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Business Associations Outline Effross - Fall 2010

I. Agency

a. Generally

i. Created by (1) mutual consent either formal or informal, express or implied that (2) one person or entity (3) undertakes to act on behalf of another person or entity, (4) subject to the principal‟s control.

ii. Restatement of Agency (Third) §1.01: Agency is the fiduciary relationship that arises when one person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act on the principal‟s behalf and subject to the principal‟s control, and the agent manifests assent or otherwise consents to such an act.

iii. Manifestation of Consent 1. Manifestation by the principal 2. Consent by the agent 3. Explanation: Manifestation attributable to the principal must somehow reach the agent,

otherwise he has nothing to which to consent. BUT the principal may initially be unaware of the manifestation.

4. Objective: Look to the outward manifestations; would a reasonable person think there was consent (words or actions).

a. Even if they disclaim the agency titles, there can be an agency relationship if the elements are present.

iv. Consent and control 1. Control need not be total or continuous or control the way the agent physically performs; at

minimum the P must have right to control the goal of the relationship. 2. Four distinct roles of consent to control within agency:

a. Establish agency relationship b. Element of “servant” status c. Control as a consequence d. Substitute method for establishing agency status

v. Relationship to contract law: Contractual obligations can differ from agency relationship. I.e., a “gratuitous agent” exists when person acts without receiving consideration, because that is not required in agency.

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1. Contract overlays agency relationship a. Can stipulate payment or limited duration b. Limited impact; can change rights and duties but cannot abrogate powers that agency

status confers on each party. When contract is violated, injured party can sue for damages but the exercise of power cannot be undone.

c. Difference between agent and “independent contractor”: “In any relationship created by contract, the parties contemplate a benefit to be realized through the other party‟s performance.”

vi. Formalities: Normally need not be in writing, but some jurisdictions use the “equal dignities” rule: 1. Statutory 2. Pertains to transactions that must be in writing in order to be enforceable 3. Provides that an agent can bind a principal to such transactions only if the agency relationship

is documented in a writing signed by the principal.

b. Ending the Agency Relationship i. Through express will of either the P or A: either party may communicate to the other that the

relationship is over (revocation). This is sometimes called renunciation when exercised by the agent. 1. Judged by an objective standard

ii. Through the expiration of a specified term: When P and A specify the relationship will last for a particular period of time; it automatically terminates at that point unless they agree to renewal. This may be inferred from conduct.

iii. Through the accomplishment of the agency’s purpose: If the manifestations creating the relationship indicated a specific objective, achieving that objective ends the agency.

1. Sometimes the A will continue to exert effort for the P even after the task is complete; P‟s acceptance/acknowledgment of such efforts may manifest consent for the agency to continue.

iv. By the occurrence of an event or condition: Sometimes the manifestations indicate a particular event will end the agency (also applies where manifestations call for agency to end if a particular event does not occur).

v. By the destruction of or the end of the principal’s legal interest in the property: If A‟s role is predicated on some property and it is no longer practically/legally available to the A, the agency ends.

vi. By the death, bankruptcy, or mental incapacity of the A or P: Traditionally, any of these terminates the relationship. Under R.3d, this is different, as it proposes to “follow the lead set by statutes of broad applicability.” (See: Kleinberger §5.3.1)

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vii. By the expiration of a reasonable time: Where no specific term set, relationship ends after a reasonable time has passed. Depends on a number of factors (manifestations, extent/nature of communications after agency created, particular objective, past dealings, custom in the locality with regard to agency relationships of same or similar type).

c. Power versus right in termination i. P and A always have the power to end the relationship; whether they have the right do so depends on

(1) contractual overlays, and (2) concepts of detrimental reliance and good faith. ii. Role of contract: can (1) set specific duration, (2) provide for it to continue indefinitely, (3) define

“cause” sufficient to allow one or both to end the agency, (4) provide for agency to continue for so long as A meets certain requirements.

1. This does not affect the power to end the relationship. iii. Implied terms

1. Rules on implying terms in an agency contract are the same as any other contract, except with respect to restricting the right of the parties to terminate the relationship.

2. Express terms can restrict right to terminate, but most courts will not easily imply such a term, but are most likely to find an implied limit on termination when:

a. (1) agency relationship outside the employment context, (2) limitation is asserted against the principal, and (3) either the principal‟s manifestations are the source of the implication OR the agent has reasonably incurred costs in undertaking the agency and needs time to earn back those costs.

iv. Non-contract limitations on the right to terminate 1. Gratuitous Agent: If the agency is gratuitous, agent‟s right to terminate is not limited by

contract but principles akin to promissory estoppel impose some restrictions. a. If a gratuitous agent (1) makes a promise or engages in other conduct that causes the P

to refrain from making different arrangements, and (2) the gratuitous agent has reason to know the P would so rely then:

i. if alternative arrangements are still possible, A has a duty to end the agency only after giving notice to the P so he can make alternative arrangements

ii. if alternative arrangements are not possible, the A has a duty to continue to perform the agency as promised

b. Gratuitous agent always has the power to renounce, but may be liable for damages if A leaves P hanging in the wind.

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2. The Principal: Even if a P has a right to terminate the agency at will, P may not exercise that right in bad faith (usually arises when P seeks to “snatch some benefit away” from the A).

d. Agency vs. Other Beneficial Relationships

i. Existence and consequences of the issue 1. Agency vel non (“Agency or not”)

ii. Distinguishing agency from other similar relationships 1. Usually relates to one of the two fundamental agency characteristics: (1) P‟s right of control, or

(2) fiduciary nature of the relationship. a. Party receiving the benefits must have right to control at least the goals of the

relationship; party providing the benefits must be acting “on behalf of” the person receiving the benefits. Beneficial relationship lacking either or both of these characteristics is not an agency.

2. Examples a. Party providing benefits is not a fiduciary and is not subject to control: Like most

ordinary contracts; arm‟s length relationship. Each has entered into contract to further its own interests. This was traditionally called an independent contractor, but under R.3d it is a “nonagent service provider” or “nonemployee agent.”

b. Party providing the benefits is subject to control but is not a fiduciary: One party may have substantial control over other‟s conduct, but is not “on behalf of” and the control is not general. (I.e., supplier of specially designed goods and its customer).

c. Party providing the benefit is a fiduciary but is not subject to control: Examples: trustee is obliged to act solely for the benefit of the beneficiary but is not controlled by the beneficiary.

e. Agent‟s Duties to the Principal

i. Agency relationship is a fiduciary relationship (with respect to matters within the scope of the agency). 1. Requires agent to act loyally and carefully 2. Examples of loyally

a. Unapproved benefits: A is accountable to P for profits arising out of transactions he conducts on P‟s behalf

b. A must act solely for the benefit of the P and not for himself

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c. A must refrain from dealing with his P as an adverse party or from acting on behalf of an adverse party

d. A may not compete with his P concerning the subject matter of the agency e. A may not use the P‟s property (including confidential information) for the A‟s own

purposes or a third party‟s purposes i. Does not apply to special skills the A develops while performing agency tasks ii. Duty continues after the relationship ends

3. Examples of carefully a. A has a duty to the P to act with the care, competence, and diligence normally

exercised by agents in similar circumstances. i. Good Conduct

b. If A claims to possess special skills or knowledge, has duty to act as normally exercised by agents with such skills/knowledge.

4. Duty to Provide Information: A may also have duty to disclose information. a. A must use reasonable efforts to give his P information which is relevant to affairs

entrusted to him and which, as the A has noticed, P would desire to have and which can be communicated without violating a superior duty to a third person.

b. This is very different from the lack of any duty to volunteer information in an arm’s length transaction.

5. Duty to Act Within Authority: A may have the power to act beyond the scope of actual authority, but does not have the right to do so. A has duty to act only as authorized by P, so A is liable to P for any loss suffered by P when A acts without actual authority. Corollary: If A has reason to doubt scope of authority, has duty to inquire of the P of the actual scope except in emergencies.

6. Duty to Obey Instructions: P always has the power to instruct the A concerning subject matter of the agency, so A has a duty to obey instructions unless they call for the A to do something improper.

7. Duty of Care a. What constitutes due care depends on (1) whether the A is gratuitous, and (2) any

relevant agreement between the P and A. b. Paid agents: due care is ordinary care; standard of ordinary negligence applies.

i. R.3d Duty of Care: Similar to negligence in tort law -- “subject to any agreement with the principal, an agent has a duty to the principal to act with the care,

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competence, and diligence normally exercised by agents in similar circumstances. Special skills or knowledge possessed by an agent are circumstances to be taken into account in determining whether the agent acted with due care and diligence.”

c. Gratuitous Agents: Older cases hold that standard of care is gross negligence, but R.3d makes no reference to whether the agent acts gratuitously or not. A comment suggests that ordinary care applies here as well, but the discussion refers to professionals with special skills. (R.3d, §8.08, comment e).

d. Agreements Affecting the Standard of Care: Agreement can determine the proper standard of care, but public policy limits the validity of some such agreements (such as where it would act to avoid liability for fault).

