I. Choice of Business Entitya. The General Partnership

i. Formation and Need for Written Agreement1. Partnership Defined

a. UPA 6(1): A partnership is an association of two or more persons to carry on as co-owners a business for profit.

i. Carry on control as co-owners, andii. Share in profits.

b. UPA 7: Joint ownership does not by itself create a partnership. Sharing of gross revenues does not buy itself create a partnership. The entity must have been

i. Formed as a joint ventureii. For the purposes of carrying on control of business

iii. To make a profit.2. Need for a Written Agreement

a. Partnership may be enforced even without a written agreement.b. However, a written agreement provides important rules for hashing out

disagreements, deciding what to do on dissolution, etc.ii. Sharing of Profits and Losses

1. Usually allocated by way of the written agreement.2. Default Rule - UPA 18(a): In the absence of a written agreement, all profits and losses are

shared equally.iii. Inadvertent Partnerships

1. Profits Presumption – UPA 202(c)(3): A person who shares in the profits of a business is presumed to be a partner.

2. Martin v. Peyton : KN&K a brokerage house partnership in financial straits. Defendants enter into an agreement giving KN&K $2 million in securities in exchange for (1) large number of speculative securities, (2) 40% of the profits up to $500,000, (3) defendants could inspect the books and veto any major business decisions, and (4) defendants had an option to turn the loan into a contribution.

a. Issue: Is this arrangement a loan or a contribution turning the defendants into partners?

b. Holding: The arrangement is a loan because, although the defendants were entitled to share in profits, this was contemplated as security for the loan. And, although the defendants had a right to veto major business decisions, this also could be seen as security for the loan given the partnership’s poor prior judgment. Veto power alone does not rise to the level of “carrying on control of business.” Finally, if this were a contribution, why would it contain an option to make it a contribution?

iv. Management of Partnership Business1. Partner Agent of Partnership as to Partnership Business – UPA 9:

a. Every partner an agent of the partnership when acting on partnership business.b. Partnership bound by the actions of any partner acting in the ordinary course of

partnership business.c. Exception: Partnership not bound by the actions of a partner (1) acting without

actual authority, and (2) where no third party reasonable reliance on actual authority.

2. Partnership’s Liability for Partner’s Tortious Acts – UPA 13-14a. Partnership liable for partner’s tortious acts committed during ordinary course of

business.b. Partnership liable for partner’s misappropriation of third party’s funds when acting

under the apparent authority of partnership.3. Nature of Partner’s Liability – UPA 15:

a. All partners jointly and severally liable for the tortious acts of a partner committed during ordinary course of business.

b. All partners jointly and severally liable for the debts of a partnership.i. General partners cannot waive their liability to third parties!

ii. However, partners can agree to indemnify each other for such liability in the partnership agreement.

4. Centralization of Managementa. Default: All partners have equal rights in the management and conduct of the

business (UPA 18(e))b. Executive Committees and Managing Partners: UPA 18 allows partners to agree to

form an Executive Committee to control the operations of the business. Executive Committee can have a Managing Partner, similar in function to a CEO.

v. Duties of Partners to Each Other 1. Partner’s Fiduciary Duty – UPA 21

a. Partners have fiduciary duty to each other and to the partnership.b. Partners have to hold any profits as trustees for the benefit of each other and

partnership.2. Meinhard v. Salmon : Plaintiff and defendant enter into a partnership agreement to own and

operate a hotel. Plaintiff to contribute the funds; defendant to run the business. The partnership enters into a 20 year lease. The hotel makes a ton of money. Four months before lease ends, the lessor comes to defendant and solicits him about leasing the whole block of buildings. Defendant agrees and the lessor and defendant enter into a separate agreement to begin after the termination of the hotel lease.

a. Issue: Did the Defendant breach his fiduciary duty to Plaintiff by failing to inform him of the new lease opportunity to begin after the termination of the partnership?

b. Holding: Yes.i. The new opportunity was created by the partnership’s success. Thus, the

new opportunity was a potential extension and enlargement of the partnership.

ii. When a new opportunity is created by a partnership’s activities, a partner has the fiduciary duty to disclose this new opportunity to the partnership and to allow the partnership the ability to take advantage of this new opportunity.

3. Contract Limiting Fiduciary Duty:a. In some jurisdictions Partners can contract to limit their fiduciary duty to the

partnership and each other through express agreement in the partnership contract. This allows a partner to enter into business arrangements that may conflict with the interests of the partnership.

b. Other jurisdictions refuse to allow partners to limit their fiduciary duty contractually.vi. Dissolution of General Partnerships

1. Defined – UPA 29: Dissolution is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.

2. Default Causes of Dissolution – UPA 31: Dissolution caused bya. Express will of partner to dissolve partnership,

i. May be subject to damages, though, for breaking the partnership agreement.ii. If one partner leaves and the business continues technically a new

partnership is formed.b. When the partnership term specified in agreement runs out, orc. By the expulsion of any partner, ord. By death of any partner.

3. Survivorship Clauses: Usually partnership agreements contain an agreement to continue the life of the partnership in perpetuity.

4. What happens to the dead partner’s interest after his death?a. Interest in partnership passes to his estate.b. However, heir does not become a partner.c. No person becomes a member of the partnership without the consent of all the

partners. (18(g).d. Heir receives a percentage of assets her husband retained; his “basis.”

vii. Limited Liability Partnerships1. Formation – UPA (1997) 101(7) & 1001 – 1003

a. Limited liability partnerships must be created expressly by filing a statement of qualification.

b. Limited liability partnerships require:i. Vote necessary to amend partnership agreement

ii. Filing of Statement of Qualificationiii. Effective the later date of the filing date or the date specified in the

statement.c. Must have LLP after its name and must file an annual report with Sec. of State.

2. Liabilitya. UPA (1997) 306(c): Any obligation incurred by the partnership, whether by contract,

tort, or otherwise, is the sole obligation of the partnership. i. Limited partners bear no personal liability!!

ii. General Partners: General partners bear personal liability, however, for the obligations of the partnership; the partnership must have at least one general partner.

iii. Varied Protection: Protection for limited partners varies in different states. Some states protect only for malpractice/negligence. Other states protect for contract debts as well.

b. Management & Control Exception: If a limited partner participates in management and control of the business he is liable to third parties who reasonably believe the limited partner is a general partner.

b. Fundamental Considerations in Choice of Entity Decisionsi. Limited Liability

1. Corporation: Corporate Veil - A corporation is a fictional legal entity. As such, shareholders and officers of corporation generally bear no personal liability for the debts of the corporation beyond their capital contributions.

2. General Partnership: All general partners are jointly and severally liable for the debts and obligations of the partnership.

3. Limited Liability Partnership: Only the general partner bears personal liability for the debts and obligations of the partnership beyond his capital contribution

ii. Informality, Flexibility and Cost of Operation and Formation1. A general partnership can act much more flexibly and be created much more cheaply than a

corporation or limited liability partnership because it can be created by default.2. However, the procedural requirements for creating a limited liability partnership or a

corporation help to protect the owners/managers expectations.iii. Continuity of Life

1. Unless expressly stated in partnership agreement, a partnership ends when a partner dies or leaves.

2. Corporations generally have perpetuity of life because they are considered a legal entity completely distinct from their owners.

iv. Centralization of Management

1. General Partners automatically have an equal right to share in the management and control of the business.

2. Limited Liability Partnerships centralize management in the general partner because a limited partner may potentially lose his/her limited liability if he/she participates too much in the business.

3. Corporations: Articles of Incorporation provide for centralization of management in particular executive offices and in the Board of Directors; separates management from control.

v. Free Transferability of Interests c. The Corporation v. The Partnership: Reflecting on Certain Basic Federal Income Tax Considerations

i. Partnership Taxation1. The IRS generally does not tax partnerships as a separate entity. However, it must file an

informational return known as a Form 1065.2. Flow Through Taxation: Partners, rather than partnership, taxed personally on their annual

income gained from the partnership.a. Partnership must provide each partner with a Form K-1 informing partner of his or

hers share in respective income and deductions.b. Partners must pay tax on any gain, regardless of whether or not the partnership

actually distributed that gain to the partner.ii. Corporate Taxation

1. Incident of Double Taxationa. C-Corporation Income Tax

i. Corporation taxed on its Taxable Income (TI) based on Corporate Tax Rates.ii. TI = Gross Revenues – Business Expenses/Credits/Deductions

b. Capital Gains Taxi. Shareholders of corporations then taxed on any dividends received from the

corporation. This tax is known as the Capital Gains Tax.1. Capital Gains Tax: Taxes on gains from capital assets (assets held

for profit making or investment purposes).2. Capital Gains Tax Rate: 20%.

ii. Retained Earnings: Retained Earnings are the amount of gain the corporation chooses to hold, rather than release in the form of dividends, after business expenses, corporate taxes and any dividends actually released have been allocated.

2. Taxation for S-Corporationsa. S-Corporation requires:

i. An affirmative election by the corporation;ii. 75 shareholders or less, none of whom are artificial entities and all of whom

are resident aliens of US;iii. Only one class of shares.

b. Taxed on a modified flow-through basis where S-Corp reports the earnings of attributable to each shareholder.

3. Strategies to Minimize Incidence of “Double Taxation”a. Zeroing Out

i. Focuses on attempting to “zero out” C-Corporations taxable income.ii. Involves earmarking shareholder payments as expenses rather than

deductions by making these payments in the form of rents, salaries, interest payments, etc.

b. Accumulation Bail/Outi. Involves taking advantage of the lower capital gains rate.

ii. Allow profits that would otherwise be distributed as dividends to accumulate in the business.

iii. Then, when the shareholder wants to get out, he can sell his stock for not less than the amount accumulated in the business; the profit incurred is then taxed at the lower capital gains rate.

d. Combination of Forms of Business Organizations: Evolution of the Modern Limited Partnership with Corporate General Partner

i. Corporations as General Partners 1. Most state statutes consider corporations legal “persons.” Thus, corporations may serve as

general partners of a limited partnership. 2. To what extent, then, can limited partners serve as executives of a corporation/general partner

and still retain their limited liability?a. Limited partners lose their limited liability if (1) they exercise substantial

control over the business and (2) third party relies on the limited partner as a general partner.

b. California: Third party must have had actual knowledge of the limited partner’s participation in and control of the business for the limited partner to lose his limited liability.

c. Delaney v. Fidelity : Fidelity a limited partnership with Interlease Corp. as its general partner. Crombie, Sanders and Kahn are all limited partners of Fidelity; they are also the President, Vice President and Treasurer of Interlease. Crombie executes a lease on behalf of Fidelity with Plaintiffs in his capacity as President of Interlease. Fidelity defaults on the lease.

i. Issue: Do limited partners bear personal liability for the obligations of the limited partnership where they serve as the officers of the corporate general partner and where they executed the contract on behalf of the limited liability partnership?

ii. Holding: No. 1. Limited partners can be liable if they exercise control over the

business. 2. However, the purpose of this statute is to protect ignorant third party

investors. Here, the Plaintiffs had actual knowledge the limited partnership had a corporate general partner. As a sophisticated legal entity, it also knew the corporation would bear sole liability for the debts of the partnership. As such, it assumed the risk that the corporation would be undercapitalized.

d. Mount Vernon v. Partridge Associates : MIW Investors is a limited partner in Partridge Associates, a limited partnership. MIW created Partridge Associates and controls 50% of its interest. The President of MIW also participated in operational meetings of Partridge Associates.

i. Issue: Did MIW Investors participate in the operations and control of Partridge Associates such it would lose its limited liability under the management and control exception?

ii. Holding: No. 1. A limited partner loses its limited liability if it participates in the

control of the organization such that it has substantially the same exercise of powers as the general partner.

2. Limited partners do not have to act as passive investors. They can have a say in company affairs, including participating in regular operational meetings, as long as their word is not effectively the last.

3. Master Limited Partnerships

a. What are Master Limited Partnerships?i. Extremely large entities with a vast amount of partners who hold interests in

the partnership that are freely transferable, much like stock.ii. Used as a tax savings device by taking advantage of flow-through status.

b. Revenue Act of 1987: Master Limited Partnerships are treated as corporations for tax purposes if:

i. Partnership interests are traded on an established securities market; or,ii. Partnership interests are readily tradeable on a secondary market.

c. “Check the Box” Regulationsi. Entity classified as a corporation if:

1. Created under a statute that describes or refers to the entity as incorporated, a corporation, body corporate or body politic;

2. If it is not classified as corporation and has at least two members, it can be classified as a corporation for tax purposes by election at the time it files its first return;

3. If it has only one member, it can elect to be taxed as a corporation or as a sole proprietorship, i.e., as individual income.

ii. Scope of Fiduciary Duty in Modern Limited Partnership1. Directors of a corporate general partner of a limited partnership owe a fiduciary duty in their

dealings with the limited partnership to act in the best interests of the limited partnership.2. In Re USACafes, LP : USACafes, LP is a limited partnership. USACafes General Partner,

Inc. is its general partner. The Wyly’s are the sole shareholders of USACafes General Partner, Inc. and also on its Board of Directors. They also own 47% of the limited shares in USACafes, LP. The Wyly’s direct a sale to Metsa, Inc. of all of the assets in USACafes, LP. In return, they receive $72.6 million for the partnership, as well as side payments totaling $14-15 million for covenants not to compete.

a. Issue: Did Wyly’s, as directors of the corporate general partner of a limited partnership, violated their fiduciary duty to the limited partnership by taking side payments and by, allegedly, selling the limited partnership’s assets for less than market value?

b. Holding: Yes.i. Directors of corporate general partner of a limited partnership owe a

fiduciary duty to the limited partnership during transactions involving the interests of the limited partnership.

ii. Taking side payments to reduce the total price of the limited partnership’s assets constitutes a breach of fiduciary duty.

II. History of the Corporationa. Race of the Lax: Competition for State Incorporation Business

i. Implications of the Separation of Ownership from Control1. Corporations originally created by charter for specific purposes with specific powers granted.

