Blaw Final Exam Business

7/30/2019 Blaw Final Exam Business

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FORMATION OF CORPORATIONS

A corporation is an artificial person. For most purposes it has legalpersonality. It has an existence separate and distinct from the peoplewho own or control it.

A corporation has limited liability; the corporation is liable for its debts.Except in certain special circumstances no one else can be heldliable for the corporate debts.

Incorporation:

A corporation can only be created by the action of a government. Inthe United States, corporations are almost always created by a state

government. Originally a state created a corporation when thelegislature passed a special statute creating the corporation. Thestatute enacted by the legislature became the charter (or basic set of

rules) which governed the corporation. During the 19th Century, allstates passed general incorporation statutes. These laws set forththe procedures, which must be followed to create a new corporation.Whenever the provisions of the law are complied with, the state willcreate a new corporation. The process of forming a new corporationis called incorporation.

Under California law the process of incorporation consists of:

1Preparation of the Articles of Incorporation. The articles arethe basic law of the corporation; they may contain any provisionswhich are relevant to the operation of the corporation.

The following things must be includedin the articles:

A) Name of the corporation.

This name must be unique. Even if the name chosen issufficiently different from names already in use to be acceptedby the Secretary of States Office, if the name is similar enoughto the name of a corporation created earlier to cause alikelihood of customer confusion the older corporation maysuccessfully sue the new corporation fortrademark


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infringement. If such a suit is successful, the corporation maybe ordered to select a new name.

B) Name and address of a registered agent for service ofprocess.

Each corporation must designate an agent to receive thenecessary papers if the corporation is sued. The agentsaddress must be within the state of California.

C) Statement of Business Purpose.

If the corporation is intended to be a bank, trust companyorto carry on aprofessional practice, the statement in the

Articles must say so. All other corporations must include astatement saying This corporation may engage in anylawful business purpose. Such a corporation may engagein any legal business other than being a bank or trustcompany or engaging in the practice of a profession (suchas law, medicine or accounting).

D) Capitalization Provisions.

The articles of incorporation must contain a provision statingthe maximum number of shares that the corporation isallowed to issue. If the corporation intends to issue morethan one type or class of shares, each class or type must bespecified in the Articles. (There are two types of shares:common and preferred. The corporation may decide toissue more than one class within each type of share.) Thearticles must contain provisions explaining the rights andprivileges of each type and class of shares. A separatemaximum number of shares must be stated for each class

and type of shares

2Execution of the Articles of Incorporation.

The Articles must be signed by the incorporator. (One incorporator isrequired; more than one may be used.) The only function of theincorporator is the purely formal one of signing the Articles.


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Incorporators have no power over the corporation or liability for itsdebts unless the Articles of Incorporation do not include the names ofthe initial members of the Board of Directors. In such a case theincorporators will have the power to select the initial directors afterthe corporation is formed.

3Submission of the Articles to the Secretary of State.

The Articles must be submitted to the office of the Secretary of Statetogether with the required filing fee. When the staff of the Secretaryof State accepts the Articles the document will be stamped,indicating the date and time of acceptance. At the moment ofacceptance the corporation comes into existence.

Piercing the Corporate Veil:

Usually only the corporation is liable for its debts. Under specialcircumstances the corporate veil can be pierced and the controllingperson(s) may be held personally liable for the corporations debts.

These are the requirements to pierce the veil:

1 The corporation must owe a debt or obligation to the personseeking to pierce the veil.

2 The corporation must be unable to pay this debt.

3 The corporation must be an alter ego of the controlling person.(Alter ego is a Latin term meaning other self) Several types ofevidence can establish that the corporation is the alter ego of thecontrolling person:

a) Commingling of Assets. This takes place when the assets of

the corporation are not kept separate from those ofcontrolling person. It also occurs when the controllingperson uses assets of the corporation for personal purposes.

b) Failure to observe Corporate Formalities. The law imposescertain rules which must be followed in the operation ofcorporations. For example, shareholders meetings and


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directors meetings must be held after proper notice has beengiven to the shareholders or directors. Minutes must betaken at the meetings. Failure to follow these legalrequirements is a ground for piercing the corporate veil.(Under California law a corporation which has no more than10 shareholders may include in its Articles a provisionstating that the corporation will be a close corporation.Such a corporation is not required to observe theseformalities its shareholders may decide to operate thecorporation like a partnership with each of the shareholdershaving an equal role in management. The fact that a closecorporation does not observe these corporate formalities isnotby itself grounds for piercing the corporate veil. Howeverthe veil may be pierced on other grounds. For example, if

such a corporation has commingled its funds with those of itsshareholders, the corporate veil could be pierced for thatreason.)

c) Fraud. If the corporation is used to perpetrate a scheme offraud, this will be a basis for piercing the corporate veil.

EXAMPLE: Martin was the President of Vita Corporation.He used the corporation to solicit people to buy parcels ofland in Baja California which were in fact located underwater. Since the corporation was being used to carry out afraudulent scheme, the corporate veil can be pierced and thecontrolling person Martin held personally liable for thecorporations debts.

d) Undercapitalization. If a corporation was initially set upwithout sufficient capital to meet the obligations, which mightreasonably be expected to arise in the normal course ofbusiness, the corporation is undercapitalized. A corporation

will not be considered undercapitalized simply because itcannot pay its debts. Undercapitalization exists only whenthe corporation began its business without sufficient capitalto meet reasonable expectations, or when at somesubsequent time capital is improperly removedfrom thecorporation leaving it unable to meet the obligations whichmight reasonably be foreseen.


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EXAMPLE #1: Dyno Corporation was established to carryout demolitions of buildings with the use of explosives. Itwas set up with $5000 of paid-in capital; it did not carry anyliability insurance. Dyno Corp. is undercapitalized. The useof explosives in demolition is very dangerous; significantdamage claims against the corporation are easilyforeseeable. Dyno was initially established without sufficientassets to meet these potential obligations.

