible and not absolute restriction. Permissible when shareholders agree to restrictions and have notice when they acquire the stock

ii. Set of purchase price is usually ok, when freely entered into.c. Share transfer agreements can be used to:

i. Prevent non-active heirs or non-wanted outsiders etc from taking control and participating in corporation.

ii. Prevent shifts in control from transfer of shares between members. (between existing shareholders)

iii. Provide a market for the shareholders stockiv. Permit the corporation to eliminate shareholders in order to give remaining

shareholders larger share of the future growth. d. This is an important area for lawyers. First a contract is created between the

parties, the bylaws are created to reflect the agreement in the bylaws. Here precise drafting is needed.

7. Type of restrictions First option – prohibits the transfer of stock unless first offered to C, SH, or both, company usually sets the price (F.B.I)

How the price is set is very important Used to prevent outsiders from obtaining ownership, and to maintain

proportionate interest in the shareholders Restrictiveness depends on relationship between option price and a fair price

when it is trigged. As long as no unconscionability in setting of price, it will be upheld *Holland

Consent restriction – requires SH or board of director approval before shares are transferred. (FBI v. Moore)

Very strictly viewed by courts. Unreasonable withholding is not permissible, but occur all the time in sales

of cooperative apts in NYC. Upheld. First refusal restriction (most liberal type)

Selling party (or third party) sets terms Shares offered to C or other SH with first option with terms set by seller Courts have ordered specific performance

Option contingent Certain event can trigger sale to corporation (firing, death, retirement)

Corporate call Corporation can call stock for purchase. (often for preferred stock) Can be used to reduce outstanding shares, also ability to avoid dividends.

Pricing Can be used, but may not be accurate, reflects historical price and may not

reflect value. o Evangelista is ex. where large difference will not void agreement

Capitalized earnings Pick price based on future stream of earnings, can be very subjective

Periodic revisions(may be agreed upon to restrictions) May lead to inability to agree, or time period may be allowed to pass causing

problemsii. FBI Farms v. Moore –

1. F –Moore sought a declaratory judgment to establish that FBI restrictions on transfer of stock (right of 1st refusal and shares can only be transferred to blood members) were unreasonable and inapplicable to an involuntary transfer (shares were sold at Sheriff’s sale b/c she owed $).

2. H – The restrictions are valid, however restrictions are trumped when it is an involuntary transfers.

a. Requirements:i. Restrictions have to be noted on the front or back of stock certificates

ii. If noted on stock, restrictions bind a person with actual notice

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iii. Restriction on board approval is valid only if reasonableiv. If restrictions arise out of fraud or breach of fiduciary duty – not upheld

b. Factors on whether a Reasonable Restriction:i. Size of corporation

ii. Degree of restraint on alienationiii. Time restriction was to continue in effectiv. Method used to determine the transfer pricev. Connection to corporate objectives

vi. Possibility of hostile takeovervii. Best interests of corporation

3. Rule – A stock transfer restriction is reasonable if it is designed to serve a legitimate purpose of the party imposing the restraint and the restraint is not an absolute restriction on the recipient’s right of alienability.

4. Involuntary Transfers – essentially trumps restrictions; restrictions can’t prevent a creditor from foreclosing on a lien, but a person that purchases the shares at a sheriff’s sale is subject to the restrictions, if they have notice of the restrictions (personal notice or on the documents themselves).

iii. Evangelista v. Holland – 1. F – SH agreement allowed C to buyout the estate of a deceased SH for $75k; at time of death,

evidence that stock worth $191k. Argue agreement violates duty of good faith b/c requires SH to sell share at much less than what worth.

2. H – No violation; agreement was entered into buy all SH when order and time of death of each SH was unknown; there was a mutuality of risk.

3. R – Questions of good faith and loyalty do not arise when all SH in advance enter into an agreement for purchase of stock of a w/drawing or deceased SH.

iv. Gallagher v. Lambert – 1. F – After his employment w/ CC was terminated, an employee/minority SH sued to void a

mandatory buy-back provision of a SH agreement giving C a right to repurchase his shares at book value.

2. H – Buyback provision is enforceable; G freely negotiated and agreed to accept book value for his shares, he got what he bargained for. Buyback provision was for the benefit of both parties

3. R – A mandatory buy-back provision, permitting C to repurchase an employee/SH stock in event his employment is terminated, is generally enforceable.

4. *Note – case emphasizes freedom of contract principles, and key factor was that G started as an employee and later became SH, this met his reasonable expectations of employment were different than if started as a SH.

5. May stand for proposition that under NY law SH are not bound by fiduciary duties if there is K setting out the parties’ rights. SH presumably have a statutory remedy to dissolve C under BCL §1104(a). Maj. ties together price of shares and emp., as to timing and consequences.

v. Jensen v. Christensen & Lee Insurance, Inc.,1. No wrongful discharge, no cause of action because Wis. wrongful discharge is limited to

discharges that violate public policya. BUT buyback price was low, benefitting remaining SH. Did not deal fairly with

minority SH. Conflict of interest, device to cut out one of the SH. h. Dissolution for Deadlock or Oppression :

i. BCL § 1001 – Non-Judicial Dissolution: Authorization permits voluntary dissolution if authorized or approved by 2/3 of outstanding shareholders (or maj. If required)

ii. BCL § 1002 – Non-Judicial Dissolution: Under COI 1. (a) COI may contain provision mandating dissolution after specific event, needs all SH

approval unless COI requires lower. iii. BCL § 1104 – Judicial Dissolution: Petition in case of deadlock

1. Minority shareholders have equitable right to dissolution if majority have committed fraud or other illegal or wasteful conduct. Otherwise must remain in corp.

2. 1104(a) – need 20% of votes of all shareholders3. 1104(b) – only used for non-publically traded corps. 4. Ct is supposed to take into account if liquidation is only feasible means for minority

shareholders to obtain a return on investment.5. 1104(a) leads to hearing, if under §1111 dissolution is ordered, brought by AG – interests of

the public is paramount, if brought by shareholder, their interests are paramount.iv. BCL § 1104(a) – Judicial Dissolution: Petition under special circumstances v. BCL § 1111 – Judicial Dissolution: Judgment or Final order –

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vi. BCL § 1118 – Judicial Dissolution: Purchase of Shares / Valuation – Ct orderes value of shares to be determined for purposes of buyout following dissolution order.

vii. Advice – SH agreement should contain clauses defining expectations of parties, then if disagreement should include buy/sell agreement. Basic idea of this chapter

viii. Dissolution for Deadlock: (Another contract to partnership law)1. Several statutes provide for involuntary dissolution on a showing of deadlock2. Deadlock Defined – (different statutes have different definitions)

a. (1) an equally divided board or body of SH, ORb. (2) a divide brought about by supermajority or veto arrangements

3. Court’s do not like to order a profitable C to dissolveix. Stages of Dissolution –

1. 1st Stage: Dissolution Granted only for Deadlock2. 2nd Stage – Dissolution on Ground of Majority’s Fault3. 3rd Stage – Dissolution on Ground of Defeat of Minority’s Reasonable Expectations 4. 4th Stage – Dissolution Converted into Mandatory Buy-Out

a. Frequently courts will find grounds for dissolution exist, but will remedy through a mandatory buy-out rather than dissolution via liquidation

x. New York Dissolution Statutes:1. § 1001 – can petition; limited to majority of board of directors or AG2. § 1002 – can obtain a provision upon occurrence of a specific event3. § 1004 – judicial dissolution in case of deadlock

a. Can bring action for fraud, oppression, illegality, looting and wasteb. Court will take into account whether liquidation is only feasible mean for SH to get

fair return on their investmentsc. Court can make a final judgment or order dissolution

xi. Valuation of Minority Shares – 1. Mandatory Buy-Out – Court must value the minority’s interest2. Dissolution – public sale of C’s business, so market values C’s shares

xii. Wollman v. Littman – 1. F – One of 2 groups of 50% SH of CC sued for dissolution of C, asserting that another lawsuit

between SH groups made it impossible to effectively conduct C business.2. I – Is dissolution of C appropriate whenever C’s management is deadlocked?3. H – No; trial court in this case should have considered (1) since both SH perform different

functions, can they function if supervised by a receiver; (2) since SH in separate suit are charged w/ luring business to their own company, wouldn’t dissolution allow them to achieve their wrongful goal?

4. R – Dissolution is inappropriate, even if SH are deadlocked, if result would be to permit one SH group to divert C’s business to itself.

xiii. Matter of Kemp & Beatley – 1. F – 2 SH who were formerly employees of CC sued for dissolution after C changed its policy

regarding corporate distributions in a way that ensured SH would not get return on investment.2. I – Is dissolution of C appropriate where a majority SH engages in “oppressive conduct”

toward a minority SH and majority SH doesn’t want to buy out minority SH at a fair price?3. H – Yes; in NY dissolution can be ordered where at least 20% of SH complaint of illegal,

fraudulent, or oppressive conduct against them by other SH. a. Oppression – conduct that substantially defeats the reasonable expectations held by

minority SH in committing their capital to a CCb. Mere disappoint is NOT enough. SH reasonable expected (job, return, other security)c. Conduct must substantially defeat expectations that, objectively, were reasonable and

central to SH desire to join Cd. Dissolution will ONLY be ordered if it is the sole means of protecting complaining

SH’s reasonable expectations (look at totality of circumstances, try to find a remedy short of dissolution that would satisfy minority SH and other parties)

4. R – Conduct by majority SH that substantially defeats the “reasonable expectations” held by minority SH in committing their capital to CC is appropriate ground for dissolution of C, provided that majority SH are first given an opportunity to buy out complaining SH at a fair price.

xiv. Meiselman v. Meiselman – Objective standard for reasonable expectations. Privately held expectations not made known are not held as reasonable.