Relatively small; owners played a large part in operations.2. As the incorporation laws became more lax, corporations incorporate for a vast array of

purposes and hundreds of thousands of shareholders. This creates (1) a separation of ownership from management that creates incentive for management abuse, and (2) huge corporations that tend to dominate the state and hold the state and its citizens hostage to their interests.

b. Pre-Eminence and Influence of Delaware Lawi. Delaware law is very popular because it tends to favor the interests of the corporations over its

shareholders.

ii. Plus, due to the fact so many corporations incorporate in Delaware and thus so many corporate cases are litigated in Delaware, the Delaware judiciary is considered particularly adept at handling corporate law cases.

c. Internal Affairs Doctrine and California Corporations Code § 2115i. Internal Affairs Doctrine

1. The law of the state where you incorporate governs a corporations internal affairs.2. Internal Affairs: Director elections, dividend disbursements, fiduciary duties, etc.

ii. California Corporations Code § 21151. A foreign corporation that maintains “significant contacts” with California will be

treated as a California corporation. Publicly Traded Corporations are exempt from this provision.

2. Foreign Corporation: Any corporation incorporated out-of-state.3. “Significant Contacts”: More than 50% of payroll, sales and property revenue generated

from California.d. The Future

i. Sarbonnes-Oxley1. A federal statute that imposes a broad new set of rules on the way a corporations organizes

financially.2. Conflicts with the Internal Affairs Doctrine by imposing federal law on internal affairs.

III. The Incorporation Process and Its Pitfallsa. Incorporation Procedures: Formation of a Corporation

i. Where to Incorporate1. Have to take into account the costs of incorporation and the advantages and disadvantages of

the state’s substantive law.2. For closely held corporations, almost always preferable to incorporate in the local state due to

the fact the corporation could be sued in its state of incorporation.ii. How to Incorporate

1. Filing Articles of Incorporationa. MBCA § 2.01: One or more people can incorporate by delivering the articles of

incorporation to the Sec. of State for filing.i. Any person can incorporate.

ii. Other corporations can serve as incorporators because they are considered legal persons.

b. California § 200(a): Same.2. Secretary of State’s Duties

a. MBCA § 1.25i. SS’s duty ministerial; if the Art. of Inc. comply with the statutory

requirements in model act, the SS has to file it.ii. If the SS files the documents, the documents considered filed as of the day of

receipt, unless the document proscribes another time.b. California Corporations Code § 110

i. SS’s duty discretional; SS ensures compliance with the law, as a whole (not just the procedural requirements).

ii. If accepted, filed on the date of receipt.3. What goes into the Articles of Incorporation?

a. Mandatory/Discretionary Provisionsi. Mandatory – MBCA § 2.02(a)

1. Name;2. Number of Authorized Shares;3. Street Address of Initial Registered Office and Name of Its

Registered Agent; and,

4. Name and Address of Each Incorporator.ii. Discretionary

1. Purpose or purposes for which the corporation organized;2. Provisions managing the business and regulating the affairs of the

corp;3. Provisions defining, limiting and regulating the powers of the

corporation, its board of directors, and shareholders;4. A par value for authorized share or classes of shares; and, 5. The imposition of personal liability on shareholders for the debts of

the corp.b. Name

i. Similar Names - MBCA § 4.01/Cal Corps Code § 201: Name must be distinguishable upon the records of the Secretary of State from other corporate names.

1. “Confusion in an absolute or linguistic sense” is the standard, rather than the effect on the competitiveness of other corporations.

2. Corporations may conduct business under an alias, just like a person.ii. Reservation of Names

1. MBCA § 4.02/: Person can reserve a name for the use of a yet-to-be created corporation; reservation lasts for 120 days.

2. Cal Corps Code § 201(c): Can reserve for 60 days only and only twice.

c. Durationi. MBCA § 3.02/Cal Corps Code § 200: Unless otherwise set out in its Article

of Incorporation, every corporation has perpetual duration.d. Corporate Powers

i. General Powers1. MBCA § 3.02: Unless otherwise provided in its Articles of

Incorporation, a corporation has the same powers as an individual to do all things necessary or convenient to carry out its business and affairs.

2. Cal Corps Code § 202(b)(1): Same default rule. 3. Cal Corps Code § 202(4): No reference to corporate powers other

than by way of limitation.ii. Limitations Provisions

1. Although it is no longer necessary to include a provision limiting the corporate powers, it may be desirable in a closely held corporation as a means of ensuring compliance with corporation objectives.

2. Example: A and B open a furniture store. A is the passive investor. B then decides to open a yogurt shop with the contribution as well.

e. Registered Officers and Agentsi. Have to include address of registered office and name of registered agent at

that office for purposes of service of process and tax purposes.ii. Corporation’s attorney usually designated as agent for service of process.

f. Number of Incorporators, Directors and Shareholdersi. Incorporators: No fixed amount for the number of incorporators needed.

ii. Directors1. MBCA § 8.02: One or more needed.2. Cal Corp Code § 312: Three or more needed, unless there are two or

less shareholders.

3. Under both MBCA and CA, directors do not need to be identified by name.

iii. Shareholders: No minimum needed. Under both MBCA and CA, shareholders do not need to be identified by name.

g. Capitalization Articlei. MBCA § 2.02(a) and Cal Corp. Code require that the Articles of

Incorporation contain the amount of authorized shares.ii. What are Authorized Shares? Total number of shares corporation authorized

to issue.iii. No minimum amount of capital contribution required, however.

iii. Post-Incorporation Procedure1. By-Laws

a. Required that each corporation adopt by-laws.b. By-laws have to be consistent with Articles of Inc. Articles always trump.c. By-laws do not have to be included in Articles of Inc.

2. Amending Articles of Incorporationa. Articles of Incorporation can be amended.b. However, requires

i. Filing an amendment with Sec. of State, andii. Board and shareholder approval

b. Corporation’s Purposes and Powers: Decline of the Ultra Vires Doctrinei. Ultra Vires Doctrine: Invalidates contracts entered into by corporations where the contract calls for

the corporation to perform powers not authorized by its Articles of Incorporation.ii. Modern Day Application: Dying out due to the default rule that, unless otherwise stated in Articles of

Incorporation, corporation can engage in any lawful purpose and exercise any lawful powers.iii. MBCA § 3.04: Only the following people have standing to challenge the validity of a corporate

action on the grounds the corporation lacks the power to act:1. shareholder attempting to enjoin the act;2. proceeding by the corporation, its receiver, trustee or legal representative, against an

incumbent or former director, employee, officer, or agent; or,3. in a proceeding by the Attorney General.

iv. 711 Kings Highway Corporation : Plaintiff leases building to defendant corporation to be used as a movie theatre. Defendant corporation’s Articles of Incorporation provide that defendant restricted to engaging in marine activities. Plaintiff sues to rescind the contract arguing that the contract is invalid because defendant corporation not authorized by its own Articles to engage in the movie theatre business. Court holds that Plaintiff did not have standing to sue because it was not a shareholder attempting to enjoin a corporate action and it was not a representative of the corporation itself suing an employee or former employee of the corporation.

v. Theodora Holding Corp. v. Henderson : Plaintiff holding corporation is a significant shareholder of defendant Alexander Dawson, Inc. Girard Henderson holds the majority of shares in Alexander Dawson, Inc. and had been effectively controlling the corporation for years. Over the years, he had had the Board of Directors contribute hundreds of thousands of dollars to a charitable trust that he controlled. The trust ran a boys camp for underprivileged youth. One year, Girard wants the Board to make another $525,000 gift. His ex-wife Theodora, who holds all the stock in Theodora Holding Corp, sues under ultra vires doctrine to enjoin the action.

1. Issue: Does a large charitable contribution to a trust owned by the majority shareholder violate a corporation’s powers?

2. Holding: No.a. Modern day corporation law allows charities to make donations for the public

welfare or for charitable, scientific or educational purposes.

b. The common law requires that these contributions be made to a legitimate charity and that the contributions be reasonable.

c. Court recognizes the trust as a legitimate charitable organization.d. Court recognizes that a gift representing less than 5% of total yearly income, which is

the maximum federal tax deduction limit, is a reasonable gift.vi. Charitable Gifts: The gifts still have to comply with fiduciary duty laws. Thus, a large gift to

Princeton by the corporation when the CEO’s daughter is trying to get in would violate fiduciary duty laws.

c. Premature Commencement of Business: Liability on Pre-Incorporation Agreementsi. Promoter Liability

1. Promotera. Person who, acting alone or in conjunction with one or more persons, directly or

indirectly takes initiative in founding and organizing the business or enterprise of an issuer.

b. The one who goes out and makes contracts to get the corporation off the ground.2. Promoter Liability

a. Default Rule: Promoters have personal liability for contracts entered into on behalf of the corporation unless the parties show the express intent to look elsewhere.

b. Novationi. An agreement by which a promoter is bound until the corporation is formed

and manifests its willingness to take over the contract.ii. Promoter’s liability extinguished when corporation takes over contract in

case of novation.iii. Has to be an express term in the contract between the promoter and the third

party vendor!!c. Adoption

i. Corporation adopts the contract as its own.ii. However, promoter still bears joint liability.

iii. Adoption can be implied by a corporation’s actions with respect to honoring the contract as its own.

d. Stanley How, Inc. v. Boss : Plaintiff seeks to recover for partial performance on a contract with Boss. Contract executed by Boss on behalf of Boss Hotels, Inc., a corporation that was at the time yet to be formed. Boss actually ended up creating Minneapolis-Hunter Hotel Co. to run the venture; they paid the checks for partial performance to Plaintiffs.

i. Issue: Is a promoter personally liable for the non-existent corporation’s debts where he signed “on behalf of the yet-to-be created corporation” on the contract?

ii. Holding: Yes.1. Absent an express intent in the agreement, promoters bear personal

liability for contracts they enter into on behalf of the non-existent corporation.

2. Here, the language cited does not overcome the presumption in favor of promoter liability.

a. Not understood as an offer by the nonexistent corporation because work began right away.

b. Not a novation because defendants failed to plead novation.e. Quaker Hill v. Parr : Plaintiffs suing the defendants for personal liability as

promoters. Defendants had entered into a contract for purchase of plants from plaintiffs. Defendants had entered on behalf of Denver Nurseries, Inc., a yet-to-be

formed corp. Plaintiffs knew the corp. was yet to be formed but pushed defendants contract because growing season was coming to an end. Denver Nurseries, Inc. never formed due to name confusion, but Mountain Nurseries, Inc. formed instead. Plaintiffs enter into a new contract with Mountain Nurseries to replace the old. Mountain Nurseries defaults on their obligation and plaintiffs want to sue Defendants for personal liability because corp. nonexistent at time of contracting.

i. Issue: Does promoter bear personal liability where third party creditor knew a corporation had yet to be formed and looked to a different corporation for payment?

ii. Holding: No.1. Intent of the contracting parties inferred from the facts of each case.2. Here, a promoter bears no liability where the third party creditor

knows a corporation has yet to be formed and ratifies an implied agreement with another corporation in substitution by accepting payment from that other corporation.

f. McArthur v. Times Corp : Plaintiff enters into an employment contract with defendant’s promoter to be an advertising solicitor for one year. Defendant is created, retains plaintiff as its advertising solicitor for about 8 months, then terminates contract. Plaintiff sues Defendant for breach of contract.

i. Issue: Does corporation bear liability for employment contract entered into by its promoter where corporation honored the contract for 8 months?

ii. Holding: Yes.1. A corporation may adopt a contract made on its behalf by a promoter

as its own contract.2. Whether the corporation adopted the contract is a question of fact.3. Here, the fact the corporation honored the contract for 8 months is

proof it adopted the contract as its own and can therefore be held jointly liable.

d. Defective Incorporationi. De Jure Corporation

1. A corporation that results when there has been compliance with the mandatory conditions required by statute.

2. MBCA § 2.04: All persons purporting to act on behalf of a corporation, knowing there has been no incorporation, are jointly and severally liable for all liabilities created while acting.

3. Robertson v. Levy : Defendant contracts with Plaintiff to buy Plaintiff’s record business. Defendant supposed to be contracting on behalf of a corporation he is starting for purposes of buying the business. He submits the Articles of Incorporation prior to the commencement of the contract. However, they are rejected after the commencement of the contract. They are eventually accepted a short time later. Plaintiff receives a few payments from the corporation under its promissory note; the corporation then defaults.

a. Issue: Does promoter bear liability where corporation’s articles submitted but rejected a few days prior to commencement of the contract, where the articles quickly approved a couple of days later and where the third party vendor looked to the corporation for payment?

b. Holding: Yes.i. A corporation is not formed until the Articles of Incorporation are approved.

ii. A promoter who purports to act on behalf of a corporation where the corporation’s articles have yet to be approved bears joint and several liability for the debts incurred in his promoter activities.

iii. Here, Levy knew that the corporation’s articles had yet to be approved but still purported to act on its behalf in executing the contract; thus, he bears joint and several liability.

ii. De Facto Corporation1. A corporation that the court implies in fact, even though it has not been created in compliance

with the mandatory conditions required by statute.2. Requirements

a. Valid law under which corporation can be organized;b. A good faith attempt to organize; and,c. Actual use of the corporate franchise.

3. MBCA § 2.04: Allows for the de facto defense as long as the promoter did not know that the corporation was actually unincorporated at the time.