8. P’s duties to an A are not fiduciary (Fiduciary responsibilities run only from the A to the P): P still has several obligations.

a. P must perform contractual commitments to the A b. Must not unreasonably interfere with the A‟s work c. Must generally act fairly and in good faith towards the A d. If the A incurs expenses or suffers other losses in carrying out the P‟s instructions, P

has duty to indemnify the agent 9. Agent’s Legitimate Disloyalty: A may legitimately act against P‟s interests in the protection of

the A‟s own interests or those of others. For the latter interest, may depend on the legitimacy of the other party‟s interest/importance of the interest, extent to which the other party reasonably expects the interest will be respected by the world in general (and by the P in particular, legitimacy of the P‟s interest, and extent to which the A might have protected the other party‟s interests while using means less injurious/disloyal to the principal.

10. Reshaping the Duty of Loyalty by Consent: P and A have wide latitude to reshape the duty of loyalty; can limit or eliminate each of the specific duties listed above.

a. Three qualifications exist: i. Duty of loyalty applies to the manner in which an A obtains agreement from the P

(overall relationship remains fiduciary) so when seeking the agreement A must not act as an arm‟s-length bargainer.

ii. Limitation to fiduciary duty must be clearly stated and unequivocal; can be implied but most are stated in writing. Ambiguities will be strictly construed against person owing the duty.

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iii. Common law disfavors “general provisions eliminating fiduciary duties.” Historically, because fiduciary duties are meant to be broad to avoid loop holes.

11. Post-Agency Relationship Duties: Right to Compete a. Once agency ends, so does absolute barrier to competition--subject to 3 limitations

i. Prohibition against using former P’s confidential information 1. Involves two different but complementary perspectives

a. Does the information warrant protection as a trade secret? i. Has the P expended effort and incurred expense to

obtain/create the information? ii. Does the P derive economic advantage from the information

not being generally known? iii. Has the P used reasonable efforts to protect the

confidentiality of the information? b. Does the information consist of facts or specialized techniques as

distinguished from general expertise that an A might develop while performing agency tasks?

ii. Duty to “get out clean” 1. During relationship, A cannot disregard loyalty obligations to further post-

termination plans. 2. Duty has two major aspects

a. A has duty to not begin actual competition while still an agent. So, during the relationship, A cannot have discussions with P‟s clients/etc. but CAN have discussions/agreements with parties other than customers, potential customers, and key fellow agents of the principal.

b. A may not actively deceive the P as to the A‟s reasons for terminating the relationship. Probably has no affirmative duty to provide reasons or even to respond to such questions.

3. Failure to get out clean may be liable to former P for (1) damages, and (2) disgorgement.

iii. Obligation to abide by any valid “noncompete” agreements 1. Law‟s strong pro-competition stances causes courts to closely scrutinize

noncompetes.

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2. Must be reasonable with respect to (1) the geographic area foreclosed, and (2) duration of the foreclosure.

3. Some states may completely throw out overbroad noncompetes, others may redraw them to become reasonable.

f. Liabilities

i. Tort Liability of Agent for Agent’s Actions 1. Being an A does not immunize the A from tort liability.

a. Tortfeasor is personally liable, regardless of whether the tort was committed on the instructions from or to the benefit of a P.

2. But rights created by agency status can negate the very existence of a tort a. An A acting within the scope of authority may exercise and benefit from its P‟s

privileges. (I.e., P purchases the right to chop wood in a forest; the A may do so on behalf of the P)

b. Corollary: duties can also flow from P to A. ii. Tort Liability of Principal for Agent’s Actions

1. Employee vs. Agent a. R.3d: Does not define “master,” “servant,” or “independent contractor,” instead opting to

define an employee as “an agent whose principal controls or has the right to control the manner and means of the agent‟s performance of work,” and the employer is subject to vicarious liability for tort committed by his employee within the scope of employment.

b. Defining an employee: R.3d, §7.07 comment f provides a list of factors to consider, with [e] favoring employee status and [n-e] against that status. No single factor is determinative, and language of agreement will not prevail over the reality of the relationship. Right to terminate is not dispositive; carries weight only to extent that it creates practical ability to control the A’s performance.

i. extent of control that the A and P have agreed the P may exercise over details of the work [e]

ii. whether the A is engaged in a distinct occupation or business [n-e] iii. whether the type of work done by the A is customarily done under a P‟s direction

[e] or without supervision [n-e] iv. the skill required in the A‟s occupation [n-e if great skill] or [e if unskilled]

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v. whether the A [e] or the P [n-e] supplies the tools and other instrumentalities required for the work and the place in which to perform it

vi. the length of time during which the A is engaged by the P [the longer the time, the more the E]

vii. whether the A is paid by the job [n-e] or by the time worked [e] viii. whether the A‟s work is part of the P‟s regular business [e] ix. whether the P and the A believe that they are creating an employment

relationship [e] x. whether the P is or is not in business [E, but “business” means any ongoing

enterprise including nonprofits] 2. Attribution: Agency law has rules for attributing an A‟s torts to the P, divided into two

categories based on the nature of the A‟s conduct and the nature of the third party‟s injury: a. A’s physical conduct causes physical harm to a third party’s person or property:

applicable doctrine is respondeat superior; only for employees. b. A’s words cause harm to third party’s emotions, reputation, or pocketbook:

servant/nonservant distinction is rarely relevant, and attribution occurs according to the same rules of actual authority, apparent authority, and inherent agency power that apply to contractual matters.

3. Respondeat Superior a. Defined: imposes strict, vicarious liability on a P when (1) an A‟s tort has caused

physical injury to a person or property, (2) the tortfeasor A meets the criteria to be considered an employee, and (3) the tort occurred within the employee‟s scope of employment.

b. Effects: Renders P liable for the employee‟s misconduct regardless of whether the P (1) authorized the misconduct, (2) fordbade the misconduct, or (3) used all reasonable means to prevent the misconduct.

c. In theory the proper place to begin analysis is whether the tortfeasor is an agent vel non but in practice it comes down to whether he is an employee vel non.

d. Rationales for the rule: i. Enterprise Liability: links risks to benefits and holds accountable the person for

the risk-creating activity ii. Risk spreading: employer should bear this risk because he can (1) anticipate

risks inherent in the enterprise, (2) spread the risk through insurance, (3) take

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into account the cost of insurance in setting prices, (4) spread risk among those benefitting from the good/service.

iii. Risk avoidance: employer is well positioned to deter the harmful conduct iv. Deep pocket: employer is probably better suited to pay the damages.

e. Scope of Employment: i. R.3d: takes a less formulaic approach than R.2d: “An employee acts within the

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

ii. Scope is not limited to the proper or authorized conduct; conduct must be of the same general nature as that actually authorized, or incidental to the conduct authorized.

1. Means an act can be within the scope even if (1) the employer has expressly forbidden the act, (2) the act is tortious, or (3) the act constitutes a minor crime.

2. Scope of P‟s control will not necessarily extend to all acts that are within the scope of employment.

iii. Travel vs. Commuting (“Special Errand” Exception): 1. R.3d: “Travel required to perform work, such as travel from an employer‟s

office to a job site or from one job site to another, is within the scope of employment but traveling to and from work is not.

a. Exception: if the employee undertakes an errand at the employer‟s request, the entire trip is part of the scope of employment, even if it happens while traveling to/from work.

b. Social events: Some cases hold that scope extends to driving home from a work-related social event if:

i. Attendance was required or part of the employee‟s job ii. Employee became intoxicated at the social event and

remained so while driving home; and iii. Employee caused an accident while driving home drunk.

iv. Tangential Acts: Frolic and Detour

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1. Even when scope includes travel on employer‟s behalf, does not include when employee‟s act is part of an intended course of conduct not intended by the employer

a. mere deviation does not exceed scope (“detour”) b. substantial deviation exceeds scope (“frolic”)

2. Detour vs. Frolic a. At least one major case suggests it must be at least incidental to

the employee‟s duties in order to be a detour(Fiocco v. Carver, 137 N.E. 309 in Kleinberger@305).

b. Another suggests that a temporary deviation is OK but a temporary abandonment is not.

c. Keep these things in mind i. Employees predictably engage in small deviations ii. Deviations more likely to result in harm than those inherent

in the servant‟s task are more likely to be frolics iii. Cases decided under workers comp statutes typically tilt in

favor of classifying activity as within the scope 3. Ending the Frolic:

a. Reentry has occurred once employee is fully back in employer‟s service

i. Again actuated at least in part by desire to serve master‟s interest

ii. Again within the authorized space and time limits iii. Actually taking some action in the master‟s interests not

necessitated by the frolic itself b. Less clear when employee negligently causes harm while “on the

way back” to employment i. Employee does not reenter scope by deciding to return ii. Does not have to return to the point the frolic began to

reenter the scope iii. R.3d: when frolic is a physical journey away from the

workplace or a material departure from assigned route of travel, employee reenters employment when employee has

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taken action consistent with once again resuming work. (R.3d, §7.07, comment e)

4. Personal/Business Multitasking: On-Site Frolics and Negligent Self-Distraction:

a. If employee undertakes personal matters at the same time as business tasks, the business task remains within the scope. BUT the employee‟s self-distraction may constitute negligence in performing the task.

f. Intentional Torts i. When employee, acting within the scope of employment, commits an intentional

tort causing physical harm, employer is vicariously liable. 1. Even an expressly criminal act can be within the scope.

ii. Purpose Test-R.3d: question is “whether the tortious act occurs within an independent course of conduct not intended by the employee to serve any purpose of the employer.” R.3d, §7.07(2).