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xv. Chesterton v. Chesterton – SH seeks transfer from C corp to S corp, one SH tried to xfer shared to another C, would end SCorp classification. P sues to stop. Ct holds that the expectations and understandings of SH were relevant in relation to the breach of fiduciary duty (under MA law)

xvi. Mullenberg v. Bikon – claims of oppression are typically remedied by arranging for C or majority SH to buy out interests of minority SH; minority can also buy-out majority

xvii. Kelley v. Axelson – maintaining an accounting system whose shortcomings have the effect of substantially preventing the outside, minority SH from ascertaining and verifying C’s income can constitute unfairness and oppression toward minority SH

xviii. Charland v. Country View Golf Club – 1. F – A minority SH appealed a judicial appraisal of his shares that had discounted their value

due to their lack of marketability and the fact that they were not enough shares to control corporate decisions.

2. R – In appraising FMV of stock of a minority SH in CC who has filed for dissolution, court should not apply either a minority discount or lack of marketability discount to determine the value of the stock.

i. Relief given in these cases where majority tries to freeze out minority SH. – try to restore a minority shareholder to the position as closest possible as to where minority shareholder would have been if there were no wrongdoing. (look at what ct is granting, eval what factors apply in relief granted)

i. Donahue – maj SH Caused C to purchase min SH stock at favorable price, while denying Euphemia the same opportunity. Ct orders rescind sale of stock to C or in alt. Give Euphemia same price.

ii. Wilkes – expectations of employment – ordered damages for loss of employment as well as the value of his shares, attempt to reset balance between maj. Right of selfish ownership and min. rights of reasonable expectations of employment.

iii. Galler – ct. specifically enforces agreement for both sides to receive the same amount (retrospect -would have been much better to buy Emma out)

iv. Kemp – reasonable expectations leading to buyout

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VIII. DUTY OF CAREa. Introduction –

i. In general a director owes C a duty of care; he must do what a prudent person would do w/ regard to his business

ii. Duty imposed b/c directors are fiduciaries of Ciii. Burden is on P to prove that Duty of Care was breached, and that breach was proximate cause of

harmiv. Basics – Duty of Attention and Be informed of what is going on; go to meetings; make sure

bookkeeping methods conform w/ industry standardsv. *Directors are entitled to rely on reports by other directors, officers, and outside parties – but have to

rely in good faith and reliance must be warrantedvi. *NOTE – you can NOT contract out of Duty of Loyalty to C or SH, or for acts or omissions that are

NOT in good faith, or involve intentional misconduct or are a knowing violation of the law1. Director should consult outside advice if necessary2. Directors owe a duty to SH, creditors (only as C is dipping towards insolvency), the C3. Directors should exercise their duty in good faith and skill. 4. Director can fail to discharge the duty by;

a. Failing to monitor C – duty of attention (Francis) b. Even if the director is disinterested, independent, and acting in good faith, by failing

to make an informed decision. (Van Gorkom) i. If researched, but decision is rash, then director protected by BJR

ii. To obtain BJR protection, director must show judgment was exercised, but it only applies in the absence of fraud, illegality, or disabling conflict of interest.

iii. Even if the duty of care has not been met, can the shareholders hold the directors liable for ruining the corporation?

1. No, requires proximate cause5. Directors can rely on repots from other employees, counsel, etc, but it must be in good faith,

and must have reasonable belief that the report is true. 6. Director can rely on a committee of the board if acting in good faith, and believes reliance on a

committee is warranted, but must read the report in order to rely on it7. Director can rely on competent outside experts, relying on relevant skill and experience

b. Basic Standard of Care – Duty to Monitor:i. BCL § 402(b) – Formation: Contents of COI

ii. BCL § 717 – Directors: Dutyiii. BCL § 719 – Directors: Liabilityiv. BCL § 720 – Directors: Action against for misconduct

1. Actions for neglect, but must be mis or non-feasance, not just misjudgmentv. Standard – Directors must discharge their duties in good faith and w/ the degree of diligence, care,

and skills that an ordinary prudent person would under similar circumstances in like positionsvi. Generally, as a Director you Should –

1. Have at least a rudimentary understanding of C’s business2. Stay informed of C’s activities3. Engage in general monitoring of C affairs and policies4. Remain familiar with financial status of C

vii. When Director discovers an Illegal Action – 1. D has a duty to object, and if C doesn’t correct the conduct, D should resign2. Sometimes D’s duty may call for more than objection and resignation – should seek advice of

counsel and even threaten suit3. Director owes fiduciary duty to C and SH and sometimes to creditors or 3rd parties, depending

on the nature of the business (banks, reinsurance co., etc.)4. *Director does these things to absolve themselves from liability5. *Note – a Director is assumed to assent if he is present at a meeting

viii. Liability – under BCL §719 – directors are jointly and severally liable. Director presumed to concur unless they actually dissent from particular action. If absent assumed to concur, unless sends dissent by registered mail or cause the dissent to be filed in the minutes of the meeting. Each director is liable for the failure where the board’s failure is liable for the act (under proximate cause)

ix. Francis v. United Jersey Bank –1. F – Mom was director of a reinsurance company and her sons who were also directors,

embezzled client funds; mom’s estate (she died) was sued for breaching her duty of care by not preventing the theft.

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2. H – Mom/Estate are liable; failed to act; this H reflects the nature of the reinsurance industry – dealing with cash and based on trust.

3. Test for Liability – Corporate directors are personally liable for violating their duty of care by failing to prevent wrongful acts by other corporate officers if:

a. They owed a duty to the victimb. They were negligent in monitoring the other officers, and (breach)c. Their negligence was the Proximate Cause of the injury

x. Aronson v. Lewis – 1. Directors have a duty to inform themselves, prior to making a business decision, of all material

information reasonably available to them2. They must act with the requisite care in the discharge of their duties3. Under BJR, director liability is predicated upon concepts of gross negligence

c. Business Judgment Rule –i. BJR - rule protects Directors from bad decisions, as long as made in good faith; does NOT protect

decisions made in bad faith1. BJR is based on presumption that D acted on an informed basis, in good faith, and in honest

belief that the action taken was in the best interest of the company2. BJR protects directors from imposition of liability based on hindsight. Also helps to

encourage D to take risks so that they are not found liable for hindsight bias. Decision turned out badly v. bad decisions.

ii. Standard of Conduct – how you should conduct a given activity or play a given role1. Director’s Duties:

a. To monitorb. To inquirec. To make prudent or reasonable decisions on matters that the board is obliged or

chooses to act upond. Duty to employ a reasonable process to make decisions

2. *Note – duties of director’s are fairly demanding, but SOR are less stringentiii. Standard of Review – the test a court should apply when it reviews an actor’s conduct to determine

whether to impose liability or grant injunctive relief. Courts tend to look at the process in reaching the decision, low standard of review in quality of decision.

1. SOR for BJR – decision must be rational, or have a rational basisa. Unreasonable decision – could be good and bad reasons for it, but can be justified or

explainedb. Irrational decision – no way to explain the particular decision, denies BJR, only way

P can win2. SOR if Conditions for BJR are NOT met – SOR is based on entire fairness or reasonability of

the decision (higher standard)iv. 4 Conditions for BJR to Apply:

1. Director must have made a decision2. Director must have employed a reasonable decision making process3. Decision must have been made in good faith4. Director may not have a financial interest in the subject matter of the decision

v. Kamin v. American Express Co. - 1. F – When a C’s directors ordered in-kind dividends which did not utilize available tax

deductions, some SH sued, contending directors carelessly wasted corporate assets. Directors issued dividends instead of declaring a loss.

2. H – Dismissed; w/in BJR, plus no evidence of fraud or self-dealing3. R – C directors’ decision on dividends are not actionable as breaches of care, absent

fraud, self-dealing, bad faith or oppression. BCL §20 neglect must stem from nonfeasance or malfeasance.

vi. Joy v. North 1. If the courts did not abide by the business judgment rule, they might well penalize the choice

of A in each such case and thereby unknowingly injure shareholders generally by creating incentives for management always to choose b (less risk, less reward)

2. BJR encourages managers to take good risks, and they will be rewarded for this. vii. Smith v. Van Gorkom –

1. F – When a corporate CEO convinces directors to sell C w/o calculating its value, SH allege they breached their duty of care. CEO did NOT tell board how he arrived at sale price and did NOT tell them that he was the one that approached the buyer and initiated the price --- no negotiations were done.

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2. I – Whether Directors breached their duty of care by failing to determine the true value of C?3. H – Yes; D were grossly negligent b/c they never examined CEO’s role in negotiations (that

basically wasn’t a negotiation), never calculated C’s intrinsic value (w/ good will); didn’t research or deliberate for > 2 hours; relied on CEO’s presentation w/o reading information.