4. Cantor v. Sunshine Greenery, Inc : Brunetti signs lease with Plaintiff on behalf of Sunshine Greenery, Inc. At the time, he thought Sunshine Greenery was a corporation; he had already signed certificate of incorporation. However, due to a delay in the mail to the Secretary of State, the certificate was not filed until two days after the lease was signed. Cantor also thought it was dealing with a corporation; he did not insist on a personal guaranty from Brunetti and he knew and expected the lease agreement to be undertaken by Sunshine Greenery. The day after signing the lease, Sunshine Greenery repudiates.

a. Issue: Does Brunetti bear personal liability as a promoter?b. Holding: No.

i. At the time the lease was executed, Sunshine Greenery was a de facto corporation because:

1. Brunetti made a good faith effort to incorporate and thought he had done so successfully, and

2. Cantor thought it was dealing with Sunshine Greenery and looked to the corporation for undertaking the contract.

5. To impose personal liability due to a delay in the mail would be unfair and inequitable. (Is this estoppel or de facto corp?)

iii. Corporation by Estoppel1. Cranson v. IBM : Cranson agrees to invest in a corporation; his lawyer tells him all the

paperwork filed and he receives stock certificates and was shown a copy of the corporate seal and minute book. Unfortunately, the lawyer’s secretary failed to file the certificate with the Secretary of State. Cranson becomes President and enters into contract with IBM on behalf of the corporation. Partial payments made to IBM on behalf of the corporation. Corporation defaults on its obligations. Court holds that IBM estopped from denying the existence of the corporation because it had dealt with the entity as if it were a corporation and had looked to the credit of the entity rather than Cranson’s credit.

2. Frontier Refining Co v. Kunkel : Court refuses to hold silent partners liable for the debts of a promoter where the promoter had solicited contributions and they had told the promoter not to enter into business until he had incorporated. Promoter instead went directly out and started business, incurred debt, and defaulted. Plaintiff wanted to hold silent partners liable. Court held that silent partners had not “purported to act on behalf of the nonexistent corporation” and thus bore no personal liability to these creditors who did not even know of their existence in the first place.

e. Promoter’s Fiduciary Dutiesi. “Perfect candor, full disclosure, good faith…and the strictest honesty are required of promoters, and

the dealings must be open and fair, or without undue advantage taken.”1. Promoters can make a profit, but they have to disclose. He can help ensure his salary by

taking a cut in dealings with the corporation, but he has to do so with full disclosure.

2. What if the promoter is also the sole shareholder? He has to disclose the nature of the transaction to third party creditors.

ii. Frick v. Howard: Promoter buys real estate for corporate venture for $240,000 and then sells it back to corporation 8 months later for $350,000. At the time the corporation bought the real estate, promoter was the sole shareholder and manager of the corporation. Court held that promoter violated his fiduciary duty to the corporation by failing to disclose the transaction to third party creditors.

IV. Piercing the Corporate Veila. Contract Creditor Cases

i. Rule: Courts will pierce the contract veil if they find evidence of fraud, misrepresentation or illegality.

ii. Alter Ego Theory: Corporation created for the sole purpose of shielding an individual from liability to third parties and, in function, the corporation not really separable from the individual.

1. Plain fraud not necessary; corporation created solely as an alter ego considered fraudulent.2. Factors

a. Gross undercapitalizationb. Failure to observe corporate formalitiesc. Non-payment of dividendsd. Insolvency of the debtor corporation at the timee. Siphoning of funds by the dominant shareholderf. Non-functioning of other officers or directorsg. Absence of corporate recordsh. Fundamental injustice or unfairness

3. Dewitt Truck Brokers v. W. Ray Fleming Fruit Co : Court holds that corporation merely an alter ego of the dominant Fleming where Fleming owned 90% of stock, he was the only real director with any authority, no corporate records of directors’ meetings were ever kept, no stockholder or officer other than the Fleming received any salary of dividend and his annual salary matched the corporation’s profits. Court agrees to pierce corporate veil where Fleming gave personal guaranty to Plaintiff that the corporation would pay its contractual obligations to Plaintiffs after corporation had fallen behind in payments. (Maynard thinks the standard still fraud, illegality or misrepresentation because Fleming fraudulently misrepresented his intention to pay the Plaintiffs then hid behind the corporate veil when the obligations became due.)

iii. Contract Creditor: A voluntary creditor. A vendor/provider who became a creditor when corporation voluntary contracted for its services.

1. Creditor cases usually hinge on the extent of the Plaintiffs’ knowledge about the structure of the corporation. Have to look at foreseeability and assumption of risk factors. Was this foreseeable by the creditor? Did he get more money and thus assume more risk?

2. Usually PCV cases with contract creditors involve individually-held corporations.3. Bartle v. Homeowners Coop : Court refuses to pierce the corporate veil where the Defendant-

corporation set up another corporation for the sole purposes of selling homes to the Defendant. Plaintiffs were contract creditors of the new corporation. Defendant-corporation had no interest in keeping the new corporation well capitalized/making a profit since it was, in essence, using the new corporation to build homes to sell to itself. Court places assumption of risk on the third party creditors who had dealt with the new corporation for years and should have done their homework.

b. Tort-Creditor Casesi. Rule: Same PCV rules apply. However, courts may tend to be a little more lenient because of the

involuntary position tort victims find themselves in and the serious personal injuries that often result.ii. Baatz v. Arrow Bar : Plaintiffs get into serious accident with drunk driver who was drinking in excess

at defendant-corporation’s bar. Court refuses to PCV where the three shareholders behind the defendant corporation had (1) made an initial contribution of $50,000 into the corporation, and (2)

executed personal guaranties on the corporation’s primary debt, a mortgage. Court found the fact that the shareholders had issued personal guaranties was proof they were not using the corporation solely to shield themselves from personal liability. The fact they did not engage in corporate formalities such as directors’ meetings was not sufficient to PCV in this case.

iii. Radaszewski v. Telecom Corp : Telecom is the corporate parent of Contrux. Contrux is completely undercapitalized; most of its contributions came in the form of loans and it had issued mostly watered down stock. But, Contrux did have an $11 million insurance policy as protection. A driver of Contrux gets into an accident with Plaintiff and seriously injures Plaintiff. Plaintiff sues; unfortunately, Contrux’s insurance carrier goes bankrupt. Plaintiff seeks to PCV to get to Telecom. Court holds that Contrux’s $11 million insurance policy found that the insurance policy in effect at the time of the accident sufficiently gave Contrux sufficient capitalization to show that it was not acting reckless with respect to potential tort creditors.

c. Parent-Subsidiary Casesi. Courts generally take view that parent corporation possesses separate legal existence from

sub/Difficult to prove that the subsidiary simply an alter ego of the parent.ii. Courts usually will not PCV unless there are circumstances involving fraud, manifest unfairness or

misconduct.iii. Fletcher v. Atex : Atex a wholly-owned subsidiary of Kodak. Atex operated on a cash management

system where it kept a zero balance bank account; all profits went to Kodak, who kept these as credits for Atex and distributed whenever Atex needed funds. Kodak had to approve all major business decisions. Kodak maintained a strong (but not majority) presence on Atex’s Board of Directors. Atex also used Kodak’s logo in its promotional literature. Plaintiff, a former employee of Atex, wants to recover against Kodak for repetitive stress injuries.

1. Issue: PCV in this parent-subsidiary context?2. Holding: No

a. Operation of a common accounting system, such as cash management, does not give rise to PCV. Kodak kept strict accounting of the funds and no evidence of commingling existed.

b. It is expected that parents will retain a great deal of authority over the major decisions of their subs. Kodak’s authority insufficient to show domination or control.

c. No evidence that Kodak trying to defraud potential tort creditors or misrepresenting to third parties the nature of the corporation.

V. The Financial Structure of the Closely Held Corporationa. Types of Securities: The Fundamental Distinction between Debt and Equity and the Concept of Hybrid

Securitiesi. Debt

1. Contract creating capital that must be repaid with interest.2. Can come internally (banks) or internally (shareholders).3. Fixed Claimants: Has to be repaid!!

ii. Equity1. Primary characteristic: Value = market value of that property - debts.2. Composed of the contributions by the original entrepreneurs in the firm.3. Residual Claimants: Equity owners have a right to everything that is left over after the fixed

claimants have been paid off.b. Overview of the Different Types of Equity Securities

i. Common Stock1. Possess voting rights.2. Possess the right to receive the net assets of the corporation after (1) preferred stock

distributions and (2) debt obligations.3. Usually no cap on earnings.

ii. Shareholder Distributions

1. Any kind of payments to shareholders, including dividends, redemption, dissolution distributions.

2. Redemption: Corporation buying back its own stock from shareholders.3. Dividend

a. Annual payments to shareholders.b. No shareholder has the right to receive dividends until the Board of Directors

declares.iii. Preferred Stock: Use of Multiple Classes of Stock

1. Shares of stock that have certain preferential rights to common stock, but limited in some way.

a. Entitle shareholders to preference in payments over common shareholders; usually the payment limited in amount.

b. Scope of preference delineated in Articles of Incorporation and may not be amended without shareholder approval.

2. Usually non-voting shares.3. Dividends on preferred shares may be paid only from funds that are legally available for

making distributions.iv. Different Types of Dividend Preferences

1. Cumulative Dividend a. Unpaid preferred dividend accumulates from year to year until paid.b. Even if cumulative dividends, not a debt on the corporation, but an order of

preference regarding distributions.2. Non-Cumulative Dividend: Unpaid preferred dividend does not accumulate from year to

year; if dividend unpaid at end of year, shareholder loses it.3. Partially Cumulative Dividend: Usually cumulative to the extent there are earnings in the

year but non-cumulative with respect to any excess dividend preference, i.e., the amount the dividend preference exceeds the earnings.

4. Voting or Non-Voting Preferred Stock?a. Preferred usually non-voting.b. However, many corporations allow preferred to vote for a certain number of directors

to preserve their power in the corporation.5. Liquidation (or Dissolution) Preference

a. Creditors get first preference.b. Usually, preferred shareholders also get liquidation preference, usually capped at a

certain amount per share.c. Residual goes to the common shareholders.

6. Use Participating or Non-Participating Preferred Stock?a. Non-Participating Preferred Stock: Preferred shareholders get their initial preferred

dividend payment and nothing more, no matter how profitable the corporation.b. Participating Preferred Stock: Preferred shareholders get their initial preferred

dividend payment and they share in residual distributions on some predetermined basis. Usually called “Class A common” stock.

7. Making Changes to Terms of Outstanding Preferred Stocka. The corporation needs approval by:

i. Board of Directors;ii. Total voting shareholder approval; and,

iii. Approval of affected class (whether or not that class has voting rights).8. Authorize Different Classes (or Series) of Preferred Stock?9. Authorize Blank Shares?

a. Blank Shares: Shares authorized by the Articles of Incorporation but not initially issued.

b. Cal § 202(e) & 401: Board can set the preferences of blank shares at a later date as long as the shares have not yet been issued.

v. Redeemable Preferred Stock1. Preferred stock “redeemable” at option of corporation – “callable” preferred stock

a. Corporation holds redemption rights at its own discretion; shareholder has no choice but to sell when corporation makes “call”.

b. Redemption price usually set in Articles of Incorporation.2. Preferred stock “redeemable” at option of holder – a form of demand indebtedness?

a. Shares payable on demand at the option of the holder.b. Similar to a promissory note with an acceleration clause; investor essentially a lender.

vi. Convertible Preferred Stock1. Convertible at Option of Holder

a. If specified in Articles of Incorporation, shareholder may convert his preferred stock to common stock.

b. Benefits: Allows a preferred shareholder to maximize participation in profits in good times.

c. Disadvantages: Subordinates order of preference for distributions.2. Forced Conversion

a. Circumstance i. Corporation calls preferred stock for redemption at a price lower than the

market price of common shares, andii. Articles of Incorporation allow a window of time after call when preferred

shareholders can convert their shares to common.iii. Board assumes the preferred shareholders will convert to take advantage of

the higher price.b. Advantage: Allows corporation to get rid of class of undesirable stock without

having to pay any cash.c. Protective Provisions – Sinking Fund Provisions: Require corporation to set aside

certain amount each year to redeem specified portion of preferred stock issued.vii. Redeemable Common Stock

1. At the option of the holder?a. Some jurisdictions have laws prohibiting common shares redeemable at option of the

holder.b. Why? (Price not fixed to a certain amount so holder could wait until market price

high then make the call?)2. At the option of the corporation?

a. Most states impose limitations on common stock redeemable at option of corporationb. Prevents corporation from speculating against its own shareholders (corporation has

insider information about its own activities).viii. Convertible Common Stock

1. Called “upstream conversion”2. Most states do not allow upstream conversion of common shares into preferred shares or debt

because it has an inherent fraudulent nature. Common shareholders with insider information can place themselves in line with ignorant preferred shareholders by converting to preferred or in line with ignorant creditors by converting to debt.

ix. MBCA § 6.01 Freedom of Contract Approach1. Allows a shareholder and corporation to contract for almost any arrangement in the Articles

of Incorporation.2. Allows for upstream conversion. Even allows for shares callable by third parties.

c. Issuance of Sharesi. Subscription Agreements

1. Preincorporation agreements whereby an investor would agree to buy a certain amount of shares in the new corporation contingent on a certain amount of capital being raised.

2. Have gone out of fashion with the creation of the modern day investment banking industry which allows for the ability to raise large amounts of capital nationwide for a new venture.

ii. Number of Authorized Shares: Herein of Dilution1. Number of Authorized Shares

a. Corporation can authorize any amount of shares it wishes, as long as:i. Total value adds up to the total amount of contributions, and

ii. Price of shares uniform amongst same class.b. Authorizing Blank Shares

i. Corporation can authorize more shares than it actually issues.ii. Advantage

1. Saves the corporation the trouble of having to amend the Articles of Incorporation later on to add more authorized shares as it raises more capital.

iii. Disadvantages1. Some states tax based on the total number of authorized shares.2. Minority shareholder faces quicker dilution of his/her

voting/financial interest.2. Disparate Contributions of Founding Shareholders

a. Shareholders can contribute capital or labor in exchange for shares of stock.3. Valuation of non-cash consideration

a. The value of property or labor contributions must be determined through negotiation between the shareholder and corporation.

