BA-Corp. Prof. Matheson

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Business Associations1) Introduction

a) Epstein-Freer View and Roberts-Shepard View i) Most people who start businesses do it to make money.

(1) The defining characteristic of a business is that economic activity is organized for the purpose of earning a profit.

b) Roberts-Shepard View i) A business is some form of activity that is organized to "create value" for its owners.

(1) A business must create a profit in some sense, but not necessarily in the conventional sense.

ii) Shepard's View(1) Believes that the goals of businesses can be broader than just earning profit.

(a) Businesses are not formed just to make money, but to help people.c) Business Structures

i) Law makes careful distinctions between business structures(1) Who the owners are (i.e. shareholders, partners, sole proprietor)(2) What rights and obligations the owners have(3) Whether the business itself is a legal entity separate from the owners.

d) Businesses are the forum for economic activity, the objective of which is often to earn an economic return, profit, or other increased value to the proprietor.

2) Views of Other Gonster Machersa) Friedman's View

i) In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business.(1) His responsibility is to conduct business in accordance with the owners' desires.

(a) Thus, the executive is the agent of the individuals who own the corporation.(i) He is, however, a person in his own right and has duties or other social

responsibilities that he assumes on his own.1. In this capacity, he is acting as a principal, not an agent.

a. He is spending his own money or time or energy, not the money of his employers or the time or energy he has contracted to devote to their purposes.

(ii) Only one social responsibility of a business1. To use its resources and engage in activities designed to increase its

profits so long as it stays within the rules of the game.a. Friedman says that any action taken should benefit the company in

some manner. There must be a nexus between the action and the benefit.

II) Agency : The fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act. RESTATEMENT (SECOND) OF AGENCY §1

iii) Principal : The one for whom action is to be taken. Id. iv) Agent : The one who is to act. Id.

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A.P. SMITH MFG. CO. V. BARLOW - (1953)FactsAP Smith manufactures valves, fire hydrants and special equipment for the water and gas industries. Its board of directors adopted a resolution which set forth that it was in the corporation's best interest to join with others in donating $1500 to Princeton University. The stockholders questioned this action, and the corporation issued a declaratory judgment action in the Chancery Division and trial was had.

The President of the company testified that such donations were expected by the community, and that the donations create a favorable environment for their business operations.

Stockholders Argumentb) Plaintiff's certificate of incorporation does not expressly authorize the contribution and

under common law principles the company does not possess any implied or incidental power to make it.

c) NJ statutes which expressly authorize the contribution may not constitutionally be applied to plaintiff, a corporation created long before their enactment.

Holdingd) A donation by AP Smith was intra vires, or within the authority of the board of directors.

i) At Common Law, a manager could not disburse any corporate funds for philanthropic or other worthy public cause unless the expenditure would benefit the corporation.(1) However, control of economic wealth has passed from individual entrepreneurs to

dominating corporations, and thus public support has developed for corporations to make reasonable philanthropic donations.(a) Such contributions have been sustained upon liberal findings that the

donations tended reasonably to promote the corporate objectives.(i) Modern conditions require that corporations acknowledge and

discharge social as well as private responsibilities as members of the communities within which they operate.

(2) Further, state legislation adopted in the public interest and applied to pre-existing corporations under the reserved power has repeatedly been sustained the US Supreme Court.

ii) The donation is valid. There is no suggestion that it was made indiscriminately or to a pet charity of the corporate directors in furtherance of personal rather than corporate ends. It was a lawful exercise of the corporation's implied and incidental powers under common-law principles and that it came within the express authority of the pertinent state legislation.

NOTES and Rulese) The MBCA and other corporate codes now expressly authorize corporations to

make charitable contributions. i) However, there are scholars who still contend that corporate giving, if it is permitted

at all, should be strictly limited to those situations where the benefit to the firm in the 2


form of higher expected profits is clear and compelling. (1) Friedman: If managers to do anything with property other than what the

shareholders want them to do would be to expropriate resources that do not belong to them.

f) The law views a business as a separate entity, a separate legal person g) A body of law has developed to control the actions that separate entity or personh) Real persons act for that corporation as agentsi) A business with more than one owner can distribute and use its funds in ways that

are opposed by at least some of its owners.

How does the owner of a business make $$ from the Business?j) She can receive distributions of all or part of the money the business has earned.k) She can sell all or part of her ownership interest in the business for more than she paid for

it.

How does the Owner know how much money the Business has made and how much the business is Worth?

l) Business entities are required to keep “appropriate accounting records,” and to make these records available to the owners. MBCA §§16.01(b) and §16.02(b)(2). i) Businesses typically maintain several financial statements, which are provided to

investors, the company’s managers, and to the public and public enforcement authorities. (1) Without these accurate reports, the company can go under without the

managers or public knowing before it is too late.

ii) Types of Financial Statements

(1) Income Statement : Computes profit during a given period, usually a year.(a) Ex: Sales – Cost of Goods Sold (COGS) - salaries = Profit Before Taxes

(PBT).(i) Depreciation changes this analysis

1. A company which purchases a machine for 5K, which is expected to last for more than 5 years, it would be misleading to add the entire 5K into the expenses in year 1. a. The profits from the machine would be understated in year 1, and

overstated in subsequent years. (b) An income statement does not show how much cash a business may be

generating or using up in a given year. (i) This is because some entries in the income statement, such as

depreciation, do not represent any actual movement of cash.

(2) Cash Flow Statement : Measures the cash made available to a business from its operations during a given period.

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(a) It is a measure of how much more cash a business has at the end of the year than it had at the beginning of that year. (i) Generally, an income statement is converted into a cash flow statement by

the following formula1. Cash flow = profits from income statement + depreciation – net

change in balance sheet asset accounts other than cash + net change in liabilities and funds from new issues of stock.

(b) An increase in a balance sheet asset account other than cash results in a decrease in cash flow.

(c) An increase in a balance sheet liability account can result in an increase in the cash account on the balance sheet and an increase in cash flow.

(d) NOTE(i) When a business buys something that will be used for more than one year,

then is an investment and only the depreciation appears on the income statement.

(ii) When company buys something that it will use up in a year, it is called an expense, and the total amount appears on the income statement.

(3) Balance Sheet : Shows the company’s assets, liabilities and the owners’ “equity” in the business. (a) It is a snapshot of a particular moment in a business’ history.

(i) 3 Main Sections 1. Assets

a. The things that the company owns that have value. i. Ex: Cash, Land, Buildings, Accounts Receivable (money

owed to the company) and machinery.ii. Assets, like cash are NOT depreciated b/c they don’t get

used up. iii. Accounts Receivable are not depreciated but may be

written off. 2. Liabilities

a. What the company owes. i. Ex: Wages payable, any debts.

3. Owner’s Equity a. What is left over after a business subtracts the liabilities from the

assets. (ii) If the assets are all of the company’s things that have value, and the

liabilities are all the “claims” on that value, then the difference between the two is the value of the business to the owners – The owners equity.

NOTES

- Matching: Costs or expenses should be “booked” in the same period as the revenues those expenditures helped generate.

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- Conservatism: Data should be conservative – they should present the firm’s financial data in an accurate way, but err on the side of understating its revenues and the value of its assets, and on overestimating its costs and liabilities.

(b) Time Value of Money : The principle that money currently possessed will not be worth as much in the future.(i) 100K now, will not be worth 100K later.

3) Sarbanes-Oxley Act and Corporate Governancea) Congress passed this in reaction to the perceived breakdown of financial accounting and

corporate accountability in the wake of the financial scandals in the 2000 time frame. i) It seeks to protect the owners of public companies.

(1) In well-functioning governance systems, the public shareholders rely upon the board of directors, who in turn delegate a fair amount of responsibility for the oversight of the company’s accounting to its audit committee.

ii) Motivation for Fraud (1) If the numbers are good, then fundamental performance is good, then the price of

the stock should go up.

4) What are the Legal Structures for Businesses?a) Decision regarding a business structure is driven chiefly by the objectives of the

business’ founder and firms’ investors, in terms of tax status, exposure to legal liabilities, and flexibility in the operation and financing of the business. i) 2 Important Differences in Business Structures

(1) Tax Treatment of Business’ profits (2) Liability exposure of the owners for the business’ debts and other potential

liabilities.

b) Sole Proprietorshipi) A person undertakes a business without any of the formalities associated with other

forms of organization.(1) Individual and business are one and the same for tax and liability purposes.

ii) Does not pay taxes as a separate entity. (1) The individual reports all income and deductible expenses for the business on her

personal income tax return. iii) For liability purposes, the individual and the business are also one and the same.

c) Corporationi) Most common legal structure for large businesses.

(1) Corporation’s owners are generally protected from personal liability. (a) In exchange for this protection, the corporation must also pay tax on its

income just like a real person. (i) Corporation pays a tax, then the owners of the corporation pay a tax on the

part of its earnings that are distributed to them as dividends.(b) This double taxation creates powerful incentives for those enterprises that

anticipate distributing earnings to use a tax-advantaged, “pass-through” form, 5


such as a partnership or a limited liability company. (2) Maximum tax rate on corporate income is 35%.

d) Partnershipi) Business entities that consist of 2 or more owners. ii) Treated like a proprietorship for tax and liability purposes. iii) Taxes are paid only at the personal level on the partner’s share of the income

(1) This is called “pass through” taxation. iv) Each partner is jointly and severally liable.

e) Limited Partnershipi) Like a partnership or proprietorship for tax purposes. ii) Somewhat like a corporation for tax purposes.

(1) A partnership that has both limited and general partners.(a) General: Assumes management responsibility and unlimited liability for

business. (b) Limited: Similar to a shareholder.

f) Limited Liability Company (LLC)i) A business structure to provide both the protection from liability of a corporation and

the protection from double taxation of a partnership. (1) Owners are not individually liable for the company’s debts.

ii) The LLC is not a tax paying entity. (1) Income taxes are only paid once – by the owners of the LLC when a part of the

company’s earnings is distributed to them.

g) How do you Choose?i) Who will the owners be?

(1) If the investors and owners will be a small group of individuals, a partnership of some form is clearly a possibility, as is an LLC. (a) If the business will require Venture Capitalists, then they typically won’t

invest in LLCs, but only corporations b/c they don’t want to be held personally liable.

ii) What are the Capital Requirements and cash flow characteristics of the business likely to be?

Sole Proprietorship: Chapter 2

h) Most common form of business i) The business and its owner are the same actual person and the same legal person.

(1) There is no legal separation of the business, the people who manage the business, and the people who own the business. (a) Therefore, the owner is responsible for the debts and obligations of the

business.

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(2) No need to draft any legal document and no need to file anything.(a) It is the “default” structure for a business with one owner; unless the owner

files papers to create some other structure, such as a corporation, his business is automatically a sole proprietorship. (i) The owner reports the business’ income on a personal tax return and pays

the taxes on that income (at his personal rate). i) Problems with a Sole Proprietorship

i) Employees and Agency Principles (1) In a sole proprietorship, the relationship between employees and owner is largely

a matter of contract law. (a) Agency

(i) Involves a delegation of a duty or goal of one person (principal) to another person. (agent) 1. Restatement (Second) of Agency (RSA)

a. §1i. Agency is a “fiduciary relation”ii. There must be some “manifestation of consent by a principal to

an agent that the agent shall act on the principal’s behalf and subject to the principal’s control.

iii. Consent by the agent so to act. b. Agency is the result of conduct, and not of the words used. The

Conduct manifests that one will do something for another, who is in charge.

(b) Third Parties and Agency(i) Authority : Power of the agent to affect the legal relations of the principal

by acts done in accordance with the principal’s manifestations of consent to him. RSA §7. 1. A deal by your agent with a 3rd party binds you if the agent had

“authority to bind the principal. (ii) Actual Authority : Created by manifestations from the principal to the

agent that the agent reasonably believes create authority. 1. Express : P tells A that A is empowered to act on P’s behalf in

accomplishing some task. 2. Implied : Agent has the authority to do what is reasonably necessary to

get the assigned job done, even if P did not spell it out in detail. (iii) Apparent Authority: Created by manifestations by Principal to a

3rd party. 1. Manifestations must be attributable to the Principle. §8 & §27. 2. Must get to the 3rd party3. Must lead the 3rd party reasonably to conclude that the agent is an

agent for principal.

ANALYSIS: 1) is there an agency relationship, 2) Is there express or apparent authority to act (cite the elements of express and apparent - §§26, 27. Finally, apply §140 to determine if the principal will be liable to the 3rd party for the agent’s actions.

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(iv)Respondeat Superior : A principal may be liable even though he is not personally negligent. 1. Does not apply in all cases of agency .

a. Applies only to a subset of principal and agent relationships called “master/servant.” RSA §220. i. Master has the right to control the details of how the servant

does the job. ii. Master has control over the day to day performance of the

agent’s task. iii. Master is liable for the torts of a servant only if the tort was

committed within the scope of employment. RSA §219b. Servant must be distinguished from an independent contractor,

who is hired to do a job, but is not told specifically how to do it. i. Servant : §2 states that a servant is employed by a master to

perform a service in his affairs whose physical conduct in the performance of the service is controlled or is subject to the right of control.

ii. Torts of ICs are generally NOT attributable to the person who hires him.

iii. Vicarious tort liability comes from the fact that the person engaging someone controls the details of how the job is to be done.

HAYES V. NATIONAL SERVICE INDUSTRIES, INC – (1999)FactsHayes sued NLS and its parent company alleging wrongful discharge from her employment as a sales representative. The attorney for the 2 parties settled the case. Hayes rejected the settlement, and National filed a motion to enforce the settlement agreement.

Lower court found that there was at least apparent authority despite the fact that the attorney believed he had actual authority to settle the case.

HoldingThe attorney’s authority is determined by the representation agreement between the client and the attorney and any instructions given by the client.