EXAMPLE #2: Vista Mar, Inc. operated a seaside hotel onMaui. It had been in business for 40 years. It had adequateinsurance coverage. In the fall of 2001, tourists especiallythose from Japan became afraid to travel by air because of

terrorist attacks using hijacked airliners. The hotel soon hadan occupancy rate of less than 10%. Vista Mar therebybecame insolvent and was unable to pay its bills. Vista Maris NOT undercapitalized. It was originally established withsufficient capital. Subsequent economic conditions haverendered it unable to pay its debts, but these subsequentconditions do not cause a corporation to be consideredundercapitalized.

If the corporate veil is pierced, only the controlling person(s) can beheld personally liable liability does not extend to all of theshareholders. Controlling persons are those persons who in thecourse of business operations have the power to determine corporate

policy. Sometimes a group of people collectively have the power todetermine corporate policy; in such a case all of the persons in thegroup can be held personally liable for the debts of the corporationwhen the veil is pierced and the separate existence of the corporationis disregarded.

Promoters Liability

Promoters are persons who bring a corporation into existence theyhave the idea to start it. They pay the attorney to draft the articles,pay the filing fee and take other steps to bring the corporation intoexistence.


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Sometimes promoters enter into contracts on behalf of thecorporation before the corporation comes into existence. In such asituation, since the principal does not exist at the time the contractwas made, the principal is not liable on the contract even after thecorporation has come into existence.

The corporation can become liable on such apre-incorporationcontractonly if the contract is adoptedby the corporation after it islegally formed. Adoption is similar to ratification; it can take placeonly if the corporation has knowledge of all of the material factsconcerning the contract.

Example #1: John, a promoter entered into a contract with Landlordto rent office space for the Bozo Corporation before Bozo was

formed. After the corporation came into existence, its Board ofDirectors passed a resolution to accept the rental contract withLandlord entered into by John. This is express adoption; thecontract is now binding on Bozo.

Example #2: John, a promoter entered into a contract with Landlordto rent office space for the Bozo Corporation before Bozo wasformed. The Board took no formal action concerning the contract, butemployees of Bozo moved into the office space covered by thecontract. Bozo moved furniture into the office and arranged to havephone and internet service connections made to the office. This is anexample ofimpliedadoption. This takes place when the corporationreceives a benefit from the contract.

All of the promoters are liable on a pre-incorporation contract if thecontract is in writing even if the names of the promoters do notappear in the contract. The promoters remain liable on the contracteven if the corporation adopts the contract unless the other party tothe contract agrees to release the promoters from further personal

liability.

Promoters owe fiduciary duties to the corporation and to persons whoare considering making investments in that corporation. Promotersmay not take advantage of the corporation or of the other promoters.


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If any promoter commits a tort in connection with setting up thecorporation, all of the promoters are liable for that tort.


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The power to manage the corporation is held by the Board of Directors.

The Board may delegate powers of management to officers of the

corporation that have been selected by the Board.

There are certain management decisions that can be made only by theshareholders the directors do not have the power to take such decisions.

The actions which can be taken only by a vote of the shareholders are:

1 AMENDEMENT OF THE ARTICLES OF INCORPORATION

The articles of incorporation can only be changed by a vote of the

shareholders; the amendment must then be filed at the office of the

Secretary of State.

2 ELECTION OF DIRECTORS

The shareholders have the power to elect members of the Board of

Directors.

3 MERGER OR CONSOLIDATION

If the corporation is to be combined with another corporation (and the

corporation will in that way cease to exist it will not be the surviving

corporation that merger or consolidation can only be carried out following

a vote of the corporations shareholders.

4 SALE OF ALL (OR SUBSTANTIALLY ALL) OF THE

CORPORATIONS ASSETS

Any sale ofall(or very nearly all) of the assets must be approved by a vote

of the corporations shareholders.


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FORMS OF BUSINESS ORGANIZATION

The most basic and simple form of business organization is the soleproprietorship. This form of business is simply an individual in his or hercapacity as a business owner. The business has no existence separate or distinctfrom that of the owner or proprietor. All property of the business belongs to the

proprietor. The proprietor is personally liable for all debts of the business. Theproprietor makes all management decisions. If additional labor is needed beyondwhat the proprietor can supply, it can be obtained by hiring employees orindependent contractors. If the business requires more capital than the proprietorcan provide, it may be obtained by borrowing.

The amount of capital which a single individual can borrow on his or her own credit

is limited. For this reason other forms of legal organization of business developed.The first of these was the partnership; the form most important in todays

economy is the corporation. The final part of this class will be devoted to the lawof corporations. There will not be time for a detailed discussion of partnership law.However this handout will provide a basic introduction to the subject in the form ofa comparison between the partnership and the corporation.

(There are several other forms of business organization which are widely used in

todays economy.)

A partnership is defined as an association oftwo or more persons to carry on abusiness for profitas co-owners.

Usually a partnership is formed by express agreement. Linda says to Mary:

Lets form a partnership to sell magazine subscriptions over the Internet.Maryagreed to Lindas proposal. They are now partners. It would be a good idea forthem to prepare a formal written contract including all of the provisions of theiragreement, but even without one they are partners.

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Partnerships can also be created by implied agreement. This happenswhenever people act like partners. Even if they do not expressly agree to be

partners the law will consider them to be partners. To determine if personswho have not specifically agreed to become partners are nevertheless

partners, the courts will look at all relevant evidence to determine the intentof the parties. If a person is entitled to a share of the profits of a business,there is a presumption that such a person is a partner in that business. Forexample, if Bill is entitled to 5% of the profits of Valley Productions, a newmotion picture business owned by John and George, then Bill will be

presumed to be a partner with John and George in that business even if therewas no express agreement that Bill would be a partner.

However this presumption is rebuttable. This means that if the person whois entitled to a share of the profits can produce evidence showing that he

received his share of the profits for reasons other than being a co-owner ofthat business, the presumption of partnership is overcome. The followingtypes of evidence are among those which will rebut the presumption of

partnership:

1. The profit share represents wages orsalary. (In the aboveexample, if Bill can show that he was promised 5% as his salary fordirecting some TV commercials because the company was unable to

pay him in cash, the court would conclude that he was not a partner.)