4. Concept of “Earn Outs”a. Vesting agreements: Agreements whereby the shareholder earns his shares over a

period of time.b. “Earn Out”

i. A & B agree to a financing structure whereby A would contribute $100,000 initially and B would contribute his labor as manager of the business. They would both get equal shares, however, B’s shares would vest over the course of a two year period.

ii. Earn Out: B earns out after 2 years, meaning he is fully vested.iii. Incentive: Incentive for B to remain with the company until his shares fully

vested.iii. Concept of “Par Value”

1. Par Valuea. The dollar amount the corporation assigns the shares in the Articles of Incorporation.b. Corporation cannot sell its shares for an amount lower than the par value.c. MBCA § 2.01: Not required to state a par value for shares of stock.

2. Balance Sheet Accountsa. Stated Capital: Par value of each issued share goes into the stated capital account.b. Capital Surplus: Amount collected from the shareholders for their shares in excess of

the par value goes into the capital surplus account.c. Retained Earnings: Amount of cash on hand the corporation chooses to retain rather

than distribute.3. Watered Stock Liability

a. Watered Stock: When a shareholder pays less than the par value of the stock.b. Hanewald v. Bryan’s Inc .: Bryan’s Inc. authorizes 100 shares of stock with par value

of $1000/share. Bryan’s issues 50 shares to Keith Bryan and 50 shares to Joan Bryan. Court finds that the corporation received no contributions in return. Keith

and Joan Bryant do loan the corporation $10,000 in initial capital. Bryan’s Inc. buys business from Hanewald; defaults on its promissory note to him. Bryan’s Inc. has no money left to pay him.

i. Issue: Do Keith and Joan Bryant have personal liability as sole shareholders under the PCV doctrine for fraudulent misrepresentation of the corporation’s assets due to the watered down stock?

ii. Holding: Yes.1. A shareholder is liable to corporate creditors for the difference

between the par value and the contribution actually made to the extent of the creditor’s debt.

2. Why? Creditors depend on the stated capital account to determine the corporation’s solvency and thus whether to do business with the corporation. Issuing watered down stock fraudulently misrepresents the solvency of the corporation.

c. Equity Dilutioni. Occurs when a shareholder contributes a certain amount into the corporation

in consideration for a particular amount of shares and another shareholder contributes a lesser amount for the same amount of shares.

ii. Example: A puts in $10,000. B puts in $5000. They both get 10,000 shares of stock. At dissolution, both A & B get half of the liquid assets.

iii. Ways to Avoid: Make B sign an “earn out” agreement where the shares vest over the course of a certain amount of time dependent on him continuing to work for the corporation.

iv. What type of consideration can be used to acquire stock?1. Traditional Forms and Prohibited Forms

a. Needs to be actual receipt of cash property, services. MBCA § 19 (1969). Most of these restrictions only apply to the original issue of stock, though, not re-issues.

b. Promissory notes and shares paid now for future services were prohibited.2. Modern Approach – MBCA § 6.21

a. Board may authorize shares to be issued for consideration consisting of any tangible or intangible benefit to the corporation

i. Includes cash, promissory notes, contracts for future services.ii. Board of Directors has to make valuation determination

b. Cal Corp Code § 409: i. Cannot issue shares in exchange for future services.

ii. Cannot issue shares for promissory notes unless promissory notes secured by other property.

v. Par Value in Modern Practice1. Modern Use of “No Par” shares

a. Today, most corporations use a nominal par value (such as $1 per share).b. No Par Shares

i. Shares that have no par value.ii. MBCA § 2.01: Does not require that a corporation include a par value in its

Articles of Incorporation.iii. However, some states that allow “no par value” shares only allow partial

allocation of consideration received for those shares to the Capital Surplus Account.

2. Legally Available Source of Funds for Shareholder Distributionsa. Board of Directors can only distribute funds to its shareholders out of the Capital

Surplus and the Retained Earnings accounts.

b. Therefore, the higher the stated par value per share, the more consideration offered for shares goes into the Stated Capital Account, the less flexibility the Board has in distributions.

vi. Legal Restrictions on Dividends and Other Shareholder Distributions 1. MBCA § 6.40(c): No distributions may be made by Board of Directors if, after giving it

effect:a. The corporation would not be able to pay its debts as they become due in the usual

course of business; or,b. The corporation’s assets would be less than its liabilities plus the amount needed to

satisfy preferred shareholder’s dissolution rights.d. Use of Debt Financing

i. Different Types of Debt Securities1. Bond: Secured debt.2. Debenture

a. Unsecured debt. b. Often convertible to an equity position, such as common stock.

3. Powers of Corporation to Incur Debta. Inherent, does not have to be laid out in Articles of Inc.b. Can be limited in Articles of Inc.

ii. Concept of Leverage1. Leverage: The increased value gained from utilizing the capital obtained by loan over the

cost of the loan.2. Why is debt financing so attractive?

a. Minimizes the amount of initial capital expenditures while retaining overall capital needs.

b. Takes less investment initially. Therefore, the return for those that do invest is greater.

3. Outside v. Inside Debta. Outside Debt: Loans from third party lenders, such as banks.b. Inside Debt: Loans from shareholders

iii. Tax Advantage of Debt1. Interest Deduction

a. Interest payments from loans deductible; reduces the overall expense of debt financing.

b. Shareholder loansi. Corporation can gain capitalization through shareholder loans, then pay

distributions as interest payments, then deduct those interest payments from taxable income.

ii. Problem: IRS may treat the loan as equity rather than debt.2. Debt-Equity Ratio

a. The ratio of debt to capital contributions.b. Look at corporations liabilities versus its retained earnings, stated capital and capital

surplus. If the liabilities greatly outweigh the cash on hand = thin capitalization.3. Thin Capitalization

a. When a corporation has heavily imbalanced debt-equity ratio.b. Corporation issues 10 shares of stock to A for $100 and 10 shares of stock to B for

$100. Par Value = $1/share. i. Total shares = 20

ii. Assets = $200iii. Stated Capital = $20iv. Surplus Capital = $180

c. Now, if A loans the corporation $99,800 to get the corporation off the ground, the debt-equity ration becomes way out of wack.

i. Total shares = 20ii. Assets = $100,000

iii. Stated Capital = $20iv. Surplus Capital = $180v. Liabilities = $99,800

vi. Debt-Equity Ratio = $99,800/$200 = 998/2 = 49/1.d. IRS will treat the $99,800 loan as equity, not as debt. Otherwise, the corporation

could write off all its income as deductible interest payments, pass on all its profits to shareholders and have minimal amounts left in stated capital account to pay creditors on dissolution.

iv. S Corporations and Safe Harbor Provisions1. An S Corporation must have only one class of stock and a certain amount of shareholders.

Thus, if the IRS reclassifies certain inside debt as equity, does the S Corporation lose its S-Corp status?

2. “Safe Harbor” Provisions for Straight Debt: S Corp does not lose its S Corp status in reclassification circumstance if the debt is “straight debt”:

a. Interest rate and interest payments not contingent on corporate profits or borrower’s discretion

b. No direct or indirect convertibility to stock, andc. Creditor is an eligible shareholder under Chapter S.

e. Use of the Limited Liability Corporation as an Alternative to Incorporationi. What is a limited liability corporation?

1. Created by an election; have to file Articles of Organization;2. Four general characteristics

a. Limited liability for all its membersb. Flow through tax treatmentc. Different management structures

i. Member managed: Default rules. Each member has an equal right to control of the LLC. Similar to a general partnership.

ii. Manager managed: Articles of Organization set up a management structure that centralizes the management functions in a particular group of individuals. Similar to a corporation. (Do members serve as Board of Directors?).

ii. Professional Responsibility1. Lawyers for joint venture contemplating LLC status have to advise their clients of potential

conflicts of interest and gain consent for representation.2. If partners interest actually conflict, cannot represent both of them.

f. Doctrine of Pre-Emptive Rightsi. Traditional Common Law Approach

1. Pre-Emptive Rights a. Shareholder had the pre-emptive right to acquire a proportional amount of the

corporation’s unissued shares upon the decision of the Board of Directors to issue them.

b. However, had to buy at the new price the Board fixed.2. Stokes v. Continental Trust Co : Board of Directors and shareholders vote to authorize the

issue of 5000 new shares of stock at a price above the book value of the shares to another corporation that wants the ability to elect 10 out of 21 Board members. Plaintiff owns 221 shares and wants the pre-emptive right to purchase 221 more. Corporation refuses. Court holds that Plaintiff has the right to protect his investment from dilution by upholding his pre-

emptive right to purchase unissued shares in an amount proportional to the amount he currently owns. Voting rights that come with the stock considered a property right; corporation cannot impair that property right unilaterally.

ii. Modern Doctrine of Quasi-Preemptive Rights1. MBCA § 6.30: Shareholder does not have a preemptive right to unissued shares unless the

corporation grants him that right in its Articles of Incorporation (“opt-in” clause)2. Quasi-Preemptive Rights: If the corporation does grant the shareholder the right, has to give

him a fair and reasonable opportunity to purchase unissued shares at an amount proportional to his current holdings at the time the Board decides to issue those shares.

3. Katzowitz v. Sidler : K, S & L own all the stock in a closely held corp. 1000 shares authorized; all three only own 15 shares each. L & S want to turn an inside loan into stock, retaining earnings in the corporation by creating new stock for the three shareholders. K does not want to turn his debt into equity. L & S then vote unilaterally (2 out of 3 directors) to issue 75 new shares at a price well below book value. They send notice of K’s preemptive right to buy 25 shares of the to-be issued stock along with a check for the amount of his debt. K ignores; L & S issue the new stock, buy it. On dissolution, K then gets substantially less because his interest has been diluted.

a. Issue: Does Board of Directors have duty to issue stock at a price close to book value where the remaining shareholders benefit from the markedly reduced price?

b. Holding: Yes. i. Board of Directors cannot force an unwilling shareholder to exercise his

preemptive rights and purchase newly issued shares to protect his investment from dilution where no valid business justification existed for the issuance of the new shares.

ii. Here, the only justification for the issuance of the new shares was to freeze K out. Thus, the Board of Directors breached their fiduciary duty to treat the shareholders fairly and was liable for damages.

VI. Management and Control of the Closely Held Corporationa. The Respective Roles of Shareholders and Directors

i. Shareholder Agreements and the Rule of McQuade1. General Rule: Board of Directors cannot subordinate their interests to shareholders by

entering into agreements that limit their voting discretion.2. McQuade v. Stoneham : McQuade buys 70 shares of stock in National Exhibition Corp from

Stoneham. Stoneham and McGraw the other shareholders. All three on the Board of Directors. All three enter into a contract stating they will do their best to help each other remain as directors. McGraw and Stoneham use their power on the Board to direct the other Board members to push McQuade out.

a. Are Defendants liable for violating their shareholder agreement?b. Holding: No

i. Shareholder agreement limiting the discretion of the Board of Directors void due to public policy concerns. We want to uphold the objectivity of the Board and ensure its loyalty to the corporation first and foremost.

ii. Exceptions to the Rule of McQuade1. Clark : Agreement limiting directors discretion upheld where:

a. directors are the sole shareholdersb. agreement does not impinge on their discretion, and c. does not harm any third parties

iii. The Modern Judicial View of Shareholder Agreements in the Context of Closely Held Corporations: Galler v. Galler

1. Rule – Shareholder Agreements Limiting Board’s Discretion: Shareholder agreements that limit the discretion of the Board of Directors are valid if the directors are also the sole

shareholders of the corporation and the agreement constitutes a slight deviation from the principal that Directors are solely the representatives of the corporation.

2. MBCA § 7.32 – Shareholder Pooling Agreements: Shareholder agreements that limit shareholder voting discretion are presumptively valid.

3. Galler v. Galler : Agreement between the sole shareholders of the corporation limiting the Board’s discretion enforceable where the agreement

a. Amended the by-laws to provide for 4 directors at the death of one of the founding membersValid because Board of Directors has power to amend by-laws already.

b. Agreement by shareholders on how to vote their sharesValid because McQuade validates pooling agreements between shareholders that have no effect on the Board’s discretion.

c. Agreement that founding Board member’s wife, also on the Board, would have the power to elect his successor at his deathValid because statutes allow the Board of Directors or shareholders to replace death on the Board.

d. Agreement requiring the corporation to pay a $50,000 dividend as long as earnings in surplus of $500,000Slight impingement because the agreement protects creditors as well as ensuring the equitable distribution of dividends.

e. Agreement that ensures that the wife of founding member and Board director receives yearly salary on his deathSlight impingement because a common term in executive agreements, limited in duration and all the shareholders are party to the agreement.

4. Publicly Held Corporations?a. Shareholder agreements that limit the Board’s discretion in publicly held

corporations are invalid.b. Why? Shareholders need less protection due to the liquidity of their shares. Plus,

shareholders do not have the ability to monitor the Board’s activities as closely.iv. The Modern Legislative Approach to Shareholder Agreements: Zion v. Kurtz and the Close

Corporation Election1. Cal Corp Law: Closely Held Corporations

a. Requirements for Closely Held Corporationi. Must have less than 35 shareholders;

ii. Must make an election in the Articles of Inc; and,iii. Not available for publicly traded corporations

b. A corporation that opts-in to become closely held has the ability to enter into shareholder agreements.

i. Shareholder agreements have to be unanimous and signed by all the shareholders.

ii. If so, no shareholder agreement shall be invalid if it interferes with the discretion of the Board (with certain limited exceptions).

2. MBCA § 7.32: Shareholder Agreements for Closely Held Corporationsa. Agreements limiting the discretion of or eliminating the Board of Directors valid for

non-public corporations.b. The existence of any such agreement must be noted conspicuously on outstanding

stock certificates.3. Zion v. Kurtz : Two sole shareholders of a corporation. One owns all the stock in Class A;

one owns all the stock in Class B. They enter into an agreement that provides that the corporation could not engage in any business activity without the consent of Class A shareholders. However, the agreement was not included in the Articles of Incorporation and the corporation was not incorporated as closely held as required by the statute.

a. Issue: Does the fact the shareholder agreement was not included in the Articles of Incorporation or that the corporation did not elect closely-held status invalidate the agreement?

b. Holding: No.i. DE public policy that shareholder agreements limiting the Board’s discretion

are not invalid.ii. The parties obviously showed their intent to be bound to this agreement by

executing a clause providing that the Class B shareholder would do whatever was necessary to validate the agreement.

iii. Although the agreement did not comply with some of the technical requirements of the statute, the corporation had met all the logistical requirements.