4. R – C directors who sell C w/o determining its true value have breached their duty of care.

5. *NOTE - Decision has been criticized for moving away from a bright line rule, allows courts to examine business decisions (that are always taken under uncertainty and risks)

i. May reduce manager’s willingness to take risksii. Creates a process-based method of decision-making.

iii. Courts lack the competence to appreciate complex business decisions. b. Gross negligence is the standard that will lead to director liability. SH did not know

that decision was reached without adequate information by the board. c. Heightened decision-making is now required for life/death decisions re: corporation.

viii. Gantler v. Stephens1. F - Directors killed deal to benefit selves, issued fraudulent proxy statement to shareholders2. I – Is SH voter approval on fraudulent proxy statement sufficient to ratify board decision.3. Test – BJR presumption is met if D acted in good faith and acted advisedly.4. H – BJR presumption overcome and D may be personally liable – Directors act disloyally.5. Major implications and clarifications for practitioners and corporations in Del re: fiduciary

duties, C restructuring, and the “SH ratification” defense.  a. C directors and officers now owe the same fiduciary duties to SH.  b. Board considering a restructuring, where there might be potential conflicts of interest

for a maj. of its directors should ensure that its actions satisfy an entire fairness review just to be safe.  Additionally, a Board may only issue a statement that it has carefully deliberated a restructuring, sale, or merger if it has, in fact, done so. 

c. “SH ratification” defense does not apply to Board actions that statutorily require SH approval.  A Board may assert the “SH ratification” defense only if it expressly requested the SH to ratify the action at issue.

d. SH ratification by disinterested SH will cleanse a board decision making process if board is questionable IF SH RATIFICATION IS NOT LEGALLY REQUIRED (not necessary) (DELAWARE)

i. Previously disinterested majority of SH ratified action of board directly therefore, even if board breach duty of care, was ok

1. Board’s deceitful activity isn’t cleansed by SH ratificationii. IE. Board wants to proceed with action, not required to get SH approval

but do so anyway, it cleans the impure decision-making process. SH must be fully informed.

iii. Then Board can use Biz Judgment Rule as defensed. Duty to Ensure that Corporation has Effective Internal Controls :

i. In Re Caremark – STONE V. RITTER RECLASSIFIES THIS DECISION1. F – When C charged with health care bribery is forced to pay $250 million and promise better

management in a settlement w/ gov’t agencies, angry SH request court to reject the settlement and permit them to sue directors for negligently permitting bribery.

2. I – Did Board meet its responsibility in creating a monitoring system so that C operated w/in the law?

3. H – Agreement is fair / reasonable; D took due care to prevent this from happening and Board already had a cmt to oversee corporate compliance.

4. R – C directors have a duty to make good faith efforts to institute a corporate monitoring system they believe will alert them of material events, but are not liable if the system fails to detect wrongdoing.

5. TEST for their to be a Breach of Duty of Care:a. D knew or should have known about violationsb. D took no good faith steps to prevent themc. D’s failure proximately caused the lossesd. *Key – D only have to put systems in place

e. Liability Shields :i. BCL § 726 – Directors: Insurance for Indemnification

ii. In assessing duties of directors and officers to act w/ care, account must be taken of 3 elements that may serve to reduce or eliminate civil liability for breach of those duties:

1. Direct limits of liability

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2. Insurance3. Indemnification

iii. COI – shield from liability provided by COI is in the nature of an affirmative defense1. Burden is on D to prove that they acted in good faith2. When claim is based solely on violation of duty of care – protection can be invoked and

appliedf. Duty to Act in Good Faith :

i. Two types of Violations:1. Where C, as a result of Board decision, incurs loss that was ill advised or grossly negligent

(Van Grokem)2. Circumstances in which a loss eventuates not from a decision but from an unconsidered action

(Caremark)ii. Breach

1. Standard of review – BJR so long as directors acta. On an informed basisb. In good faithc. In the honest belief that the action taken is in the best interest of C

2. Bad Faitha. “Subjective bad faith” - conduct of directors motivated by an actual intent to do harm

to the corporation.  This type of conduct as “classic, quintessential bad faith.” b. “Intentional dereliction of duty, a conscious disregard for one's responsibilities.” 

i. Failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.

1. Cant be indemnified or exculpatec. Gross negligenced. If directors comply with statutes and strive to act in the best interests of the C they

won’t have acted in bad faith, even if their decisions lead to loss in SH value. 3. Waste – P must show the exchange was so one sides that no biz person of ordinary judgment

could find it received adequate consideration. Cannot be attributed to any rational biz purposeiii. Emerald Partner v. Berlin – D bears burden of proving good faith and duty of care where P has

factual basis proving otherwise.iv. In Re Walt Disney Company – *Supplement p. 57-89

1. F – Disney hired O by giving him a salary was well as stock options; O terminated 14 months after he was hired w/o cause, resulting in a $130 million severance payment. SH sue Board b/c of this payout to O.

2. Ct. sates that the duty of directors to act in good faith is separate and distinct from the duty of directors to act with due care.

3. H - failure to act in good faith is diff from and more culpable than conduct of breach of fiduciary duty of care (ie gross negligence) 

4. R – *Court sets forth what are Best Practices for a Board, p. 67.v. Stone v. Ritter –

1. F – AmSouth failed to fill out Suspicious Activity Reports; was a Ponzi scheme (u promise higher rate of return than is normally feasible and pay current investors w/ new investors $ until run out of new investors); AmSouth pays penalty and SH sue claiming they failed to implement a monitoring system.

2. H – This wasn’t a failure of the board, but a failure of the employees; 3. *Note – Court re-interprets Caremark as a duty of loyalty case rather than a duty of care

case, essentially changing its holding. a. §107 – duty of care does not apply if there is a breach of duty, but doesn’t work if

there is a lack of good faith duty of loyalty. Caremark decision is reclassified (to good faith duty of loyalty) Standard in Caremark is sustained or systematic failure of the board to assure oversight. If this fails, then establishes a lack of good faith. Draws heavily upon concept of director failure to act in good faith, differs from the breach of duty of due care.

i. Showing bad faith is essential to establish director oversight liability. ii. Duty of care v. duty of loyalty

iii. Not independent, good faith is a subsidiary aspect of the duty of loyalty.

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iv. In either case, P must show that D weren’t discharging fiduciary obligations.

4. For a derivative complaint to withstand motion to dismiss, only a sustained or systematic failure of the board will overcome a summary judgment motion.

g. Directors and Officers Liability Insurance :i. Liability and legal expenses of D and O who are subject of claims based on lack of due care, and for

certain other wrongful acts, are often covered by liability insuranceii. D & O Policy has 2 separate insurance agreements –

1. Corporate reimbursement – insures C against potential liability to O and D under the latters’ right to indemnification from C

a. Does not require insurer to defend (but insurer is required to indemnify for losses, including defense costs)

b. Insurer’s obligations do no accrue until claim is settled or adjudicated2. Personal Coverage – insures D and O themselves against losses based on claims against them

for wrongful conduct when they are not indemnified for the loss by Ca. Ex. Law prohibits indemnification (ex. D or O’s loss is from a judgment against him

in a duty-of-care action); C is insolvent; C refuses to make indemnification where it is discretionary

3. D & O insurance doesn’t render D & O completely risk free -a. Some claims are excluded from coverage; including some kinds of duty-of-care

claims (especially those owed to the public)b. Policy limits apply to the total amount of liability and legal expensesc. Insured v. Insured Exclusion – insurer is not liable in connection w/ claims made

against D or O by C, except made in SH derivative actiond. Only applies to claims made while the policy is in force

4. In some Settlements D & O are required to pay out of pocket -a. Ex. WorldCom and Enron cases

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IX. DUTY OF LOYALTYa. Introduction :

i. Requires directors to act in a manner that doesn’t harm the corp.ii. Easier to identify in comparison with violations of duty care

iii. Requires the directors to avoid using the position to gain a benefit for himself, which belongs to the corp.

iv. Decisions should be reached in an impartial environment, disclosure, approval by an impartial board, and it should be fair to the corp. at the time it was entered into

v. A director is expected to make decisions objectively, to obtain approval from the corp. where there is a relationship that impairs the directors objectivity

vi. Fairness – 1. Fairness requires not only that terms of a self-interested transaction be fair, but also that

entering into the transaction on the fair terms is in C’s interest2. Courts have been willing to invalidate a contract entered into by a corp. if it was found to be

unfair to the corp.vii. Conflicts of Interest – nothing is per se wrong with a conflict of interest or interested transaction, so

long as procedures are followed to provide disclosure of the interest, the board fairly considers the matter, and it is fair and reasonable to C at time decision is entered into (see BCL § 713)

viii. Remedies for Violation of Duty of Loyalty – 1. Restitutionary in Nature – recission, return of gain, etc.2. legal sanctions for violation of duty of loyalty are usually less severe than legal sanctions for

violation of duty of care (pay damages)3. Sometimes punitive damages can be assessed

ix. Lyondell Chemical v. Ryan1. F – P alleges that D failed to act in good faith in sale of C, thus D violated fiduciary duty. 2. I – whether board breached duty of loyalty by failing to act in good faith3. H – Decisions of the board have to be reasonable, not perfect

a. Lower court already determined that board was independent, therefore no conflict of interest.

b. In order to show bad faith, P must show that board knowingly and willingly failed to undertake their fiduciary responsibilities.

c. Lower court makes mistake in holding that failure was doing nothing after 13D was filed indicating company was in play. (therefore Revlon (filing with SEC, ) duties did not kick in, only does when a sale in inevitable)

i. Allows anyone who views to see why the person acquiring is doing so. Informs the corporation that somebody may be trying to take over the company. (real importance)

d. Court says that Revlon duties arise when a company’s board actively decides to sell the company, or gets an unsolicited offer that will clearly arise to a change in control

b. Self Interested Transactions :i. BCL § 713 – Directors: Interested Directors – Directors must obtain approval from C when there is

a conflict of interest, existing when D has direct interest in K between C and 3rd party. ii. BCL § 714 – Directors: Loans to Directors

iii. Lewis v. SL&E – Merit Based Fairness Test / Conflict of Interest1. F – SH brought a derivative action against his family’s CC and its directors, claiming the

director’s failure to charger their own CC the fair market rental value constituted corporate waste; SEL was essentially run for LGT, and directors were the same for both companies.