1. Example: Employee‟s intentionally violent conduct may be within scope when the conduct closely relates to a dispute that at least initially concerned the employer‟s interests (i.e., a bouncer at a bar).

iii. Incidental/Foreseeable Test: Some recent cases abandon the purpose test, and look at whether the tort was foreseeable or incidental.

1. R.3d is critical of this test g. Scope of employment and seriously criminal behavior:

i. Many of the incidental/foreseeable cases bend concept of respondeat superior to hold employer liable without fault to get at the deep pocket

ii. In most jurisdictions the purpose test remains key, so unlikely that employer will be liable for serious crime

1. R.3d: “Extreme quality...of a serious crime may indicate that the employee has launched upon an independent course of action” not intended by the employer. R.3d §7.07(2)

4. Liability for Physical Harm Beyond Respondeat Superior a. Generally, P not vicariously liable for physical harm caused by torts of nonemployee A b. Exceptions

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i. Principal Owes Direct Duty to a Third Party: P owes direct duty of care to a third party and relies on A for the necessary performance, A‟s conduct may result in liability

ii. Intentional Torts of Nonemployee Agents: 1. Some sources say P not liable unless (1) P intended or authorized the

result or manner of performance, (2) the P owed a duty to the injured party to have the A‟s task performed with due care.

a. Exceptions: findings of control by P, P‟s ratification of wrongful act, breaching duty to customer; some simply hold that independent contractor status does not bar vicarious liability for intentional torts

c. Misrepresentation by an Agent or Apparent Agent i. If (1) a person has actual or apparent authority to make statements concerning a

particular subject, (2) the person makes a misstatement of fact concerning the subject, (3) a third party relies on the misstatement, and (4) the third party suffers physical harm as a result, then the actual or apparent principal is liable to the third party. (R.3d §§7.04 (actual authority) and 7.08 (apparent authority)).

iii. Duties and Obligations of the Principal to Third Parties 1. Agency Law Duties

a. Duty to Properly Select and Use Agents: P has duty to use reasonable care in choosing, informing, training, and supervising its agents. If a P breaches this duty and, as a foreseeable result the P‟s agent injures a third party, the P is liable.

b. Fact that A acts negligently does not necessarily establish that P breached the duty of care.

c. Nexus Requirement: Must be a nexus between the P‟s negligence in selecting/controlling the A, the A‟s work, and the harm suffered by the third party. **If the act was within the scope of employment, this is likely satisfied** (R.3d §7.05, comment c).

d. Standard of Care/Vulnerable Customers, etc.: Depending on the totality of circumstances, the care demanded of the P may be different (i.e., difference in selecting a person to be a janitor, as opposed to a teacher--because the teacher is charged with taking care of kids where they‟re vulnerable).

e. Relationship of Principal’s Direct Duty to Principal’s Vicarious Liability: Liability under direct duty is different than respondeat superior, but they can overlap.

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Principal Breached Duty of Care

Principal Did Not Breach Duty of Care

A‟s Conduct (Negligent) Employee vel non, P is liable on direct claim if nexus exists; also vicariously liable if A acting within scope

P not liable on direct claim, but vicariously liable if A acting within scope

A‟s Conduct (Not Negligent)

P liable on direct claim only, employee vel non

P not liable

iv. Contract Liability from the Agency Relationship 1. Contract between A and third party can impose liability on P, depending on the type of P that is

present at the transaction a. Disclosed: At time of transaction, the third party has notice that the A is acting for a P,

and has notice of the P‟s identity. Can be disclosed even though third party has to reasonably infer the identity of the P from the information at hand.

b. Partially disclosed: At time of the transaction, the third party has notice that the A is or may be acting for a P, but the third party has no notice of the P‟s identity.

c. Undisclosed: At the time of the transaction, the third party has no notice that the A is acting for a P.

2. Liability of the A to the Third Party a. Disclosed: If A contracts with third party on behalf of disclosed P, generally the A is not

a party to the contract/not liable. (R.3d § 6.01(2)) b. Partially/UndisclosedIf A contracts with a third party on behalf of partially disclosed or

undisclosed P, general rule is that A is a party to the contract and is liable to the third party (even if P is not liable to third party). (R.3d § 6.02(2), 6.03(2), 6.09).

i. Auctioneer’s Exception: When an auctioneer sells an item for an undisclosed P, no one expects to hold the auctioneer liable. (R.3d § 1.04, Reporter‟s Notes, section b).

c. Warranty of Authority: A purporting to act on behalf of a P makes implied warranty of authority; if the A lacks the power, A is liable to the third party for breach of the implied warranty (unless A conveyed that he was not making such a warranty or third party knew that A had no authority). (R.3d § 6.10)

i. When applicable:

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1. true A‟s who act outside their authority and to purported A‟s witho no actual authority at all;

2. Regardless of whether the purported P is disclosed or partially disclosed; and

3. Even though the third party could have discovered the lack of authority by exercising reasonable care.

ii. Warranty does not apply: 1. Purported A disclaims having authority to bund or indicates that it doubts

its own authority; or 2. Third party knows for some other reason that the purported A lacks

authority. iii. If purported A acts without actual authority but manages to bind the purported P

through (1) apparent authority, (2) inherent agency power, or (3) estoppel, the warranty of authority is not breached. That is because the third party has a good contract with the purported P; same if the purported P ratifies the contract.

iv. A may also be liable under theory that he tortuously misrepresented his authority. (R.3d § 6.10 comment a).

d. **If A becomes party to contract with third party & third party breaches, he may be liable to the A** (R.3d § 6.03 comment e).

e. These rules are defaults; can be overridden by express or implied agreement between the A and the third party.

f. Agent’s Liability and Available Defenses: i. Unless otherwise agreed, A‟s contractual liability is as a guarantor. ii. A enjoys any of the P‟s defenses arising from the transactions, as well as any

personal defenses or setoffs the A has against the third party (but may not assert defenses that are personal to the P).

3. Four Ways in Which A’s Action can Bind P to the Third Party a. Actual Authority (also: express authority, authority, or authorized): Arises from the

manifestation of a P to an A that the A has power to deal with others as a representative of the P. An A who agrees to act in accordance with that manifestation has actual authority to so act, and his actions without more bind the P. In other words, if the P’s words/conduct would lead a reasonable person in the A’s position to believe the A has authority to act on the P’s behalf, the A has actual authority to bind the P.

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i. Elements: (1) objective manifestation by the P, (2) followed by the A‟s reasonable interpretation of that manifestation, (3) which leads the A to believe that it is authorized to act for the P. The P‟s manifestation may reach the A directly or indirectly, and a manifestation reaching A through intermediaries can still give rise to actual authority.

1. R.3d: “An A‟s understanding of the P‟s objectives is reasonable if it accords with the P‟s manifestations and the inferences that a reasonable person in the A‟s position would draw from the circumstances creating the agency.” (R.3d § 2.02(3)).

a. R.3d also makes a connection between the A‟s interpretation and his fiduciary duty to the P (§ 2.02(2)), so the A‟s interpretation must be in a reasonable manner to further purposes of the P that the A knows or should know, in light of the facts that the A knows or should know at the time of acting. So, A is not free to exploit gaps/ambiguities in the P‟s instructions, etc. **Facilitates agency creation process** (R.3d § 1.01, comment e).

ii. Manifestation can consist of inaction, if when reasonably interpreted creates the authority.

iii. P can countermand a manifestation; latter manifestation trumps the earlier one (so long as it reaches the A).

iv. Elements regarding actual authority have nothing to do with third parties, so an A can have it even though a third party does not know of it at the time of a given transaction.

v. May be express (i.e., oral/written statements with provisions indicating the authority) or implied (i.e., inferred from the principal‟s prior acts).

1. Common type of implied actual authority is incidental authority, which is the authority to do acts that are incidentally related to the authorized transaction.

2. R.3d, Ch. 2, Introductory Note & § 2.01, comment b vi. Where agency relationship involves an “interface function” with third parties, the

P‟s manifestation to the A necessarily creates actual authority in the A. (i.e., hiring a cashier for a store).