4. Current DE lawa. Zion eventually overruled.b. To make valid shareholder agreements limiting Board’s discretion, have to comply

with every provision of the statute.v. Shareholder Monitoring of Directors and the Business Affairs of the Corporation: Auer v. Dressel

1. Removal of Director - MBCA § 8.08(a) & Cal Corp Code: Shareholders may remove one or more directors with or without cause unless the Articles of Incorporation provide that directors may be removed only for cause.

a. Who can call a special meeting to remove a Board Director? MBCA § 7.02 & Cal Corp Code

i. Board of Directors;ii. Person or persons authorized by Articles of Incorporation or by-laws; or,

iii. Shareholders with at least 10% of all votes entitled to be cast on an issue on the delivery of written demand.

b. Can the purposes of a special meeting called by the shareholders be to remove the President? NO.

2. Filling Vacanciesa. MBCA § 8.10: Unless otherwise stated in the Articles of Incorporation, vacancies

may be filled by:i. The shareholders;

ii. The Board of Directors;iii. If the Board no longer has enough members for a quorum, by a majority of

the remaining members.b. MBCA § 8.05(e): Despite the expiration of his term, Director continues to serve

until his replacement is elected.b. Shareholder Voting and Shareholder Pooling Agreements

i. Election Inspectors and Other Mechanics of Shareholder Election of Directors1. Procedural Requirements for Shareholder Meetings

a. When?i. Annual – MBCA § 7.01: Every corporation has to hold an annual

shareholders meeting.ii. Special – MBCA § 7.02 (supra)

b. Notice?i. MBCA § 7.05

1. Notice has to be given no fewer than 10 days and no more than 60 days before the meeting.

2. Annual: No purpose description needed.3. Special: Purpose description needed.

ii. Waiver of Notice – MBCA § 7.06 & Cal Corp Code § 601.

1. Shareholder may waive notice. Must be in writing.2. Shareholders attendance at meeting waives his right to argue that he

lacked sufficient notice.c. Quorum?

i. MBCA § 7.251. Shareholders can only vote on an issue if they have a quorum

present.2. Unless stated otherwise in the Articles of Incorporation, a quorum is

a majority of those eligible to vote on an issue.ii. What about abstainers?

1. If a share is represented at a meeting, it is deemed present for the purposes of the meeting.

2. Thus, voters that abstain are still considered present for the purposes of determining whether the meeting has a quorum.

2. Votinga. RMBCA §7.07b. CA §701c. Record Owner v. Beneficial Owner

i. Record Owner = the person who owns the shares in name/certificate.ii. Beneficial Owner = the person with the interest in the company.

iii. In the Ling case (575), the court found that stocks may be transferred by signing a certificate but the endorsed stock certificate does not make the person with the endorsed stock certificate the record owner, but rather the person has to go to the corporation and get the corporation to reissue new stocks in that person’s name and cancel the old stocks in the seller’s name to make the buyer the record owner.

d. Record Date: The date set by the Board on which the people with shares on that date will be able to vote at the meeting.

i. Must be set within 60 days of the meeting.ii. Hypothetical: C corp. sets the annual meeting date for July 7 and sets June 6

as the record date. On June 25, S sells her C Corp. shares to B. Who votes the shares at the annual meeting? S gets to vote because S owned the shares on the record date.

e. Proxy Votingi. RMBCA §7.22

ii. CA §705iii. Can vote by proxy.iv. Hypothetical: same as above. What should the B do? The buyer should

bargain with the seller to obtain the proxy from the seller and hold the proxy. Proxy voter = S. Proxy Holder = B. a proxy is revocable unless it is coupled with an interest by the proxy holder.

f. Monitoring Electionsi. CA §707 and §709

ii. The election inspector monitors the annual and special meetings.3. Salgo v. Matthews (529): annual meeting of General Electrodynamics. There are 2 factions,

one headed by Salgo and the other by Matthews. Matthews got the proxy from Pioneer, inc. a company that is in receivership because it has filed for bankruptcy. The election inspector refused to accept the proxy.

a. The authority to act for Pioneer is obtained by going to the bankruptcy court.b. For Matthews to validly assert the proxy, he has to show up at the annual meeting

with

i. Certificates showing that Pioneer owns the stockii. Proxy document giving him the right to vote from Pioneer signed by the

Receiver1. Court paper giving the receiver the power to act on behalf of Pioneer.

c. The court found that the election inspector has the discretion to decide who gets to vote and who doesn’t and only after the election is over and the votes are tabulated and the results announced can the other side sue for injunction and/or preliminary injunction for the uncounted votes and question the discretion of the election inspector.

d. The election inspector’s decisions are reviewable but only after the final results of the vote are announced.

e. RMBCA §7.24(b)(3): The election inspector has the discretion to determine if the “…evidence is acceptable to the corporation…”

i. The statute limits the discretion of the corporation and it does not have unfettered discretion, but the discretion is reviewed only after the final count of the vote.

f. This case is before Street Ownership.ii. Cumulative Voting vs. Straight Voting

1. Shareholder Voting Rulesa. Who gets to vote?

i. Rule of Record Date Ownership.b. There are 3 different standards for when an action has been passed by

shareholdersi. Old Model Act

1. Majority of the shares present at the meetingii. RMBCA §7.25

1. Majority of the shares actually votingiii. CA §602(a) Public policy behind the 2nd prong is to prevent situations in

which a small number of shareholders are deciding the actions of the company (extreme example: 1 yes, 0 no, 599 abstaining which would pass under the RMBCA).

1. Majority of the shares present and voting AND2. Majority of the required quorum.

c. For the election of directors, the rules require a plurality to elect a director.2. There are 2 types of voting for the Election of Directors

a. Straight Votingb. Cumulative Voting

i. This gives the minority shareholder(s) a chance to get an opportunity to get somebody on the board because under straight voting there is no chance for the minority shareholder(s) any say in the election of the board.

3. Cumulative Voting Hypotheticala. Facts

i. A = 74 sharesii. B = 26 shares

iii. [s/(d+1)] + 11. [shares/(number of directors + 1)] + 1 = the number of shares a

shareholder needs to have in order to win 1 director’s seat.2. S = total number of shares voting, NOT outstanding.

b. A is the controlling majority.c. This is a 3 person board.d. If Straight Voting:

i. A1, A2, A3 Nominated by Aii. B1, B2, B3 Nominated by B

iii. All of A’s nominees are going to be appointed because each is going to get 74 votes vs. B’s 26 votes.

e. If Cumulative Voting:i. A gets 74 x 3 votes = 222 total votes

ii. B gets 26 x 3 votes = 78 total votesiii. In this company, in order for the minority shareholder to elect a director, the

minority shareholder needs 26 shares1. [100/(3+1)] + 1 = 25 + 1 = 26

iv. If you want to vote cumulatively, need to give notice (usually 24 or 48 hours before the meeting).

1. The purpose of the notice requirement is to allow for the voter to “vote smart.”

4. Opt In v. Opt Out Provisionsa. Opt In: The rule does not apply unless the Articles of Incorporation expressly

provide.b. Opt Out: The rule applies unless the Articles of Incorporation state otherwise.c. RMBCA §7.28 – Opt In Provision

i. Cumulative Voting is present when the company opts-in and the articles provide for cumulative voting.

d. CA §708(b) and §301.5 – Opt Out Provisioni. Cumulative voting is mandatory unless you have opted out.

ii. The only corporations that may opt out are those that are publicly traded on the NYSE.

1. The CA code also allows for staggered voting for publicly traded corporations.

iii. Under CA §301, cumulative voting is mandatory unless publicly traded.1. If not publicly traded, must have cumulative voting and cannot have

staggered voting (must elect directors at the same time and for the same terms).

5. Humphreys v. Winous Co. (526): 3 person board and each stands for election every year allowing the minority shareholder to get in at least one board member. The majority shareholder gets mad and classifies one of the directors, staggering the election of directors. Each director is given a 3 year term.

a. The P (minority shareholder) argues that the statute grants cumulative voting to guarantee a seat on the board, but by staggering the terms, the D (majority shareholder) has nullified cumulative voting and rendered it straight voting.

b. The court rules in favor of D and finds that the statute guarantees cumulative voting, but not a seat on the Board.

c. In CA, this problem will never come up for a small closely held corporation. This rule only applies to large publicly traded corporations.

6. Removal Rulesa. Problem of Circularity - CA & MBCA § 8.08: No Director may be removed when

the votes cast against his removal would be sufficient to elect the Director if voted cumulatively in an election where the same number of total votes were cast.

i. Prevents circularity because the Director’s supporters cannot just re-elect him again and again by voting cumulatively.

ii. CA §301.5 Implemented as a result of the race of the lax.b. Act requires shareholders to approve, fill vacancies on the Board, adopt/amend by-

laws.

iii. Shareholder Pooling Agreements and the Use of Irrevocable Proxies1. Shareholder Pooling Agreements: Agreements between shareholders that dictate how the

shareholders will vote their shares in particular situations.2. MBCA § 7.31

a. Two or more shareholders may provide for the manner in which they will vote their shares by signing an agreement for that purpose. A voting agreement created under this section is not subject to the rules on voting trusts (§ 7.30).

b. A voting agreement created under this statute is specifically enforceable.3. Ringling Bros – Barnum & Bailey Combined Shows v. Ringling : Corporation has 1000

outstanding shares: 315 to Edith Ringling, 315 to Aubrey Ringling and 370 to John Ringling. Shares could be voted cumulatively. Edith and Aubrey had a shareholder voting agreement that provided the following: (1) the right of first refusal in case one party wanted to sell; (2) the exercise of joint voting; (3) the introduction of a binding mediator to settle voting disputes; and, (4) ten year time limit. A dispute arose. The mediator is brought in and he makes a judgment about how the parties should vote their shares. Aubrey votes in contradiction to his recommendation. Edith sues for breach of contract. Aubrey argues that the agreement is invalid because it created a voting trust and did not comply with the statutory requirements.

a. Issue: Does the shareholder voting agreement providing for joint voting and subjecting disputes to a mediator whose recommendations are binding constitute the designation of an irrevocable proxy, or voting trust?

b. Holding: No.i. Voting trusts usually involve a transfer of all voting rights to a third party.

Here, the parties retained their discretion on how to vote by retaining the ability to negotiate voting strategies between themselves without involving a third party.

ii. Irrevocable proxies retain their power by the fact the trustor transfers possession of his shares. Here, although Mr. Loos’s recommendations were ostensibly binding, the parties could take matters into their own hands and vote any way they chose. (This is kind of B.S. because, if they did, they would be liable for breach of contract.)

iv. Use of Voting Trusts1. MBCA § 7.30: Shareholders may create a voting trust, conferring on trustee the right to vote

or otherwise act for them, bya. Transferring their shares to the trustee;b. Signing a written agreement;c. Delivering a list of all the beneficial owners of the shares and the number of shares

involved in the agreement along with a copy of the agreement to the corporation’s principal officer; and,

d. Limiting its duration to 10 years.e. Extensions beyond 10 years require

i. Signed agreement;ii. Trustee’s consent; and,

iii. Delivery of extension agreement to corporate agent.2. Legal v. Beneficial Owners

a. Trustee, or irrevocable proxy, becomes the legal owner due to the transfer of title.b. Beneficiary, or shareholder, becomes the beneficial, or equitable, owner and usually

retains the financial rights (right to distributions).3. DE Corp Law § 212(e): Irrevocable Proxies

a. Must be in writing;b. Must identify who the proxy is on the note/share certificates; and,

c. The proxy must have an interest in the corporation.4. Brown v. McLanahan : Under reorganization plan, new class of preferred stock created for

corporation’s creditors which gives them exclusive voting rights to elect all directors except one whenever dividends in arrears. The plan also created eight voting trusts representing the preferred shareholders. The eight voting trusts elected themselves as Directors. They then created an amendment to the corporation’s Articles that undermined the preferred stock’s arrearage voting rights and passed the resolution as the voting trustees.

a. Issue: Did voting trustees exceed their power by impairing the overall voting rights of the shares they were representing?

b. Holding: Yes.i. Trustee may not exercise powers that are detrimental to the beneficiary of the

trust. Here, the voting trustees completely undermined the voting rights of the beneficiaries.

ii. Debtors sold their ownership rights when they sold their preferred shares. Therefore, trustees actions in favor of the corporation’s creditors still violate their duty.

v. Use of Classified Stock to Elect Directors1. Lehrmann v. Cohen : AC shares owned by Cohens. AL shares owned by Lehrmanns. Four

board members. To avoid any potential deadlock, the families decide to create a third class of shares, AD. AD shares would have the exclusive voting rights to elect one director. They issue one share to Danzansky for $10. Danzansky elects himself. Everything runs smoothly until he retires and fills the vacancy with West.

a. Issue: Did the creation of a class of stock to elect one director constitute a voting trust by the AC and AL shares?

b. Holding: No.i. The primary characteristic of a voting trust is the separation of voting rights

from ownership. Here, the owner of the AD shares, Danzansky, retained the voting rights.

ii. Capitalization structures that create “classified directors” are acceptable under both the Model Rules, DE and CA law.