The client is therefore “bound by his attorney’s agreement to settle a lawsuit, even though the attorney may not have had express authority to settle, if the opposing party was unaware of any limitation on the attorney’s apparent authority.

NOTES- The law of agency provides the foundational structure for many of the legal

consequences that follow from the relationship between a lawyer and a client, as well as the relationship between an individual and a law firm.

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Franchises and other Business Relationships- An agency relationship involves consent and control, but an agency will arise if a

franchisor/principal has the requisite degree of control over the franchisee/agent, notwithstanding the customary boilerplate provision in the franchising agreement that the parties do not intend an agency relationship.

MILLER V. MCDONALD’S CORPORATION – (1997); FRANCHISORS AND VICARIOUS LIABILITY

FactsMiller bit into a Bic Mac and suffered an injury when she bit into a heart-shaped sapphire stone embedded into the sandwich. The trial court granted summary judgment to McDonald’s on the ground that it did not own or operate the restaurant, but was a mere franchisor and 3K was the proper party to sue.

3K owned the restaurant under a license agreement with McDonald’s that required it to operate in a manner consistent with the McDonald’s System. This agreement specified numerous different things that had to be strictly complied with.

Despite the numerous specifications that 3K was bound to uphold, there was a provision that stated that 3K was not an agent of McDonalds, but an IC, and any claims by a 3rd party would be solely against 3K.

IssueWhether there is evidence that would permit a jury to find McDonalds vicariously liable for those injuries because of its relationship with 3K.

HoldingReversed. There is sufficient evidence to raise a jury issue under both actual agency and apparent agency principles.

- Miller went to the restaurant under the assumption that McDonald’s owned, controlled, and managed it.

o Therefore, Miller was justifiably relying on McDonalds. If the franchise agreement goes beyond the stage of setting standards,

and allocates to the franchisor the right to exercise control over the daily operations of the franchise, an actual agency relationship exists.

The court believes that a jury could find that McDonald’s retained sufficient control over 3K’s daily operations that an actual agency relationship existed.

McDonald’s required precise methods that 3K must fulfill McDonald’s regularly sent inspectors McDonald’s uniforms, menus, recipes, etc. were to be used.

- RSA §267 – Apparent Agency

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o “One who represents that another is his servant or other agent and thereby causes a 3rd person justifiably to rely upon the care or skill of such apparent agent is subject to liability to the 3rd person for harm caused by the lack of care or skill of the one appearing to be a servant or other agent as if he were such.”

The crucial issues are whether the principal held the 3rd party out as an agent and whether the plaintiff relied on that holding out.

It seems clear from the requirement of uniformity with other McDonald’s restaurants that 3K was an apparent authority of McDonald’s and that Miller was justifiably reasonable to believe that she was eating at a McDonald’s restaurant.

How does a Sole Proprietorship Grow?

Funding by the Ownerj) A business is often at greatest risk when it is just starting.

i) 1st investment into a business almost always comes from the owner. ii) When money goes into the business, it goes in as an investment (“equity”), not as a

loan to be repaid to the entrepreneur.

k) Overview of Debt and Equity i) All financing for a business is either 1) debt or 2) equity or 3) some combination of 1

and 2. (1) Debt Funding : A loan that the business is legally obligated to repay – generally

with interest. (2) Equity Funding : An investment that the business receives for selling part

ownership in the business.

(3) Differences(a) When a business borrows money, the creditor is entitled to receive both

repayment of the amount borrowed (“principal”) and interest on that principal, according to a set schedule.

(b) If someone provides equity funds the business is NOT legally obligated to pay anything, although the business may choose to distribute some cash as dividends.

1. Main Benefit of equity holders is ownership interest in the firm. a. However, the equity owner has no right to repayment if the

business fails. (c) Debt has a fixed cost: the interest rate the business pays to borrow the money

is the cost of those funds. (d) If equity is sold to investors, then those investors share in the success of the

company. (i) Owners give up a certain measure of control when they give up

equity.1. The investors have a right to have a voice in how we run the business.

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l) Borrowing Moneyi) People can do several things to structure a loan so it will be perceived as low risk

(1) Pledge personal or corporate assets against the loan, as a form of collateral(2) Promise to pay the $$ back in a short time(3) Give the creditor some measure of control over the business

(a) Seat on the board of directors of a corporation, for example.

m) Sharing Profits with a Lenderi) The ultimate issue concerning whether a payment is a loan or an equity investment

has significant legal meaning.

IN RE ESTATE OF FENIMORE – (1999); SHARING PROFITS IS A PARTNERSHIP!!!FactsMrs. Serge’s brother had borrowed an excess of 12.5K over the course of a few years. Subsequent to Serge giving the money to her brother, they entered into an agreement by which the brother and Serge would “divide the profits from each vehicle bought and sold.” The agreement does not specify the giving of the money as a loan, but as an “advance.”

Upon the brother’s death, Villabona came to collect on the brother’s debts to them. Serge did likewise.

Serge argues that she gave a loan to her brother, and therefore the money remaining should first go to her. She doesn’t want the court to consider her a partner with her brother because then the creditor (which she would be if she is considered to have given a loan) gets paid first.

HoldingThe Court found that a partnership existed because she was to receive a share of the profits and the allocation of expenses.

It is not essential to the existence of a partnership that all partners have the right to make decisions and a duty to share liabilities on dissolution, but at least one of these factors must be present.

Partnerships – Chapter 3

Partnership: A business with more than one owner. - All statutory and common law definitions of a partnership refer to owners, plural.

UPA §6(1)- Partnership: “An association of two or more persons to carry on as co-owners a

business for profit.” o Obligations of a business operated as a partnership are also the obligations of its

owners.

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- A partnership, however, in some other respects, is treated legally as an entity separate from its owners.

o RUPA §201 Partnership: “An entity distinct from its partners.”

UPA - Embraces an “aggregate theory”

o It considers a partnership not as a separate legal person but rather is merely the aggregate of its partners.

Distinction without significance. - Partnership itself DOES NOT pay tax on its profits

o Partners pay tax on any distribution made to them.

- What is Partnership Law? o Deals with the rights and obligations of partnerships and the rights and obligations

of the partners. Case law remains an important part of partnership law.

Interprets the provisions in partnership statutes, as well as gaps in these statutes.

- UPA §5 and RUPA §104o “the principles of law and equity” govern to the extent not provided by statute.

- Primary Source (1) The partnership agreement

(a) Relations among the partners and between the partners and the partnership are governed by the partnership agreement. (i) If the partners fail to agree upon a contrary rule, RUPA or the UPA will

provide the default rule. (b) Therefore, the UPA and RUPA are fallback provisions

(i) Apply only if the partners have not agreed to the contrary. 1. Businesspeople should be left to structure their relationship as best

suits them.

- Legal Problems in Starting a Partnershipo Both sole proprietorships and partnerships do NOT require paperwork to establish

them. A partnership is assumed if more than one person shares in a

business’ profits regardless of the persons’ intentions.

o Although partnership agreements are not legally required, in the real world these documents are extremely important.

Partnership agreements are CONTRACTS Partnership agreements can change much of the statutory law that

otherwise would govern.

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o For those people who do not form agreements, UPA and RUPA provide reasonable rules that most people would put in a partnership agreement if they had created one.

Problems in Operating a Business as a Partnership- Under both UPA and RUPA, partnerships can and do own property.

o The individual partners do NOT own partnership property.

Who decides what the Partnership will do?- Questions regarding who makes decisions for a partnership arise in two ways:

o Disputes between the partnership and some “outside” 3rd party.o Disputes among the partners.

Look to the partnership agreement first, then to provisions of relevant partnership statute, and then common law agency principles.

MEINHARD V. SALMON – (1928)FactsSalmon and Meinhard entered into an agreement whereby Meinhard would provide $$ for renovations to a building in exchange for a share of the profits from the building over the course of a 20 year lease. The agreement also provided that Salmon and Meinhard were to share any losses equally but that Salmon had the sole power to manage the building.

Right before the 20 year lease expired, Gerry approached Salmon with a proposal. Gerry wanted someone to lease all of these properties, to destroy the existing buildings, and to put up a new, single, larger building.

Salmon accepted Gerry’s proposal and entered into a lease and development agreement with Gerry. Meinhard was not a party not a party to this agreement, but when he learned of the deal, he sued.

HoldingMeinhard and Salmon were co-adventurers, subject to fiduciary duties akin to those of partners. Joint adventurers, like copartners, owe to one another, while the enterprise continues the duty of finest loyalty.

- To the eye of an observer, Salmon held the lease as owner in his own right, for himself and no one else. He held it for himself and another, sharers in a common venture.

o If this fact had been known to Mr. Gerry, he have laid before both Salmon and Meinhard his proposal.

- The very fact that Salmon was in control with exclusive powers of direction charged him the more obviously with the duty of disclosure, since only through disclosure

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could opportunity be equalized. o Authority is abundant that one partner may not appropriate to his own use a

renewal of a lease, though its term is to begin at the expiration of the partnership.

- A managing co-adventurer appropriating the benefit of such a lease without warning to his partner might fairly expect to be reproached with conduct that was underhand, or lacking in reasonable candor.

DissentThere was no general partnership, merely a joint venture for a limited object, to end at a fixed time. The new lease, covering additional property, containing many new and unusual terms and conditions, with a possible duration of 80 years, was more nearly the purchase of the reversion than the ordinary renewal with which the authorities are concerned.

NOTESWhen there is a fiduciary relationship, there is, at a minimum, a duty to disclose business matters.

- §404: General Standards of Partner’s Conducto §404(a)

Loyalty and care owed to the partners and partnershipo §404(d)

(ii) Good faith and fair dealingo These obligations cannot be eliminated, but can be modified to a degree.

§1031. If the modification is reasonable, then it is not violative.

a. In many cases, however, an elimination of a certain duty will be violative.

Who is Liable for What to Whom?- Liability of the Partnership

o A partnership is a legal person or entity. Thus, a partnership can be held liable and can sue or be sued.

A third party can sue the partnership for the contracts entered by its agents and for the torts committed by its agent.

- A partner can sue the partnership to enforce her rights under RUPA or the partnership agreement.

Liability of the Partners

- Under RUPA, partners are jointly and severally liable for all obligations of the partnership. §305, 306, and 307.

o UPA §15

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Partners are jointly, but NOT severally liable in contract but jointly and severally liable in tort.

o With joint liability, the plaintiff must sue all of the partners together in a single suit.

With joint and several liability, however, the plaintiff is free to sue one or more of the partners.

- §306o All partners are liable jointly and severally for all obligations of the partnership

unless otherwise agreed, and in those situations in (b) and (c) Person admitted as partner is not liable for any partnership obligation

incurred before he becomes partner. Applies to LLPs only – See page 30.

§307 – Actions by and Against Partnership and Partners - A partnership may sue and be sued

o An action may be brought against the partnership and, to any extent not inconsistent with §306, any or all partners in the same action.

A judgment against partnership is not itself a judgment against a partner. A judgment against a partnership can’t be satisfied from a partner’s

assets unless there is also a judgment against that partner.

- A person trying to secure $$ of a partner may not get the assets of the partner to satisfy a judgment based on a claim against the partnership unless the partner is personally liable for the claim under §306 AND:

o A judgment based on the same claim has been obtained against the partnership and a writ of execution on the judgment has been returned unsatisfied in whole or part.

Huh? You cannot go after a single partner’s assets unless you first

exhaust the partnership’s assets first AND the partner is personally liable.

How Does a Partnership Business Grow?- Requires $$$ which usually comes from one of four sources:

o Existing Ownerso “Outside” Lenders

- New Investors- Earnings from the Business Operations

Existing Owners- There is no statutory requirement that partners make initial or additional capital

contributions.o Partners themselves agree on capital contributions

- Look to the partnership agreement.

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o Properly drafted, such provisions will state: Vote or events that trigger the obligation to contribute Amount of each partner’s contribution obligation Time in which to make the additional contribution Consequences of a failure to contribute.

Outside Lenders

- Bankso See Chapter 2’s discussion concerning what a business can do in order to make a

business venture appear less risky to a bank.

Additional Owners (i.e. Investors)

Financial Issues- Again, investors are going to be balancing risk and return.

o If risk is high, then the short or long-term return to the investor has to be high to induce the investment.

- Common Method of Measuring Return on Investmento Compare the amount of cash flow (i.e. the cash from business operations that

could be paid to the business’ owners) with the amount of the owner’s investment in a business.

An owner’s risk ad his “return on equity” are affected not only by the business’s cash flow but also by the business’s financial structure.

The higher the amount of debt a business has, the higher the risk to the owner, and the higher the rate of “return on equity” that the investor will look for.

Legal Issues

Approval of New Partners- RUPA §401(i)

o Requires consent of all existing partners unless the partnership agreement provides otherwise.

Liability of New Partner- §306(b)

o A new partner is not personally liable for partnership obligations “incurred before the person’s admission as a partner.”

Earnings from Business Operations- Partnerships should evaluate whether he partnership can earn a higher return than the

partners could earn individually if the money were distributed to them.

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o Earnings should be distributed unless the partnership has some lucrative use for the funds.

How do the Owners of a Partnership Make Money?- Salary

o Receiving all or part of the profits from that businesso Law is found in the partnership agreement and other contracts and laws.

§401(b) “Each partner is entitled to an equal share of the partnership profits

and is chargeable with a share of the partnership losses in proportion to the partner’s share of the profits.”

- Selling her interest in the business o Sale of Ownership Interest to 3rd Party

Problems Finding a buyer Gaining any necessary approval from existing partners Dealing with the question of “inherited” obligations

(c) RUPA §502(i) “The only transferable interest of a partner in the partnership is the

partner’s share of profits and losses of the partnership and the partner’s right to receive distributions.”