2. H – There was a conflict of interest, and D failed to meet their burden to show that rental price was fair and reasonable.

3. GR – BJR dictates the decisions of C’s directors to enter into a transaction; but it presuppose D have no conflict of interest

4. R for Conflict of Interest - challenge to a transaction entered into by interested D, D have burden of proving transaction was fair and reasonable.

iv. Talbot v. James – Self Interested Transaction1. F – SH sued O and D of C for violating his fiduciary duty when D failed to disclose his interest

in a contract entered into by C; basically he hired his own construction company to do the work and gave himself a fee for doing it, but never disclosed financial information to the others.

2. H – J violated his fiduciary duty by not disclosing his personal interest, nor the material terms of the transaction

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3. R – O and D of C stand in a fiduciary relationship to individual SH and in every instance must make a full disclosure of all relevant facts when entering K between C & 3rd party

4. *Key - D have a duty to disclose any personal interest they have in a transaction effected by C.c. Statutory Approaches :

i. DE: Impartial Director Approval – requires a majority of disinterested directorsii. NY: § 713 BCL – NY’s approval requirements, if comply with the statutes, it provides immunity.

Approval has to be in good faith. Looks at the fairness of the transactioniii. Cookies Food Products v. Lakes Warehouse –

1. F – Originally H and C entered into an agreement where H was a SH of C and owned a warehouse where he distributed auto parts; he offered to distribute C’s BBQ sauce for them, which he got a profit from the distribution. Later agreement amended to give H more sales and other compensation. SH claimed H breached fiduciary duty b/c he didn’t disclose the benefit he was to receive.

2. H – Yes there was a breach, but H’s efforts in fact saved the company, so he is only required to repay his profits;

a. As a majority SH H did owe a fiduciary duty; b. D’s that engage in self-dealing must:

i. Fully disclose interest to C ii. D BOP that they acted in good faith, honesty and fairness

1. Fair and Reasonable transaction requires that self-dealing has the earmarks of an arms-length transaction

2. Fairness isn’t solely defined by fair price, but also a showing of fairness of bargain to interests of C

3. *Note – after you satisfy statutory hoops, still have to establish that you acted in good faith, honesty, and fairness

iv. In terms of complying with statute – 3 approaches1. Disinterested director approval

a. C will often establish independent committees for interested transactions2. SH approval (i.e. Del. – will put distinction on approval by maj. of disinterested SH) 3. Proof of a transactions fairness

a. Board of directors must show that transaction is fair (if C does not go through statutory hoops)

d. Compensation and Doctrine of Waste; Effect of Shareholder Ratification :i. BCL § 202(a)(10) – Corporate Powers: Appointments and Compensation

ii. BCL § 202(a)(13) – Corporate Powers: Pensions and Bonusesiii. BCL § 712(a)(3) – Directors: Committeesiv. BCL § 714 – Directors: Loans to Directorsv. BCL § 720 – Directors: Action against for Misconduct

vi. Compensation – 1. Duty of Directors to set compensation of officers; NOT SH2. Compensation should bear some reasonable relationship to the services and effort performed3. Courts give more deference to compensation payouts in public C, then in CC4. Stock Options – gives directors a stake in the corporations, and puts them on same level as

shareholders.a. Theory – outstanding performance is warranted. Stock options are supposed to

provide an all or nothing payoff.b. Reality – even if the investor loses, executives can still win. Options have strike price

reset.c. Until recently federal tax and options policy kept them tax-free. d. Excess of options has led to –

i. Refrstricted shares as a replacement – issued to employees, but can only be sold at some point in the future – advantage is receive dividends and voting rights even before shares have vested. Still getting something even if stock price declines

1. BUT typically get lower and will lose shares if leaving company before they can sell shares.

ii. Gross ups – corp gives perk or bonus, pays exec additional figure = tax on what that perk is

iii. Pensions for executivesiv. Death benefits, or corporate funded life insurance

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vii. Waste – 1. Principle of Waste – waste entails an exchange of corporate assets for consideration so

disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade

a. Can’t give consideration for past servicesb. TEST – no person of ordinary, sound business judgment would say that the

consideration received for the options was a fair exchange for the options grantedc. Waste is very hard to prove

2. Defense – waste will not be found if there is substantial consideration received by C, and if there is a good faith judgment that in the circumstances the transaction is worthwhile, even if it was unreasonably risky

3. Application – principle is applicable to actions of Board and SH, but more effective against SH b/c a Board that commits waste would normally also violate BJR

viii. In Re Tyson Foods – 1. F – Granted options that would receive FMV on day of grant, but the options were backdated.2. I – Did they exercise BF when they offered options at FMV when they knew the market price

should have been higher, and they controlled the information?3. H – This was indirect fraud or deception; if SH offer options to be granted at FMV and they

tamper with the pricing, that is an act of bad faith. Board has duty to SH to grant options in accordance with SH wishes, must prove issued in accordance with SH approved plans.

4. Back Dating – options dated when market price of stock was at a low, to enable execs to make that much more when they exercise their stock options; this is in essence giving D more $ than SH agreed to when they agreed to provide D with stock options.

ix. Ryan v. Gifford – 1. F – P alleges D breached duty of care and loyalty by approving / accepting backdated options

that violated the SH approved Stock option plan and Stock incentive plan.2. H – Demand was excused.

a. Cannot issue options below the fair market value of the stock therefore it is a breach of fiduciary loyalty to the shareholders.

b. Bad faith – intentional violation of shareholder approved options plan, plus intentional misinformation on disclosures.

c. Board was not completely honest, and SH were owed candor from the directors even after the plan was approved

d. This was disloyalty and directors cannot rest defense on BJR.3. Demand - When SH suit is brought, must first make a demand on board of D to give them an

opportunity to address grievance and determine if bringing such action is in best interest of C.a. Both NY and DE allow for the demand to be excusedb. Demand Excusal Rule in DE (Aronson v. Lewis):

i. 1st Prong – There is doubt that the majority of the board is disinterested or independent;

ii. If majority is NOT disinterested or is NOT independent go to 2nd Prong – P can prove a demand would be futile by providing reasons to doubt whether the challenged transactions were a valid exercise of BJR

c. *In this case – was a decision by subcommittee, not whole board so court went to 2nd prong of Aaronson; Aaronson was a decision by whole board

4.e. Corporate Opportunity Doctrine :

i. Different Types of Corporate Opportunities – 1. A business opportunity that is discovered through the use of corporate property, information,

or position should be a corporate opportunity regardless of X’s corporate position2. A business opportunity that X discovers on his own is a corporate opportunity solely because it

is closely related to the corporation’s business, depends on X’s corporate positionii. Tests – for determining whether D or O has wrongfully appropriated a corporate opportunity:

1. Interest or Expectancy Test – corporate opportunity doctrine applies only when D or O has acquired property in which C has an interest already existing or in which it has an expectancy growing out of an existing right, or when his interference will in some degree balk C in effecting purposes of its creation

2. Line of Business Test – whether the opportunity was in C’s line of businessa. Whether opportunity is w/in C’s line of business depends on facts and how it relates

to core business function of Cb. This is the test in NY

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c. DE – uses an expansive definition of opportunity (Harris case)i. Test – if O or D is presented with a business opportunity that C is

financially able to undertake, is in C’s line of business, is advantageous to C, then C has a reasonable interest and D can’t take the opportunity for himself

d. *Note – a solvent corporation Always has an expectation to expand3. Fairness Test – (Durfee) not really a test but ad hoc decision by court as to what is fair to a C

a. Test in Mass4. Mille Two-Step Test – combines line of business and fairness test

iii. Defense: Ability of C to take the Opportunity – 1. X’s ability to raise as a defense, C’s inability to take advantage of opportunity, 2. Courts have responded differently to this as a defense

iv. Three Important Principles of Fiduciary Duty –1. Corporate-Opportunity Principle – prohibits a corporate fiduciary from taking a corporate

opportunity2. Use of Corporate Assets Principle – prohibits a corporate fiduciary from using corporate

property, information, or position for personal gain3. Competition Principle – prohibits a corporate fiduciary from competing with the corporation

v. Remedies – 1. C may recover the appropriate asset or business property by taking profits after an accounting2. Court may award punitive damages

vi. Northeast Harbor Golf Club v. Harris – 1. F – A country club sued one of its former Ds claiming that D’s efforts to purchase and develop

land adjacent to the club amounted to a breach of fiduciary duty to refrain from taking a corporate opportunity for herself; She claimed C didn’t have resources to take advantage of opportunity.

a. 1st Opportunity – came to her in her capacity w/ club; she was a fiduciary and had a duty to disclose it

b. 2nd Opportunity – came to her while golfing on golf course2. H – This was a corporate opportunity and it is the responsibility of C – not a director – to

determine if C has the resources to do something.3. R – A director must make full disclosure prior to taking advantage of any corporate

opportunity and failure to do so is a per se breach of director’s fiduciary duty.4. *Note – Court adopts ALI principles § 5.02: Key is full disclosure to C of the opportunity

and C has to reject it; BOP initially on challenger, unless no procedures followed, then it shifts to C. key is formal rejection of the offer by disinterested D of C then conflicted D can act.

a. Criticism that business moves too fast for this to be practical. vii. In re eBay Inc. Shareholders Litigation (2004)

1. IPO case, Goldman bribed fiduciaries of corporations for whom it was doing business. They got further business as a result of the granting of stocks at IPO prices.