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vii. When A binds P in a contract with actual authority, the P is always bound and the third party is almost always bound to the P.

b. Apparent Authority i. Arises from the manifestation of a P to a third party that another person is

authorized to act as an A for the P. I.e., if the P‟s words would lead a reasonable person in the third party‟s position to believe the A has authority to act on the P‟s behalf, the A has apparent authority to bind the P. (R.3d §§ 2.03, 3.03). The other person has apparent authority and an act by him within the scope of that apparent authority binds the P. (R.3d §§ 6.01-.02)

ii. Commonly arises when a P creates impression that A has broad authority, though that is not actually true.

iii. Third Party’s Interpretation: Reasonableness Requirement 1. Mere belief not enough; must be reasonable. This takes into account the

same information that an A would consider for an actual authority analysis. NOTE: ASK PROF. EFFROSS; BUT IF A HAS FIDUCIARY DUTY TO INTERPRET, WOULDN’T THIS BE A DIMINISHED REQUIREMENT IN PRACTICE?

2. Third party has a duty of inquiry, for example, where the manifestations are ambiguous or unusual.

iv. Conceptual difference: Actual authority flows from P to A; Apparent authority flows from the P to a third party

1. Thus: apparent authority cannot be created by representations of purported A to a third party

2. Exception: Apparent agent can supply the “necessary peppercorn of manifestation” only if the apparent A (1) is actually authorized to act for the P, and (2) while actually authorized, accurately describes the extent of its authority--so such statement is attributed to the P. (R.3d does not address this as precisely as R.2d so be careful here; it only says that an agent‟s own statements about nature or extent of A‟s authority to act on behalf of the P do not create apparent authority by themselves. R.3d § 6.11). NOTE TO SELF: SO WHAT DOES THIS MEAN? ASK PROF. EFFROSS.

v. Scope of apparent authority can be coterminous with the scope of actual authority. BUT the source of authority can affect the P‟s liability.

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vi. Apparent authority can exist in the absence of an agency relationship. 1. R.3d § 2.03: “Apparent authority is the power held by an A or other actor

to affect a P‟s legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the P and that belief is traceable to the P‟s manifestations.” Id. at comment a: “The apparent authority definition in this section does not presuppose the present or prior existence of an agency relationship...this applies to actors who appear to be agents but are not, as well as to agents who act beyond the scope of actual authority.

vii. May be established through the A‟s title or position viii. Reliance: Whether third party must establish detrimental reliance is imprecise;

under R.3d, the claimant‟s inference of authority must be traceable to P‟s manifestation. (R.3d § 2.03). R.3d does not require further reliance, but many jurisdictions do; in fact, many refer to it as agency by estoppel.

ix. Case-by-case basis: claims must be analyzed separately, even when the parties are the same, because authority can vary among the different transactions.

x. “Lingering” Apparent Authority: It is reasonable for third parties to assume that an agent‟s actual authority is a continuing or ongoing condition. (R.3d § 3.11, comment c). Length of the lingering can depend on the circumstances.

xi. Partially/Undisclosed P’s: 1. Undisclosed: A‟s for undisclosed P can never have apparent authority,

because by definition the third party is unaware that the A is acting for a P at all.

2. Partially: Apparent authority is possible in theory but rare in practice, because the third party would need to allege manifestation attributable to some P but not the specific P.

xii. Contracts: same results as actual authority. c. Estoppel

i. R.3d: § 2.05: “A person who has not made a manifestation that an actor has authority as an agent and who is not otherwise liable as a party to a transaction purportedly done by the actor on that person‟s account is subject to liability to a

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third party who justifiably is induced to make a detrimental change in position because the transaction is believed to be on the person‟s account, if:

1. The person intentionally or carelessly caused such belief, or 2. Having notice of such belief and that it might induce others to change their

positions, the person did not take reasonable steps to notify them of the facts.

ii. R.3d attempts to distinguish estoppel from apparent authority by applying estoppel to apply only in the absence of a manifestation by the asserted P.

iii. Related to apparent authority; both focus on holding P responsible for a third party‟s belief that a person is authorized to act on P‟s behalf. (R.3d § 2.05).

1. Reliance: In order to assert estoppel, must prove detrimental reliance. R.3d § 2.03 comment e.

iv. Applies when the P has not made any manifestations of authority to the third party at all, but P still contributed to third party‟s belief or failed to dispel it.

1. Most often applies as consequence of failure to use reasonable care, either to prevent circumstances that foreseeably led to the belief, or to correct the belief once on notice of it. (R.3d § 2.05 comment c).

d. Ratification: i. Elements: (1) there must have been some transaction or event involving an

unauthorized act, (2) at the time of the unauthorized act, the purported P must have existed and must have had capacity to originally authorize the act, (3) and at the time of the attempted ratification the purported P must have knowledge of all material facts and the third party must not have indicated either to the P or A an intention to withdraw from the transaction. If these elements exist, a P ratifies by either making a manifestation that objectively indicates a choice to treat the unauthorized act as though it was authorized, or engage in conduct that is justifiable only if the purported P had made such a choice.

ii. Even if A did not have authority, P liable to a third party if (1) the A purports to act or on the P‟s behalf, and (2a) the P affirmatively treats the A‟s act as authorized, called express ratification, or (2b) the P engages in conduct that is justifiable only if the P is treating the A‟s act as authorized, called implied ratification. R.3d §§ 4.01-.03.

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iii. Does not occur unless the P, at the time of the ratification, is fully aware of all the material facts involved in the original transaction. R.3d § 4.06

iv. Occurs as soon as the P objectively manifests his acceptance of the transaction, even if the ratification is not communicated to the third party/A/anyone else (R.3d § 4.01), so it‟s the same as if the P had originally authorized it (R.3d § 4.01(1), 4.02(1).

v. Not effective if: third party withdraws before the ratification, or if it would be unfair to the third party as a result of changed circumstances (R.3d§ 4.05).

vi. Clarifies situations with uncertain authority; makes it unnecessary to establish apparent authority/estoppel. Also eliminates P‟s potential claims against the A for acting without authority. R.3d § 4.01 comment B.

vii. Cannot operate to prejudice the rights of persons not parties to the transaction but who acquired rights or other interests in the subject matter of the transaction before the ratification. R.3d § 4.02(2)(c).

viii. Traditionally, by definition, this cannot include undisclosed P‟s because there is no notice that the A is acting on a P‟s behalf. R.3d changes this; allows ratification by an undisclosed P by stating that a person may ratify an act if the actor acted or purported to act as an A on the P’s behalf (so it does not have to appear to be an A to the third party). R.3d § 4.03.

ix. Ratification typically involves contracts, but can include torts. x. P can also ratify by accepting/retaining benefits while knowing they derived from

an unauthorized act; if the P accepts them without this knowledge, the third party may have an action in restitution or quantum meruit. Ratification allows for full benefit of bargain, while the latter entitles third party only to the value of the benefit actually conferred.

xi. P can only ratify the entire transaction; does not get to pick and choose provisions. If the P makes a piecemeal affirmance, whether ratification occurs depends on whether the P manifested: (1) an intent to ratify and has sought to impose some exclusions/qualifications, in which entire transaction ratified and the exclusions are ineffective, or (2) an intent to be bound only if the exclusions are part of the transaction, in which case there is no ratification and neither party is bound, unless the third party manifests consent to the conditions.

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xii. Definition of material facts: R.3d uses a briefer formulation than R.2d, but is more vague: refers to material facts involved in the original act, and a comment explains that the point of materiality is the relevance of the fact to the P‟s consent to have legal relations affected by the A‟s act. R.3d § 4.06, comment c.

1. Under R.3d, fact finder may conclude that a purported P has assumed risk of ignorance and ratified when P had facts that would have led reasonable person to investigate further, but ratified without doing so.

2. P‟s ignorance ceases to be a factor if the third party has learned of and detrimentally relied on the P‟s affirmance. R.3d § 4.08.

4. Contract Liability of Third Party to P a. Disclosed/Partially: When A makes contract for a disclosed/partially disclosed P, third

party is liable to the P if the A acted with authority so long as the P is not excluded as a party by the form or terms of the contract. R.3d § 6.01(1), .02(1).

b. Undisclosed: Third party liable to the P if the A had authority so long as the P is not excluded by the form/terms of the contract, the existence of the P is not fraudulently concealed, and there is no set-off or similar defense against the A. R.3d § 6.03, 6.06, 6.11(4).

c. Fraudulent Concealment exception: When A acting for an undisclosed P falsely represents that he is acting solely for himself; R.3d allows third party to avoid contract if the P or A had notice that the third party would not have dealt with the P. R.3d § 6.11(4).

d. Undisclosed P cannot bind a third party if the P‟s role in the contract substantially changes the third party‟s rights or obligations. R.3d § 6.03 comment D.

e. Third Party can avoid an otherwise binding affirmance (ratification) in two situations: i. Changed Circumstances: Third party avoids liability if the circumstances change

so materially that holding the third party to the contract would be unfair; must inform the P, but does not have to be before the affirmance. R.3d § 4.05, Ill. 2

ii. Conflicting Arrangements: Third party can avoid ratification if the third party (1) learns that the purported A acted without authority, (2) relies on the apparent lack of authority, and (3) makes substitute, conflicting arrangements or takes some other action that will cause prejudice to the third party if the original transaction is enforced. R.3d § 4.05(2). Third party must act before learning of the P‟s affirmance.