(2) Sale of Ownership Interest Back to Partnership(a) It is common for the partnership agreement or some separate agreement

among partners to provide for sale of partnership interests back to the partnership or to other partners.(i) “Buy-Sell” Agreements

1. Should address the following:a. Remaining partners obligation to buy or do they have the option to

buy?b. The events which trigger an obligation or optionc. How the selling partner’s interest is to be valuedd. Method of funding the paymente. ***Pay attention to tax effects!!

(3) Withdrawal of a Partner(a) UPA §29

(i) Dissolution : 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.

(b) UPA §30(i) On dissolution the partnership is not terminated, but continues until the

winding up of partnership affairs is completed. (c) Winding Up : A liquidation of the business, after which the partnership will

actually terminate. (d) RUPA §602

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(i) Any partner has the “power” to dissociate withdraw at any time. 1. If the withdrawal or dissociation violates the partnership

agreement, or occurs before the expiration of the partnership term, or satisfies any other circumstance set out in §602(b), it is “wrongful.” a. If the dissociation is wrongful, the partner may be paid less than

otherwise for her partnership interest and, more importantly, may be paid later. RUPA §602(c)

(e) RUPA §701: Purchase of Dissociated Partner’s Interest(i) If partner dissociated from partnership his buyout price will be determined

by (b).(ii) Buyout price is the amount that would have been distributable to the

dissociating partner under 807(b) if, on the date of the dissociation, the assets of the partnership were sold at a price equal to the greater of the liquidation value or the going concern value without the dissociated partner.

CREEL V. LILLY – (1999)FactsIn 1993 Mr. Creel began a retail business selling NASCAR racing memorabilia. In 1994, Creel entered into a partnership agreement with Lilly and Altizer to form a general partnership called “Joe’s Racing.” 9 months later, Creel died. His wife demanded that the partnership liquidated all of its assets in order to determine the proper amount to be given to Creel’s estate. The partners refused.

In their partnership agreement, there was a crudely prepared section entitled “termination.” See page 117.

IssueWhether Maryland’s UPA permits the estate of a deceased partner to demand liquidation of partnership assets in order to arrive at the true value of the business.

Holding- WHEN CONFLICTS BETWEEN PARTNERS ARISE, COURTS MUST FIRST LOOK TO THE

PARTNERSHIP AGREEMENT TO RESOLVE THE ISSUE. o The “termination” provision is really discussing the dissolution of the partnership

and the attendant winding-up process that ultimately led to termination. Paragraph 7(a) was

- Maryland’s UPA does not grant the estate of a deceased partner the right to demand liquidation of a partnership where the partnership agreement does not expressly provide for continuation of the partnership and where the estate does not consent to continuation.

o To hold otherwise vests excessive power and control in the estate of the deceased partner, to the extreme disadvantage of the surviving partners.

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Paragraph 7(a) requires that the assets, liabilities, and income be “ascertained,” but it in no way mandates that this must be accomplished by a forced sale of the partnership assets.

o In this case, the winding up method was outlined in 7(a) was followed exactly by the surviving partners.

Further 7(d) makes no mention of a sale or liquidations being essential in order to determine the deceased partner’s proportionate interest of the partnership.

7(d) more appears to be a crude attempt to draft a “continuation clause” in the form of a buy out option by providing that the deceased partner’s share of the partnership goes to his estate, and if the estate wishes to sell this interest it must first be offered to the remaining partners.

o When subsections (a) and (d) of paragraph 7 are read in conjunction, it is apparent that the partners did not intend for there to be a liquidation of all partnership assets upon the death of a partner.

- Further, where the surviving partners have in good faith wound up the business and the deceased partner’s estate is provided with an accurate accounting allowing for payment of a proportionate share of the business, then a forced sale of all partnership assets is unwarranted.

NOTESBook Value: The cost of inventory.

G. Partnership Endgame

1. Dissolution, Winding Up and Termination as Endgame for the Partnership

- Under RUPA, the partnership faces 2 choices when a partner dies or otherwise withdraws from the partnership:

o The remaining parties can purchase the departing partner’s interest and continue the partnership business [§701(a)-(b)], or

o The partnership can dissolve, liquidate, and terminate. [§807(b)]

- Dissolution is not the end of the partnership. o It is the beginning of the end.

Comment 2: RUPA §801 “Dissolution” is merely the commencement of the winding up

process. o Partnership continues for the limited purpose of

winding up the business. Winding up the partnership business entails selling

its assets, paying its debts, and distributing the net

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balance, if any, to the partners in cash according to their interests.

The partnership entity continues, and the partners are associated in the winding up of the business until winding up is completed.

o When the winding up is completed, the partnership entity is terminated.

o The problems of a dissolving partnership’s distributions to the partners “according to their interests” can be much more complicated, if the partnership agreement does not fully address the problems.

RUPA provides default rules to address the problems in §§401 and 807. 4 basic concepts that need clarification:

o Unless the partners agree to the contrary, They share responsibility not only for losses from

partnership business but also for partners’ losses from investments in the partnership. §401(b)

Amount of each partner’s loss from her investment in the partnership is determined from her partnership account, a bookkeeping device which keeps track of how much a partner puts into the partnership, how much she has taken out of the partnership, and her share of the partnership’s profits and losses. §§ 401(a), 807(a)-(b).

When the partnership is dissolved, the partnership is legally obligated to pay each partner an amount measured by the balance in her partnership account. §807(b).

- Summarizing §401, the amount in each partner’s account will be:o Investment in partnership (-) Distributions received (+) equal share of

anything left over after creditors are paid. If there are insufficient funds to cover the creditors, this loss will be

divided equally among the partners’ accounts. If a partner has a negative balance in his account (for whatever

reason), he will have to contribute additional funds to the partnership in the amount of the negative balance. §807(b).

KOVACIK V. REED – (1957)Facts

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In 1952, Kovacik and Reed entered into a joint venture whereby Kovacik would invest about 10K into a venture for some remodeling work for Sears. Kovacik said he would supply the investment if Reed would perform the labor and they would split the profits 50/50. Kovacik did not ask Reed to agree to share any loss that might result and Reed did not offer to share any such loss.

In 1953, Kovacik informed Reed that the venture had been unprofitable and demanded contribution from Reed as to amounts which Kovacik claimed to have advanced in excess of the income received from the venture.

Procedural HistoryTrial court concluded that the two were to share equally all their joint venture profits and losses between them.

IssueWhether or not a co-venturer who invests only his labor into a project can be held liable for financial loss as a result of the venture.

Holding- General Rule:

o In the absence of an agreement to the contrary, the law presumes that partners and joint adventurers intended to participate equally in the profits and losses of the common enterprise, irrespective of any inequality in the amounts each contributed to the capital employed in the venture, with the losses being shared by them in the same proportions as they share the profits.

- Exceptiono Where one partner or joint adventurer contributes the money capital as against the

other’s skill and labor, neither party is liable to the other for contribution for any loss sustained.

- Rationaleo Where one party contributes money and the other contributes services, then in the

event of a loss each would lose his own capital – the one his money and the other his labor.

**In this case, the partnership had already paid its obligations to creditors; it had paid these 3rd parties with partnership funds that had been invested in the partnership by Kovacik.

- The partnership had ended. It had no more debts. o The question was not whether creditors of the partnership would recover on their

claims, but whether Kovacik would recover anything on his investment in the partnership.

Unless it is answered in the partnership agreement, that question will be answered by RUPA §807.

2. Expulsion as an Endgame for a Partner

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- Expulsion is not expressly dealt with by RUPA.

BOHATCH V. BUTLER & BINION – (1998)FactsBohatch became an associate at the officers of Butler & Binion in 1986. She was made partner in 1990 and began receiving internal firm reports showing the number of hours each attorney worked, billed, and collected.

She became concerned another partner was overbilling, so she met with the managing partner and discussed this. Shortly thereafter she was told that she should begin looking for other employment. In 1991 the firm denied her a year end partnership distribution for 1990 and reduced her tentative distribution share for 1991 to 0. In September, she found new employment. She filed this suit in October 1991, and the firm voted formally to expel her from the partnership 3 days later.

IssueWhether there should exist an exception to this rule by holding that a partnership has a duty not to expel a partner for reporting suspected overbilling by another partner.

Holding- General Rule:

o The relationship between partners is fiduciary in character, and imposes upon all the participants the obligation of loyalty to the joint concern and of the utmost good faith, fairness, and honesty in their dealings with each other with respect to matters pertaining to the enterprise.

A partnership exists solely because the partners choose to place personal confidence and trust in one another.

Charges of overbilling may have a profound effect on the personal confidence and trust essential to the partner relationship.

- The firm did not owe Bohatch a duty not to expel her for reporting suspected overbilling by another partner.

PAGE V. PAGE – (1961)FactsThe partners entered into an oral agreement in 1949 as partners in a linen supply business. Each had invested about $43,000 for the purchase of land, machinery, and linen needed to begin the business.

From 1949 to 1957 the enterprise was unprofitable, losing about $62,000. The partnership’s major creditor was a corporation, wholly owned by the plaintiff that supplies the linen and machinery necessary for the day to day operation of the business. This corporation held a $47,000 demand note of the partnership.

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Shortly thereafter, the business began to improve. However, dispute this, the plaintiff wished to terminate the partnership.

ArgumentsDefendant believes that plaintiff is acting in bad faith and is attempting to use his superior financial position to appropriate the now profitable business of the partnership.

IssueCan a partner withdraw from a partnership so he can take the partnership’s business for himself?

Holding- There is no showing of bad faith or that the improved profit situation is more than

temporary. o Even though the UPA provides that a partnership at will may be dissolved by the

express will of any partner, this power, like any other power held by a fiduciary must be exercised in good faith.

Partners may not obtain any advantage over him in the partnership affairs by the slightest misrepresentation, concealment, threat, or adverse pressure of any kind.

- A partner at will is not bound to remain in a partnership, regardless of whether the business is profitable or unprofitable.

o A partner may not, however, by use of adverse pressure “freeze out” a co-partner and appropriate the business to his own use.

A partner may not dissolve a partnership to gain the benefits of the business for himself, unless he fully compensates his co-partner for his share of the prospective business opportunity.

- Plaintiff has the power to dissolve the partnership by express notice to defendant. o If it is proved that plaintiff acted in bad faith and violated his fiduciary

duties by attempting to appropriate to his own use the new prosperity of the partnership without adequate compensation to his co-partner, the dissolution would be wrongful and the plaintiff would be liable.

Chapter 9: Limited Partnership and How Does it Work?

A. What is a Limited Partnership and what is Limited Partnership Law?

- The most obvious difference between a limited partnership and a general partnership is that a limited partnership has limited partners.

o Limited partnership (LP) must have at least 1 general partner. Limited partners are not personally liable for the debts of the limited

partnership. The general partners have the same rights and duties as partners in

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a general partnership. - Because of the hybrid nature of LPs, they are subject not only to limited partnership

laws but also to general partnership laws.o RULPA §1105

In any case not provided for in this act, the provisions of the UPA govern.

B. What are the Legal Problems in Starting a Business as a LP?

- LPs to do not come into existence until there has been a public filing, usually with the secretary of state of the state of organization.

o Certificate of Limited Partnership document. The more important document to clients is the LP agreement.

- LP statutes require that:o LP must have at least 1 partner

This general partner, unlike the limited partners, is liable for the debts of the partnership

o The name and the address of the general partner must be set out in the Certificate of Limited Partnership, which is filed in public records.

LP statutes do not, however, require that the general partner be an actual person.

A corporation may be a general partner, for example.

C. What are the Legal Problems in Operating a Business as a LP?

1. Who decides what?

- This is answered in either 1) a LP statute or 2) a LP agreement. o Rule of Thumb: General Partner decides.

RULPA establishes this as a default rule. Unless the LP agreement specifies otherwise, the general partner

has the same rights as a partner in a general partnership. RULPA §403.

NOTE- RULPA §303(b)(6)(v) is the only provision in RULPA relating to removal of a general

partner.

- LPs are not liable for the acts or debts of the LP. o They are more like shareholders of a corporation – they make an investment

(which is at risk), but are not liable for what the business does. As the law developed, it became clear that a LP who exerted “control”

over the business of the LP would become liable for the acts and debts of the business.

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By exercising “control,” the LP had essentially become a general partner for liability purposes.

o §303(a) Even if a limited partner exercises “control,” he will

nonetheless be liable only when he acted in a way that caused a third party to reasonably believe that he was a general partner.

o §303(b) Safe harbor provision which lists activities that will

NOT constitute “control” by the limited partner. - Under ULPA, there is NO CONTROL TEST

2. Who is Liable to Whom for What?

a. To 3rd Parties

- Each general partner of a LP is personally liable for the partnership’s debts to 3rd parties as if the partnership were a general partnership.

o RULPA 403(b) Except as provided in this Act, a general partner of a LP has the liabilities

of a partner in a partnership . . . to persons other than the partnership and other partners.

ZEIGER V. WILF – (2000)FactsZeiger was supposed to receive 27K/year for 16 years after he had sold certain property to Trenton, Inc. The contract for sale stipulated that Trenton could assign its property interests to another entity, and Trenton assigned it to a limited partnership called Trenton LP.

After 2 years, however, the payments ceased due to a failing project and Zeiger sought to hold Wilf personally liable for the payments.

Wilf’s ArgumentHe maintains that in doing so, he was functioning as vice president of the Trenton, Inc. which was the only general partner of the limited partnership.

Holding- Limited Partnership Law establishes a differentiation between the broad liability of a

general partner for the obligations of a limited partnership, and the non-liability of a limited partner for such obligations.

o Zeiger’s argument rests on Wilf’s key role in the renovation project. Wilf acknowledges that role, but argues that his actions were taken as a

VP of Trenton, Inc – the corporation which was the sole general partner of Trenton, LP.

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Since Trenton is an artificial entity, it can only function through its officers, and that is precisely what Wilf was doing at all times when he acted concerning this enterprise.