2. Ebay’s agents were under a duty to account for the profits from the transactions that related to his/her company. The benefits of the IPO belonged to the corporations.

3. This isn’t really the taking of corporation’s property, but kind of a use, the taking of good will of eBay’s charity.

f. Duties of Controlling Shareholders :i. BCL § 903 – Merger: Authorization by Shareholders

ii. Parent and Subsidiaries – 1. Raise many of same conflict of interest concerns as arise between directors and corporations

a. Can arise when directors of the parent serve on the board of the subsb. Parent by definition has a controlling shareholder positionc. When a sub is wholly owned by the parent (no minority sharholders) parents can

pretty much do what it wants with the sub (duties only owed to creditors)d. Duties between a parent and a partially owned sub – then several risks exist

i. Sub can declare dividends beneficial to parent at detrimentii. Sub can adopt no dividend policy which can harm minority shareholders

iii. Sub can issue stocks at less than fair value, or purchase at more than fair value from parent.

iv. Other difficulties from parent/sub transaction. v. Parent may take business opportunities away from the sub

e. Corp statutes don’t really guide where parent must not take action detrimental to minority shareholders of sub.

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f. Most ct. accept the argument that parent should be able to exercise its control positiong. Parent sub dealings are subject to a fairness review only if minority shareholders can

show that the parent benefited itself at the expense of the subi. Then assumed that parent dominates the board of the sub, and parent must

show that the transaction was fair to the sub.ii. Approval by a majority of disinterested shareholders may insulate a parent

sub transaction. iii. Parent / Subsidiary Dealings:

1. Different jurisdictions have differed on the degree of scrutiny that court will give to p / sub dealings; most courts, including DE, accept that a Parent should be able to exercise a control position

2. P / Sub dealings are subject to fairness review, only if minority SH can show that P preferred itself at sub’s expense

3. Approval by a majority of informed / disinterested SH may insulate a P/sub transaction4. Parent owes a limited duty to its subsidiary5. This duty is breached when self-dealing occurs – when P stands on both side of transaction and

there is a disproportionate transfer of assets in favor of parent receives a benefit from the sub, to the exclusion of the sub and it’s minority SH.

iv. Sinclair Oil v. Levien – 1. F – A minority SH in a wholly owned subsidiary sued parent C for causing Sub to pay out

excessive dividends for breach of contract.2. I – Is challenged transaction self dealing between Parent and Sub 3. H – No; but here, minority SH and P received a similar benefit, so it is subject to BJR instead

of intrinsic fairness test4. R – When transaction involves a parent and sub, with parent controlling transaction and fixing

terms, the test of intrinsic fairness, with its resulting shift of the burden of proof, is applied.a. Intrinsic Fairness Test – Apply if there is Self-Dealing

i. Use test when there is self-dealing – when P, by virtue of its domination of S, causes S to act in such a way that P receives something from S to the exclusion and detriment of minority SH of S

ii. Self Dealing party has BOP to show transaction was fair to other party (likely S or minority SH) COI only exists when sub is hurt.

b. Business Judgment Rule – Apply if there is NO Self-Dealingi. Use when Sub has lost something, but minority SH have rec’d same gains

as parentii. P has to show gross overreaching, waste; difficult to win

v. David J. Greene v. Dunhill International – opportunity for S and P took it; here P got an advantage over S and under Sinclair, this is self-dealing and burden on P to show the transaction is intrinsically fair to S

vi. Kahn v. Lynch Communications Systems – 1. F – K sued L for breach of fiduciary duties concerning a cash-out merger.2. H – Committee had no bargaining power, BOP of proving entire fairness doesn’t shift to Kahn.3. R – A SH owes a fiduciary duty only if it owns a majority interest in or exercises control

over the business affairs of C.a. To show SH controls business affairs, absent a majority interest – must establish

domination by a minority SH thru actual control of corporation conducti. This case Actel owned < 50% of shares of Lynch stock, but board deferred

to it on decision making; did control business (threat of hostile takeover, not renewing D contracts)

b. Entire Fairness Test: As a controlling SH, D owes SH the fiduciary duty of entire fairness, including fair dealing and a fair price

i. Fair Dealing – involves the manner in which a transaction is conducted, including its timing, structure, negotiations, disclosure and approval

ii. Fair Price – focuses on financial considerations of the proposed mergeriii. *Must view both components as a whole to determine fairness

c. Burden of Proof under Entire Fairness Test:i. Initial burden of proving fairness rests on party that stands on both sides of

the transactionii. If merger is considered and approved by an independent committee of

disinterested directors, BOP shifts to SH to demonstrate that the merger was unfair

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1. To shift burden, majority SH must NOT dictate the terms of the merger and the independent committee must have real bargaining power that it can exercise with the majority SH on an arms length basis

d. Application of Entire Fairness Test – i. Test for when you have an Interested Merger Transaction

ii. Always applies in P / S mergers b/c of the nature of the transactiong. Sale of Control :

i. Zetlin v. Hanson Holdings, Inc. – 1. F – A minority SH claimed that he and other minority SH were entitled to the premium

received by controlling SH when they sold their controlling interest.2. R – Absent looting of corporate assets, conversion of a corporate opportunity, fraud, or other

acts of bad faith, a controlling SH is free to sell, and a purchaser free to buy, that controlling interest at a premium price.

ii. Perlman v. Feldmann – 1. F – A steel company’s minority SH brought a derivative action against C’s former controlling

SH for selling his controlling bloc at a premium to a group of buyer’s who were solely interested in using C’s supply of steel during a tight market.

2. I – May a SH sell his controlling share at a premium in any manner he wishes, absent fraud or foreseeable looting?

3. H – No; As a dominant SH F owed a duty to minority SH; F siphoned off for his personal gain corporate advantages deriving from a favorable market situation; This diversion of corporate opportunities represented a breach of fiduciary duty.

4. R – Where a call on C’s product commands an unusually large premium, a fiduciary may not appropriate to himself the value of this premium.

5. POINT – the exception applied in this case prevents a controlling SH from selling control in a manner that deprives C of a business opportunity.

a. Control of Corporate Affairs – may be sold at a premiumb. Control of Corporate Assets – this control belongs to C; and C is entitled to any profit

derived from the use, sale, or diversion of corporate assets6. *NOTE – Blocks of shares worth more b/c they bring more control

a. In this case an independent committee (plus resigning from the board) may have helped Feldman’s case here.

b. If Feldman was a minority shareholder – he could probably sell his shares. c. Recovery against Feldman – Feldman had to account to shareholders the premium he

was paid – the opportunity was distributed to the other shareholders.i. Went to the minority shareholders (otherwise it was have been paid to

Wilport, the purchaser) Feldman was allowed to keep his portion. d. Pearlman could be read – control cannot be sold at a premium to those who would

injure the corporation by failing to maximize profits.

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X. INSIDER TRADINGa. Common Lawb. Securities Exchange Act § 10(b) and Rule 10(b)(5)

i. SEA § 10b – Regulation of manipulative / deceptive devicesii. SEA Rule 10b5 – Employment of manipulative / deceptive devices

iii. SEA Rule 10b5-1 – Insider Tradingiv. SEA Rule 10b5-2 – Duties re: Insider Tradingv. SEA § 14(e) – Proxies

vi. SEA Rule 14(e)(3) – Transactions based on Insider Trading re: Tender Offervii. SEA § 20A – Liability for Insider Trading

viii. SEA § 21A – Civil Penalties for Insider Tradingc. Liability for Short-Swing Trading Under § 16(b) of SEC Act

i. SEA § 16 – Directors, Officers and Principal Shareholdersd. 13B (D) filing – under Williams Act (part of SE Act of 1934) – when any person acquires 5% of the class of

public co stock, w/in 10 days of acquisition must send to issuer, stock exchange, and SEC certain information; facts about identity and bkground of purchaser, # and shares sold, and if purchaser seeks control of the company, must disclose any plan or proposal; this is triggered by 5% control of stock

Insider Trading 1934 Act is a hodgepodge of regulation, including of insider trading. §9,10 – manipulation of stock prohibited, 10a – audit standard 10(b) - related to fraud in connection to purchase/sale of existing securities, viewed as catch all, not self-executing §12, 13, 14 controls corporate information 13 – filing of periodic reports with SEC 14 – certain materials filed and sent to stock holders §16 – provides for the recording of insider transactions and the recovery of short swing trading profits. 17 – applies to fraud in the offer or sale of securities. 18 – deals with liability for misrepresentation of documents filed with SEC.