2. The profit share represents rent for the use of property. (In theabove example, assume that Mark agreed to lend camera equipmentfor use in the business. Since the business was financially unable to

pay him rent in cash, he agreed to accept instead 5% of anticipatedprofits of the business for the next two years. The court wouldconclude that he was not a partner.)

3. The profit share represents interest on a loan orrepayment ofprincipal on a loan. (Suppose that Maria agreed to lend $50,000 to

the business. Since the business was low on cash, Maria agreed toaccept 5% of the profits of the business until such time as she had

been repaid the value of the loan plus 10% interest. The court wouldconclude that she was not a partner.)

The following chart compares partnerships with corporations. We will learnmore about corporations during the rest of the semester. By providing a


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contrast with the law of corporations, the following table will provide youwith the basics of partnership law.


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PARTNERSHIPS CORPORATIONS

Partnerships are legally formed by theagreement of the parties. As explainedabove, this agreement may be eitherexpress orimplied.

Each partner has an equal right toparticipate in management of thebusiness unless the partners haveagreed otherwise. In day to day affairsdecisions are made by a majority vote

(unless otherwise agreed.) Whenmaking very important decisions---those which could change the verynature of the business---a unanimousvote of the partners is required.

Corporations are legally formed byactions of thegovernment, though in

practice the government will form acorporation when people have properlyrequested such action.

Management power is vested in aboard of directors elected by theshareholders. In this election eachshareholder is entitled to one vote foreach share which he or she owns. The

shareholders have no individual rightto participate in management.

The partnership is aseparate entity forsome purposes and an aggregate ofindividuals for other purposes.

A corporation is an entity separate anddistinct from the persons who own orare otherwise involved with it.

The partnership as an entity is liablefor all of the business debts. Each

partner is alsopersonally liable for allof the partnership debts.

The partnership as an entity owns all ofthe partnership property; the partnerseach have an ownership interest in the

partnership. Partners do not directlyhave any ownership interest in the

partnership property

The corporation is liable for thebusiness debts. Except in a few specialsituations, shareholders have no

personal liability for the corporations

debts.

The corporation owns all of thebusiness property. The shareholdersown shares in the corporation. Theydo not have any direct ownership

interest in the corporations property.


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The partnership is an association ofpersons bound together by ties ofagency. Each partner is an agent of the

partnership and of all of the otherpartners; each partner is therefore alsoaprincipalto each of the other

partners. Partners may have express,implied or apparent authority to bindthe partnership. The scope of thisauthority is determined by the ordinaryrules of agency law. The partnershipmay also ratify unauthorized acts of

partners

Corporations are represented by agentswho have been given authority---express, implied or apparent--- by the

Board of Directors. This scope of thisauthority is determined by the ordinaryrules of agency law. Shareholdershave no authority to represent thecorporation unless they have receivedsuch authority from the Board.

Partnerships are not liable for incometax. They are required to file taxreturns with the IRS to provide thegovernment with information, but theyare not themselves required to pay tax.The income of the partnership isallocated among the partners for tax

purposes; each partner must payincome taxes on his or her share of the

partnership income even if that incomeis retained by the partnership instead of

being distributed to the partners.

The corporation must pay income taxesat the corporate rate on its income.Corporate income which is passed onto shareholders in the form ofdividends is taxable income to theshareholder. (Under a special sectionof the Internal Revenue Code somesmall corporations are taxed like

partnerships.)

Partners share equally in thepartnership income unless otherwiseagreed by the partners.

Shareholders have no right to thecorporations income unless the Boardof Directors has declared a dividend.In that case each shareholder is entitledto the same amount for each sharewhich that person owns.


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LIABILITY FOR DEBTS

An LLC is a separate legal entity. Only the LLC is liable for its debts.The members of the LLC are not personally liable for the debts of thebusiness.

In some special circumstances the persons who control the LLC maybe held personally liable for its debts. The veil of immunitymay be

piercedand the controlling persons held liable under in situationscomparable to those in which the controlling persons of a corporationcould be held liable for the corporations debts. However the failureto hold meetings or observe formalities in connection with theoperation of the LLC will be grounds for holding the controlling

persons liable for the LLCs debts only if the holding of such meetingsis specifically required in the Articles of Organization or the Operating

Agreement.

PROFITS AND LOSSES

Unless otherwise provided in the Articles of Organization or theOperating Agreement, profits are shared among the members in theratio of the amount of capital they have contributed to the LLC.Losses are also shared in the proportion of capital contributionsunless the Articles or Operating Agreement provide for a differentmethod of division.

EXAMPLE #1: Alpha, Baker and Charlie were the members of ABCLLC. Alpha contributed $500,000 to the capital of the LLC. Bakercontributed $300,000 and Charlie contributed $200,000. Thebusiness made a profit of $1 million. Since Alpha contributed 50% ofthe LLCs capital -- $500,000 of a total of $1 million in capitalcontributions -- he will receive 50% of the profits (in this case

$500,000). Baker contributed 30% of the capital and will receive 30%of the profits. Charlie contributed 20% of the capital and will receive20% of the profits of the LLC.


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MANAGEMENT

Unless stated otherwise in the Articles of Organization, all membershave an equal right to participate in management. They makedecisions by majority vote. However unless the Articles ofOrganization or the Operating Agreement provide otherwise themembers vote in accordance with their right to receive profits.

EXAMPLE #2:

XYZ LLC had three members: Xilo, Yolo and Zeno. Xilo contributed$600,000 in capital to XYZ; Yolo contributed $300,000 and Zenocontributed $100,000. Since there was no provision in the Articles of

Organization or the Operating Agreement on how the profits would bedistributed, Xilo would receive 60% of the profits; Yolo would receive30% and Zeno would receive 10%. If a vote were held concerning amanagement decision, Xilo would cast 7 votes; Yolo would cast 3 andZeno 1. (The position that received Yolos voting support wouldtherefore prevail no matter how the other members voted.)