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f. Binding the P via Actual Authority: Special Rules for Contracts Involving Undisclosed P’s

i. When the P is undisclosed, the third party is sometimes entitled to (1) insist on rendering performance to the A, or (2) escape the contract entirely.

ii. Rendering performance to the A: Third party may insist upon this if the contract requires the third party to perform personal services, or if in some other way rendering performance to the P would significantly increase/change the third party‟s burden. This is because the third party expected to render performance to the A.

iii. Escaping the Contract Entirely: Escape is possible if: 1. Contract so provides (i.e., it states it is inoperative if the A is representing

someone); or 2. A special kind of fraud exists, which is difficult to prove:

a. A fraudulently represented that the A was not acting for the P; b. the third party would not have entered into the contract knowing the

P was a party; and c. the A or undisclosed P knew or should have known that the third

party would not have made the contract with the P. **Mere filure to disclose the P‟s existence is always insufficient**

g. Liability of Agent to Principal i. A is liable to his P for any loss suffered by the P where the A exceeds authority.

R.3d § 8.09, and comment b. ii. If the A breaches duty of loyalty, the P‟s remedies include not only damages but

also disgorgement of any profits derived by the A from the disloyal transaction and rescission of any transaction between the P and the A if the breach infected that transaction. These are considered equitable remedies, and do not require proof of damage.

iii. In many jurisdictions, breach of duty of loyalty can support a claim for punitive damages, and in others the statute of limitations does not start until the P knows/has reason to know of the breach.

h. Liability of Principal to Agent i. P‟s duties to an A are not fiduciary in nature, but nevertheless a P has several

obligations.

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ii. Must perform contractual commitments iii. Must not unreasonably interfere with the A‟s work iv. Must generally act fairly and in good faith towards the A (R.3d §§ 8.13, 8.15 for

all of these) v. If the A incurs expenses or suffers other losses in carrying out P‟s instructions, P

has duty to indemnify the A. (R.3d § 8.14). 1. When in actual authority 2. Made to the P‟s benefit but without authority if

a. A acted in good faith and mistakenly believed it to be authorized, and

b. Under principles of restitution it would be unjust to not require indemnity

3. Claims made by third parties entered into by the A, with authority, and on the P‟s behalf

4. Claims made by third parties for torts allegedly committed by the A, if: a. The A‟s conduct was within the A‟s actual authority, and b. The A was unaware that the conduct was tortious

vi. No duty to indemnify exists for 1. Payments made or expenses incurred that are neither within the actual

authority nor benefit the P 2. Losses resulting from A‟s negligence or from acts outside the A‟s actual

authority 3. Losses resulting from the A‟s knowing commission of a tort or illegal act

vii. To invoke P‟s duty to defend, A must (1) give P reasonable notice of the claim, (2) allow the P to manage the defense, and (3) cooperate with the P in the defense.

viii. P‟s duty to indemnify is a default to rule that is subject to change by any valid contractual agreement.

ix. P’s Duties in Tort (Physical Harm to the A) 1. Non-employees: P owes its non-employee agent whatever tort law duties

the P owes to the rest of the world. Also, P has duty to warn its nonemployee agent of any risk involved in the A‟s tasks if the P knows or

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should know that (1) risk exists, and (2) the A is unlikely to be unaware of the risk.

2. Employees: a. “Fellow Servant” Rule: Prevented servants from holding masters

vicariously liable for the tortious conduct of a fellow servant. b. Assumption of risk: At one time, this applied generally within tort

law; it barred servants from recovering for injuries arising form the ordinary dangers of their work, because it was said they assumed the risk (making recovering more difficult in more dangerous job settings).

c. Contributory negligence: At one time, barred recovery when the injured servant‟s own negligence helped cause the injury.

d. Today, workers comp statutes provide a no-fault compensation regime and preempt these common law rules.

3. Contract-based duties a. Implied terms: law can supply a term (“implied in law”) and implied

“in fact” from the (1) express terms of the agreement, (2) the parties‟ conduct before or after contract formation, and (3) other circumstances including usages of trade. No implication arises from the fact that an agency relationship exists or from the fact that the P promised to pay the A.

5. Partnership Illustrations of Agency Law a. Every partner is an agent of the partnership (UPA §9(1), RUPA §301(1)

Power to Bind Through a Partner‟s...

UPA Provision RUPA Provision

Contractual Undertaking and Similar Acts

§ 9 § 301 (drawn closely from UPA § 9)

Wrongful Act § 13 § 305(a) (drawn closely from UPA § 13)

Breach of Trust § 14 § 305(b) (intended to encompass UPA § 14 claims)

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Knowledge, Notice § 3 (definition of knowledge)

§ 102 (modeled on UCC, Art. 1 definitions)

Effect of Publicly Filed Statements

N/A Comprehensive System Providing Constructive Notice

b. Binding the Partnership in Contract - UPA § 9

i. UPA § 9 continues to be good law in many jurisdictions ii. Agency Law Empowering rule: UPA §9(1) states that every partner is an agent of

the partnership, but the rest of the section qualifies this. iii. The “Apparent/Usual” Empowering Rule (Statutory Apparent Authority): UPA

§9(1), clause 2: act of partner for apparently carrying on in the usual way the business of the partnership...binds the partnership--analogous to agency‟s apparent authority by position. Person seeking to use this attribution rule must show that: (1) at the time of the transaction, (2) it reasonably appeared to the person that the partner‟s act was: for carrying on the business of the partnership, and for doing so in the usual way. CANNOT APPLY WHEN PARTNERSHIP IS UNDISCLOSED.

1. (Just like apparent authority) this can exceed actual authority 2. The partnership need not benefit; the A can be the one that takes the

benefit of the transaction. iv. The “Flip Side” Constraining Rule: Not “Apparently/Usual” and No Actual

Authority: Under UPA §9(2) a partner lacks the power to bind the partnership if (1) the partner is not authorized by the other partners, and (2) the partner‟s act is not apparently for the carrying on of the business in the usual way.

1. Taken together with the Apparent/Usual Empowering clause, this means that:

a. A partner who has actual authority binds the partnership within the scope of that authority, regardless of what appears to the third party, and

b. A partner who lacks actual authority can bind the partnership only by satisfying the apparently/usual empowering rule

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v. The “No Authority” Constraining Rule: UPA § 9(4) and last lines of § 9(1) state the same rule; regardless of apparently/usual empowering rule, the partnership is not bound if (1) the partner acts without actual authority, and (2) at the time of the act the third party knows of the lack of authority.

vi. The “Unanimous Consent” Constraining Rule: Under UPA § 9(3), unless the other partners have abandoned the business, a partner needs either actual authority or unanimous consent from copartners to:

a. assign the partnership property in trust for creditors or on the assignee‟s promise to pay the debts of the partnership

b. dispose of the good will of the business c. do any other act which would make it impossible to carry on the

ordinary business of a partnership d. confess a judgment e. submit a partnership claim or liability to arbitration or reference

2. In these areas, a partner lacking the authority to bind the partnership also lacks the power to bind.

3. If a partner lacks actual authority, copartners‟ unanimous consent can remedy the situation; if consent precedes the act the consent creates actual authority, but if after, the consent is ratification.

vii. The Import of the Partnership‟s Receipt of Benefits: Under contract/agency principles, partnership‟s acceptance of benefits from a transaction can bind the partnership to the transaction under ratification, quantum meruit, or unjust enrichment.

c. Binding the Partnership in Contract--RUPA § 301 i. RUPA keeps the same basic principles as those in UPA §9(1) but is much

shorter. It also differs from the UPA in six noteworthy ways: 1. Replaces UPA‟s “apparently/usual” formulation with the phrase “for

apparently carrying on in the ordinary course.” but has no effect on meaning.

2. Delineates a partner‟s “apparently/ordinary” power by referring both to “the ordinary course [of] the partnership business” and to “business of the kind carried on by the partnership.” This broadens the scope of statutory apparent authority.

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3. Eliminates as inflexible the “unanimous consent” constraining rule of UPA § 9(3), which removes an outdated barrier to agreements to arbitrate.