-o There is no claim that Zeiger was misled, or that he relied on some

impression that Wilf was a general partner of Trenton, LP, and thus there is no basis for any for any finding of personal liability against Wilf.

§303, therefore will not hold Wilf accountable.

b. To the Partnership and Partners

- A general partner in a LP has liability exposure not only to third parties for the obligations of the LP but also has liability exposure to the LP and to the limited partners for breach of fiduciary duties.

KAHN V. ICAHN – (1998)FactsKahn brought this suit on behalf of AREP against AREP’s general partner API, and the general partner’s sole shareholder and CEO ,Icahn.

Kahn alleged that Icahn breached his fiduciary duties to AREP and usurped, for himself, a corporate opportunity of AREP by failing to make the opportunities completely available to AREP and, instead, keeping a percentage of the profits for his other endeavors and ventures.

The agreement between AREP and API provides that the general partner, may “compete, directly or indirectly with the business of the Partnership.”

Holding- Delaware law permits partners to agree on their rights and obligations to each other

and to the partnership.o They may expand or restrict duties as they wish pursuant to the Delaware

Revised Limited Partnership Act. The defendant’s duties to AREP are defined by the Partnership Agreement

that clearly permitted the Icahn Defendants to make the investments without bringing them to the limited partners.

The clause in the partnership agreement was unambiguous that it authorized competition with the partnership.

o Therefore, plaintiffs can hardly be said to have a legitimate expectancy to be informed of relevant investments made by API.

Chapter 10: LLCs

A. What is an LLC and what is LLC Law?

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- An LLC offers all of its owners, generally referred to as members, both:o Protection from liability for business’ debtso Same pass-through income tax characteristics of a partnership

- LLC law is primarily contract law, with state statues being default provisions if there is no contrary provision in the operating agreement.

o Typically, members of an LLC enter an operating agreement, which sets out the rules that govern the firm.

Delaware LLC Statute : Gives great deference to the operating agreement.

B. What are the Legal Problems in Starting a Business as an LLC?

- An LLC is formed at the time of the filing of the initial certificate of formation in the office of the Secretary of State. §DLLCA §18-201.

o The most important document is the Operating Agreement.

What are the Legal Problems in Operating a Business as an LLC?

- Who decides what?o Owners of an LLC can elect the form of management.

Member-Managed Decision-making authority of the members of a member-managed

company is much like that of the partners in a general partnership. Operating Agreement will answer:

o How to determine how many votes each member haso How to determine what matters require more than majority

vote Manager-Managed

Decision-making authority is similar to a corporation with a board of directors.

Operating agreement will answer:o How members elect and remove managers ando What issues require a member vote.

- Who is Liable to Whom for What?

o Members’ Liability to 3rd Parties LLC is an entity, and creditors must collect from the LLC, not its

members. LLC statutes protect the owners from personal liability for these

claims against the company. o There is NO general partner who is liable.

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An advantage over a limited partnership.

o Members’ and Managers’ Liability to the Company A member acquires her ownership interest in a LLC by making or

agreeing to make a payment or other contribution to the company. Look to the operating agreement for specifics!

o Fiduciary Duties Member Managed

Members owe fiduciary duties Manager-Managed

Managers owe fiduciary dutieso Members doe NOT.

LYNCH MULTIMEDIA CORP. V. CARSON COMMUNICATIONS, LLC – (2000)FactsCLR has 3 owners: Lynch, Carson, and Rainbow (hence CLR). Carson was appointed as president of CLR, and was given “general and active management” of CLR’s business, and he carried out order and resolutions of the Board of Managers.

There was an OA which stated that any “opportunity which comes to the attention of a Member to purchase cable television systems . . . shall first be offered to CLR.” Another provision, however, also said that any Member or Manager may engage independently or with others in other business ventures of every nature and description, and would not be deemed improper.

Carson learned of an opportunity that certain cable systems might become for sale. He notified the company, and was essentially brushed off about the prospect. He persevered on the matter, but to no avail, and eventually he purchased the cable systems for himself about 3 years after he first notified the Board of CLR.

Lynch sued Carson, alleging breach of OA, and breach of fiduciary duties.

Lynch’s ArgumentsCarson could not fulfill the duty created by the OA unless he presented the other members with a no-strings-attached purchase offer at a properly called special meeting of the members.

- Carson, however, argues that “offer” simply means that he must notify the members of the opportunity.

IssueWhether Carson, acting as president of CLR, breached his OA and fiduciary duties owed to CLR.

HoldingNo. The interpretation of “offer” proffered by Lynch must be rejected.

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- The provisions must be read in context of the entire OA.o Also, the OA is plainly directed at permitting the members to enter into separate

and additional business relations in the cable television industry. Carson informed the other members of CLR Video of certain opportunities

to purchase cable companies. Only after the passage of several months or years, and at one

point after the rejection of the proposal, did Carson independently acquire the companies.

D. How do the Owners of a Business Structured as a LLC make Money?

- OA provides how and when a LLC’s earnings are to be distributed to its members. o Statutory provisions are default rules: ULLCA §405, for example.

LIEBERMAN V. WYOMING.COM, LLC – (2000)FactsIn 1994, Wyoming was formed by the Mossbrooks and Lieberman. The initial capital contribution to Wyoming was about 50K. Lieberman’s contribution represented a 40% ownership interest in the LLC. In 1995 the OA was amended to reflect an increase in capitalization of 100K due to two new members receiving 2.5% interest. Lieberman’s interest remained the same.

In 1998, Lieberman was terminated as VP of Wyoming and required to leave the business premises. Lieberman then demanded a return of “his share of the current value of the company,” valued at around 400K (which was based on a recent offer from the Mossbrooks. Wyoming accepted his withdrawal and approved the return of his 20K contribution. Lieberman refused to accept.

Procedural HistoryDistrict court granted Wyoming’s motion for summary judgment and denied Lieberman’s motion for partial summary judgment.

Holding- A member’s interest in an LLC consists of economic and non-economic interests.

o One interest is a member’s capital contribution, which a member may withdraw under certain conditions.

A member also generally has the right to receive profits. o A member’s interest usually grants him the ability to participate in management.

Overall, a member’s interest is transferable, although the management rights of a transferee may be limited.

- Court goes on to hold that the Wyoming statutes provide for the return of only the initial

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or stated capital contribution of a member. o Nothing in the statute indicates that the FMV of a member’s interest is to be

included in the amount to be paid to a member upon withdrawal of that member’s capital contribution.

The statute requires that the Articles of Organization be amended when the amount or character of contributions changes.

The amount of a member’s contribution is a constant not subject to market fluctuations.

o Other state statutes allow for the FMV to be distributed, but they contemplate dissociation, which isn’t present here.

- However, the court says that Lieberman has NOT forfeited his interest upon his withdrawal b/c he did not have an intent to do so.

o The fact that he demanded the 400K indicates his unwillingness to forfeit his interest unless paid the 400K.

So the court looks to the Operating Agreement There is nothing in the record indicating what became of

Lieberman’s membership certificate; there is no indication it has been canceled or forfeited.

Chapter 4: Corporations

A. What is a Corporation and what is Corporate Law?

- A corporation is whatever the relevant state law says it is. o Every state has a general corporation statute which provides:

Corporation is a separate legal entity and Owners (shareholders) are generally not personally liable for the debts of

the corporation. No statutory limit on how much money an owner of a corporation

can make from her investment in a corporationo The most that she risks is the amount that she paid for

the shares of stock. This is the limit of her liability .

- Purpose of Corporate Law o The facilitation of cooperative activity that produces wealth.

- Economists View of Corporationso A way to reduce transaction costs as compared to frequent transactions in

markets. o Economists sometimes view the corporation as a set of contractual relationships

among the suppliers of all of the corporation’s inputs. o Economists are concerned about “agency costs.”

Any employee or other agent of the corporation may have an incentive to 30


benefit himself rather than the corporation. Much of corporate law and lawyering attempts to control agency

costs.

- 4 Sources of Corporate Law o State statutes

More than half the states have modeled their statutes in some measure on the MBCA.

o Articles of incorporation (AOIs), Bylaws and other agreements o Case Law

Serves 2 corporate law functions Cases interpret and apply the provisions in corporate statutes and

in a corporation’s articles and bylaws. Cases fill gaps in the law

o Federal statutes There is no general federal corporation statute.

There are important federal statutes that govern certain corporate activities.

B. What are the Legal Problems in Starting a Business as a Corporation?

- Preparing the Necessary Paperso AOIs

A corporation does NOT exist until the AOIs are properly executed and filed with the appropriate state agent or agency.

MBCA §2.03o Where the articles are to be filed

§2.02(a)o What AOIs must contain.

o Bylaws MBCA requires that a corporation adopt bylaws

§2.06(a) Traditionally, this is not required.

In the real world, almost every corporation does have bylaws, so perhaps the MBCA is simply requiring what everyone does anyway.

o Delaware does NOT require bylaws §109

Bylaws are not required to be filed with any state agent or agency They are internal documents.

- Contracting Before Incorporatingo Promoter : Someone acting on behalf of a corporation that is not yet formed.

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- “Secret Profit” Ruleo After a corporation is formed, a promoter might sell property to the corporation.

When this happens, she has a duty to disclose to the corporation any profit she is making.

If she fails to do so, the corporation can recover her “secret profit.” o This recovery emanates from the fiduciary duties that the

promoter owes to the corporation. There is no fiduciary duty and no secret profit

liability for the promoters’ pre-incorporation transactions.

When the corporation comes into existence, the fiduciary duties attach and retroactively prohibit the promoter from making a secret profit on her dealing with the corporation.

o ANALYSIS Has the promoter made a profit?

For property acquired while he was a promoter, the test for profit is the price paid by the corporation minus the price paid by the promoter.

o A promoter is liable to the corporation ONLY if the profit was secret.

- Issuing Stocko Shares of stock are the units of ownership in a corporation.

MBCA §6.03 A corporation may issue the number of shares of each class or

series authorized by the AOIs. o Shares that are issued are outstanding shares until they are

reacquired, converted or canceled. o Corporation sells its own stock

Called an issuanceo AOIs determine the number of shares a corporation may issue

Called “authorized shares”o A corporation is not required to issue all of its authorized shares

Shares that the corporation actually does issue are called “issued shares.” o “Outstanding shares” consist of issued shares that the corporation has not

reacquired A corporation can have more than one type (“class or series”) of stock.

VOCABPreferred Stock: If the AOIs provide that a certain kind of stock is to be treated more favorably than the other class of stock, then it is preferred stock.

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Common Stock: Type of stock that does not enjoy special treatment.

Outstanding Stock: The amount of shares that have been issued and are in the hands of the public.

Par Value: The minimum price for which a corporation can issue its shares. - Par value affects only the issuance price. - MBCA and a majority of statutes have eliminated the requirements that AOIs provide a

par value for stock and that corporations maintain a “stated capital” account.

Stated Capital: Includes the aggregate par value of all issued shares of par value stock. - The stated capital account cannot be distributed to shareholders.

o It is a cushion to protect creditors, to ensure that the company retains at least some money to pay its bills.

Capital Surplus: Excess money from the stated capital which may be distributed to shareholders.

- Choosing the State of Incorporation and Qualifying as a “Foreign Corporation.”o Business can choose to incorporate in any state, even one in which there is no

business activity. The laws of that state will then become the default rules that govern the

“internal affairs.” Internal affairs include procedures for corporate actions and the

rights and duties of directors, shareholders and officers.o Usually, the corporation selects its home state or

Delaware. - Costs of Incorporating in Delaware

o Extra costs to incorporate (attorney’s fees, filing, etc.)o Fees to State of Delawareo Making payments as a foreign corporation

Foreign corporations transacting business in its state to “qualify to do so. Includes:

o Obtaining authorization from appropriate state agencyo Appointing a registered agent in the stateo Filing annual statements in the stateo Paying fees and franchise taxes to the state.

Chapter 5: How does a Corporation Operate?

A. Who is Liable to the Corporation’s Creditors?

- A corporation is an “entity” and a “person.”o It can be sued for the actions of its agents.

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- A shareholder’s protection from personal responsibility for the corporation’s liability is basic to the corporate structure and to corporate law. MBCA §6.22(b)

- There are contractual and judicial exceptions to the rule that shareholders are not personally liable for the acts or debts of the corporation.

o 3rd parties often refuse to extend credit to a corporation with limited assets unless that corporation’s shareholders agree to be personally responsible.

DEWITT TRUCK BROKERS, INC. V. W. RAY FLEMMING FRUIT CO. – (1975)FactsFlemming owned FFC, which contracted with Dewitt for Dewitt to transport fruit that FFC was selling for a 3rd party on commission. Because FFC was struggling financially, Dewitt wanted assurance that Flemming, the principal shareholder, would be personally responsible for payment. He orally agreed to be responsible.

This oral promise was not legally enforceable b/c of the statute of frauds, and so Dewitt asks the court to “pierce the corporate veil.”

Procedural HistoryDistrict Court found that the corporate veil may be pierced and hold Flemming personally liable.

IssueMay the corporate veil be pierced in this situation in order to hold Flemming personally liable for the debts of his corporation?

HoldingYes. The corporate veil may be pierced.

- “Clearly Erroneous” standard applies and the District Court was not clearly erroneous .o General Rule:

A corporation is a separate entity and its debts are not the individual indebtedness of its stockholders.

o Exception: “Piercing the Corporate Veil” The courts will decline to recognize the general rule whenever recognition of the

corporate form would extend the principle of incorporation ‘beyond its legitimate purposes and would produce injustices or inequitable consequences.

Power to pierce the corporate veil is to be exercised “reluctantly” and “cautiously” and the burden is on the party asserting such a claim

- This claim, in every case is to be decided in accordance with its own underlying facts. o Since the issue is one of fact, its resolution is particularly within the province of the

trial court.