However amendment of the Articles of Organization requires aunanimous vote of the members. The Articles may provide for theuse of other forms of management including management bypersons who are not members of the LLC.

TRANSFER OF OWNERSHIP INTERESTS

Members may transfer or assign their ownership interest in the LLCto another party. The assignee the new owner of the interest hasthe right to receive the share of the income of the LLC that themember would have received had he or she not assigned theinterest. However the assignee is NOT a memberand will not be

allowed to participate in the management of the LLC. The assigneecan become a memberof the LLC only if the existing members of theLLC vote to admit the assignee as a member. Any such vote will bemade in accordance with the members voting power.

EXAMPLE #3:


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WXYZ LLC had 4 members: Wizardo, Xilo, Yolo and Zeno. Wizardocontributed $400,000 in capital to WXYZ; Xilo contributed $300,000;Yolo contributed$200,000 and Zeno contributed $100,000. Zenoassigned his interest in WXYZ to Milo. Milo desired to become amember of WXYZ. Milo could become a member only if the existingmembers approved his becoming a member. If such a vote were heldWizardo would have 4 votes; Xilo would have 3; Yolo would have 2votes and Zeno would have 1. If a majority of the votes were cast toapprove Milo becoming a member of WXYZ, then Milo would becomea member of the limited liability company in place of Zeno.


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LIMITED PARTNERSHIPS

Limited partnerships are a form of business organization. A limitedpartnership is created by filing a document Articles of Limited Partnership-- containing certain information about the limited partnership with the officeof the Secretary of State of the state in which the limited partnership isformed.

A limited partnership must have at least one general partner. The generalpartners manage the partnership; they have unlimited personal liabilityforall debts of the partnership.

A limited partnership may also have limited partners who invest money inthe limited partnership. These limited partners are entitled to a share of the

profits the amount of the profits that a limited partner is entitled to receiveis determined by the provisions in the Articles of Limited Partnership.

Limited partners generally do not have the right to participate inmanagement. Limited partners have no personal liabilityfor the debts ofthe limited partnership. (It is possible that a limited partner may ultimatelylose the amount that he invested in the partnership. That is the only lossthat a limited partner may suffer from the operations of a limitedpartnership.)

EXAMPLE: On 10 December 2000 Loren filed Articles of LimitedPartnership with the office of the California Secretary of State. Thesearticles provided that the general partner would be entitled to 20% of thelimited partnerships profits; the limited partners would share equally in theother 80% of the partnership profits. XYZ Inc. became the general partner.

A, B, C and D each became limited partners. The limited partnership owed$10 million to Bozo Bank.

Is XYZ Inc. liable for this debt to Bozo Bank? YES the general partnerhas unlimited liability for the debts and obligations of the limitedpartnership.

Is A liable for this debt to Bozo Bank? NO limited partners have noliability for the debts of the limited partnership.


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Forincome taxpurposes limited partnerships are not taxable entities. Allpartnership income is allocated to the general and limited partners and istaxable income to them.


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SECURITIES REGULATION

INTRODUCTION

Before 1933 there was little legal regulation of the securities markets.Many people thought that uncontrolled speculation in securities hadbrought about the Great Depression which began in 1929. Congressdecided to establish legal regulation of the securities markets.

THE 1933 ACT

The first securities regulation statute passed by Congress was theSECURITIES ACT OF 1933. This act was designed to regulate the

primarysecurities market. This market consists of the issuance of

new securities by corporations. For example, suppose that XYZCorporation decided to issue 5 million new shares and sell them toinvestors. This would be part of the primary securities market. The1933 Act requires most new issues of securities to be registered withan agency of the federal government, the Securities and ExchangeCommission (SEC). The registration must contain certain informationconcerning the securities that are to be issued. Along with theregistration statement, the corporation issuing the securities mustprepare a document called aprospectus. The prospectus also must

disclose certain information concerning the securities which are to beissued. A copy of this prospectus must be provided to eachprospective purchaser of the securities before that person can buythe securities.

It is a violation of the 1933 Act to make any false or misleadingstatement in the registration statement or the prospectus. It is also aviolation of this law for the registration statement or the prospectus tofail to disclose certain types of information which the law requires tobe included in the statements. In other words, it is sometimes illegal

to remain silent about certain matters.

It is illegal under the 1933 Act to sell any securities that have notbeen registered. Violations of these rules are civil violations of thelaw; under certain circumstances they may also be criminal violationsof the law.


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DEFINITION OF A SECURITY

The federal securities laws apply to all securities. What is a security?Obviously stock (or shares) in a corporation are securities. Alsoincluded within the definition are corporate bonds certificates whichrepresent loans which have been made to the corporation. (Since theholders of corporate bonds are creditors of the corporation, bonds arereferred to as debt securities.)

Some investment vehicles other than stocks and bonds are alsoconsidered to be securities. Decisions of the Supreme Court haveestablished that any investment scheme as part of which money isinvested in any sort of common situation in which the profitability ofthe investment depends in part on the activities of the managers of

the investment scheme is a security.

EXAMPLE A: A developer owned a large orange grove. He soldnarrow strips of land containing orange trees to investors; theinvestors were also required to enter into a contract under which thedeveloper would manage and maintain all of the strips of land whichhad been sold to the investors. The developer would cultivate theland, harvest and market the crops and then share the profits with theowners of the strips of land. The Supreme Court held that eventhough this scheme in theory involved the sale of land which is nota security these investments should be legally considered to besecurities. The purchasers invested their money in a commonsituation in which the potential profitability of the investmentdepended in part on the managers of the investment scheme.

The 1934 ACT

THE SECURITIES EXCHANGE ACT OF 1934 was designed toregulate the secondary marketin securities. This is the market where

already issued securities are bought and sold.EXAMPLE B: John directed his broker to buy for him 1000 shares ofMicrosoft. These shares would be purchased from another owner.This is a transaction in the secondary securities market.


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RULE 10(b)5.