4. Eliminates as redundant UPA § 9(4), but has no effect on meaning. 5. Modifies the “no authority” constraining rule, so that it applies not only if

the third party knew that the partner lacked actual authority, but also if the third party “had received a notification that the partner lacked authority,” altering the balance of risk between partners/third parties.

6. Establishes a system of recorded statements of authority, and limitations of authority, which can affect both the apparently/ordinary empowering rule and the no authority constraining rule; primary effect is on the power to transfer real property.

ii. Modifying the No Authority Constraining Rule 1. Under RUPA § 102(d), a person receives a notification when the

notification (1) comes to the person‟s attention; or (2) is duly delivered at the person‟s place of business or at any other place held out by the person as a place for receiving communications.

iii. Establishing a System of Recorded Statements That Can Significantly Affect the Operation of RUPA § 301

1. One of RUPA‟s big innovations is a system of public statements to establish what amounts to “constructive notice.”

2. Under RUPA § 303, providing for statements of partnership authority, such statement must be executed by at least two partners, must contain certain basic information, and may state the authority, or limitations on the authority, of some or all of the partners to enter into other transactions on behalf of the partnership and any other matter.

3. Transfers of Real Property a. § 303 notices help real property transfers because real property

lawyers like having things in the public record to help establish chain of title, so statements pertaining to authority to transfer real property reflect the core of § 303.

b. If a statement limiting the authority of a partner to transfer real estate is properly filed, a person not a partner is deemed to know of the limitation. § 303(e)

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c. When real property is involved, proper filing means filing a statement with the Secretary of State, PLUS having a “certified copy of a filed statement of partnership authority recorded in the office for recording transfers of that real property.” RUPA § 303(d)(2)

4. Other Transactions and Other Matters: The effect of an “other matter” filing is more limited than in the real property context and the limitation tilts against the oartnership:

a. A grant of authority contained in a filed statement of partnership authority is conclusive in favor of a person who gives value without knowledge to the contrary, so long as and to the extent that a limitation on that authority is not then contained in another filed statement but has no effect in favor of the partnership, and

b. A person not a partner is not deemed to know of a limitation on the authority of a partner merely because the limitation is contained in a filed statement.

5. Changing and Canceling Statements of Authority a. May be canceled by filing a statement of cancellation (RUPA

§§303(d)(1),(d)(2), and (g) assume such statements exist), and can be nullified by filing a statement containing a statement of limitation which contradicts the grant (RUPA §303(d)(1) and (2)).

b. Unless earlier canceled, a filed statement of partnership authority is canceled by operation of law five years after the date on which the statement/most recent amendment was filed with the Secretary of State.

d. CASES i. National Biscuit Co. v. Stroud (1959) (p. 53):

1. Facts: General partnership to sell groceries (two partners). One told Nabisco they would not need to deliver any more bread, but the other partner continued to order bread from Nabisco.

2. Holding: General partnership generally grants power to any partner to bind the partnership in any manner legitimate to the business; this is true both for sales and purchases. Thus, since Freeman (the other partner) was a

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general partner, with no restrictions on his authority to act within the scope of the partnership business, had equal rights in the management and conduct of the business.

ii. Smith v. Dixon (1965) (pg. 19, handout 1) 1. Facts: W.R. Smith acted as the managing partner for a large family

partnership; in this capacity he contracted to sell a parcel of land to appellee for $200,000 but appellants, the rest of the partnership, assert that he had no authority to do so; they claim that he was only authorized to sell for $225,000 or more.

2. Holding: Partnership is bound by the acts of a partner when he acts within the scope or apparent scope of his authority; to determine apparent scope, look at past transactions. Here, W.R. Smith had customarily been delegated the responsibility of handling the partnership‟s business affairs, so the contract stands.

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II. Partnerships

a. General Partnerships

i. Generally 1. Definition: Formed whenever there is an “association of two or more persons to carry on as co-

owners a business for profit (UPA § 6) [...whether or not the persons intend to form a partnership (RUPA § 202(a))].

a. See UPA§ 7, RUPA § 202(c) for rules for assisting in the determination of whether a partnership has been formed.

i. Most important: person who receives a share of the profits of a business is presumed to be a partner in the business, unless the profits were received in payment of a debt as wages, or for other exceptions (UPA § 7(4), RUPA § 202(c)(3)).

b. Does not need to be publicly filed; just needs to fall within the definition (so a partnership can be created even if the partners do not realize that they are forming such an enterprise).

i. Thus, the only intent that is relevant is the intent to do those things which constitute a partnership.

c. “Paradigmatic Partnership” is: i. An unincorporated business intended to make a profit, ii. That has two or more participants, who may be either individuals or entities, iii. Each of whom “brings something to the party,” such as efforts, ideas, money,

property, or some combination iv. Each of whom co-owns the business, v. Each of whom has a right to co-manage the business, and vi. Each of whom shares in the profits of the business

d. UPA/RUPA both refer to a partnership as “an association” (UPA § 6(1), RUPA § 202(a)).

e. Profit sharing is not dispositive (other business forms may require profit sharing) -- in other words, it‟s necessary but not sufficient

f. Express agreements to share losses intensify the co-management/co-ownership inclinations, and in all jurisdictions such agreements are strong evidence of a

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partnership. In some jurisdictions, such an agreement is actually a prerequisite to a finding of partnership. **THIS IS NOT THE MAJORITY RULE**

i. UPA/RUPA: do not mention loss sharing as a prerequisite, and both treat it as a consequence of partnership status (UPA § 18(a)/RUPA § 401(b))

g. Co-ownership is a key characteristic, but it is not defined in the UPA or RUPA and has different meanings. For partnership formation, they‟re agreeing to co-own the assets, and the co-right to benefit.

2. Aggregate vs. Entity? a. UPA: generally adopts an aggregate view, rejecting notion that partnership is its own

legal entity. (See, e.g., § 29). i. BUT a partnership can own property (UPA§ 25(1)) because a partner is co-owner

with his partners of specific partnership property holding as a tenant in partnership (“tenancy in partnership” form of ownership).

ii. Each partner has three property rights in the partnership (UPA § 24) 1. Rights in specific partnership property 2. Interest in the partnership 3. Right to participate in the management

iii. Management Prerogatives Disguised as Property Rights: Partner as the right to (1) use the assets of the partnership in furtherance of the partnership‟s business (UPA § 25), and (2) the right to participate in the management of the partnership (UPA § 24).

iv. RUPA takes a more straightforward approach by stating: 1. A partner is not a co-owner of partnership property and has no interest in

partnership property which can be transferred, either voluntarily or involuntarily (RUPA § 501)

2. A partner may use or possess partnership property only on behalf of the partnership (RUPA § 401(g)

3. As for property rights, there is only the transferable interest, which is the partner‟s share of profits and losses and the partner‟s right to receive distributions. (RUPA § 502).

v. Partners thus.. 1. Have a right to possess partnership property for non-partnership purposes

(UPA § 25(2)(a))

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2. May not assign his interest in partnership property (UPA § 25(2)(b)) 3. Partner‟s right in partnership property is not subject to attachment or

execution on a claim against the partner (UPA § 25(2)(c)) 4. On the death of a partner, his right in partnership property vests in the

surviving partners ( UPA § 25(2)(e)) vi. Also allows for partnership to acquire real property in its name, somewhat

contrary to the aggregate theory (UPA § 8(3)) 3. UPA & RUPA Flexibility: Default Rules and Agreements Among Partners

a. Rules of both UPA/RUPA an be divided into two categories: i. Those that govern the relationship among the partners (inter se rules), and ii. Those that govern the relationship between the partnership (and its partners)

with outsiders (third party rules). b. Inter se rules are “default rules,” applicable only in the absence of a contrary agreement

among the partners; such agreements can be express/implied, written/oral. i. Adopting a partnership agreement always requires unanimity, but amendment

can be on a less-than-unanimous basis (e.g., majority vote of the partners). So, changes to default rules can require less than unanimity.

ii. Straying too far from the default rules may negate the partnership (i.e., eliminating profit sharing) and some cannot be eliminated (i.e., fiduciary duties).

1. Governed by case law for UPA, generally 2. RUPA devotes a lot to this: § 103 states that generally the partnership

relations are governed by the agreement, but the general rule is subject to a list of specific exceptions that are mostly constraints on the partnership agreement‟s power to

a. reshape the fiduciary duties that partners owe each other and the partnership; and

b. limit the ability of partners to “dissociate” themselves from the partnership (RUPA § 103(b)).

c. Third party rules are mandatory rules that cannot be changed by agreements among partners, as third party consent is also necessary.

4. Partnership types a. Partnership at will: each partner has the right to cause the partnership to come to an

end, at any time and without having to state or have “cause.”