In ordinary commercial transaction, each party free to keep to self any information that might affect value of the commodity which is the subject of the negotiation. Exception: one party stands as a trustee or in a fiduciary duty to another, then can’t stand w/o bias.

Fraudulent to intentionally tell half-truths, also to take intentional steps to conceal the truth Jurisdictional basis –

a. Applies broadly to all securitiesb. Interstate commerce (telephone call or letter)c. Can be brought under state law for actual fraudd. Special facts doctrine – may have causes special duty to disclose

10b, 10b5 Prohibits manipulative devices

a. Any device or artifice of fraudb. Misstatement of material factc. Omission of material fact necessary to not make statements misleadingd. Any acts or practices in the course of business that operates as defrauding

10b-5(b) Remedya. Corporate accounting, 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

Outsider trading – trading on other companies on non-public information is also prohibited. Misappropriating information is often outsider trading, often called insider trading in the media.

Insider – Person, who possesses insider information, knows or should know that the information is non-public, and receives the information in his/her business capacity, for a legitimate business reason by virtue of his relationship giving access to the information. Insider exploits advantage whether the information is good or bad.

Goodwin v. Agassiz It would be a difficult situation if a director could not buy/sell on an exchange w/o seeking out other party in order to share information. Personal transaction here was ok.

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Strong v. Repide – shares sold for 1/10 of value 3 months after sale of properties to gov’t, using broker. Defendant was in full charge of the negotiations, and concealed that he was the purchaser. (agent hired to work through broker, to purchase from seller) Special duty arises when there are special circumstances.

Old common law majority rule – no duty to disclose if trading over an impartial exchange (because cannot seek out purchaser) (MA)

Strong rule (Special Circumstances) – normally no duty to disclose unless there are special circumstances (intermediate) while director has no relationship to stockholder, has to disclose all special facts that may have a material effect on the value of the stock.

Third rule – Kansas 1932, director’s duty is that of a trustee, and director is under a duty to deal fairly with SH and communicate all material facts that the Dir. knows or should know. (was minority rule) fiduciary duty to SH

The Wharf (Holdings) Limited v. United International Holdings, Inc. F - U had tech capacity, W bidding on cable contract in HK, promised 10% option. U said only would help if given

right to invest. Option to last for 6 month, only able to exercise if able to raise capital. D never intended to honor the agreement for 10% This case shows how 10b5 and 10b are applied.

I – did D’s intent to never honor the 10% amounted to a misrepresentation or other conduct which violated 10b5 H - To succeed under 10b5 – private P must show that the D used, in connection with the purchase/sale of a security,

on of the four kinds of manipulative or deceptive practices.o 4 parts of basic fraud. – Intent to deceive, manipulate or defraud, material misrepresentation, and

plaintiff must sustain damage through reliance on the misrepresentation.

Kardon v. National – This was the first case to imply a private right of action under 10b5. Affirmed by SCOTUS.

In the Matter of Cady, Roberts & Co. F - SEC administrative hearing. Stocks & options of Curtis Right were sold with light of knowledge of future

dividend. SEC fined selling executive, held that sale acted as a fraud. H – there is an affirmative duty to disclose. CR stock could not have been sold w/o disclosing material information

that he knew and the purchaser did not. (This was a transaction on an exchange) If information cannot be disclosed, sale must be withheld from closing until information can be disclosed.

o Gintle – seller – came to be known as a tippee. Rec’d a tip from an insider (tipper) o This applies to somebody who is in a special relationship to the company and has access to information

available only to a corporate purpose. The inherent unfairness that is involved where one party takes advantage of this news is to be prevented. “Intimacy demands restraint lest the uninformed be exploited.”

Extended the duty of disclosure in several wayso Affirmative duty to disclose material information to purchasero Applicable to exchange transactionso Broadened beyond traditional insiders.o Applies to all participants in the marketplaceo Owed to purchasers of securities, not to holders of securities.

Tippee inherits the fiduciary duty of the tipper. No longer law – following expansion of 10b and 10b5 then SCOTUS cut back & adopted common law rule –

has to be a fiduciary duty between the insider and the person they are trading with (Chiarella v. US)

SEC v. Texas Gulf Sulphur Co. Under SEC 1934 act, SEC can bring an action when it appears that a party is about to violate (Test of Cady admin dec.) F - TSG finds large deposit, TSG press release considered misleading. SEC alleges that stock was purchased

(options) on the basis of material information regarding the results of drilling that had not yet been disclosed. H – anyone in possession of material non public information must either disclose it to the investing

public, or if not allowed, abstain from trading until that information becomes public. Applies to people who are not traditionally insiders.

o Court holds that the duty to abstain applies – arises in the situations that are essentially extraordinary in nature and reasonably certain to have an effect of the share price if that information is disclosed. Only basic facts must be disclosed so that outsiders can judge based on that.

o When to disclose is a business judgment for management. o If the corporation is helped by non disclosure, those responsible for that policy, cannot leak to others

or trade on their own (in light of this information) o When insiders can trade depends on the definition of materiality – def – any fact is material if a

reasonable investor would attach importance to it. Any material fact may affect the value of the stock.

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Whether facts are material depends on the balance on when the event may occur and the magnitude of the event.

R – Material information must be effectively disclosed in order for the investing public to have this knowledge, insiders cannot jump the gun.

o Would a reasonable investor find the information important in reaching an investing decision? No longer law – following expansion of 10b and 10b5 then SCOTUS cut back & adopted common law rule –

Has to be a fiduciary duty between insider and the person they are trading with ( Chiarella v. US) What is the meaning of “in connection with” (the sale of purchase of securities)

o Here requirements were met because the press release was the type of information that reasonable people would rely on when purchasing stock. (reasonably calculated)

o There is no intent necessary that the violator (here TSG) has to be buying or selling stock. (Only plaintiff has to be buying/selling securities, defendant does not)

One in possession of material non public information has a duty to disclose information or disclose from trading. (applies to all material information) Materiality is to be determined on the basis of the facts of each case. Ct. says that any fact is material if a reasonable investor would attach importance to it and that such information may

affect the value of the stock (p.543) Materiality depends on a balancing of the indicative probability that the event would occur combined with the

magnitude of the event. Duty to disclose applies only to situations that are extraordinary in nature and are reasonably certain to affect the

value of the stock price. (totality of the company activity) The information to be disclosed is only applied to basic information, expert information needs not be disclosed.

NOTE - SEC could see other than injunctive purposes in order to effect the enforcement of the rules. (often injunction)Calculation of reimbursement (by district court) was the valuation of the price on set date and the date that TSG knew the full value of the mine. Private judgments paid out of settlement fund held in escrow. Corporation damage – corporate good will harmed, investor relations harmed. Criticisms of – insider trading may impede the dissemination of information to the investing public, effects the efficiency of markets. Skews the dissemination of information. Also harm to the corporation and idea of fair play.

Blue chip stamps case Q re standing to sue, P not entitled to sue for violations of 10b5 because persons who are not actual purchaser or

sellers of the security involved cannot face a private action under 10b5. Use as filter to strain out lawsuits

Ernst & Ernst - Another filter for 10b5 regulation – scienter requirement. P are investors in accounts who claim that D aided and abetted – they failed to discover practices that should have

been disclosed to SEC, which would have flushed out the fraud that was occurring. Lower Ct (7th cir.) holds that any irregularities that should have been discovered will lead to liability. D is held liable. H- Scienter is a necessary element of a 10b5 damage action. Therefore conduct by D that was merely negligent

does not give rise to damages or liability. (2nd cir. Later holds that recklessness will satisfy scienter (reckless is highly unreasonable, extreme departures from standards of ordinary care, 1995 act eliminates recklessness)

Santa Fe Industries v. Green. F - Merger to cashout SH. Min. objected to terms but did not seek appraisal. 10b5 claim – low valuation was fraud. Issue – Can rule 10b5 be used to remedy conduct that essentially amounts to a breach of fiduciary duty under state

corporate law? If so 10b5 provides an entre into federal courts.o May federal courts interpret fraud so broadly so as to catch conduct by a fiduciary that is objectionable

because it was substantially unfair, even if it did not involve lies or half-truths? H – 10b5 does not encompass all breaches of fiduciary duty in connection with a securities transaction. There has to

be deceptive of manipulative conduct. No material misrepresentation of a material fact therefore no deception. No federal cause of action, P has a state remedy.

R – 10b5 cannot be used as a basis for the development of a federal corporate law of fiduciary duty, rule not available to mere breaches of fiduciary duty or substantial unfairness in a transaction. 10b aimed at deception and manipulation.

Corporate mismanagement is a matter for state court.

Goldberg v. Meridor - Shows that scope of Santa Fe decision could be limited F – partially owned sub purchased parent co’s assets at inflated price, using sub stock as means of pmt. Press releases

failed to disclose material facts not disclosed re: value of assets. 2nd cir. Says this is a violation of 10b5. This transaction involved stock, material facts not disclosed, & was deception. Followed by other circuits (escape valve for 10b5) not closed by SCOTUS.