2. MBCA § 6.01: Places no restrictions on the Board’s limitation of the rights of a class of shares except that all shareholders in one class must have the same rights.

vi. Use of Stock Transfer Restriction1. MBCA § 6.27

a. Articles of Incorporation, by-laws or shareholder agreements may impose restrictions on the transfer of shares.

b. Restrictions are valid against the holder or transferee of a share if the existence of the restriction is noted conspicuously on the front or back of share certificate. Not valid or enforceable against a BFP.

c. Restriction mayi. Obligate shareholder to offer the shares to the corporation first;

ii. Obligate the corporation or other persons to acquire the shares;iii. Require the corporation or other shareholders to approve the transfer, if the

requirement is not manifestly unreasonable; or,iv. Prohibit the transfer to certain people or entities if the prohibition is not

manifestly unreasonable.2. Ling & Co. v. Trinity Savings & Loan : Court upheld an alienability restriction on class of

shares that required that, prior to transfer, the holder (1) get the consent of the NYSE, (2) offer sale to the corporation, and (3) if the corporation refused, offer sale to all of the other shareholders. Court held that (1) restriction was reasonable because no showing how many other shareholders existed, (2) clause on front of certificate which referred the reader to the

back, where back stated the existence of the restriction and cited the particular article, was conspicuous for purposes of the corporations law, and (3) not conspicuous for purposes of UCC.

vii. Use of Buy-Sell Agreements1. Right of First Refusal: Corporation gets the right to buy back the shares first if the

shareholder seeks to transfer.2. Buy-Sell Agreement: Corporation must buy back the shares at certain trigger event.

a. Protects Corporation: Ensures that shares not transferred to undesirable party (this includes the widows/heirs of shareholders who pass away in closely held corporations).

b. Protects Shareholder: In closely held corporation, where shares illiquid, ensures that a shareholder’s heirs will have a valid exit strategy.

3. Buy-Sell Agreements and Distribution Rulesa. Repurchase of a shares by a corporation pursuant to a buy-sell agreement triggers the

distribution rules.i. MBCA: Cannot make distribution out of Stated Capital. Cannot make

distributions if it will leave you with insufficient funds to pay creditors.ii. California: Can make distribution as long as corporation remains solvent.

b. How to get around thisi. Buy-Sell Agreement between shareholders, rather than between corporation

and shareholder.ii. Key-Man Life Insurance Policies: Life insurance policies that insure the

corporation for when a major shareholder dies. Pays out when he dies, providing the corporation with the funds to repurchase the shares.

c. The Problems of Dissension and Deadlocki. Gearing v. Kelly : Court refuses to use its equitable powers to set aside the election of a director at

petitioner’s request where petitioner’s refusal to attend the director’s meeting to replace a vacancy on the Board caused the meeting to have an insufficient number of attendees for a quorum. Court finds that petitioner violated her fiduciary duty to the corporation by willfully attempting to cause paralysis; thus, the Court would not allow the petitioner to benefit from her own misconduct.

1. What should the unsatisfied Board member/shareholder have done?a. Created a buy-sell agreement that required corporation to buy back her stock when

Board hopelessly deadlocked (fraud problem).b. Petitioned Court for involuntary dissolution.c. Attempted to sell her shares back to corporation, to other shareholders, or out on

market.ii. In Re Radom & Nierdorff : Brother and brother-in-law own very successful corporation. They are

only shareholders and only members of the board. Brother-in-law dies and sister takes over. Sister and brother hate each other. Sister files a derivative suit against brother for enriching himself at corporation’s expense. Sister refuses, in her capacity as member of the Board, to sign brother’s salary checks. However, sister does not involve herself in brother’s running the corporation and the corporation remains very successful. Court refuses to use its equitable powers to dissolve the corporation because it is competing so successfully in the market. It wants to incentivize the parties to make the situation work.

d. The Modern Remedies for Oppression, Dissension and Deadlocki. MBCA § 14.30: Grounds for Judicial Dissolution

1. In a proceeding by shareholder if it is determined that:a. Director deadlock that shareholders cannot fix where deadlock threatens to cause

irreparable harm to the corporation;b. Directors or those in control of corporation have acted, are acting, or will act in a

manner that is illegal, oppressive, or fraudulent;

c. Shareholders are deadlocked in voting power and have failed for a period of two consecutive years to elect successors to directors whose terms have expired; or,

d. The corporate assets are being misapplied or wasted.2. In a proceeding by the corporation to have its voluntary dissolution continued under court

supervision.ii. What is oppressive conduct?

1. Burdensome, harsh and wrongful conduct;2. Lack of probity and fair dealings in the affairs of a company to the prejudice of some of its

members; or,3. Visible departure from the standards of fair dealing, and a violation of fair play on which

every shareholder who entrusts his money to the company is entitled to rely.4. Really depends on the expectations the shareholders had when entering into their relationship

with the corporation.iii. What are some other remedies for oppression, dissent and deadlock?

1. Election to Purchase in Lieu of Dissolution – MBCA § 14.34a. In a closely held corporation, if a shareholder petitions for dissolution under §

14.30, the corporation or another shareholder may make an election to purchase the petitioning shareholder’s shares at FMV. The election is irrevocable unless the Court decides it would be equitable to set aside or modify the election.

b. May be filed anytime within 90 days of the dissolution petition under § 14.30.c. Davis v. Sheehin: Court orders that corporation buy-out 45% minority owner’s

shares where 55% majority owner and his wife, 2/3 of the Board, refused to allow the minority owner to inspect the books, tried to conspire to deprive him of his stock ownership, made informal dividends to his detriment, used corporation funds to pay legal fees, etc. Court ordered as a remedy, even though TX law had never recognized buy-out as a remedy for oppression before.

2. Use of Provisional Directorsa. Instead of dissolving a corporation for deadlock or mismanagement, a court can

appoint a provisional director. i. Provisional directors generally have all the rights and duties of a regular

director; however, they are technically officers of the court and thus, the court can review their decisions.

ii. In appointing provisional directors, courts will look at the best interests of the corporation and try to appoint someone familiar with the corporation’s operations, its history and someone with a great deal of experience in running corporate affairs.

b. Abreu v. Unica Indus. Sales, Inc : Plaintiff the successor in interest to her husband’s 50% ownership shares in a food manufacturing corporation. Defendants where co-owners and the only directors of the corporation that owned the other 50% interest; they were the distributors for Plaintiff’s corporation. Defendants found guilty of violating their fiduciary duty of loyalty by creating another corporation to directly compete with Plaintiff’s corporation and trying to steal trade secrets to leverage their own self-interests. Defendant kicked off board. Left board with only two members: Plaintiff and one of Defendant’s representatives. Court appoints Plaintiff’s son-in-law as provisional director.

i. Issue: Did trial court error in appointing son-in-law as provisional director?ii. Holding: No

1. TX statute does not require, unlike some other statutes, that provisional director be a completely neutral and detached third party.

2. When appointing provisional directors, trial court only considers what is best for the corporation. Here, the son-in-law had 17 years

experience in helping to manage the corporation and there was no evidence he would put his familial relationships ahead of his duty to the corporation.

e. Action by Directors and Authority of Officersi. The Meeting Requirement for Board Action - MBCA § 8.20

1. Board may hold regular or special meeting in or outside state of incorporation.2. Board can hold meeting via any means where all directors can hear each other and

participate, i.e., through teleconference, videoconference, etc.ii. Board Action by Written Consent – MBCA § 8.21 (Cal Corp Code too)

1. Unless provided otherwise in by-laws or Articles of Incorporation, Board can act without a meeting if it gets written consent from each Director.

2. The consenta. Must state the action being taken;b. Must be delivered to the corporation;c. Can be revocable.

iii. Mechanics of Board Action1. Notice of Meeting – MBCA § 8.22

a. Unless provided otherwise in by-laws or Articles of Incorporation, regular meetings require no notice.

b. Unless otherwise provided, special meetings require at least two days notice regarding the time, place and date.

2. Waiver of Notice – MBCA § 8.23a. Director may waive any notice requirements before or after the date for the meeting.

Waiver must be in writing and filed with corporation’s records or minutes.b. Director’s participation at meeting waives his right to dispute notice.

3. Quorum and Voting – MBCA § 8.24a. Unless stated otherwise, a quorum of Board of Directors consists of:

i. A majority of the fixed number of directors if the corporation has a fixed board; or,

ii. A majority of the directors prescribed, or if no number is prescribed, a majority of those in office immediately prior to the meeting.

b. Quorum can never be less than 1/3 of the fixed or proscribed members, no matter what the Articles provide.

4. Action by Board – MBCA § 8.24a. If a quorum is present, an action of the Board is binding if approved by a majority of

the members present, unless the Articles of Incorporation require a higher percentage. 5. Committees - MBCA § 8.25

a. Unless Articles of Incorporation or by-laws provide otherwise, Board can create committees to decide certain issues. The Board can appoint one or more members of the Board to serve on the committees.

b. Limitations - Committees cannot i. Authorize distributions,

ii. Approve action where the Model Act requires shareholder approval,iii. Fill vacancies on the Board, oriv. Adopt, amend or repeal by-laws.

VII. Corporate Governance in the Publicly Traded Corporationa. What are (or should be) the goals of a publicly traded corporation

i. Traditional View: Primacy of Shareholder Interest1. Property Conception

a. Traditional view of corporate goals.

b. Corporation viewed as the property of the shareholders. Primary goal to make money for the shareholders by maximizing profits. If management takes into account corollary goals they are violating their responsibility as agents of the shareholders.

2. Social Entity Conceptiona. Shareholders get charter to operate and granted limited liability from government.b. As such, they are another tool by which the government seeks to promote the general

welfare. c. Thus, corporations have a duty to act socially responsible as well as to maximize

profits.ii. The Scope of a Corporation’s Social Responsibility

1. Promulgation of “other constituency” statutesa. The American Law Institute and various states have passed statutes that generally say

the following:i. Corporations should have as its objective the conduct of business activities

with a view to enhancing profit and shareholder gains, andii. Corporations may take into account the effects of its actions on the

community and other constituencies when making its business decisions.b. Statutes appear normative; because they employ the word “may”, they do not offer a

cause of action.b. The Role of Shareholders

i. Publicly Held Companies and the Agency Costs of Separation of Ownership from Control: To Whom is Management Accountable?

1. Introductiona. Three types of Control

i. Managementii. Majority Shareholders

iii. Active Minority Shareholdersb. In large corporation with vast amount of shareholders, management control becomes

nearly absolute. Usually, an individual’s power to dissent is reduced to his ability to sell the stock; his vote does not really matter.

2. The Reputation Market for Corporate Managersa. Manager has incentive to perform effectively because high stock prices increase

demand for his services.b. Plus, CEO’s members of very exclusive group; ego drives them to remain effective.

3. Use of Incentive Stock Options to Align Managers’ and Shareholders Interestsa. Grant of Stock: Executive given stock for free as part of compensation plan.b. Incentive Stock Option: Executive given the right to but stock at the market price set

on a given day.c. Incentive Stock Options incentivize managers to work to increase the stock prices

because it makes them money on their stock options.4. Exercise of the Wall Street Vote: Shareholder v. Stakeholder.

a. Most shareholders rightly view themselves as passive investors; they have a stake rather than an ownership interest in the corporation.

b. In case of dissent, therefore, stakeholder votes his displeasure by selling the stock.ii. “Street Name” Ownership: The Use of Nominees

1. Distinction between Record Owner and Beneficial Ownera. Record Owner: Owner entered on corporation’s books as the record owner of certain

amount of issued shares.b. Beneficial Owner: Actual owner of shares who receives the right to vote and the

financial interest.

2. Most shareholders do not take physical possession of their stock certificates. Instead, they buy the stock through third party brokerage houses who remain the “record owner.” Thus, the shareholders become the “beneficial owner.”

3. These layers mean that, in the issuance of proxy statements and other messages to shareholders, the corporation has to give to the record owner who passes on to the beneficial owner.

iii. Concept of “Control”1. Majority Shareholder Control2. Active Minority Control: The shareholder owns a large enough percentage of the stock that

he usually dominates all meetings because less than 100% of shareholders show up.3. Management Control

iv. Publicly Held Companies and the Efficient Market Theory1. Thesis: At any point in time, the market for shares in publicly traded corporations operates

efficiently.a. The market keeps tabulates and analyzes all the company’s publicly available

information; the price reflects this information.b. Price moves randomly. A stock’s historical price cannot predict its future price.c. The stock moves with the consensus of the market. Stock price is not reflective of

what it would cost to buy all the shares at once. Rather, stock price is reflective of what one seller can get for one share from one willing buyer.

v. The “Market for Corporate Control”1. Proxy Contests2. Negotiated Acquisitions - Mergers require:

a. Board approvalb. Shareholder approval

3. Tender Offersa. Instead of offering a merger to the corporation, the hostile corporation solicits the

shareholders instead.b. This allows the hostile corporation to take effective control without having to go

through the corporation.vi. Institutional Investors

1. Entities other than individuals that own stock.a. Pension fundsb. Foundationsc. Universitiesd. Mutual funds

2. Currently own approximately 50% of all stock on the NYSE. Their power to influence corporate affairs has grown dramatically.

3. What if institutional investors decide they are disgusted with the stock’s performance?a. Dump Stock: This could seriously diminish stock price depending on the size of

their holdings.b. Vote out the Board of Directors

c. The Respective Role of Officers and Directors in Public Companiesi. Who Manages the Business Affairs of the Modern Publicly Held Corporation?

1. President/CEOa. Handles the day to day operations of the business.

2. Profit Centersa. Large corporations often resemble umbrellas, with each spoke ruled by semi-

autonomous subsidiary.b. Usually, these subsidiaries have their own Board of Directors who rule the roost and

report to the centralized management.

ii. What is the Function of the Modern Board of Directors?1. MBCA § 8.01

a. All corporate powers exercised by or under authority of Board of Directors.b. Affairs of corporation managed by or under authority of Board of Directors.