Factors to Determine Whether the “Corporate Veil” should be Pierced1. Substantial Ownership of stock in a single individual2. Undercapitalization (i.e. any situation where a business cannot acquire the funds they need).3. Failure to observe corporate formalities (i.e. records, payment of dividends, siphoning, etc).4. Combine #s 1-3 with other factors clearly supporting disregard of the corporate fiction on grounds of equity and fairness.

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**When one induces a creditor to extend credit to the corporation on such an assurance (as that made by Flemming), that fact has been considered by many authorities a sufficient basis to pierce the corporate veil.

NOTES- A corporation can be a shareholder of another corporation.

o Usually, a corporation is often the only shareholder of another corporation. A corporation whose stock is owned by another corporation is commonly

referred to as a “subsidiary.”

Subsidiary: A corporation, a majority or all of the outstanding stock of which is owned by another corporation, called the parent corporation.

- Parent corporations are NOT liable for the contracts, torts, and other obligations of its subsidiary corporation unless there is a contractual or judicial exception to the rule that a shareholder is not liable for the acts or debts of the corporation.

o A corporation may not be held liable for the actions of another company merely because it has an ownership interest in it.

Control Test Liability will be attached to a parent corporation if the parent

company exerts a direct intervention in the transaction, ignoring the subsidiary’s paraphernalia of incorporation, directors and officers.

- Sometimes veil piercing is used, not to impose liability on a corporation’s owners, but instead to create personal jurisdiction over them.

o Personal jurisdiction exists if defendant has “minimum contacts” with the state where the court is located.

Enterprise Liability: Piercing the walls of one corporation, not to go after the assets of a shareholder, but to go after the assets of related companies.

- Corporations that, although technically separate, are commonly-owned and in reality engaged in one enterprise together should be treated as a single legal entity for purposes of liability.

- As the scale of business enterprises enlarged, the process of subdivision began; subsidiary corporations wholly-owned or partly-owned.

o Usually, a single large-scale business is conducted, not by a single corporation, but by a constellation of corporations controlled by a central holding company, the various sectors being separately incorporated.

This is because the corporations were once independent and later acquired by the larger corporation or because the large corporations want to expand into different fields.

B. Who Gets to Make Decisions for the Corporation?

- The answer to “who decides what” varies with the corporation. o Ownership in large corporations is widely dispersedo No single shareholder owned sufficient stock to control the corporation’s agendao Larger the corporation, the smaller the proportion of stock held by management.

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1. BOARD OF DIRECTORS AND OFFICERS

- Generally, if a corporation has more than 4 or 5 shareholders, most shareholders play virtually no role in making decisions regarding the operation of the business.

o Their important decision is when to sell their shares.

- Under the corporation codes of all states, it is the board of directors that is entitled to make the corporation’s most important decisions.

o Shareholders select Board of Directors, who select CEOs and other corporate officers.

A director can also be an officer. “Inside” Directors: Those directors who are also officers “Outside” Directors: Those directors who are NOT officers.

o Board Members are NOT agents of a corporation or its shareholders . AGENCY LAW DOES NOT APPLY TO BOD

AGENCY LAW DOES APPLY TO ITS OFFICERS

MCQUADE V. STONEHAM – (1934)FactsStoneham was majority owner of NEC and McQuade and McGraw each purchased 70 shares of his stock, still leaving Stoneham with a large portion of shares. McQuade had paid Stoneham over 50K for the stock he had purchased. As a part of the transaction, an agreement was entered into whereby Stoneham, McQuade, and McGraw would appoint McQuade and McGraw as directors of NEC.

Stoneham became president and McGraw VP. McQuade became treasurer. This continued for a short time until Bondy was elected to succeed McQuade as treasurer. Apparently, before this had happened, Stoneham had appointed for “outside” directors who all unanimously voted against McQuade in favor of Bondy, with McQuade being the only person voting for himself to remain as treasurer. McQuade was therefore dropped as a director of NEC.

At trial, the evidence was fairly clear that Stoneham got rid of McQuade merely in order to get rid of him.

Holding- Directors are the exclusive executive representatives of the corporation, charged with

administration of its internal affairs and the management and use of its assets. o They manage the business of the corporation.

- Stoneham and McGraw were not trustees for McQuade as an individual. o Their duty was to the corporation and its stockholders, to be exercised according to

their unrestricted lawful judgment. A contract is illegal and void so far as it precludes the board of directors

from changing officers, salaries, or policies or retaining individuals in office, except by consent of the contracting parties.

**Board of Directors (BOD) should manage the business, not the shareholders- Courts will uphold shareholder agreements so long as they do not TOTALLY usurp

or sterilize the Board’s power to manage its affairs

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SIDENOTE- NY has adopted a statute that permits shareholders of corporations with relatively few

shareholders to enter into agreements controlling board decisions.

2. SHAREHOLDER’S DECISIONS INSTEAD OF DIRECTORS’ DECISIONS

VILLAR V. KERNAN – (1997)FactsVillar and Kernan agreed to go into the brick oven pizza business. Villar operated the business and Kernan, the finances. They incorporated, calling it “Ricetta’s,” and Kernan received 51% and Villar receiving 49%. They had orally agreed that “there would never be salaries.”

Later on, the manager of Ricetta’s acquired 1% from both Kernan and Villar.

The relationship deteriorated between Villar and Kernan, and Villar and Stephan tried to buy Kernan out, but he refused. Subsequently, Stephan realigned with Kernan. In 1994, Kernan entered into a “so-called consulting agreement” with Ricetta’s, providing automatic 2K payments to him every week. This agreement was ratified at a BOD meeting where Villar wasn’t present.

Villar’s ArgumentVillar argued that the oral agreement between Villar and Kernan not to receive salaries prevented Kernan from receiving anything.

Procedural HistoryThe Court agreed with Villar on the breach of contract issue.

IssueWhether Main law preclude an action for breach of an oral contract between 2 shareholders of a closely held corporation prohibiting their receipt of salaries from the corporation.

Holding- Because the language of subsection (1) of §618 refers to written agreements between

shareholders, stating that “no written agreement will be invalid,” it is logical to conclude that the legislature intended to validate only written agreements that meet the requirements of the statute.

o To conclude otherwise would nullify the word “written.”

3. SHAREHOLDERS’ DECISIONS ABOUT DIRECTORS AND CUMULATIVE VOTING

- One person can wear several hats simultaneously in the corporate setting. o Ex: 1 person can be a director, an officer, and a shareholder.

This person is subject to different rules depending upon whether she is acting as a director, officer, or shareholder.

- Shareholder’s Role:o Make decisions about directors.

Shareholders elect and remove directors. Del. §211(b); MBCA §8.03(c).

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o In large, publicly-held corporation, the role of most shareholders in electing and removing directors is of little practical consequence.

They own too few shares to have any impact. The shareholders in a position to call the shots will usually be other

corporations that own many shares.

- Straight Voting v. Cumulative Votingo Straight Voting : When there is a separate election for each seat on the board.

Each shareholder gets to cast her number of shares in any way she desires for each of these separate elections.

o Cumulative Voting : One at-large election in which the shareholders cast votes and the top vote getters would win the position.

To Cumulate: Take a person’s shares and multiply by the number of directors to be elected.

Ex: 50 shares x 5 directors = 250 votes. o A person can allocate her votes as she sees fit.

Calculating the Number of Shares needed for a shareholder to elect various numbers of directors:

[(N x S) / (D+1)] + 1o N = Number of directors the shareholder wants to electo S = Total number of shares votingo D = Total number of directors to be chosen at the election

NOTEo This equation gives the total number of SHARES. From

here, multiply this number by the number of directors being voted on. This number gives you the amount of VOTES a shareholder has.

o If one voter’s vote trumps another, then the loser retains their votes (i.e. the votes don’t disappear if voter loses).

- Shareholders’ Voting on Directors’ Decisions on “Fundamental Corporate Changes”o Certain fundamental corporate changes require shareholder approval

Amendment of the AOIs Dissolution Merger Sale of all or substantially all of assets

o Because these things are not routine business decisions, the corporation codes do not leave them entirely to the board of directors.

o 3 Differences b/t Voting on Fundamental Corporate Change and Electing BOD Shareholder vote on election or removal of directors is a shareholder action.

A shareholder vote on a merger or other fundamental corporate change is approval or disapproval of a BOD decision, a reaction to the BOD action.

There may be a supermajority approval requirement NO cumulative voting

- Where Shareholders Vote and Who Votes

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o Annual Meeting : Meeting held once a yearo Special Meeting : Any other meeting held within a year. o Person who has the legal right to vote at an annual or special meeting of

shareholders is the “record owner.” o Record Owners : Owners that the corporation keeps a record of.

The corporation is required to send notice of annual meetings and special meetings to its record shareholders. Del. §213(a); MBCA §§7.05 and 7.20(a).

Who gets Notice/Gets to Vote o The record owner at the record date

The record owners as of that date are entitled to notice and a vote at the meeting.

o §213 – Delaware Earliest Corp. may give notice: 60 days before

meeting. Latest: 10 days before meeting

o §§7.07(b) & 7.05 70 days – Earliest 10 days – Latest

- Who Votes (and what are Proxies)?o A shareholder does not have to be present at the annual or special meeting to vote her

shares. State corporation statutes provide for shareholder voting by “proxy.”

Means that the person who is entitled to vote authorizes another person to vote for her.

o Proxy is a form of agency, and thus a principal may terminate an agent’s authority at any time.

A proxy may be revoked even if it states that it is irrevocable

- Shareholder’s Inspection Rightso Access to the corporation’s books and records can be important to a shareholder who

wants to act in an informed and responsible way in exercising her right to vote. Every state provides for access by statute.

KORTUM V. WEBASTO SUNROOFS, INC. – (2000)Issue1. Whether the inspection rights of a director may be limited by ordering the director not to disclose those records to the 50% stockholder that designated the director as a board member.

2. Whether the plaintiff stockholder’s stated purpose for inspection is bonafide, and if so, whether the scope of inspection relief should be limited b/c of the possibility of conflicting interests between that 50% stockholder and the corporation.

Holding

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No to #1. Yes to #2.

- If a board member or stockholder’s purpose for inspecting a company’s documents is genuine and substantial, then they should have unrestricted access, subject to any reasonable restrictions.

RINGLING BROS ET AL. V. RINGLING; VOTING AGREEMENTS AMONG STOCKHOLDERS

- Generally speaking, a shareholder may exercise wide liberality of judgment in the matter of voting, and it is not objectionable that his motives may be for personal profit, or determined by whims or caprice, so long as he violates no duty owed his fellow shareholders.

o Shareholders may lawfully contract with each other to vote in the future in such way as they from time to time determine.

SEE DEL. §218(C) AND MBCA §7.31 Oftentimes, specific performance will be granted in the event of a

breach.

C. What are the Responsibilities of a Corporation’s Decisionmakers and to Whom are they Responsible?

1. What are the Decisionmakers’ Business Responsibilities?

- Management’s job is to create value for the owners.

Shareholders Derivative Suit: A shareholder sues officers of a corporation on behalf of the corporation.

2. What are the Legal Responsibilities?

A. DUTY OF CARE

(i) Breach of Duty of Care by Board Action

SHLENSKY V. WRIGLEY – (1968); BUSINESS JUDGMENT RULE

FactsStockholder’s derivative suit, alleging that Wrigley was not acting in the stockholder’s best interests by failing to erect lights so the cubs could play night games b/c Wrigley believed that baseball is a “day game.”

IssueWhether a plaintiff may bring a stockholder’s derivative action against the board of directors of a company without asserting fraud, illegality and conflict of interest.

Holding- Directors are the decision-makers of a company.

o They are chosen to pass upon such questions and their judgment unless shown to be tainted with fraud is accepted as final.

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Business Judgment Rule : Court made Rule Courts will respect a business’ call regardless of its stupidity,

unless fraud is involved.

JOY V. NORTH – (1982); BOARD HAS A DEGREE OF RESPONSIBILITY TO THE CORPORATION

FactsNorth was Citytrust’s CEO and Schaff was its CLO during the period in question. Management was completely dominated by North. North also exercise strong control over the activities of the BOD. In fact board members were not given materials or agendas prior to meetings and requests for long range planning documents were left unanswered.

Holding- A corporate officer who makes a mistake as to economic conditions, consumer tastes

or production line efficiency will rarely, if ever, be found liable for damages suffered by the corporation.

o The fact that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.

After-the-fact judgment as to whether a decision was wise cannot be the basis for finding a board liable.

- Business Judgment Rule (BJR) does NOT apply to situations in which the corporate decision lacks a business purpose, is tainted by a conflict of interest, or is so egregious as to amount to a no-win situation.

o Directors who willingly allow others to make major decisions affecting the future of the corporation wholly without supervision or oversight may not defend on their lack of knowledge, for that ignorance itself is a breach of fiduciary duty.

SMITH V. VAN GORKOM – (1985); BOARD MUST MAKE REASONABLY INFORMED DECISION

FactsClass action seeking a rescission of a merger of the corporation into a new corporation. Alternate relief was sought against the BOD. Court of Chancery granted judgment for the BOD, holding that their conduct was not reckless.

HoldingReversed and Remanded. The record compels the conclusion that the BOD lacked valuation information adequate to reach an informed business judgment.

- The BOD didn’t reach an informed business judgment on in voting to sell the company for $55/share pursuant to a merger proposal.

o None of the directors had any prior knowledge that the purpose of the meeting was to propose a cash-out merger of Trans Union.

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- Members of the board were required to rely entirely upon Van Gorkum’s oral presentation of the proposal.

Gross Negligence: Negligence + BJR

(ii) Breach of Duty of Care by Board Inaction

BARNES V. ANDREWS – (1924)FactsAndrews took office as a director and his only attention to the affairs of the company consisted of talks with the president as they met from time to time. During his time as director, a force of officers and employees was hired at substantial salaries. Funds of the company were steadily depleted.