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SEC v. Zandford F – Securities broker takes on elderly man and retarded daughter, Essentially steals 400k, later convicted of wire

fraud and ordered to pay 10k restitution. SEC then filed civil complaint for alleged violation of 10b and 10b5 I – does “in connection with the purchase or sale of any security” apply to misappropriation of funds following a legit

sale of securities. H - SCOTUS orders Zandford to repay funds. Statute should be construed flexibly, notes that SEC consistently

adopts broad reading of “in connection with purchase or sale of any security”. Says - “a broker who accepts payment for securities he never intends to deliver, or sells securities with intent to misappropriate the proceeds violates 10b and 10b5.”

o But 10b and 10b5 cannot be construed so broadly to encompass every type of fraud. Here fraud was not an independent event (from security transactions)

If a broker takes advantage of the fiduciary relationship to induce person to act on a fraudulent transaction, this does not satisfy “in connection with”

Does not transform every breach of fiduciary duty into a federal cause of action. Or facts like Santa Fe. “this is what you’re getting for shares, too bad”

Basic Inc. v. Levinson (cite for materiality of information) Company in merger negotiations, makes statements during eventual agreement to merge, issued 3 public denials of

negotiations. P – SH who sold after denials prior to delisting claim that under 10b5 stocks were affected and were injured when relying on the market price of the stock.

I – Do misleading or incomplete statements re: incomplete negotiations become material in violation of 10b5 H – In order to prevail on 10b5 P must show that statements were misleading as to a material fact.

o Ct. adopts substantial likelihood test for materiality – Same from TSC v. Northway, an omitted fact is material if there is a substantial likelihood that this disclosure would have been considered significant by a reasonable investor. Materiality in a merger context depends on the probability that the transaction will be consummated and the significance to the issuer.

o Same as TSG – must be decided on a case by case basiso Disclosure is the purpose of the securities law.

Materiality requirement filters out useless info a reasonable investor would not consider insignificant

Cites TSG - materiality depends on any given time upon the balancing of both the indicative probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.

Statements are not required, but if saying something must be truthful and not misleading. o Corporation will need to disclose when markets (or exchange) requires information. o Disclosure is an operation of the BJR.

Fraud on the market (Basic Cont’d) Principal mechanism thought to cause market price to reflect true valuation of company is market competition. 1934 act requires periodic disclosures. Efficient capitals markets hypothesis. (Securities markets respond very rapidly to newly released information.)

o Fraud on the market theory piggybacks on ECM hypothesiso Based on hypothesis that in an open and developed securities market, the price of the companies stock is

determined by the material information available regarding the company and it’s business Misleading statements will defraud purchasers of stock even if they do not directly rely on the

statement of the corporation. o Causal connection between D’s fraud and P’s trans of stock is no less significant than case of direct reliance. o There is a rebuttable presumption of reliance supported by fraud on the market. o Mkt price transmits info to the buyers/sellers, market performs a substantial part of the valuation process.

(skt acts as an unpaid agent of the inv by informing on value of the stock in light of all available info) Scienter, proximate cause, materiality, & reliance, needed to show for damages (basic torts) for suing under 10b5

o First 3 shade into each other in securities areao Scienter requires P to show that P acted with intent to deceive or defraudo P must show that statement was the cause of damages. (rebuttable)o Causation directly implicates materiality requirement, P must show that reasonable investor would

considered the statement important. If a reasonable investor considers something important it will affect the price of the stock, which brings back to causation.

Stock was sold on a depressed market that was created by management (Basic) o Reliance test fades into materiality standardo Ct. adopts rebuttable presumption if fail to disclose– absent proof to contrary, plaintiff relied on information.

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Would be too hard to prove this for a class action, so court accepts a presumption of reliance if information is material (therefore causal connection between D’s misrepresentation and P’s injury)

o Information transmitted to investor in form of the market price. Investor is entitled to rely on market absent of any evidence of reliance on misrepresentation of D.

PSLRA—private securities litigation reform act. What LRA does is establish appointment of lead plaintiff in securities actions. After the filing of a securities fraud class action, the p has to give notice to potential class members inviting them to serve as lead class members. Supposed to appoint most appropriate class member with a significant financial stake in the action. Limits to the frequency a particular individual can serve as lead member. Congress also requires scienter to weed out class actions. Two components: 1) specific intent to mislead; 2) or the defendant acted recklessly. Unler LRA, recklessness isn’t sufficient scienter under 10b5 for forward looking statements. What about statements that are not forward looking? Open. Fraud under the federal rules needs to be pleaded with particularity. Under the 2nd circuit, the p must state with particularity facts which give  a strong inference to the requisite intent. Under this standard, the p could establish the required strong inference by detailed factual allegations that show a direct evidence of scienter and 2) the D had motive and opportunity to commit fraud. To prove the 2nd prong p had to allege d benefited in some concrete and personal way from his purported fraudWhat would have been strong inference that person acted with required intent to show scienter? 7th circuit said if the complaint alleged facts, which if true a reasonable person could infer that the d had requisite intent that was enough. You have to look at all of the evidence pled to see if there was sufficient motive of the plaintiff that there was intention to commit fraud. A person who doesn’t improperly trade may nevertheless aid or abet another who does. For instance an accountant or a lawyer. There had to be some degree of knowledge by the aider and abettor that his role furthered improper activity. Had to reach some level of significance in furthering improper activity. Liability cannot be imposed on a person under 10b5 solely b/c that person aided and abetted a violation of the rule. The ’34 act did not include giving aid to a person who commits a manipulative or deceptive act by allowing them to rope in deep pockets. Secondary actors could not be sued on aiding or abetting theory but could be sued as primary violators. Secondary actors are not always shielded from 10b or 10b5 actions. Court adopted an SEC proposed rule for primary liability of a 2ndary party: when a person acting alone or with others creates a misrepresentation on which investor p’s rely, person can be held as a primary violator if he acts with the necessary scienter. In 01/08, SCOTUS examined whether a private right of action extended to a suit against an aider and abettor. Upon whom were the investors trying to impose liability? No economic substance to transaction, and charter had fake documents to show separate transactions and charter would book fake advertising revenue, showing that charter’s income was a lot higher than it really was. Two vendors were scientific Atlanta and Motorola. Charter paid extra for the cable boxes and money flowed back in form of advertising. Vendors essentially knew what was going on, booked the transactions as a wash on their financial statements, so scientific Atlanta and Motorola were aiders and abettors. Court said: no private right of action for aiding and abetting. Actions by scientific Atlanta and Motorola, plaintiffs didn’t rely on them. They relied on charter, and since there was no reliance on the aiders and abettors by the p’s the 8th circuit found in favor of the D. aiders and abettors had no duty to disclose to the public and therefore petitioners did not rely on them. Petitioners say the fraud itself wouldn’t have succeeded if the D’s hadn’t participated in it.

Court’s concern was that it would just go everywhere. Reliance is tied to causation and the actions of Motorola and scientific Atlanta were remote to the injury. It was charter, not Motorola or SA who mislead auditor. P’s were trying to extend 10b action beyond the securities marketplace to normal business actions. Court says 10b doesn’t reach all common law fraud. Does this mean aiders and abettors will completely get off? No, SEC will go after them. Court is concerned that p’s with weak settlements will extort innocent co’s. if you have a secondary actor who commits a primary violation they could still be covered.

Insider tradingChiarella v. USChiarella was someone who was setting type and he deduced the names of the companies merging etc. Supreme court rejects possession theory (where you have to abstain or disclose). Court said C didn’t have affirmative duty to disclose b/c he wasn’t an insider. Abstain or disclose rule applies only to those who have fiduciary duty. When does the duty to disclose arise? When you are a fiduciary and the other party in the transaction is entitled to know because there is a relationship of trust and confidence between them.

C doesn’t have to disclose or abstain because more possession of non public knowledge is not enough. C doesn’t have a duty to anybody who has shares in corporation B, nor does he have a duty to corporation B. court rejects parity of information rule.

What is the basis of Tippee liability? Only if the insider has fiduciary duty in giving tippee information. Tippee’s obligation has been viewed as arising from his role as a participate after the fact in the insider’s breach of a fiduciary duty. If the tippee knows that it is confidential info then the tippee’s obligation arises out of the tipper’s breach.

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There is no fraud when there is no duty to speak.  If we were talking about the director of corporation B, he would have to abstain or disclose. Plaintiff would have to allege in order to get a conviction that there was a duty owed to the public or to the employer or to the acquiring corporation or its shareholders. C stands for not every instance of financial unfairness constitutes fraudulent activity.

14a(e)(3) says prohibits trading by anyone who gets information directly or indirectly from either someone from Corp A or Corp B. the rule also prohibits insiders of the offeror as well as tippers. No reason under 14e3 that tipper need breach fiduciary duty.

A duty to disclose information arises if there is a relationship of trust and confidence between parties to the transaction. Chiarella had no such duty. He was not a corporate insider in the acquiring corporation and he did not receive confidential information from the target company. He also had no fiduciary relationship with the shareholders of the target company: he was not their agent; they placed no trust or confidence in him; indeed, they had no prior dealings with him. A duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.