Section 10(b)5 of the Securities Exchange Act of 1934 is one of themost important provisions of the securities laws. It was intended torestrict fraudulent manipulation of the securities markets. It providesthat it is unlawful to "use or employ...any manipulative or deceptivedevice" in connection with the purchase or sale of any security. In1941, the SEC issued Rule 10(b)5. This was an attempt to interpretand explain the statute. The provisions of this rule are printed on p.903 (footnote 6) of the textbook. The language of this rule is alsoquite general. The contours of the modern law of 10(b)5 have beendeveloped on a case by case basis in the courts. The originalintention was that enforcement of Rule 10(b)5 would be limited to theSEC and other government agencies. However the courts have held

that in addition to the government's power to enforce this law there isalso an implied private right of action. This means that any privateparty who believes that he has been injured by another party'sactions in violation of 10(b)5 may bring a private lawsuit for damagesagainst the allegedly offending party. In effect 10(b)5 has become anew tort. This outline will set forth theprima facie case for a privatelawsuit under Rule 10(b)5.

I. MISREPRESENTATION OR FAILURE TO DISCLOSE

A 10(b)5 action can be based on misrepresentation (a false ormisleading statement) or upon failure to disclose (remaining silentabout a fact). Some cases are of course based in part upon both ofthese theories.

In cases involving failure to disclose, it must be decided to whomdisclosure must be made. In face to face transactions, disclosuremust be made to the other party. For example, Bill is a geologist forEwing Oil. He knows that the company has just made a major oil

discovery. He offers to buy Tom's shares of Ewing stock. He mustmake full disclosure to Tom before buying the securities. When atransaction is made indirectly (for example through a broker or on astock exchange) disclosure must be made to the entire investing

public. In practice this means that disclosure must be made throughthe business media. The person making disclosure must not buy or


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sell the securities until the financial markets have had time to absorbthe information.

II. (DUTY TO DISCLOSE)

There is no need to show that a duty existed if the case is based upona misrepresentation theory since all persons have a duty not to makefalse and misleading statements concerning securities. However if thecase is based on a claim that the defendant failed to disclose somefact, it is necessary first to establish that the defendant had a duty todisclose. Only persons in certain categories are under such a duty tomake full disclosure.

A. INSIDERS

These are people who because of their relationship with thecorporation have access to inside information concerning thecorporation. Possession of this non-public information would givethem an unfair advantage in the securities markets. Eliminating thisadvantage is one of the chief purposes of the rule. Insiders includedirectors, officers, and controlling shareholders. Lower levelemployees are also included if their connection with the corporationbrings them into contact with inside information. For example, asecretary who types a document containing reference to a new oildiscovery made by the corporation which has not yet become publicknowledge is an insider. The insider category also includesindependent contractors who while working for the corporation gainaccess to non-public information. This would include outside legalcounsel, accountants and auditors, investment bankers and manyothers. Insiders violate Rule 10(b)5 if they buy or sell securitiesissued by their corporation without first making full disclosure of theinside information.

B. TIPPERS

Tippers are persons who give tips. They possess inside informationand pass that information on to other persons without disclosing it toeverybody. Tippers are in violation even if they do not trade (i.e. buyor sell securities of the corporation in question). For example, thechairman of the board of Weaponsco, Inc. calls his girlfriend and says


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"we just got a huge new government contract, but it won't be publiclyannounced until next Monday. Buy shares before Wall Street findsout!". The chairman is liable for violating Rule 10(b)5 even if he doesnot buy any shares himself.

C. TIPPEES

Tippees are persons who receive tips from tippers. Tippees aretreated like insiders; that is they violate 10(b)5 only if they trade in thecorporation's securities. They can also incur liability by passing theirinformation to other people without disclosing to everyone, in whichcase they become tippers. Tips must be distinguished from mererumors. A tip is information which the recipient knows to come froman informed source and which the recipient knows to be non-public.

For example, if a director of RCA calls a friend and says "GE has toldus they want to take us over" the friend is a tippee. He got hisinformation from an informed source (a director) and he knows thatthe public has not yet learned of the news.

D. MISAPPROPRIATORS

The categories listed above all involve people who have insideinformation from the corporation whose securities are being traded.In recent years some courts have extended the duty to disclose topersons who possess non-public information (even though it did notcome from within the corporation whose shares are being traded) ifthe defendant had a fiduciary duty to keep the information secret andbreached that duty. For example, in one case a printer wasemployed by a financial printing house. In this job he obtained non-public information about corporations that were the targets ofupcoming takeover bids. His employer obtained this information fromlaw firms representing the companies which were planning to makethe takeover bids. It did not come from the target companies whose

shares would be involved in any market speculation based on thisinformation. The defendant had a duty of secrecy to his employer tokeep this information confidential. He breached this duty by trading inthe shares. The court held that anyone in such a position has a dutyunder Rule 10(b)5 to make full disclosure before trading in the sharesof the takeover-target corporations. (Obviously if he complies withthis duty and discloses the information he will have breached his


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fiduciary duty to his employer. The only legal course of conduct for aperson in this position is to refrain from trading the shares ofcorporations concerning which he possesses non-public information.)

Another example involved a reporter who wrote the "Heard on theStreet" column for the Wall Street Journal. This was a sort of gossipcolumn for the financial world. The reporter knew that the publicationof items in this column often caused short-term fluctuations in theprice of the shares. He gave advance word of the contents of eachcolumn to a friend who was a broker. The broker then traded in theshares. The court held that the reporter had a duty to the Wall StreetJournalnot to disclose its' publication schedule to outsiders. Whenhe breached this duty the court held that he had the same duty as atipper, even though his tip was not true inside information from the

corporation whose shares were traded. All he disclosed wasinformation concerning the Journals publication schedule.

Misappropriators are treated like true insiders. They are liable only ifthey trade shares or if they pass the information to others, therebybecoming tippers.

III. MATERIALITY

A misrepresentation or omission is material if a reasonable personwould take the information into account in deciding whether to buy orsell the securities. There is no requirement that it be the only factor --or even the most important factor -- merely that it be importantenough for the other party to take into account in deciding whether ornot to buy or sell.