2. Modern board of directors spends less than 123 hours a year in their capacity as Directors.3. Thus, the management of corporation usually sets agenda for the Board’s meetings. Most of

their meetings consist of decisions on very noncontroversial decisions.4. Two Major Duties of Board

a. Ensure the viability and structural integrity of the corporation.i. Make sure functioning management in place.

ii. Make sure internal information/monitoring system in place (primarily for purposes of putting together financial statements.)

b. Take action when the Board sees serious signs of trouble.iii. The Role of Outside Directors

1. Outside v. Inside Directorsa. Inside Directors: Directors who are also on the management/executive team.b. Outside Directors: Independent directors who are not otherwise employed with the

company.d. The Reforms Adopted as Part of the Sarbannes-Oxley Act

i. Audit Committee1. Oversees internal and external auditing processes.2. SOX: Mandatory that Audit Committees of publicly traded corporations consist only of

outside directors!!ii. Compensation Committee

1. Determines the compensation packages for the CEO and other senior executives.2. CEO usually granted the ability to hire and fire senior executives since he works with the

people everyday and he knows the kinds of capabilities he needs.iii. Nominating Committee

1. Responsible for nominating new members of the Board for shareholder election.2. Obviously, this leads to a great deal of nepotism. Nominations based on friendships and

family ties rather than qualifications.e. Federal Proxy Regulations

i. Scope of Federal Regulation of the Solicitation of Proxies: Definition of Reporting Companies1. “Reporting Companies”

a. Companies that register with the SEC pursuant to Section 14(a) of the SEC Act of 1934.

b. Companies that exchange securities in interstate market must register with the SEC if they meet the following:

i. Assets totaling more than $10 million, andii. More that 500 shareholders.

2. Annual Filing with SECa. Reporting Companies must file the following forms with the SEC

i. Initial report detailing information about the issuer, its organization, its finances, its securities and similar matters.

ii. Annual and Quarterly Updates1. Annual Update: 10K2. Quarterly Update: 10Q

3. Proxy Regulations for Reportinga. SEC proxy regulations only apply any time a Reporting Company is Soliciting a

Shareholder.b. Soliciting Shareholders

i. 1934 SEC Act § 14(a): It shall be unlawful for any person…in contravention of such rules and regulations as the Commission may prescribe as necessary…to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security registered under Section 12.

ii. 1934 Act Rule 14a-1(l)(1): Terms solicit and solicitation include:1. Any request for a proxy whether or not accompanied by or included

in a form of a proxy;2. Any request to execute or not to execute, or to revoke, a proxy; or3. The furnishing of a form of proxy or other communication to

security holders under circumstances reasonably calculated to result in procurement, withholding or revocation of a proxy.

iii. Studebaker v. Gittlin : Gittlin a minority shareholder of Studebaker. Gittlin wants to start a proxy contest to get rid of Studebaker’s current board of directors. He needs to see the shareholder list to start proxy contest. State law says that if he has 5% of registered shares authorization, he is lawfully entitled to see shareholder list. Gittlin goes out and gets written authorization from 5% of the shareholders. Held: Gittlin’s letter to these shareholders served as a solicitation because it was part of a “continuous plan intended to end in solicitation and to prepare the way for success.”

c. Safe Harbor Provisionsi. SEC eventually relaxed the rules for shareholder solicitation to facilitate

shareholder communication.ii. 1934 SEC Act § 14a-1: Communication by shareholder not engaged in

proxy solicitation, but for the purposes of stating how the shareholder intends to vote, is exempt from proxy regulations.

ii. Proxy Solicitation Materials: Proxy Forms, Proxy Statements and Annual Reports1. Proxy Forms:

a. Contain various requirements to ensure that shareholder has right to approve or disapprove of issues/candidates.

b. Usually do not allow nominee to vote for a director not listed on the proxy statement.2. Proxy Statements

a. Subject to various disclosure requirement depending on the issue to be decided.3. Annual Reports

a. Solicitations by management in conjunction with annual meeting must be accompanied by an annual report.

b. Various disclosure requirements; must be in laymen’s terms.iii. False and Misleading Proxy Solicitation Materials

1. 1934 Act Rule 14a-9: No solicitation subject to this regulation shall be made containing false or misleading information with respect to a material fact, or which omits material facts.

a. Allows private cause of action (shareholder derivative suits) for false and misleading proxy statements. (J.I. Case Co. v. Borak)

b. Federal courts have jurisdiction over suits under 14a-9.2. TSC Indus, Inc. v. Northway, Inc.

a. Facts: Founder of TSC Indus, Inc. sells his 34% shares to National. National gets five people on the TSC Indus, Inc. Board. They then have TSC issue a proxy statement to shareholders recommending a liquidation sale of all of TSC’s assets to National. Proxy solicitation successful.

b. Issue: Does the fact the proxy statement omitted facts about the degree of National’s control over ownership of TSC represent the omission of a material fact?

c. Holding: NO.

i. Material Fact: A fact is material if there is a substantial likelihood a reasonable shareholder would consider it important in deciding how to vote.

iv. Rule 14a-8: Shareholder Proposal Rule1. Shareholders with 1% or $2000 worth of shares can submit shareholder proposals to the

company to include in its proxy statement.2. Framed as “recommendations” because shareholders have no authority over the operations of

the company (completed vested in Board of Directors).VIII. The Duty of Care and the Business Judgment Rule

a. The Traditional Statement of the Business Judgment Rulei. Common Law Rule: In the absence of fraud, illegality or conflict of interest, the decision of the

Board of Directors receives the presumption that it was formed in good faith and was designed to promote the best interests of the corporation

ii. Policy Reasons1. Encourage Board of Directors to take risks.2. Discourage Courts from going outside their arena of expertise and second-guessing business

decisions.iii. Schlensky v. Wrigley : Shareholders bring a derivative action against Wrigley Board of Directors

alleging that it breached it duty of care by acquiescing to Mr. Wrigley’s desire to continue to play baseball exclusively during the daytime. Shareholders cite the ubiquity of nighttime play and the speculated amount of revenue lost.

1. Issue: Did Board violate its fiduciary duty of care by refusing to allow night games at Wrigley?

2. Holding: No.a. Business Judgment Rule = Presumption of good faith.b. Court could point to many hypothetical legitimate reasons for day games, including

preserving the character of the park as to preserve neighborhood property value, preserving the traditional character of the Cubs as to increase tourist interest, cost of stadium renovations, etc.

b. The Modern Statement of the Business Judgment Rulei. MBCA § 8.30

1. Each director shall act a. In good faith, andb. In manner the director reasonably believes to be in the best interests of the

corporation.2. When monitoring the corporation’s activities or becoming informed for the purposes of

making a decision, director shall exercise reasonable care. ii. Pragmatic Approach

1. Director liable for breach of fiduciary duty of he acts with gross negligence in the decision making process. MBCA § 8.30 more of an aspirational statute.

2. Courts more likely to impose liability if the decision involves fundamental questions dealing with the corporation’s existence. (See Smith v. Van Gorkam as opposed to Wrigley)

iii. MBCA § 8.24: Director can formally object to a decision in writing, thus protecting him from liability for breach of fiduciary duty.

iv. Smith v. Van Gorkom : Trans Union, a highly successful corporation, has tax credit problem; it cannot find enough income after its annual depreciation deductions to use accumulated tax credits. Board gets together and they start to run through some scenarios, including a leveraged buy-out. The CFO & CEO run some simulations, without expert advice, and decide that the stock worth between $50 and $60 a share. CEO wants to sell his 75,000 shares and meets with corporate takeover expert; CEO uses the $55 figure as appropriate figure for proposed “cash out” merger. Directors approve the

cash out merger at $55/share based solely on the CEO, CFO and takeover expert’s recommendations; no study commissioned. 70% of shareholders approve the merger.

1. Issue: Did the Board of Directors violate their duty of care?2. Holding: Yes

a. Board failed to reach and informed business decision regarding the cash out merger.b. Simple comparison of the $55 price with the current market price was too simplistic;

no study of intrinsic value of corporation, no valuation study, etc.c. Directors basically acquiesced to the CEO and CFO’s recommendations without

asking how they had reached the $55 figure and how accurate and fair that figure was.

c. Statutory Limitations on Director and Officer Liabilityi. Raincoat Provisions - Del. Gen. Corp. Law § 102(b)(7) (California has similar statute): Articles of

Incorporation may (“opt-in” provision) include provision eliminating or limiting personal liability of Board of Directors, provided the provision does not eliminate or limit liability for:

1. Breach of Duty of Loyalty2. Intentional Violations of Duty of Loyalty3. Unlawful Dividends or Stock Repurchases4. Any Transaction Where Director Received Improper Personal Benefit

ii. Policy: Encourage qualified people to serve on Boards.iii. Effects on Derivative Suits for Breach of Duty of Care

1. Eliminates suits for damages based on good faith violations of fiduciary duty of care.2. Shareholders can still seek to enjoin Board action.

d. Is their a fiduciary duty of disclosure?i. In Re Caremark: Court approval of settlement of derivative action. Caremark, a health care provider,

had paid $250 million to settle suit relating to kickbacks paid to other health care providers for referrals. Shareholders bring derivative action seeking the imposition of certain monitoring and compliance programs.

ii. Rule: Corporate boards have a duty to ensure that information and reporting systems exist in the organization that are reasonably designed to provide senior management with accurate information sufficient to allow Board to reach informed business decisions.

IX. The Duty of Loyalty and Conflicts of Interestsa. Self Dealing Transactions

i. The Common Law Rule of Voidablility: Under the common law, all transactions between the corporation and a director that benefited the director were voidable at the election of the corporation.

ii. The Modern Fairness Standard1. Modern Standard: Transaction between the corporation and a director does not constitute a

breach of director’s duty of loyalty as long as the transaction intrinsically fair to the corporation.

2. Marciano v. Nakash : Court holds that a $2.5 million loan to the corporation by one of the directors a valid debt against the dissolving corporation, even though the transaction had not received the approval of the board or the shareholders, where the transaction intrinsically fair.

3. California General Corp. Law § 310 – A contract between corporation and director not void or voidable if:

a. Shareholder Approvali. Full and adequate disclosure to all shareholders;

ii. Shareholders approve1. In good faith, and2. By majority of the disinterested shareholders.

iii. Where these requirements met, the transaction receives an irrebuttable presumption of intrinsic fairness.

b. Director Approval

i. Full and adequate disclosure to all directors;ii. Directors approve

1. In good faith2. By sufficient majority of the disinterested directors.

a. Example Onei. Total Board Members: 7

ii. Total Present: 4iii. Yes: 3 (2 disinterested, 1

interested)iv. No: 1v. Transaction not cleansed under § 310 because the

transaction did not receive a sufficient number of disinterested directors.

b. Example Twoi. Total Board Members: 7

ii. Total Present: 4iii. Yes: 3 (3 disinterested)iv. No: 0 (1 abstains)v. Transaction cleansed because a quorum present and

the issue received approval of the majority of the quorum, even absent the disinterested directors.

iii. Where these requirements met, the transaction receives a rebuttable presumption of intrinsic fairness.

c. If contract not approved by Shareholders or Directors, the person asserting the validity fo the contract or transaction bears the burden of proof.

b. Executive Compensationi. Rule:

1. Executive Compensation packages considered invalid and their approval a breach of director’s fiduciary duty of loyalty where the packages constitute waste.

2. Waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which a reasonable person might be willing to trade.

ii. Heller v. Boylan : Executive compensation plan giving executives 10% of profits approved by shareholders in the corporation by-laws. Company takes off and executives making ridiculously high salaries. Very small minority of shareholder sues them for waste.

1. Issue: Does the executive compensation plan amount to waste?2. Holding: No

a. Executives are paid a princely amount of money in this case, more than most people at the time could fathom.

b. However, court reluctant to overturn the executive compensation plan where:i. Vast majority of the shareholders had approved of the plan in the by-laws;

ii. The corporation was performing extremely well and only a very small minority of shareholders had any problem with the plan; and,

iii. No evidence was proffered on how to measure the true value of the executive’s labor and how their salaries compared to others in the same fields.

iii. Brehm v. Eisner : Court holds no breach of duty of care where old board approved Michael Ovitz’s exorbitant severance package where Board’s compensation expert had not quantified the corporation’s potential exposure, but where Board knew how the severance package would be calculated. Court holds no waste occurred where the Board made a good faith decision about Ovitz’s worth to the corporation and expected to receive valuable consideration in the form of his highly prized services. Why? Have to look at transaction at the time the contract executed. At that time, the

compensation structure seemed much more reasonable, and, in light of the business judgment rule, plaintiff could not meet its burden of proof.

c. Parent-Subsidiary Dealingsi. Self-Dealing in the Context of a Parent-Subsidiary Relationship

1. Sinclair Oil, Corp. v. Levien: a. Sinclair Oil Corp. owns 97% of Sinven. They nominate all the Board of Directors.

By reason of its control, Sinclair Oil has a fiduciary duty to Sinven (because they in essence control its Board). Plaintiff alleges three breaches of fiduciary duty against Sinclair: (1) Sinclair caused Sinven to pay out excessive dividends ($38,000,000 in excess of Sinven’s earnings during the period) to shore up Sinclair’s own cash flow issue; (2) Sinclair breached its fiduciary duty by allowing one of its other wholly owned subsidiaries to breach a contract with Sinven.

i. Issue 1: What is the standard applied to determine the validity of transactions between parent and subsidiary in this context?

ii. Holding: Intrinsic fairness is the standard to determine the validity of “self-dealing” transactions between a parent corporation and its subsidiary.

iii. Issue 2: What is “self-dealing” in the context of a parent-subsidiary relationship?

iv. Holding: “Self-dealing” in the context of a parent-subsidiary relationship is where the parent receives a benefit to the exclusion and at the expense of the subsidiary.

1. Obviously, this does not apply if the subsidiary is “wholly-owned”2. Applies to situations where there are minority shareholders that are

not affiliated with the parent corporationv. Issue 3: Did Sinclair breach its fiduciary duty by paying out excessive

dividends?vi. Holding: No

1. Sinven could not prove “self dealing” because the minority shareholders not excluded from receiving their fair share of dividends.