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b. Partnership for a term: Comes to an end at the end of the time period specified in the partners‟ agreement

c. Partnership for a particular undertaking: Comes to an end when the particular task or goal specified in the partners‟ agreement has been accomplished. **Under the law of most states, joint ventures are analogized to partnerships and therefore governed by partnership law**

5. Factors affecting characterization a. Control: The more control an alleged partner exercises, the more likely it‟s a

partnership; gets dicey when a mere employee provides the business full-time services (RIPA § 202(c)(3)(ii); UPA § 7(4)(b)).

b. Agreements to Share Losses: Creditors and debtors rarely agree to this, nor do any of the other relationships according to RUPA § 202(c) and UPA § 7(4) that involve profit sharing but aren‟t partnerships

c. Contributions of Property to the Business: If party has contributed property to the business, it favors partnership characterization (especially where it is in return for control/profit sharing/etc.)

i. Not a prerequisite, but does “cut against” the protected categories in RUPA § 202(c) and UPA § 7(4)

d. The Extent to Which the Profit Share Constitutes the Recipient‟s Only Remuneration from the Business: If profit share is just “icing on the cake,” courts are more inclined to one of the protected categories.

e. Parties‟ Own Characterization of Their Relationship: While parties‟ labels aren‟t dispositive, in close situations the courts will look at this. Probably more influential when the dispute does not involve third parties.

6. Partnership Accounting a. Finances are distinct from those of the individual partners b. Partners‟ interests usually reflected in capital accounts; sets forth the partner‟s

ownership interests c. RUPA § 401 describes how these capital accounts are constructed and maintained d. Capital account can be negative from time to time, but if its negative upon final

settlement when the partnership is terminated, that partner must may the partnership that amount (RUPA § 807(b)).

e. Not essential that partnership actually maintain a formal capital account.

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f. Settling Accounts When the Business is Liquidated i. Agreement among the partners can govern this inter se matter; in the absence of

such an agreement, UPA §§ 38, 40, 42 supply the default rules (which provision is used depends on whether the business is being continued/liquidated and on whether the dissolution was rightful/wrongful).

ii. When partnership is being liquidated following rightful dissolution, UPA default rules provide a relatively simple approach for distributing assets/settling accounts

1. Property loaned/rented to the partnership returns to the contributing partner.

2. Assets belonging to the partnership are marshaled and liquidated (UPA § 38(1); from these

a. Outside creditors are paid off b. Inside creditors are paid off c. Partners are repaid their invested capital (i.e., the value of any

property they have contributed to the partnership, plus any profits previously allocated to the partners and left in the business, less any returns of capital previously made); and

d. Any remaining funds are divided, as profit, according to the partner‟s ordinary profit percentages (UPA § 40(b).

3. If the partnership lacks sufficient funds to pay off its creditors and repay capital contributions, partners must pay in according to their respective obligations to share losses. (IPA §§40(a)(II) and 40(d)).

4. Accounts must be settled among partners in cash (UPA § 38(1)), unless there is an agreement to the contrary.

5. Function of Partners‟ Capital Accounts in Dissolution a. Partners are paid the amounts owed in respect of capital (UPA

§40(b)(III) b. Property contributed to the partnership increases that partner‟s

capital account by an amount equal to the fair market value of the assert as of the time of contribution, as do profits allocated to partners from ongoing activities (UPA § 18(a)); profit distributions and shared losses reduce the capital accounts.

iii. Settling Accounts Following Wrongful Dissolution

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1. Same as if the dissolution were rightful, except that the wrongfully dissolving partner‟s share may be decreased by the amount of damages due the other partners for breach of the partnership agreement. RUPA §§38(2)(c)(I) and (2)(a)(II). Also, wrongful dissolver has no right to wind up the partnership. UPA §37.

iv. Settling Accounts Among Partners When the Business is Continued: Rightful Dissolution

1. Settling Accounts by Express Agreement: For partnership to continue after dissolution, there must be some agreement among the partnership. Such agreement can be made before or after dissolution--need not include the wrongful dissolver. Without such an agreement, the default mode is liquidation.

2. Agreement will normally govern how the partners will settle the accounts; any such agreement should at minimum address five topics:

a. transfer of rights and obligations of the dissolved partnership to the successor partnership

b. conversion of the continuing partners‟ rights in the dissolved partnership to rights in the successor partnership

c. compensation of the dissociated partner for that partner‟s rights in the dissolved partnership

d. the indemnification or (if possible) the release of the dissociated partner for debts of the dissolved partnership; and

e. the indemnification of the dissociated partner for debts of the successor partnership

3. Possibility of a Tacit Agreement to Continue the Business: If a partner rightfully dissociates and fails to seek liquidation, a court may decide that the partner tacitly consented to a continuation of the business. This is not a preordained result.

4. Compensating the Dissociated Partner: An issue when a tacit agreement is found, or the express agreement neglects the compensation issue.

a. UPA § 42 provides a default rule; treats the value of the dissociated partner‟s interest as a loan to the successor partnership. The value is calculated at the date of dissolution, and as compensation for

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that loan, the dissociated partner receives either interest on that value or a share of the profits attributable to the successor partnership‟s use of the dissociated right in the property of the dissolved partnership.

b. This default rule leaves open seven important questions: i. How long may the successor partnership wait to cash out the

dissociated partner? There may be an agreement for a pay-out deadline but, if not, the court will give the partnership some breathing room.

ii. Must the successor partnership make interim payments to the dissociated partner pending the cash-out? Nothing in cases penalizes partners for failing to make interim payments, but there is nothing requiring it either.

iii. When does the dissociated partner elect between the interest option and the profit-sharing option? Dissociated partner may wait until an accounting reveals both the value of the partnership at dissolution and the value of the dissociated partner‟s interest; can delay until he can determine which is more lucrative. This creates an incentive for the continuing partners to cash out the dissociated partner as soon as possible.

iv. May the dissociated partner change the election? No, but a representative of a deceased partner may lack the authority to make a binding decision until an accounting reveals the value.

v. How is the interest rate determined? Very little authority, but may be the legal rate for interest on judgments, legal rate for prejudgment interest, etc.

vi. How is the profit share calculated? Equals the ratio of the value of the dissociated partner‟s interest in the partnership at dissolution to the value of the entire partnership at dissolution.

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vii. How long may the business continue before fully cashing out the dissociated partner? May proceed indefinitely but the dissociated partner can sue to collect.

v. Remuneration for Property Provided by Partners to the Partnership 1. Absent a contrary agreement, partners receive nothing extra for their

contribution (UPA § 18(d), RUPA § 401(d)). 2. Complexity exists because there are two ways by which a partner can

provide property for the partnership‟s use: a. Contribution: Transfers to partnership, no remuneration for use,

property not returned to partner and the risk of depreciation/benefit of appreciation is for the partnership

b. Furnish property--use for either the duration of the partnership or some other period, while retaining title to the property

c. Lease or loan--providing use of property for the duration of the partnership for some period of time, retaining title and receiving rent, interest, or royalties as compensation.

3. Modes of Providing Property a. UPA Approach: Contains no rules for distinguishing the modes

(UPA §8(2) does contain rules for property purchased with partnership funds). Instead, depends on case law--which looks at the intent of the parties, to be determined objectively from the parties‟ manifestations, and in the absence of an express agreement, court is unlikely to find a lease or loan unless the partnership has made payments that can be construed as rent/etc.

i. As for distinguishing contributed from furnished, following factors indicate contribution: use of the property in the partnership business (esp. if it‟s crucial to the business), the use of partnership funds in improving or maintaining the property, indications in the partnership‟s books that the property belongs to the partnership, and nonreceipt of rent or other compensation by the partner who provided the property.

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b. RUPA Approach: Places considerable emphasis on title. First part of rule looks at the formalities of property acquisition (i.e., in whose name), and the other looks at the assets used to accomplish the acquisition (i.e., who paid for it). First facet is controlling (see: RUPA § 204(a)(1) and (2)).

7. Transfer of Partner‟s Interest a. Fundamental property of partnerships is that you get to “pick your partners,” as it‟s a

voluntary association; UPA and RUPA therefore limit the assignability of partnership interests and the ability of a judgment creditor of a partner to access the partner‟s rights in the partnership.

b. Assignability i. Only a partner‟s economic rights are freely assignable (UPA §§25-28; RUPA

§§501-504). ii. Partner may not assign/transfer to someone else the right to participate in

management or the right to use partnership property for partnership purposes, unless an agreement among the partners allows for that. Such an agreement may be general, or apply to a specific assignment/transfer.

iii. This is sort of like adding a new member to the partnership, so cannot assign a complete partnership interest without an agreement with the copartners (UPA § 27(1)). Similarly, under UPA §18(g), without a contrary agreement, no person can become a member of a partnership without the consent of all the partners.

1. Under RUPA: “A person may become a partner only with the consent of all the partners” (RUPA §401(i)). The only transferable interest of a partner is the partner‟s share of the profits and losses, and the partner‟s rights to receive distributions. (RUPA § 502).