IV. (RELIANCE)

In a suit based on a misrepresentation theory, the injured party must

show that he bought or sold securities in reliance upon thedefendant's false or misleading statement. Reliance is a subjectiverequirement: Did thisparticular plaintiffrely on this misrepresentationin deciding whether or not to buy or sell the shares? In contrastmateriality is an objective test: would a reasonableperson haverelied on this information? When the plaintiff has bought or soldshares through a stock exchange or broker, the courts now assume


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that reliance existed; it is not required that the plaintiff be able toshow specifically that she relied on the misrepresentation or even thatshe had heard the false or misleading information. The theorysupporting this rule is that the plaintiff "relied on the fairness of themarkets". When a 10(b)5 case is brought by the SEC or othergovernment agency, the reliance requirement is notapplicable.Obviously the reliance requirement is not applicable to failure todisclose cases, since there is no way to rely on something that hasnot been disclosed.

V. PLAINTIFF WAS PURCHASER OR SELLER OF SECURITIES

In order to win a lawsuit, the plaintiff must show that he actuallybought or sold some of the corporation's securities. If shares are

exchanged as part of a merger this requirement is considered to havebeen met. This requirement does not apply to suits brought by theSEC or other government agencies.

VI. INTERSTATE COMMERCE

Rule 10(b)5 was promulgated pursuant to an act of Congress. Underthe U.S. system of government, Congress is allowed to exercisepower only if it is authorized to do so by the U.S. Constitution. Sincethe Constitution is silent concerning power to regulate securitiesmarkets, it was necessary for Congress to enact this law under somesection of the Constitution which could be interpreted to includepower over the securities markets. The only plausible choice was theprovision included in Article I Section 8 which gives Congress power"to regulate Commerce with foreign Nations, and among the severalStates". The federal courts have jurisdiction over a securities caseonly ifinterstate (or international) commerce is involved. This meanseither that there must have been some activity which crossed statelines or that some use must have been made of a facilityof interstate

commerce even if in fact it was not used to do business across statelines. Any use of the U.S. mail, or of the telephone system, or of asecurities exchange satisfies this requirement even if no state lineswere crossed. For example Broker has offices in Beverly Hills. Hecalls Customer at his home in San Francisco and makes falsestatements concerning a security. Interstate commerce is involvedsince the same telephone system could have been used to


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communicate across state lines, even though it was not in fact usedin that manner.

VII. SCIENTER

Scienter is a Latin word meaning knowledge. In a case based uponmisrepresentation, the plaintiff must show that the defendant knewthat his statement was false. In a case based upon a theory of failureto disclose, it must be shown that the defendant had actualknowledge of the fact which she did not disclose. It is not enough toshow that the defendant was negligent and that if the defendant hadacted reasonably she would have discovered the material fact whichwas not disclosed.

REMEDIES

If all of the elements of theprima facie case can be established, theplaintiff's lawsuit will be successful. What remedies will the courtgrant? The basic remedy is money damages. In cases involvingface to face transactions, the amount of damages is the differencebetween the actual sales price of the shares and the price that theshares would have had if the whole truth had been known to bothparties. For example, when Bill bought shares of Ewing Oil fromTom, he failed to disclose that Ewing had just made a large oildiscovery. Bill paid $5 per share. The evidence indicated that if thetruth had been known the true market value of the shares would havebeen $15 each. Tom is entitled to damages of $10 per share. Thismeasure of damages also applies in cases where the plaintiff is abuyer rather than a seller. As an alternative, the plaintiff may ask forthe remedies of rescission and restitution. This means that the buyermust return the securities and the seller must return the purchaseprice.

In addition to private lawsuits, the SEC may bring enforcementactions under Rule 10(b)5. The SEC can ask for an injunction, whichis a court order requiring the defendant to cease all further violationsof 10(b)5. If the defendant subsequently violates such an injunction,the defendant may be fined or imprisoned for contempt of court. TheSEC can bring disciplinary actions against any defendant who is aregulated broker, dealer, or underwriter. The SEC can also ask the


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court to require the defendants to disgorge their illicit profits and toimpose a civil penalty of up to three times the profits gained or lossesavoided. (Ivan Boesky agreed to disgorge profits of $50 million and topay a fine of $100 million.) Finally the SEC may refer cases to theDepartment of Justice for criminal prosecution. Criminal violation of10(b)5 is punishable by 10 years in prison and a fine of $1 million($2.5 million for partnerships or corporations) for each count.

SECTION 16: SHORT TERM INSIDER TRADING

Section 16 of the Securities Exchange Act of 1934 governs trading ofsecurities by certain persons designated as insiders of a corporationwith securities registered pursuant to that law.

There are two types of securities that must be registered under the1934 Act.

1. Any class of securities of a corporation with assets that exceed$10 million held by at least 500 owners that are traded in interstatecommerce.

2. Any securities that are traded on a national stock exchange.

Registration consists of filing a document with the SEC containingcertain required information about the corporation and the securities.

The definition of insider under Section 16 is different from that underRule 10(b)5. Under Section 16 any person in any of the followingcategories is an insider:

1. An officerof any corporation that has issued equity securitiesregistered under the 1934 Act.

An officer is the President of the corporation, the Treasurer(or other principal financial officer), the Secretary of thecorporation and any other person performing comparablefunctions. Vice-presidents are also considered to be officersif they have actual executive functions within the corporation.

Also considered to be officers are assistants to officers that


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carry out the functions of the officer, and any otheremployeeswho perform executive duties that are likely to provide theemployee with access to inside information from within thecorporation. The head of any division or unit of thecorporation is also an officer.

2. A directorof any corporation that has issued equity securitiesregistered under the 1934 Act.

3. Any person that owns more than 10 percent of any class ofequity securities of any corporation that has issued equitysecurities registered under the 1934 Act.