Holding- While directors are collectively the managers of the company they are not expected

to interfere individually in the actual conduct of its affairs. o However, they have an individual duty to keep themselves informed in some

detail, and it is this duty which Andrews failed. Andrews was bound to inform himself of what was going on with some

particularity, and, if he had done so, he would have learned that there were delay in getting into production which were putting the enterprise in most serious peril.

- If there are NO apparent damages, however, a director cannot be held accountable.

NOTES1. Plaintiff must show that a defendant’s dereliction caused harm to the corporation. 2. A complaining shareholder must establish some linkage between the director’s bad behavior and corporate loss- Causation- It must be demonstrated that the accused director’s slothfulness was a cause of the company’s loss. 3. A board has the right to rely on subordinates IF reasonable.

IN RE CAREMARK INT’L, INC. DERIVATIVE LITIGATION – (1996)FactsCaremark, a health provider, settled for violation of Medicaid and Medicare violations for over $250 million. A shareholder’s derivative suit was filed alleging that the directors violated their duty of care by failing to supervise the conduct of Caremark employees. Holding

- Breach of Duty of Care may arise in 2 situations:o Board decision that results in loss b/c decision was ill advised or “negligent.”o Unconsidered failure of the board to act in circumstances in which due attention

would have prevented loss.

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- Where a director exercised a good faith judgment, he or she should be deemed to satisfy fully the duty of attention.

o Absent grounds to suspect deception, neither corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company’s behalf.

Only a sustained or systemic failure of the board to exercise oversight will establish the lack of good faith that is a necessary condition to liability.

NOTE- Criminal violations do not automatically give rise to breach of fiduciary duties.

MCCALL V. SCOTT – (2001)FactsSimilar to IN RE CAREMARK. McCall sustained significant losses b/c of health care fraud. The defendants alleged and the District court agreed that a director need to have intentionally acted to harm the corporation.

IssueWhether there was a substantial likelihood of liability for intentional or reckless breach of the fiduciary duty of care.

Holding- Intentional conduct NOT necessary to be liable and recklessness is not necessarily

intentional. Gross negligence is the standard. o However, it is unclear whether some reckless acts or omissions may be

excluded from the protection of provisions under Del. §102(b)(7) Gross negligence is the standard for measuring a director’s liability for a

breach of the duty of care. Gross negligence does not necessarily include intentional conduct.

Intent – Subjective standardRecklessness – Objective (May not have know, but should have known)

- Sometimes substituted by courts for intent. Gross Negligence – Objective (Slightly less than recklessness; wanton conduct)

- Difference b/t recklessness and gross negligence is unclearNegligence – Objective standard (duty of care and breach)

(iii) The Special Case of Executive Compensation

- Basically, CEOs and similar executives get paid a lot of money. o Shareholders may sometimes sue derivatively, asserting that the directors’

approval of massive compensation violated their fiduciary duties.

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B. DUTY OF LOYALTY

- Duty of Care cases arise when executives or board members were lazy or dumb in the decision making process.

o Duty of Loyalty, however, asserts that the executives or board members were greedy and put their own financial interests ahead of the interests ahead of the interests of the corporations and its shareholders.

(i) Competing with the Corporation

JONES CO., INC. V. FRANK BURKE, JR. – (1954)FactsJones, Inc. began to suffer hard times because of “behavior lapses” by its founder Duane Jones. Several of the company’s officers, while still in its employ, began a new competing agency. They lured to the new agency both Jones’s key employees and many of its clients. Once the new agency got on its feet, the disloyal officers resigned from Jones. Eventually, 71 of Jones’s 132 employees were employed by the new agency.

Holding- The conduct of the individual defendants as officers, directors or employees of Jones

fell below the standard required by the law of one acting as an agent or employee of another.

o Each of these defendants was “prohibited from acting in any manner inconsistent with his agency or trust and was at all times bound to exercise the utmost good faith and loyalty in the performance of his duties.”

(ii) Usurping Corporate Opportunity

NORTHEAST HARBOR GOLD CLUB, INC. V. HARRIS – (1995)FactsHarris was president of a golf club. Over time, she began purchasing property around the golf club, without the BODs knowledge or previous consent. She continued doing this over a period of time. Eventually the BOD brought suit alleging breach of loyalty and usurpation of corporate opportunity.

IssueWhat is the extent of the duty of loyalty?

Whether the opportunity of the golf club “was so closely associated with the existing business activities . . . as to bring the transaction within that class of cases where the acquisition of the property would throw the corporate officer purchasing it into competition with his company.

Holding- Court discussed the Line of Business test: DELAWARE USES THIS TEST

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o If executive or director is aware of a business opportunity that the business is capable of undertaking,

o it is in the line of the corporation’s business, o is of practical advantage to it,o they have an interest or reasonable expectancy in the opportunity, and o by embracing the opportunity, the self-interest of the officer or director will

be brought into conflict with that of his corporation,

Then, the law will not permit him to seize the opportunity for himself.

- Disclosure of the opportunity is a MUST.o The disclosure-oriented approach provides a clear procedure whereby a

corporate officer may insulate herself through prompt and complete disclosure from the possibility of a legal challenge.

The requirement of disclosure recognizes the paramount importance of the corporate fiduciary’s duty of loyalty.

o Corporate opportunity is defined broadly Includes:

Closely related to a business in which the corporation is engaged.

BROZ V. CELLULAR INFORMATION SYSTEMS, INC. – (1996)FactsBroz was a director of CIS and was the sole stockholder and President of RFBC, a competitor of CIS. Mackinac approached Broz about the possibility of RFBC (Broz) acquiring its license. Broz bought the license for RFBC without making formal disclosure to and obtaining the approval of the CIS board, however he did mention it to a couple members of the board.

Also, PriCellular was attempting to acquire CIS.

IssueWhether or not Broz ursurped CIS’s corporate opportunity?

Holding- Although a corporate director may be shielded from liability by offering to the

corporation an opportunity which has come to the director independently and individually, the failure of the director to present the opportunity does not necessarily result in the improper usurpation of a corporate opportunity.

o A corporate fiduciary agrees to place the interests of the corporation before his or her own in appropriate circumstances.

- Court cites GUTH V. LOFT’S elements of Usurpation of Corporate Opportunity

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o A corporate officer or director may not take a business opportunity for his own if:

Corporation is financially able to exploit the opportunity; Opportunity is within the corporation’s line of business; Corporation has an interest or expectancy in the opportunity By taking the opportunity for his own, the corporate fiduciary will thereby

be placed in a position adverse to his duties to the corporation.

- Must look to the totality of the circumstances.o It is a factual question not be decided by reasonable inference from objective

facts.

(iii) Being on both sides of a deal with the corporation (“interested director transactions”)

HMG/COURTLAND PROPERTIES, INC. V. GRAY – (1999)FactsGray and Fieber are two of the five directors of HMG, which bought and sold real estate. HMG was negotiating a major scale of HMG real estate to NAF, with Gray negotiating. Fieber owned an interest in NAF and discloses that interest and abstains from voting on the proposed sale to NAF at the HMG directors meeting.

Gray, in the same position as Fieber, does NOT disclose his interest to HMG and votes on the sale. Fieber knew of Gray’s interest but fails to disclose Gray’s interest to the other directors.

HoldingFieber and Gray breached their fiduciary duties of loyalty and care and defrauded the company.

- Where directors stand on both sides of a transaction, they have the burden of establishing its entire fairness, sufficient to pass the test of careful scrutiny by the courts.

o The concept of entire fairness has two components Fair Dealing

When the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.

Fair Price Relates to the economic and financial considerations of the

proposed merger, including all relevant factors: Assets, market value, earnings future prospects, and any other elements that affect the instrinsic or inherent value of a company’s stock.

- In this case, Fieber and Gray failed to persuade the court that HMG would not have gotten a materially higher value had they disclosed Gray’s interest.

D. Who Sues and Who Recovers? 46


1. WHAT IS A DERIVATIVE SUIT AND WHY DO WE HAVE THEM?

- In a derivative suit, a shareholder sues to vindicate the corporation’s claim. o The suit is “derivative” because the shareholder’s right to bring it “derives” from

the corporation’s right. A small shareholder should not be permitted to tie up a corporation in

expensive litigation without some assurance to the corporation that it will not be out of pocket if the suit is a loser.

Therefore, oftentimes a shareholder is required to send a “demand” to the board, requesting that action be taken on behalf of the company.

EISENBERG V. FLYING TIGER LINE, INC. – (1971)FactsEisenberg owned stock in Flying Tiger, which operated a freight and charter airline. Flying Tiger formed a wholly owned subsidiary, called FTC and FTC formed a wholly owned subsidiary called FTL. Then Flying Tiger merged into FTL, and FTL tool over the airline.

Shareholders, however, received stock in FTC, but not FTL (which ran the business). Eisenberg sued.

Eisenberg’s ArgumentThis action deprived him of any vote or influence over the affairs of the corporation that now runs the airline. He was pissed that he was now the minority owner of a corporation that owned another corporation that ran an airline.

Flying Tiger’s ArgumentEisenberg’s case was a derivative suit and he was required to post a bond.

IssueWhether Eisenberg should have been required to post security for costs as a condition to prosecuting his action.

HoldingNo. Reversed. If the crux of the complaint is injury to the corporation, the suit is derivative. - If the injury is one to the plaintiff as a stockholder and to him individually and not to the corporation, the suit is individual in nature.

- Testo Whether the object of the lawsuit is to recover upon a chose in action belonging

directly to shareholders, OR whether it is to compel the performance of corporate acts which good faith requires the directors to take in order to

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perform a duty which they owe to the corporation, and through it, to its stockholders.

Security for costs could not be required where a plaintiff does not challenge acts of the management on behalf of the corporation.

Eisenberg is claiming that Flying Tiger is interfering with the plaintiff’s rights and privileges as stockholders.

- Where a shareholder sues on behalf of himself and all others similarly situated to enjoin a proposed merger or consolidation he is not enforcing a derivative right; he is, by an appropriate type of class suit, enforcing a right common to all the shareholders which runs against the corporation.

2. HOW DOES A DERIVATIVE SUIT COMPARE TO A CLASS ACTION?

- Although derivative suits and class actions share some characteristics, they are fundamentally different procedural devices.

o Derivative Suit: Plaintiff-Shareholder steps up to assert the corporation’s claim.o Class Action: A class representative sues on behalf of a class of claimants who

are similarly situated. The representative also asserts a personal claim. In a class action, nobody is asserting a claim on behalf of the

corporation.

3. DEMAND ON DIRECTORS

- Statutes impose upon the derivative suit plaintiff a requirement that she make a written demand on the directors that they assert a claim allegedly existing in favor of the corporation.

MARX V. AKERS – (1996)FactsMarx alleged that during a period of declining profitability at IBM the director defendants engaged in self-dealing by awarding excessive compensation to the 15 outside directors on the 18-member board. Marx also appears to allege that the director defendants violated their fiduciary duties to IMB by voting for unreasonably high compensation for IBM executives.

Holding

1. Demand is excused because of futility when a complaint alleges with particularity that a majority of the BODs is interested in the challenged transaction. 2.

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AUERBACH V. BENNETT – (1979); NEW YORK LAW

FactsA derivative suit was brought against 4 board members out of a 15 member board. 3 of the director members of the special litigation committee joined the board after the suit was brought. The special litigation committee dismissed the suit.

IssueWhether the Business Judgment Rule applies in its full vigor to shield from judicial scrutiny the decision of a 3 person minority committee of the board acting on behalf of the full board not to prosecute shareholder’s derivative action.

Holding- While the court may properly inquire as to the adequacy and appropriateness of the

committee’s investigative procedures and methodologies, it may not under the guise of consideration of such factors trespass in the domain of business judgment.

o Proof that the investigation has been so restricted in scope, so shallow in execution, or otherwise so halfhearted as to constitute a pretext or sham, would raise questions of good faith or conceivably fraud which would never be shielded by that doctrine.

If there was a fair process then the BJR applies. If there was not a fair process, then the court will look at the

substance of the decision.

ZAPATA CORPORATION V. MALDONADO – (1981); DELAWARE LAW

Holding- A stockholder does not necessarily have a continuing right to control litigation if the

board dismisses an action.

- A board may delegate authority from the board to disinterested persons, and this committee can exercise all of the authority of the board to the extent provided in the resolution of the board.

2 Step Test applied by the court.

1. Court should inquire into the independence and good faith of the committee and the bases supporting its conclusion. - Corporation should have burden of proving independence, good faith and a reasonable investigation, rather than presuming independence, good faith and reasonableness.

2. Court has discretion in granting the motion. - The court should determine, applying its own independent business judgment, whether the motion should be granted.

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- A board may delegate authority from the board to disinterested persons, and this committee can exercise all of the authority of the board to the extent provided in the resolution of the board.

4. DEMAND ON SHAREHOLDERS

- Before bringing a derivative suit, the shareholder must either:o Make a demand on the corporation’s directors ORo Show that the demand should be excused (futility of demand).

5. RIGHT TO JURY TRIAL

- Because a right to jury trial generally attaches only at law, there may be some question as to whether one can have a derivative suit tried to a jury.

6. COURT APPROVAL OF SETTLEMENT OR DISMISSAL

- In routine, non-representative litigation, the parties may settle at will. o Derivative suits and class actions have more at stake; the named parties are not

the only people who can be affected. A judge is therefore required to police the terms of the proposed

settlement or dismissal to ensure they are fair to everyone before the court and those who are not present but may be affected.

Court has wide discretion to demand that notice be given to people affected, etc.

7. RECOVERY IN DERIVATIVE SUITS

- Recovery in successful derivative case goes to the corporation. o Most courts will allow the successful shareholder to recover her costs from the

losing litigant and her attorneys’ fees from the corporation. o Under some statutes, the defendants may be able to recover their attorneys’

fees from the shareholder if the court finds that she sued “without reasonable cause.”