Dirks v. SECo F – Dirk got information from Secrist who had been fired and disseminated information which affected the stock price. Dirks

tipped off firms and funds. How does dirks differ from C in source of nonpublic information. in C, C obtained information on his own efforts.. Dirks is charged with aiding and abetting.

o I – When are individuals other than corporate insiders obligated to either disclose material non public information of disdain from trading.

o H - Dirks reaffirms Chiarella – There has to be the existence of a relationship or a duty affording access to inside information that was intended to be available for corporate purpose. Duty under 10b and 10b5 does not arise from mere possession of non public information. Absent a breach from an insiders there is no derivative action available. The United States Supreme Court held that Section:10(b) should not be read so broadly as to hold tippees liable when they use inside information received by insiders who were not breaching their fiduciary duties in their disclosure. The Court held that the insider must first breach a fiduciary duty and then the tippee’s conduct will be examined to see if they breached a duty. Most important part is footnote 14 (p.591) Under certain circumstances corporate information is revealed legitimately to an underwriter, accountant, lawyer

or consultants working for the C, these outsiders may become fiduciaries to the SH, they are temporary insiders. Lawyers and accounts can be held liable for insider trading under certain circumstances. (outsiders may become fiduciaries to the insiders.)

o Basis is the special confidentiality and access these people haveo When they breach they are not tippees, they are tippers. o They are required to disclose or not trade when there is a relationship of trust between shareholders & directors

that has given access to information meant to be confidential, but merely having possession of information is not enough. Breach of duty depends on the purpose of the disclosure, will the insider benefit directly or indirectly from the breach, absent personal gain there is no breach (objective criteria)

Does not mean that tippees are off the hook, but any action is derivative, and there is a relationship between the tippee and tipper, in this situation the tippee will be held liable.

This duty to not trade of corporate insiders is held to the shareholders and the corporation itself. Classic insider must disclose or abstain from the trading of stock if the information is non public material Dirks deals with when information held by people other than officials.

o Chiarella tells, Dirks reaffirms, that there has to be a duty (due to relationship) to withhold corporate information where there would be an obligation to retain the information as confidential.

o Duty under 10b and 10b5 does not arise from mere possession of non-public market information. P.593 – whether there is a breach of duty depends in large part on the breach

o Absent a breach of an insider, there is no derivative action. o Will the insider benefit either directly or indirectly from the breach

Pecuniary gain or reputational benefit that may translate into future earnings Relationship may suggest quid pro quo

o If the tippee has knowledge or scienter that the information source has knowledge that the information shouldn’t be used, then tippee is guilty like a classical insider.

Concern of the court if the Dirks conviction was upheld – it would have a negative effect on the efficiency of the market, would discourage security analysts and impose liability on anyone in possession of non public information.

o Would have an impact of market analysts and w/o investigatory efforts of them corporate frauds would not be discovered, and investors will be harmed.

Basis of tippee liability from this case – o must know it was breach of fiduciary duty insider used confidential info that shouldn’t have been disclosedo Courts will look at the purpose of the insider and will the insider personally benefit.

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Did Seacrist violate his fiduciary duty, he had previously been fired from equity funding and there was no evidence that his disclosure deceived or defrauded anybody. Ct. says that he did not personally or directly receive any benefit.

Test for materiality of information – would a reasonable investor chance their mind on an investment in light of the insider information?

o Can argue here that a reasonable investor might have regarded the information as preposterous – WSJ and SEC didn’t take the information when offered.

o Seacrist was just fired, his information could be retribution, had a long rap sheet, no credibility. o So arguably the information was not material. o Information concerning criminal activities is not regarded as inside, it doesn’t belong to the corporation, and may

belong to the government (investigating the crime) SEC v. Yun ( note case) – builds on Dirk, showing a benefit does not have to be exclusive.

o “The showing needed to prove an intent to benefit is not extensive. The Supreme Court in Dirks, after establishing the tipper benefit requirement, proceeded to define ‘benefit in very expansive terms.’

SEC after Dirks and Chiarella – Misappropriation theory - developed alternative basis for insider trading - liability can occur under 10b5 when a person trades on confidential information even when the source is not direct. (fiduciary relationship) (misappropriation theory, had mixed results in course)(criticism is that it is not an active type of fraud, difficulty in seeing this misappropriation as a fraud in connection to a securities transaction, if the victim is unlikely to engage in any securities trading at all)

Chester case - unilaterally trusting someone with confidential information does not create a fiduciary relationship. SEC creates 10b52 following this case.

Carpenter v. US – WSJ reporter (author of heard on the street) SCOTUS split 4-4 on misappropriation theory (therefore no precedential value)

United States v. O’Hagan - affirmed misappropriation theory F - O’Hagan was a partner in a law firm, represented client, and purchased calls on information known, then sold when

information of offer to purchase company. ~$4.3m profits. SEC prosecutes under fraud using 10b-5 and 14e-3(a) I – was this really “in connection with the purchase/sale of securities” – court finds that it was closely enough linked to

the stealing of information and securities transaction to bring it under 10b5 (v. santa fe industries, which was not fraud) H - basis for liability - he breached the duty owed to the source of information. He deceived those people. Misappropriation theory outlaws trading on the basis of non-public information by a corporate outsider, in breach of a

duty owed not to the trading public, but due to the corporation. o As an outsider, he owes a duty to his firm, and the firm’s client. o Ct. finds that O’Hagan’s conduct was a fraudulent device in connection of the sale or purchase of securities.

Upheld 14e, prohibiting fraud actions in connection with a tender offer.o 14e3 violated when trading with information acquired directly or indirectly from an insider. Court upholds this

as a reasonable rule designed to prevent fraudulent trading. O’Hagan suggests that there could be no 10b5 insider trading if there was no breach of trust or confidence. Thus a

person who gains access to material non public information such as by theft would not cease to be guilty of fraud sanctions. If the person who steals the information discloses, or receives information from the source, there would be no breach of duty, thus no 10b5 violation.

o O’Hagan leaves unanswered who has duty for breach of confidence, and when does this duty attach.

SEC v. Rocklage Wife took confidential information from husband, president of a publically traded company, who then tells brother

leading to trades on information. Liability is found on misappropriation. This is not insider trading, Mr. Rocklage expects or receives no benefit. Mrs. Rocklage contends that she didn’t violate 10b5 because she told husband that she was going to tell brother. Court

deals with by deciding that telling wasn’t the deception, but was in tricking husband to reveal confidential information. Case differes from O’Hagan – doesn’t deal with if he tricked firm in gaining access to information. Here was a scheme in

getting the information, deceived husband initially, when gave to brother it was another deception. 10b5-2 – rule promulgated in aftermath of Chester case – applies misappropriation to person obtaining non-public

material information from spouse, partner, or child. Closes family relationship loophole. Person receiving information has to demonstrate no duty of trust of confidentiality.

SEC’s position on pre-tip disclosure, that she told husband she would tell brother, marital privilege prevents him from getting an injunction on wife to stop use of information.

Unlike in O’Hagan (one deceptive device) here there are sequential acts of deception (to qualify as a scheme) Mrs. Deprived Mr. Of exclusive use of the information. Relied on the WSJ (Carpenter) case. Mrs found guilty.

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SEC v. Talbot Director of fidelity nat’l bank, (part owned company, lending tree) Director or lending tree tells that there was an offer from 3rd party, who then mentions with CEO of fidelity. Leading to

discussion among board, (happy with potential sale) board member states it is confidential information (info from lending tree -> bank was not classified as confidential but known to be)

Talbot is only one on board who buys calls and stock on lending tree, sells stock after confidentiality agreement. Indicted for these actions.

Trial Ct. holds that fidelity, lending tree, Talbot were not linked through fiduciary duty. Reversed that Talbot should have known this information was material and confidential. Remanded to determine if material information.

So long as it is a link in a chain, then there is a scheme in connection with the purchase/sale of securities.

December 7, 2010§16 of the 1934 SEA has been criticized as a trap for the unwary, seeks to limit insider trading. 16b requires 6 month wait to sell/buy stock from information. 16a – purpose – means to bring to light possible violations of 10b5 as well as purchases and sales in light of 16b (inside directors, officers, 10% shareholder report requirements) also is a disclosure device that may be used by others in evaluating the security of others. May be used to detect an involving change in control. Deterrence to certain insider trading because it is so publicized. Text p.613 – 14 benefits of §16 – Also penalizes the unfair use of inside information by insiders, and the use of softer types of information that members of the investing public may not have, but the directors do. Also want to eliminate the possibility of insiders to manipulate corporate events to benefit themselves.Under 16b squeeze out maximum profit possible, match lowest purchases against highest sales over six months, disregard losses, sum = profit. Potential 16b violation is also a violation of 10b5, but sometimes 10b5 not 16b or vice versa. 16b liability is often referred to as draconian, it is strict liability. Under 16b all loss sales are disregarded. 16a1f – in terms of who comes under 16b, and is an officer, look at those who perform significant policy making functions. Titles becomes less significant then function person is engaged in. deputization theory – director may be held to be representative of corporation (hedge fund/ dr corporation relationship) is the hedge fund subject to 16b liability?

Succeeded in 2nd cir case – Feder v. Marietta. Stock purchased while bunker was director (deputization) was returnable to corporation due to transaction within 6 months.

o Must you be an insider at the time of each transaction? SCOTUS 1970’s case – language of subsection does not apply to person who becomes 10% owner at time of transaction. (need to be 10% at both ends of transaction)

o One need not hold post of director at both ends of the transaction (sale & purchase) for 16b to apply.

Exam5 questions1 includes series of short answersdifferent time allotments for questions. Open book – can bring stat sup, casebook, outline, No page limits, but no need to type needlessly.

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