A person is an ownerunder Rule 16 only if that person has

actual control over the securities and the ability to use anyprofits made from their purchase and sale. It is presumed thatthe legal owner of the shares does indeed have such control,but that presumption may be rebutted by contrary evidence.

Whenever any person in any of these categories engages in short-swing trading of securities issued by the corporation of which he orshe is an insider, the corporation may recover from the insider anyprofit made.

Short-swing trading means the purchase of securities followed bytheir sale (or the sale of securities followed by re-purchase ofequivalent securities) within a period of6 months or less.

This liability exists without regard to the insiders intent to use insideinformation or actual use of that information.

The corporation is entitled to acquire the profit made only if thepurchaser-seller was an insider at the time of both transactions.

EXAMPLE #1: The Dingbat Corporation had 100,000 shares ofstock. John purchased 100 shares of the Dingbat Corporation on 10January for $10 each at this time he had no other connection withthe corporation. On 10 February John was elected to the DingbatBoard of Directors. On 10 May John sold 100 shares of Dingbat for


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$15 each. John will NOT be required to turn his profit over to Dingbat John was not an insider at the time he purchased the shares.

At the time of the purchase of shares that brings a persons stockownership over the 10% threshold that person is NOT an insider forRule 16 purposes.

EXAMPLE #2: There were 100,000 shares outstanding of commonstock of the Nitwit Corp. Lou had owned 6000 shares since 2000.On 10 June 2005 Lou bought another 5000 shares of Nitwit stock at aprice of $10 each. On 10 August 2005 Lou sold 500 shares at a priceof $12 per share. The corporation is not entitled to the profit made byLou. The transaction on 10 June 2005 pushed Lou over the 10%limit at the time of that transaction Lou was NOT considered to be

an insider.

EXAMPLE #3: After the events in Example #2, Lou bought 2000shares on 12 September 2005 at a price of $10 each. On 18 October2005 he sold 1000 shares at a price of $12 each. When thepurchase of 2000 shares is matched up with the sale of 1000 shares,Lou has made a profit of $2000. The corporation is entitled torecover this profit of $2000 since Lou was the owner of 10% of theshares at both the time of the purchase and the time of the sale andthe events happened within 6 months of each other.

EXAMPLE #4: LMN Corporation had 9500 shares of stockoutstanding. On 15 May 2006 Linda, who had owned 1000 shares ofLMN Corp. stock since 2003, purchased 2000 shares at a price of$100 each. On 15 August 2006 Linda sold the 3000 shares of LMNthat she owned at a price of $110 each. (After this transaction Lindaowned no shares of LMN.) LMN is entitled to recover $20,000 fromLinda this is the profit she made from the sale of those shares thatshe had purchased less than 6 months before the sale of the shares.

At the time of a transaction that takes a shareholder below the 10%threshold (such as the sale by Linda on 15 August 2006) theshareholder IS considered to be an insider for purposes of Rule 16.

EXAMPLE #5: In 2000 Holly was elected to the Board of Directors ofMoneybags Industries; she has been a member of the Boardcontinuously since that time. On 5 June 2005 (at which time she


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owned no shares of Moneybags stock) Holly purchased 10,000shares at a price of $10 each. On 10 October 2010 Holly purchased1000 shares at a price of $15 each. On 25 February 2011 she sold1000 shares at a price of $17 per share. In deciding whether Rule16 requires the profits made from a securities transaction to be paidto the corporation the last-in-first-out (LIFO) rule applies. The mostrecently purchased sharesthose purchased on 10 October 2011are assumed to be the shares that were sold on 25 February 2012.The sale of shares on 25 February 2011 came less than six monthsafter the purchase of shares on 10 October 2010. ThereforeMoneybags Industries is entitled to recover $2000 from Holly.

EXAMPLE 6: In 2000 Hortense was elected to the Board of Directorsof Moneybags Industries; she has been a member of the Board

continuously since that time. On 5 July 2005 (at which time sheowned no shares of Moneybags stock) Hortense purchased 10,000shares at a price of $10 each. On 10 November 2010 Hortensepurchased 500 shares at a price of $15 each. On 25 March 2011 shesold 1000 shares at a price of $17 per share. In deciding whetherRule 16 requires the profits made from a securities transaction to bepaid to the corporation the last-in-first-out (LIFO) rule applies. Themost recently purchased sharesthose purchased on 10 November2011 are assumed to be among the shares that were sold on 25February 2012. The sale of shares on 25 February 2011 came lessthan six months after the purchase of shares on 10 November 2010.Therefore Moneybags Industries is entitled to recover $1000 fromHortense from the sale of the 500 shares that were assumed to havebeen purchased by her on 10 November 2011. Hortense may keepthe profit made from the sale of the other 500 shares that she sold on15 February 2012. These shares must have been purchased on 5July 2005. Since this was more than 6 months before the date of thesale Hortense is NOT required to turn over the profit from their sale toMoneybags Industries.

All insiders of corporations that have registered securities under the1934 Act must report any purchases or sales of securities in thecorporation of which they are insiders to the SEC no later than thesecond business day following the purchase or sale of thesecurities.


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FIDUCIARY DUTIES OF SHAREHOLDERS

Under most circumstances shareholders are notfiduciaries they donot owe any fiduciary duties to the corporation. For example, noduties are violated if a shareholder of General Motors purchasesshares in one of that corporations competitors such as Ford.

However under some special circumstances shareholders do owefiduciary duties. Several of these circumstances involve fiduciaryduties that are imposed only on controlling shareholders. Acontrolling shareholder is a shareholder who has the powertodetermine the policies of the corporation in the ordinary course of thecorporations business.

Persons who own a majority of the shares are of course controllingshareholders. (A person who owns a majority of the shares canalways determine the election of a majority of the directors andtherefore such a shareholder can determine the policies of thecorporation.)

Under some circumstances a shareholder who owns less than amajority of the shares may still be a controlling shareholder.