E. WHO REALLY PAYS?

1. INDEMNIFICATION

- Directors do NOT have a common law right to indemnification for any judgment or settlement that they have to pay or for the litigation costs they incur in connection with their corporate duties.

o An agent has a right to be indemnified by its principal, but a director is not an agent of the corporation.

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The legal bases for a corporation’s indemnification of a director are found in indemnification statutes, AOIs, bylaws and contracts between the corporation and its directors.

These statutes typically distinguish when the corporation is required to indemnify and when the corporation may indemnify a director.

2. INDEMNIFICATION

- MBCA §8.57 authorizes a corporation to buy liability insurance for its directors and officers.

o D&O insurance typically covers “loss” arising from claims made against directors and officers for negligent, rather than intentionally dishonest, conduct causing economic injury.

Most insureds want a broad definition of the term “claim” because most D&O policies provide “claims made” coverage, which is triggered when the claims are made, not when the alleged wrongful conduct occurred.

o Defense costs are incurred by the insureds and typically indemnified by the corporation, which then seeks reimbursement from the carrier for the amounts paid.

Chapter 6: How does a Business Structure as a Corporation Grow?

- Basic Choices for a Business to procure money:o Borrow o Sell interests in corporationo Use earnings if available

A. BORROWING MORE MONEY

Who is going to make the loan? What covenants will the lender require?

Lenders reduce risk by requiring financial and operational commitments from the borrower until loan is paid.

How is the corporation going to service the debt (i.e. Pay the monthly interest and then repay the loan?

What happens if the corporation defaults? Lenders oftentimes require personal guarantees.

B. Issuing More Stock

1. To whom?

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a. Preemptive Rights and other Rights of Existing Shareholders

Existing shareholders can be protected from dilution of their percentage of shares with “preemptive rights.” Preemptive Rights : A shareholder with preemptive rights has the right to purchase that

number of shares of any new issuance of shares that will enable the shareholder to maintain her percentage ownership. MBCA § 6.30

Do NOT provide for automatic preemptive rights. They must be in the AOIs.

Preemptive rights only apply to transactions involving CASH.

BYELICK V. VIVADELLI– (1999)FactsByelick owned 10% of VTIC. The Vivadellis owned the remaining 90%. In 1996, the Vivadellis eliminated the shareholders' preemptive rights which were provided for in the by-laws. VTIC's director’s then issued 50K additional shares to Vivadelli. This reduced Byelick's ownership interest in the company from 10% to 1%.

Byelick alleged that the issuance constituted a breach of fiduciary duty.

Vivadellis' ClaimSay that Byelick's breach of fiduciary duty claim as an attempt to gain preemptive rights, which were lawfully eliminated by a properly conducted board meeting.

Procedural HistoryTrial court denied summary judgment motion.

IssueWas denial of summary judgment proper when Byelick alleged a breach of a fiduciary duty when the Vivadellis eliminated Byelick's preemptive rights, issued 50K extra stocks for themselves thereby diminishing his ownership percentage?

HoldingIssue should be decided at trial. Stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another. - A lawful amendment of a corporation's AOIs to eliminate preemptive rights requires:

No violation of fiduciary duties is involved Procedures required to effectuate such amendment are allowed.

Even where preemptive rights are not provided to shareholders in the AOIs or the by-laws, a director’s fiduciary duty nonetheless constrains the issuance of shares.

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Issuance of shares at favorable prices to directors or the issuance of shares on a non-proportional basis for the purpose of affecting control rather than raising capital may violate that duty.

b. Selling to Venture Capitalists

What and Why is Venture Capital?

Venture capital is a substantial equity investment in a non-public enterprise that does not involve active control of the firm. Most often associated with high-tech companies.

Most companies that seek venture capital are unstable and risky. 1/3 of venture capital-financed companies wind up in bankruptcy.

Venture capitalists demand high returns because the successful 1/3 must cover the losses generated by the other 2/3, as well as the high transactions costs that venture capitalists pay in seeking, monitoring, and evaluating their investments.

Venture Capitalists usually obtain a significant voice in the control of the firm.

Venture Capitalists: A shareholder, but a shareholder with special rights including:1. Downside protection: requires the venture capitalists to be paid first the company's assets

are sold off.2. Upside Opportunities: Right to acquire additional stock at a predetermined price3. Voting and Veto Rights4. Exit Opportunities: Right to sell the shares back to the corporation.

c. Selling to a Person or to the Public

A corporation can sell stock to a few people or to thousands. If a corporation goes “public” there are rigorous registration requirements that federal and

state laws impose on some stock sales.

2. What are the Legal Constraints on How a Corporation Issues its Stock?

a. Registration Requirement for Public Offerings.

(i) Some of what your clients might have learned about securities registration in business school.

Why Go Public Raise money

Public markets are viewed as the largest and least expensive source of capital. How much $$ to Raise

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Most companies tend to use a public offering to raise enough money to meet anticipated needs for at least 2 years.

How many additional shares to sell? Company will first calculate what it is currently worth:

Price/share [x] # of shares outstanding. The price/share is a reflection of the voting that takes place every day in the stock

market on these relative values. The number of shares sold must equal the number bought.

Companies that have not started yet: To calculate current value:

Look at comparables that are publicly traded and determine the market value of these enterprises. Ex: If several fast food chains sell for about 20 times the past year's earnings,

then Bubba's Burritos should be worth about 20 times its expected future earnings. If Bubba's Burrito's expects to earn 10 million, then it should be valued at 200

million. Once the company has estimated what its entire business is worth, it will then divide

that sum by the number of shares outstanding. This results in the value per share.

How does a Corporation make a Public Offering? A public offering is about a registration process filed with the SEC and the marketing of the

stock by an underwriter. An underwriter manages the process of drawing up the offering memorandum that is filed

with the SEC. It is responsible for advice on structuring the offering, pricing the securities, and

maintaining a market for the securities after the offering.

Where does the money come from? Underwriting activities are conducted on either a “firm commitment” or a “best efforts”

basis. Firm Commitment : Underwriter buys all of the shares in the public offering from the

issuing company at the public offering price, less a negotiated discount. Underwriter then resells the shares to other investment bankers and the public. Underwriter bears the risk that the shares cannot be resold at the offering price.

This can be reduced somewhat by ensuring that the offering price is not set until very late in the offering process.

Best Efforts : Money comes from the public, not the underwriter. Rather than buying the stock itself and then reselling it, the underwriter instead uses its best efforts to help the issuer to find buyers for the stock. The corporation bears the risk that shares cannot be sold at the offering price.

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Most underwriters work on a best efforts basis.

(ii) Some of what you can learn about securities regulations from the SEC website.

Federal securities law is a product of the 1929 Market crash and the New Deal of the 1930s. They involve the 1933 Securities Act and the 1934 Securities Exchange Act.

33 Act: Governs the issuance of securities by the corporation itself. Requires a company issuing securities will first file a detailed and extensive

“registration statement” with the SEC and will provide a copy of the main part of that registration statement (“the prospectus” to all people to whom the securities are offered.

34 Act: Provides information to the markets for new securities and resales by requiring many corporations continually to provide detailed public reports about their operations.

Chapter 7: How do the Owners of a Corporation Make Money?

- An owner of a business makes money either because she receives all or part of the money that a business earns or because she sells her ownership interest.

Close Corporation: A business entity typified by 1) a small number of stockholders, 2) the absence of a market for the corporation’s stock, and 3) substantial shareholder participation in the management of the corporation.

- Close corporation shareholders “usually expect employment and a meaningful role in management, as well as a return on the money paid for their shares.”

- Both legislative and judicial efforts have been made to ease the plight of the “oppressed” close corporation shareholder.

o Many state legislatures have amended their dissolution statutes to include “oppression” by the controlling shareholder as a ground for involuntary dissolution of the corporation.

Some courts have imposed an enhanced fiduciary duty between close corporation shareholders and have allowed an oppressed shareholder to bring a direct cause of action for breach of duty.

A. RECEIVING SALARIES FROM THE CORPORATION

- MBCA §8.01: Generally authorizes the board of directors to manage “the business and affairs of the corporation.”

1. Who Decides Which Shareholders Get Salaries?

HOLLIS V. HILL – (2000)Facts

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Hollis and Hill jointly founded FFUSA, which marketed first lien mortgage notes and other non-security financial products. Both were 50% owners of FFUSA, with Hill as president and Hollis as VP. Hill stopped paying Hollis’ salary and rejected all of Hollis’ proposals to resolve the dispute.

During the dispute, Hill took FFUSA annuity business and without Hollis’ knowledge, placed it into a sole proprietorship without first consulting Hollis. Hill stopped sending FFUSA financial reports to Hollis, to which Hollis demanded his right to inspect the reports. They came to a temporary agreement, but problems resurfaced. Eventually, Hill told Hollis that his position commanded no salary.

Hollis filed suit, alleging shareholder oppression.

Procedural HistoryDistrict court, applying Nevada law, concluded that Hill’s conduct was oppressive and ordered him to buy Hollis’ shares in FFUSA. The Court ordered Hill to buyout Hollis for nearly 800K.

IssueWas a duty of loyalty breached by Hill and, if so, whether the district court erred in granting a retroactive buyout remedy?

HoldingYes. A fiduciary duty existed between Hollis and Hill.

- With only 2 shareholders and management responsibilities divided between them, a fiduciary relationship was created not unlike that in a partnership.

o Court concedes that many of the actions by Hill fall within the business judgment rule, they nevertheless held that certain actions by a director, however, receive much different treatment when the corporation only has a few shareholders, including that director.

Close corporations present unique opportunities for abuse because the expectations of shareholders in closely held corporations are usually different from those of shareholders in public corporations.

- Court applies Massachusetts law, and holds that the duty existing between controlling and minority shareholders in close corporations is the same as the duty existing between partners.

o A controlling shareholder cannot effectively deprive a minority shareholder of his interest as a shareholder by terminating the latter’s employment or salary has been widely accepted.

2. What are the Legal Limitations on Salaries?

EXACTO SPRING CORP. V. COMMISSIONER OF INTERNAL REVENUE – (1999)- Courts are not the proper authority to determine appropriate salaries for corporate

officers.

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o Indirect Market Test The owner pays the manager a salary and in exchange the manager works

to increase the value of the assets that have been entrusted to his management

The higher the rate of return that a manager can generate, the greater the salary he can command.

GIANNOTTI V. HAMWAY – (1990)FactsHamway and others filed a complaint against Libbie, alleging that Libbie’s board members were authorizing and making payments from corporate funds to themselves for directors’ fees and officers’ salaries “grossly in excess of the value of the services they have rendered to Libbie.” In facts in 1985, for every dollar of profit earned, the board received $2.67 in compensation. Including other aspects, the ratio of compensation to profits was 4 to 1.

Hamway also charged that Libbie refused to declare dividends on Libbie common stock which should have been declared.

Hamway asked the court to order the liquidation of the assets and business of Libbie.

Procedural HistoryChancellor found in favor of the plaintiffs and ordered the dissolution of the corporation.

IssueWas the BOD’s actions “oppressive,” and if so, was the order of dissolution and liquidation of the corporate assets and business proper?

HoldingYes.

- Oppressive means conduct by corporate managers toward stockholders which departs from the standards of fair dealing and violates the principles of fair play on which persons who entrust their funds to a corporation are entitled to rely.

o Does not necessarily mean fraudulent conduct and is not synonymous with the statutory terms “illegal” or “fraudulent.”

- Further, the court notes that it is hesitant to question the reasonableness of a corporate officer’s compensation when it is set by a disinterested board.

o However, where the directors elect themselves as officers and set their own salaries, it is impossible to have a “disinterested board.”

- Court analyzed the status of the BOD’s employment and determined they were part-time employees with little knowledge of the industry.

o The court applied various factors in its analysis:

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Time spent working Responsibilities Qualifications Knowledge Outside interests Who is actually running the operation

- Because the trial court’s finding of oppression in this case is not plainly wrong or without evidence to support it, the court refused to say that the trial court abused its discretion in decreeing dissolution.

B. RECEIVING DIVIDENDS FROM THE CORPORATION

1. What is a Dividend?

Dividend: A special type of distribution, a payment to shareholders by the corporation out of its current or retained earnings in proportion to the number of shares owned by the shareholder.

- Most corporations do not pay dividends.o This includes closely held corporations

- Under the MBCA §6.40(c), a distribution is proper so long as the corporation is not insolvent and as long as the distribution does not render the corporation insolvent.

o Assets > Liabilities

- Traditional Approach: A > L + Earned Surpluso The distribution may come from different funds or accounts.

Earned Surplus or Retained Earnings : Value generated by the business itself.

Consists of all earnings minus all losses minus distributions previously paid.

Capital Surplus : When a corporation issues par stock, the surplus over the par value may be used to make distributions.

o Stated Capital : The amount of money accumulated as a result of establishing a par value for stock.

May not use this to make distributions .

ZIDELL V. ZIDELL – (1977)FactsZidell owned 3/8 of issued and outstanding stock of 4 affiliated different corporations that bought and sold scrap metal. The other 5/8 was owned by Zidell’s brother and his brother’s son. In 1973, Zidell wanted a pay raise, and the board declined. Zidell resigned.

Prior to his resignation, the customary practice had been to retain all earnings in the business rather than to pay dividends and Zidell agreed while he worked there. However, once Zidell

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quit, he demanded a dividend be paid. A dividend was declared and paid on the 1973 earnings of each corporation.

Arnold contended that these dividends were unreasonably small and not set in good faith.

Procedural HistoryTrial court declined to rule that defendants acted in bad faith but held that larger dividends should have been declared in order to allow Zidell a reasonable return. The court then ordered a much larger dividend than that set by the board.

Holding- Those in control of corporate affairs have fiduciary duties of good faith and fair

dealing toward the minority shareholders. o Insofar as dividend policy is concerned, however, that duty is discharged if

the decision is made in good faith and reflects legitimate business purposes rather than the private interests of those in control.