2. In the absence of “self dealing” the standard applied is the business judgment rule.

vii. Issue 4: Did Sinclair breach its fiduciary duty by allowing another wholly-owned subsidiary to breach its contract with Sinven?

viii. Holding: Yes1. Sinclair benefited from the contract to the exclusion of the subsidiary

by receiving the products produced by Sinven without having to pay Sinven for the products.

ii. Modern Standard of Judicial Review of Squeeze Out Casesd. Corporate Opportunity Cases

i. Rule: To prevail on derivative action for breach of fiduciary duty for failure to take advantage of a corporate opportunity, Plaintiff has to prove either

1. Line of Business Test: The opportunity arose from the corporation’s business activity, or2. Expectancy Test: Corporation had a reasonable expectation that it would share in the

opportunity.ii. How does a Director cleanse a self-interested transaction arising from a corporate opportunity?

1. Full Disclosure: Give full disclosure to the corporation and offer the corporation the opportunity first.

2. Burden of Proof: Once corporation passes after full disclosure, burden of proof shifts to Plaintiff to prove that the transaction unfair to the corporation.

iii. Sinclair Oil v. Levien : Sinven’s activities confined to the exploitation of Venezualan oil reserves. Sinclair, Sinven’s parent company, has many other subsidiaries in other parts of the globe; each subsidiary confines its activities to its particular region. Derivative action against Sinclair alleging that it refused to allow Sinven to take advantage of new oil exploitation opportunities that arose in other parts of the world. Court holds against plaintiffs because (1) the opportunities did not arise from Sinven’s activities in Venezuala, and (2) Sinven did not really have a reasonable expectation that it would share in opportunities developed in other countries when its Board had limited its activities to Venezuala.

iv. Northeast Harbor Golf Club v. Harris : The Club owns a golf course. Harris, the President of the Club, begins buying pieces of property that come up for sale around the golf course; the sellers originally approach her in her capacity as President of the Club. Each time she buys, she discloses to the Board after the purchase. Club did not have the financial resources to purchase the property if it wanted. Problems arise between Harris and the Club when she decides she wants to develop a subdivision on the property.

1. Issue: Did Harris breach her fiduciary duty of loyalty?2. Holding: Yes.

a. The opportunity was a corporate opportunity because:i. Harris learned about the opportunity in her capacity as President; and,

ii. Although the Club was not engaged in real estate development, it had an interest in keeping the property undeveloped.

b. Harris failed to disclose the opportunity to the Club prior to buying the property.X. Shareholder Derivative Litigation and the Business Judgment Rule

a. What is the appropriate standard for judicial review of a decision made by the Company’s Board of Directors [or more likely, by a Special Litigation Committee (SLC) appointed by the Board], which recommends dismissal of derivative litigation brought by the company’s shareholders?

b. The Traditional Business Judgment Rule Approachi. Common Law Rule

1. A derivative action asserts the corporation’s rights.2. It is therefore within the business judgment of the corporation whether to allow derivative

suits against current and former board directors.3. Absent allegations of fraud, collusion, self-interest, dishonesty or other misconduct the court

applies the business judgment rule to determine if shareholder derivative suits allowable when the corporation’s Board of Directors refuses to sanction the suit.

ii. Structural Bias: Obviously, this “hands off” approach fails to account for the structural bias that directors will automatically have towards other directors.

iii. Federal Securities Suits and the Business Judgment Rule: Galef v. Alexander, a 2nd Circuit Court of Appeals Decision, finds the Business Judgment Rule inapplicable to derivative suits alleging violations of the Federal Securities Act.

iv. Gall v. Exxon : Court refuses to dismiss derivative suit on summary judgment where Exxon’s Special Litigation Committee recommends the disallowance of all derivative suits, but where the Court feels that the Plaintiff has not had a proper opportunity to conduct discovery to determine the independence of the Committee.

c. A Broader Standard of Judicial Review: Zapata Corp. v. Maldanadoi. Facts: Board of Directors approve an incentive option plan for themselves. Using insider

information, they accelerate the exercise date of these options to make more money. Shareholder files a derivative suit against the Board alleging breach of fiduciary duty. Shareholder does not file a demand with the Board first, saying that demand would be futile. During the litigation process, four of Zapata’s Board changes; Zapata appoints a Special Litigation Committee to determine whether the suit in the company’s best interest, headed by two of the Board members who were not at the company at the time of the problems. The SLC finds the suit would not be in the best interests of the

corporation and brings a Motion to Dismiss. The trial court allows the suit to go forward, holding that, in certain circumstances, a shareholder has a right to bring a derivative action.

ii. Issue: When can a court allow a shareholder derivative action to continue even after the Board of Directors has disapproved of the litigation?

1. When the shareholder makes specific allegations of fraud, illegality or self-dealing (Business Judgment Rule applies), or

2. When demand would be FUTILE.iii. Issue2: When a Board is tainted by self-interested directors, can the Board delegate its managerial

authority to a disinterested Special Litigation Committee for the purposes of purging the taint?1. A Board, tainted by self-interest, can delegate its managerial power to terminate a derivative

suit to a disinterested SLC.iv. Issue3: What is the test for a corporation’s Motion to Dismiss (i.e., once lawsuit already started) in a

derivative suit by a shareholder against its directors?1. Good faith recommendation of an independent SLC, and2. Court, using its own business judgment, finds it fair to dismiss the suit.

d. The Demand Requirement and the Test for Demand Futilityi. What is FUTILE in the context of a preliminary demand?

1. FUTILEa. The directors are interested parties to the transaction, ORb. The challenged transaction was not the product of a valid exercise of business

judgment.2. Aronson v. Lewis : Court finds that Plaintiff failed to show that a petition for derivative

action would be futile where Plaintiff brought a derivative action against the former CEO of the corporation for a “golden parachute” consulting contract. Plaintiff alleged that the Board were interested parties since they were all nominated by the Defendant and the Defendant still owned 47% of the outstanding stock; Court held this was not enough to challenge the presumption of independence.

XI. Insider Tradinga. The (Evolving?) Approach Under State Law

i. Traditional Common Law Rule1. State Fraud Laws: Fraud requires (1) an affirmative misstatement, (2) of material fact, (3)

that induces reliance, (4) to the person’s detriment.2. Traditional Common Law Rule

a. Common Law actions for securities fraud predicated on state law.b. State law did not recognize securities fraud actions alleging fraud based on omission

of material fact, no duty to disclose unless a duty of trust and obligation and no duty of trust and obligation between a corporate officer and a shareholder. (Goodwin v. Agassiz)

3. The Modern Approach and the Scope of the Insider’s Duty to Shareholdersa. Strong v. Repide : Court recognized a securities fraud action prior to 10b-5 where a

corporate officer took advantage of insider information about a big deal about to go through to buy stock through an intermediary from another shareholder where the value of the stock subsequently skyrocketed. Court pointed to the “special facts” of the case, including the officer’s primary role in the negotiations and the active role he took to conceal his identity when purchasing the stocks.

b. Hotchkiss v. Fischer : Court recognizes a securities fraud action prior to 10b-5 where widow in need of money goes into director’s office and asks if the company planning on declaring dividends at an upcoming meeting. Director claims he does not know, paints dark picture of corporation’s assets, and buys her shares at $1.25/share; corporation declares dividends the next day at $1/share. Court holds that corporate officers owe a duty to act with the utmost fairness in transactions with shareholders.

c. The Modern Trend: Most state courts have adopted a “strict accountability” approach that holds a director who solicits a shareholder to purchase his stock and omits a material fact liable for damages or rescission.

b. The Development of an Implied Remedy Under Rule 10b-5: Kardon and Its Progenyi. Securities Exchange Act of 1934 Rule 10b-5: It shall be unlawful for any person, directly or

indirectly, in purchase or sale of securities,1. to employ any device, scheme, or artifice to defraud, 2. to make any untrue statement of a material fact or to omit to state a material fact necessary in

order to make the statements made, in light of the circumstances under which they were made, not misleading, or

3. to engage in any act, practice, or course of business which operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

ii. Modern Rule: Rule 10b-5 can be used as the basis for a private cause of action (Kardon v. National Gypsum)

c. The (Shrinking?) Scope of the Rule 10b-5 Remedy: Elements of an Implied Cause of Action Under Rule 10b-5

i. Jurisdiction1. Interstate Commerce

a. Federal Courts will have jurisdiction as long as any piece of the transaction involves interstate commerce.

b. Example: The stock certificate printed in a different state.2. Security: Has to involve some sort of debt or equity instrument.

ii. Standing to Sue for Rule 10b-5 Violations: Blue Chip Stamps v. Manor Drug Stores1. Actual Buyers or Sellers

a. Face to Face Transaction Rule: i. Only actual buyers or sellers of securities have standing to sue.

ii. Blue Chip Stamps v. Manor Drug Stores : Court holds plaintiff has no standing to sue under 10b-5 where he alleges that a materially misleading prospectus caused him to pass on an opportunity to purchase securities.

iii. Why? Open the door to countless number of frivolous lawsuits where facts difficult to disprove and settlement value potentially high.

b. Open Market Exchanges Rule:i. Where insiders traded through brokerage, anyone who bought or sold the

shares during the period the insiders traded have standing to sue. (Is this correct??)

2. SEC always has standing to sue.iii. The Scienter Requirement: Ernst & Ernst v. Hochfelder

1. Rule 10b-5 claims require allegations of intentional or willful misconduct.2. Ernst & Ernst v. Hochfelder : President of securities brokerage firm making fraudulent side

deals with his customers, saying if they sent him personal checks he would get them in on the big deals. He had them mail their personal checks to him directly and had a “mail rule” requiring that no one else open his mail but him. Firm goes bankrupt. Plaintiffs sue Ernst & Ernst, the firm’s accountants, for aiding and abetting the President’s fraud through their negligent malfeasance in the audit process. Court dismisses suit on demurrer for failure to state a cause of action because Plaintiffs did not claim Ernst & Ernst acted to intentionally defraud Plaintiffs.

iv. Conduct that Violates Rule 10b-51. Fraud2. Failure to Disclose Material Non-Public Information where there is some Independent Source

of Duty to Disclose (Chiarella and O’Hagen)3. Insider Trading – tippee liability (Dirks)

v. Material Fact1. Test: Would a reasonable investor consider this an important fact to know in deciding on

transaction?2. Fact that defendant bought or sold the shares based on the insider information probably

enough to show materiality (Texas Gulf Sulphur) vi. Reliance Requirement

1. Actual Reliance2. “Fraud on Market” Theory (Basic v. Levinsen) WE DON’T NEED TO KNOW!

vii. Damages1. Disgorgement: Court orders that the defendants pay the profits they made on the transactions

as damages.d. Insider Trading as a Violation of Rule 10b-5

i. The Nature of the Problem1. Two Rationales

a. Insiders have information that is supposed to be used for corporate purposes, not for trading purposes – misappropriation of the information.

b. Unequal access to information = unfair playing field.ii. The Genesis of the Rule 10b-5 “Duty to Disclose or Abstain” from Trading: SEC v. Texas Gulf

Sulphur Co.1. Duty to Disclose or Abstain:

a. Rule: Anyone in possession of material inside information must either disclose it to the investing public, or if he must keep the information secret to protect a corporate confidence, he must abstain from trading. THIS IS NO LONGER THE RULE!!

b. Rationale: Congress wanted to ensure that investors in the market had a parity of information available to them. Encourages people to invest if they feel like they are playing on a level playing field.

2. When can an Insider trade? a. Rule: Insider cannot trade until insider information has been disclosed in a manner

sufficient to insure its availability to the investing public.3. SEC v. Texas Gulf Sulfur Co: Rule 10b-5 violation where company executives and

employees trade on inside information about recently found metal deposits without disseminating information to fellow shareholders.

iii. The Modern View: The Supreme Court Scales Back the Scope of the Rule 10b-5 “Duty to Disclose or Abstain” from Trading

1. Modern Rule: An insider must disclose insider information or abstain from trading if:a. The information is material, andb. The insider has an independent fiduciary duty to disclose the information to the

other party in the transaction.2. Chiarella v. US : Printing company employed by corporation to print a tender offer for the

possible takeover of target corporation. Defendant, an employee of the printer, deduces who the target company is and buys stock in the target company. The SEC indicts Defendant for securities fraud under Rule 10b-5. The Supreme Court reverses the conviction. Although defendant failed to disclose inside information material to the securities transaction, he owed no independent duty to disclose this information to the shareholders of the target company: he was not an employee or officer of the target company, and his printing company was employed by the possible purchaser, not the target. (Today, Chiarella would have faced liability under the Misappropriation Theory)

3. Rule 14e-3a. Passed in response to Chiarella v. US.b. Imposes an independent duty on anyone to disclose material insider information or

abstain from trading in the context of a tender offer.

iv. The Misappropriation Theory of Liability for Insider Trading Violations Under Rule 10b-51. Misappropriation Theory

a. Rule: Person commits security fraud when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information

b. Instead of predicating the theory on just a duty to the corporation, expands to predicate on theory of duty to the source of the information. Why? To protect the integrity of the market from people who constantly have access to insider information due to their professions but who otherwise would have no duty not to trade on that information because they have no fiduciary duty to the corporation or its shareholders.

2. United States v. O’Hagen : O’Hagen is a partner in a major law firm. The law firm is hired by Grand Met to put together a tender offer for a possible merger with Pillsbury. O’Hagen discovers insider information through one of the partners working on the deal. O’Hagen goes out and buys a huge amount of call options. SEC indicts him. Court holds that O’Hagen owed an independent fiduciary duty of loyalty and confidence to his employer, the law firm; thus, his conviction stands because (1) he owed an independent duty of disclosure, and (2) he failed to disclose material information in the trading of securities.

v. Tipper-Tippee Liability1. Rule: Tippee faces liability for securities fraud under 10b-5 if:

a. He discloses confidential, material information,b. Tipper relayed the information to the tippee in breach of his fiduciary duty,c. Tipper gained personally from relaying the information to the tippee (this includes

more than just pecuniary gain, includes reputation gain, vocational gain, etc.), andd. Tippee knew or should have known that the tipper breached his fiduciary duty.

2. Dirks : Tippee faces no liability for securities fraud where he where he used information to pull some of his clients out of troubled stock because the tipper, a former employee of the corporation, did not gain personally from the disclosure (he was trying to stop corporate abuse).