EXAMPLE: Martin owned 40% of the shares of Bozo Corporation.The remainder of the shares were held by 5000 other shareholders,none of whom owned more than of 1% of the shares. Unless theother shareholders have organized themselves as a bloc to outvoteMartin, Martins 40% of the shares will allow him to elect a majority ofthe directors; therefore Martin would be a controlling shareholder.

Listed below are the situations under which shareholders are subjectto fiduciary duties to the corporation or to the other shareholders.

1. Duty of controlling shareholders not to sell control of thecorporation to a looter.

Controlling shareholders have a duty not to sell their controllinginterest in the corporation to a looter. A looter is a person that thecontrolling person knows or has reason to know is likely to loot the


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corporation. A corporation is looted if its assets are stolen by fraud,embezzlement or any other illegal method.

EXAMPLE: Wilson founded Super Corporation; the business wasvery successful. Wilson owned 60% of the shares. The remaining40% had been given by Wilson to Alpha, Beta, Gamma and Delta,who were valuable employees of Super Corp. Wilson decided toretire from business. For this reason Wilson sold his 60% of theshares to Harding. Harding had once been convicted ofembezzlement; he had also been successfully sued in three civil suitsfor fraud. All of these cases involved corporations for which Hardinghad once worked. Information about these suits was publiclyavailable; however Wilson made no effort to check on prior lawsuits.Harding was a very good friend of Wilsons and Wilson did not

believe that he needed to check on Hardings background. Hardingpaid a fair price for the shares. During the next three years, Hardingused his control of Super Corp. to divert its assets. Harding thendisappeared and Super Corp declared bankruptcy. The minorityshareholders sued Wilson for breach of fiduciary duty. If Wilson haddone a background check on Harding, he would have learned fromthe court records that there was a good chance that Harding mightloot the corporation. Therefore Wilson should have known thatHarding might loot the corporation. Wilson has breached his fiduciary

duty; the suit brought by the minority shareholders would besuccessful.

2. Duty of controlling shareholders to act fairly towards thecorporation and towards the other shareholders in connectionwith any transaction to which control of the corporation isrelevant.

EXAMPLE: Santa Ana Savings and Loan Association had 1000outstanding shares. Roto owned 520 of these shares; the remainder

were held by other owners. Santa Ana was very profitable; butbecause of the small number of shares outstanding there was noregular market in Santa Ana shares. Roto then established a newcorporation, Fullerton Holding Corporation. It was authorized by itsarticles to issue 1 million shares. Roto obtained all of the Fullertonshares; as consideration he transferred his 520 shares of Santa Anato Fullerton Holding Corp. Roto, working through local brokerage


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houses, then sold 499,000 of his Fullerton Holdings shares to otherinvestors. A regular market in Fullerton Holdings shares thendeveloped. Since there was no market for Santa Ana savingsshares, the minority shareholders of that corporation could not easilysell their interest in that corporation. They were unable to participatein the share market created by the establishment of FullertonHoldings.

The minority Santa Ana shareholders sued Roto, seekingcompensation for having been frozen out of the market for shares.Of course Roto had not sold control of the corporation; through hiscontrol of Fullerton Holdings, which owned a majority of the shares ofSanta Ana Savings, Roto still had the power to control Santa Ana.But controlling shareholders have a fiduciary duty to act fairly towards

both the corporation and the minority shareholders in connection withany transaction to which control of the corporation is relevant.

Control of Santa Ana Savings was clearly relevant to Roto stransactions here. By failing to grant equal treatment to the minorityshareholders of Santa Ana Roto breached this fiduciary duty. Hecould be ordered either to buy the shares of the minority shareholdersin Santa Ana at a value determined by an independent appraiser or topermit those minority shareholders to exchange their Santa Anashares for new Fullerton shares (at the same ratio for which Roto hadexchanged his shares).

3. Fiduciary Duties of shareholders in closely held corporations.

A closely held corporation is one for which there is no regular marketfor the shares the shares are not regularly traded. Shareholders inclosely held corporations are subject to the same fiduciary duties asarepartners. This means that they are subject to the full set offiduciary duties: loyalty, care and skill, obedience and the duty to

account. The duties are owed both to the corporation and to the othershareholders. (These duties are imposed because in closely heldcorporations the shareholders often participate directly inmanagement in ways similar to partnership management.)

EXAMPLE: Xitro Corp. had 2 shareholders: Loraine and Mike.Loraine owned 51% of the shares; Mike owned 49%. Mike was the


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corporations secretary-treasurer; he received a salary of $100,000per year, which was his only source of income. Loraine decided toforce Mike out of the management of the corporation. She and theother directors whom she had elected voted to fire him from hisposition as secretary. Loraine, who was already Xitros president,was also appointed to be secretary-treasurer. By freezing out Mikefrom the corporation, Loraine has violated her fiduciary duties to othershareholders.

Normally this duty protects minority shareholders from oppressiveconduct by controlling shareholders. However minority shareholdersin closely held corporations are also subject to these fiduciary duties.

EXAMPLE: Selwyn owned 50% of the shares of Rexford Rand

Corporation; his sons Gregory and Albert each owned 25% of theshares. The name Rexford Rand was used on the corporationsproducts and in its advertising. Selwyn and Albert decided to removeGregory from his position as Vice-President and Treasurer of thecorporation. (Gregorys salary from this position was his only sourceof income.) One year later, Rexford Rand failed to file its annualreport with the state of Illinois; as a result the corporation wasdissolved by the state. Gregory learned about the dissolution. Sincethe name Rexford Rand was once again available in Illinois as acorporate name, Gregory set up a new corporation using the nameRexford Rand Corporation. (As a result, the original corporationcould not re-incorporate under the Rexford Rand name.)

Selwyn and Albert sued Gregory. The court held that Gregory, as aminority shareholder, owed fiduciary duties to the corporation and tothe other shareholders. He breached those duties by appropriatingan asset that belonged to the corporation the trade name RexfordRand for his own use.

(Note that in this case Gregory could have sued Selwyn and Albert forbreach of fiduciary duty, since they had frozen him out of thecorporation. Instead, Gregory breached his duty to the corporation bymisappropriating the trade name.)

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