Factors showing bad faith Intense Hostility Exclusion of Minority from Employment High salaries, or bonuses or corporate loans made to the officers in

control The fact that the majority group may be subject to high personal

income taxes if a dividend is paid Existence of a desire by the controlling directors to acquire the

minority stock interests as cheaply as possible.

SINCLAIR OIL CORPORATION V. LEVIEN – (1971)FactsSinclair (parent corp.) owned about 97% of Sinven’s (a subsidiary of Sinclair) stock and Levien was a minority shareholder. Sinclair nominated all members of Sinven’s BOD, who were not independent of Sinclair. Levien sued Sinclair, alleging that they were paying out too much in dividends (nearly 38,000,000 in excess of its profits).

Levien attacks these dividends on the ground that they resulted from an improper motive – Sinclair’s need for cash.

Procedural HistoryChancellor held that because of Sinclair’s fiduciary duty and its control over Sinven, its relationship with Sinven must meet the test of intrinsic fairness.

Intrinsic Fairness Test- Under this standard, the burden is on Sinclair to prove, subject to careful judicial

scrutiny, that its transactions with Sinven were objectively fair.

Sinclair’s Argument59


The transactions between it and Sinven should be tested by the Business Judgment Rule.

IssueDid the Chancellor err when holding that Sinclair must satisfy judicial scrutiny pursuant to the Intrinsic Fairness Doctrine?

HoldingYes. If a plaintiff can meet his burden of proving that a dividend cannot be grounded on any reasonable business objective, then the courts can and will interfere with the board’s decision to pay the dividend.

- Court does not believe that the Intrinsic Fairness Test (IFT) must be applied to a dividend declaration by a dominated board, but at times it may apply.

o Ex: If there is a case of self-dealing, it will likely apply.

- The BJR should have applied. o The motives for causing the declaration of dividends are immaterial unless

the plaintiff can show that the dividend payments resulted from improper motives and amounted to waste.

2. To Whom are Dividends Paid: Preferred, Participating, Cumulative?

- Although all shares in a particular class must have identical rights, one class can have greater rights, or “preferences,” than another.

Preferred Stock: Class of stock with a preference is generally referred to as “preferred”o A typical preference for a class of stock is priority in the receipt of dividends. o Preferred means “pay first.”

Common Stock: Class without such a preference is generally referred to as “common.”

Preferred Participating Stock: Stock that not only gets paid first, but also gets paid again. These shares get paid pursuant to its preferred stock status and get paid again with the funds that will also be paid to the common stock holders.

Cumulative Preferred Stock

NEED IN-BETWEEN NOTES

What are the Legal Duties Applicable to Buying or Selling Stock?

A. Buying or Selling with Inside Information

DIRKS V. SEC – (1983)Facts

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Dirks received material nonpublic information from “insiders” of a corporation with which he had no connection. He openly discussed the information he had obtained with a number of clients and investors. Some of these persons sold their holdings of Equity Funding securities.

SEC’s argumentWhen tipees come into possession of material ‘corporate information that they know is confidential and know or should know came from a corporate insider,’ they must either publicly disclose that information or refrain from trading.

IssueDid Dirks violate the antifraud provisions of the federal securities laws by disclosing the nonpublic material information?

HoldingNo. Court reiterates the CADY/ROBERTS standard announced in CHIARELLA:

- Two elements for establishing a Rule 10b-5 violation: o Existence of a relationship affording access to inside information intended to

be available only for a corporate purposeo Unfairness of allowing a corporate insider to take advantage of that

information by trading without disclosure. - A duty to disclose under §10(b) does not arise from the mere possession of

nonpublic market information, but only from the existence of a fiduciary relationship.

o There must also be “manipulation or deception.” There must be an inherent unfairness involved where one takes advantage

of information intended to be available only for a corporate purpose and not for the personal benefit to anyone.

An insider will be liable under Rule 10b-5 for inside trading only where he fails to disclose material nonpublic information before trading on it and thus makes “secret profits.”

- There can be no duty to disclose where the person who has traded on inside information was not 1) the corporation’s agent, 2) was not a fiduciary, or 3) was not a person in whom the sellers had placed their trust and confidence.

Court then addressed when a person may inherit a fiduciary duty: - CHIARELLA COURT

o Anyone who regularly receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to disclose.

- Court goes on to hold that a fiduciary duty attaches only when a party has legal obligations other than a mere duty to comply with the general antifraud proscriptions in the federal securities laws.

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o A duty to disclose arise from the relationship between parties and not merely from one’s ability to acquire information because of his position in the market.

This should not be interpreted to mean that tippees always are free to trade on the information.

Some tippees must assume fiduciary duties because the information given to them has been provided improperly.

o A tippee assumes a fiduciary duty to the shareholders only when 1) the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and 2) the tippee knows or should know that there has been a breach.

***Remember the elements for a tippee are derivative. There is no tippee without a tipper who violated a fiduciary duty to the source.

ANALYSISDIRKS RULE: a tippee can be liable but must be derivative from tipper:

1) Tipper liability exists when:a) insider (tipper) breached a fiduciary duty ANDb) tippee knew or should have known that breach occurred ANDc) Insider (tipper) received some personal benefit (not necessarily financial)

2) Classical theory also applies to others who become temporary fiduciaries of corporation

UNITED STATES V. O’HAGAN – (1997); CLASSICAL AND MISAPPROPRIATION THEORIES APPLY

FactsO’Hagen was a partner in a law firm. The law firm represented Grand Met to help them tender an offer to acquire Pillsbury. The offer was announced on October 4, 1988. Although O’Hagen was not working on this transaction, he learned of it. About 2 months before the offer was announced O’Hagen bought Pillsbury stock and options to acquire Pillsbury stock. The stock rose in price after the sale, and O’Hagen sold the stock for a profit of $4.3 million. He was indicted on federal charges.

Procedural HistoryO’Hagen was convicted and the 8th Circuit reversed.

IssueShould O’Hagen be convicted under Rule 10b-5?

HoldingYes. Court discusses the “Classical” Theory and adopts a second “misappropriation theory” of Rule 10b-5.

- Classical Theory

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o Rule 10b-5 is violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information.

- Misappropriation Theory o Purpose: To protect the integrity of the securities markets against abuses by

‘outsiders’ to a corporation who have access to confidential information that will affect the corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders.

o Holds that a person commits fraud in connection with a securities transaction, and thereby violates §10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.

A fiduciary’s undisclosed self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.

A fiduciary who feigns loyalty to the principal while secretly converting the principal’s information for personal gain, defrauds the principal.

ANALYSISRULE: A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to source of information is guilty of violating rule 10b-5.

- RULE 10b-5 can be based on misappropriation of confidential informationo Supreme Court adopts misappropriation theory

2 forms of misappropriation theory: Rule 10b-5: deceptive conduct in connection w/ a securities

transaction knows or has reason to know

RELIANCE ELECTRIC CO. V. EMERSON ELECTRIC CO. – 1972- This case discusses Section 16(b) of the Securities Exchange Act of 1934.

o §16(b) says that a corporation may recover the profits realized by an owner of more than 10% of its shares from a purchase and sale of its stock within any 6 month period, provided the owner held more than 10% both at the time of purchase and sale.

- Ex: R owns no stock in A. He then purchases 15% of A’s stock. That purchase is not

covered under §16(b), because immediately before the purchase, his ownership was zero. Now R buys an additional 5% of A’s stock. That purchase is covered, because he was about 10% when he made this purchase. Now R sells all 20% of A’s stock. That sale is covered because he was above 10% when he made the sale.

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o §16(b) applies only to large corporations – those required to register under §12 of the ’34 Act.

- If the person is an officer or director when he bought or sold, he would be covered by the statute, regardless of how much Bubba’s stock he owned.

- §16(b) ONLY APPLIES WHEN THERE IS A PROFIT FROM PURCHASES OR SALES MADE WITHIN 6 MONTHS OF EACH OTHER.

Common Law Duty of Selling Shareholder

DEBAUN V. FIRST WESTERN BANK & TRUST CO. – (1975)FactsMattison ran a color photography business into the ground after acquiring the majority of shares from First Western Bank (who acquired them as executor of the majority stockholder’s estate.). First Western had knowledge that Mattison had judgments against him for a lot of money, but did not pursue an investigation into the public records where a mass of derogatory information lay.

Two minority stockholders sued First Western, asserting their right to recover for damage caused by First Western.

IssueMay a majority stockholder be held liable to minority stockholders when selling the majority of stock in a company without reasonable investigation?

HoldingYes. First Western owed a duty to the corporation and its minority shareholders to act reasonably with respect to its dealings in the controlling shares with Mattison.

- In any transaction where the control of the corporation is material, the controlling majority shareholder must exercise good faith and fairness “from the viewpoint of the corporation and those interested therein.”

o That duty of good faith and fairness encompasses an obligation of the controlling shareholder in possession of facts such as to awaken suspicion and put a prudent man on his guard that a potential buyer of his shares may loot the corporation of its assets.

A reasonable and adequate investigation of the buyer is necessary.

- Measure of Damages

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o Value of Corporation as a going concern at the time of breach = Corp.’s Assets at time of breach + Goodwill factor (computed on basis of future net income reasonably to be anticipated from Corp.’s past record.).

PERLMAN V. FELDMANN – (1954)FactsFeldmann was the dominant stockholder of a corporation which operated mills for steel sheet production. He sold all his shares to Wilport, end-users of steel, interested in securing a source of supply in a market becoming tight due to the Korean War.

Plaintiff’s ClaimThe consideration paid for the stock included compensation for the sale of a corporate asset, a power held in trust for the corporation by Feldmann as its fiduciary. Thus, Feldmann must account to the non-participating minority stockholders for that share of their profit which is attributable to the sale of the corporate power.

Procedural HistoryCourt below held that the rights involved in the sale were only those normally incident to the possession of a controlling block of shares, which in the absence of fraud or foreseeable looting, was entitled to deal according to his own best interests.

IssueMust Felmann, as a majority stockholder, pay the profit received from his sale of shares to the minority stockholders?

Holding- Both as director and as dominant stockholder, a person stands in a fiduciary relationship

to the corporation and to the minority stockholders as beneficiaries. o The same rule should apply to his fiduciary duties as majority stockholder,

for in that capacity he chooses and controls the directors, and thus is held to have assumed their liability.

Fiduciaries always have the burden of proof in establishing the fairness of their dealings with trust property.

The actions of defendants in siphoning off for personal gain corporate advantages to be derived from a favorable market situation do not betoken the necessary undivided loyalty owed by the fiduciary to his principal.

- The corporate opportunities of whose misappropriation the minority stockholders complain need not have been an absolute certainty in order to support this action against Feldmann.

o When the sale necessarily results in a sacrifice of this element of corporate good will and consequent unusual profit to the fiduciary who has cause the sacrifice, he should account for his gains.

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To Whom May a Shareholder Sell Her Shares?

DONAHUE V. RODD ELECTROTYPE COMPANY OF NEW ENGLAND, INC. – (1975)FactsDonahue, a minority stockholder in a close corporation, was angry that Rodd had purchased Mr. Rodd’s shares without first offering to purchase hers. She sued to rescind Rodd’s purchase of Mr. Rodd’s shares.

Plaintiff’s ClaimDonahue urged that the distribution constituted a breach of fiduciary duty owed by the Rodds to her because the Rodds failed to accord her an equal opportunity to sell her shares to the corporation.

Holding- The close corporation bears striking resemblance to a partnership.

o Just as in a partnership, the relationship among the stockholders must be one of trust, confidence and absolute loyalty if the enterprise is to succeed.

Stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another.

Stockholders in close corporations must discharge their management and stockholder responsibilities in conformity with this strict good faith standard.

o In a close corporation, the corporation cannot discriminate among shareholders when repurchasing shares.

The controlling group may not, consistent with its strict duty to the minority, utilize its control of the corporation to obtain special advantages and disproportionate benefit from its share ownership.

JORDAN V. DUFF & PHELPS, INC. – (1987)FactsD&P was a closely held corporation where Jordan had acquired 188 shares of the company’s outstanding stock. Under his employment agreement, he was obligated to resell his shares back at book value to the corporation upon his leaving the company. He resigned on November 16, 1983, Jordan resigned and Hansen did not volunteer any information about an upcoming merger. As a result, he lost out on about 430K because shortly after his resignation D&P announced a merger.

IssueWas B&P’s failure to disclose the merger to Jordan required, and if so, was the information material?

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Holding- Close corporations buying their own stock, like knowledgeable insiders of closely

held firms buying from outsiders, have a fiduciary duty to disclose material facts. o In this case, whether or not Jordan was defrauded is a question for the jury.

BERREMAN V. WEST PUBLISHING CO. – (2000)FactsPlaintiff former employee alleged breach of fiduciary duty, unfairly prejudicial conduct in violation of a Minn. Stat., and fraud. Plaintiff asserted that West had a duty to disclose to him, before he retired and sold his stock back to the company, that West directors had begun to consider the sale of the company. West merged with (Thomson) ended up paying much more for stocks than Berreman received when he retired.

IssueWas the failure to disclose discussions among West’s own officers about the future of West, and if so, did they violate a fiduciary duty to Berreman by a failure to disclose the fact that they were considering selling?

HoldingIn this case, the court assumed for purposes of the case West was a close-corporation, although they were not sure b/c West had far more shareholders than typical close corporations. The court then held preliminary discussions about merger are not material.

- Information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

- Court then discussed the Probability-Magnitude Test:o Materiality will depend at any time upon a balancing of both the indicated

probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.

Probability : Measured by evaluating the indicia of interest in the transaction at the highest corporate levels

Magnitude : Should be assessed by considering such facts as the size of the two corporate entities and of the potential premiums over market value.

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Documents

BA-Corp. Prof. Matheson