2. Transfer is permissible but does not, as against the other partners or the partnership, entitle the transferee to participate in management or conduct of the business, require access to information, or to inspect the records. (RUPA §503(a)(1) and (3).

c. Rights of a Partner‟s Judgment Creditors--the Charging Order i. Creditor may not attach/levy on the partnership‟s property for a claim against an

individual partner, but they can do so for a claim against the partnership. (UPA § 25(2)(c)).

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ii. Partner‟s judgment creditor has no access or right to the partner‟s noneconomic rights; plus, under UPA/RUPA the sole remedy for a partner‟s judgment creditor is a charging order, which is like a lien on a partner‟s economic rights--it obligates the partnership to pay to the creditor any amounts that would otherwise be paid to the debtor partner. (UPA §28(1) and RUPA §504(b)).

1. Charging order also functions as a judgment lien; other partners can use their own funds to redeem the charged rights, and partnership funds may be used with the consent of all the partners whose interests are not so charged or sold. (UPA §28(2)(b); RUPA §504(c)(2) and (3)).

2. If the circumstances of the case require (UPA §28(1), RUPA §504(b)), the court may order the charged interest foreclosed and sold; in that event, the economic rights of the debtor partner are sold like any other property subject to a judgment lien.

8. Partners‟ Authority a. Right to Be Involved in the Business

i. Each partner has the right to be involved in the business ii. This right does not bring extra compensation because under UPA §18(f) and

RUPA §401(h) working in the business does not increase a partner‟s remuneration.

b. The Right to Bind the Partnership i. See Table, Kleinberger 274 ii. Deducing Extent of Actual Authority

1. Partnership agreement may define authority of each partner to bind the partnership; also possible to infer the default scope of a partner‟s actual authority from various statutory provisions.

2. UPA: Default scope implied through sum of §§9(1), 18(e), 18(b), and 18(h).

3. §9(1) deals primarily with partner‟s power to bind, it does contain clause relating to authority-- “Every partner is an agent of the partnership for the purpose of its business.” So, use agency law binding principles.

4. §§18(e) and (b) support this from a different angle: since all partners have equal rights, they all must have some authority to bind the partnership; (b)

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suggests that acts “reasonably made in the ordinary and proper conduct of the partnership‟s business” qualify for indemnification.

5. RUPA: Similar to UPA (§301(1) mirrors UPA §9(1) and §401(f) mirrors UPA §18(e)), but its indemnification provision does not refer to reasonably; agency law “easily fills that gap.” (RUPA §104(a) and Comment). See also, RUPA §401(c) for indemnification.

6. An Implied but Important Limit: If a partner knows or has reason to know that another partner would object to a proposed commitment, the first partner has no actual authority to commit the partnership (unless the agreement provides otherwise or partners already voted on the matter). (UPA §18(h) and RUPA §401(j); disputes among partners to be settled by a vote).

c. Right to Participate in Decision Making i. Basic approach: when partners disagree, the default rules of RUPA and UPA call

for: 1. the partners to resolve the disagreement by a vote (UPA §18(h) and

RUPA §401(j); 2. each partner has one vote, regardless of how much each partner has

contributed to the partnership and regardless of how much each partner works in the partnership‟s business (UPA §18(e) and (h); RUPA §401(f) and (j)); and

3. some disputes are resolved by majority vote, while others require unanimity (UPA §§18(h) and 9(3); RUPA §401(j)).

ii. Determining What Vote is Required-UPA 1. UPA §§9(3) and 18(g) list particular matters requiring unanimous consent:

Under §9(3), unless partnership agreement provides otherwise, following actions require unanimity: (1) assigning partnership‟s property in trust to creditors or in return for the assignee‟s promise to pay the partnership‟s debts; (2) disposing of the good will of the business; (3) doing any other act which would make it impossible to carry on the partnership‟s ordinary business; (4) confessing a judgment against the partnership; (5) submitting a claim by or against the partnership to arbitration. And, under

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18(g), (6) no person can become a member of the partnership without the consent of all the partners.

2. UPA §18(h) provides general rule for disagreements not covered by UPA §§9(3) or 18(g): any difference arising as to ordinary matters can be decided by a majority of the partners, but no act in contravention of any agreement between the partners may be done rightfully without the consent of all the partners. Problem with this: omits situations that are not ordinary but are in contravention of a partnership agreement; some cases hold that decision to depart substantially from past practices does contravene agreement because of implied agreement, others just establish a rule for this omitted category.

iii. Determining what vote is required-RUPA 1. Simpler than UPA; unanimous consent cases has been winnowed down to

the admission of a partner (RUPA §401(i)). 2. Omitted category has been expressly included as requiring unanimous

consent: “a difference arising as to a matter in the ordinary course of business of a partnership may be decided by a majority of the partners. An act outside the ordinary course of business of a partnership and an amendment to the partnership agreement may be undertaken only with the consent of all the partners.” RUPA §401(j).

iv. Boundary Between “Ordinary” and “Extraordinary” 1. Bright line between ordinary/extraordinary difficult to find, but a few

generalizations are possible: substantial changes to the nature of the partnership‟s business are likely to require unanimity, as well as those substantially increasing the size of the business where that increase requires a significant increase in the liability exposure of each partner, and changes in the standards for admitting new partners/expelling old ones.

v. Problem of Management Deadlock: 1. Cases hold that partner proposing the change loses

9. Partner‟s Power to Bind the Partnership a. See Agency sections based on Kleinberger 311-324.

10. The Partnership Agreement

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a. RUPA makes clear that a partnership agreement may be oral, written, or implied (RUPA § 101(7).

b. Written may be necessary, however, when real estate is to be contributed as partnership property or the agreement includes a term of one year--in order to comply with the statute of frauds.

c. Advantages of a written agreement are so great that failing to advise client to enter into one may even constitute malpractice.

d. Agreements that Change Management Rights i. Some areas in which partners often vary default management rules: delegating

to one partner/committee some or all decisions on business conduct; changing the “one partner/one vote” rule; changing the unanimous consent requirements; requiring supermajority votes for important decisions; creating a right to expel partners; requiring partners to seek approval before making certain kinds of commitments on behalf of the partnership; delegating to a management or executive committee the right to bind the partnership to any significant obligations.

ii. Limits on Inter Se Agreements that Restructure Management 1. UPA: Three constraints

a. No agreement among partners can totally remove fiduciary obligations

b. More fundamental the obligation involved, more likely it will face judicial scrutiny (i.e., fundamental=important justification, not overbroad, does not leave partners who lack access vulnerable to oppression)

c. Partner may have nonwaivable right to veto any fundamental changes in the partnership agreement which would substantially prejudice the partner‟s interests; later cases suggest the contrary, at least where the partners are sophisticated

2. RUPA: Purports to collect in one place all the limits on the power of the partnership agreement; §103(a) provides that “except as otherwise provided in subsection (b), relations among the partners and between the partners and the partnership are governed by the partnership agreement.”

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(B) contains 10 restrictions, including that an agreement may not unreasonably restrict access to books and records.

3. Effect of Inter Se Agreements on Third Parties a. Increasing Third Party‟s Ability to Hold the Partnership Liable:

Partner binding the partnership through actual authority means no need to rely on special rules that partnership law contains for binding the partnership to third parties

b. Undercutting a Third Party‟s Claim: The Agreement can limit actual authority granted to some partners.

11. Sharing of Profits and Losses a. In the absence of an explicit agreement, see UPA §18(a) and RUPA §401(b) for how

profits/losses are shared: they‟re shared equally (regardless of how much each individual partner contributed to the partnership).

b. Does not matter if the partners contributed unequal amounts (See Dunn v. Summerville).

c. Loss sharing arrangements among partners do not affect the personal liability of each partner for the debts of the partnership; if it‟s not an LLP, each partner is either jointly liable or jointly and severally liable regardless of the inter se situation. RUPA--always joint and several, varies in UPA.

i. BUT: Inter se agreement can govern what happens if a creditor collects a partnership debt from an individual partner but it lacks the funds to indemnify the partner; in that case, the agreement will determine how much each of the other partners must compensate that partner.

d. Profits can be divided a number of ways i. May be shared on a flat basis ii. Fixed weekly/monthly “salary” iii. Percentage, recomputed each year based on average amount invested in the

business iv. In large partnerships, fixed percentage applied against say, 80 percent of the

income v. Agreement may be silent so each year the division can be agreed

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e. In cases where sharing of losses not discussed, courts might be sympathetic and take that as evidence that no partnership was created; many cases, however, hold that loss sharing provision is not required which is consistent with UPA §§6-7 and RUPA §202.

f. Timing i. Neither UPA nor RUPA specifies how often profits are to be

calculated/distributed, but UPA suggests a partnership must repay contributions and discharge liabilities before doing so. (UPA § 18(a)).

ii. In practice, what happens is that contributions are only repaid when a partner withdraws from a partnership or when the partnership business comes to an end.

iii. For when profits are actually distributed, UPA has no definition and RUPA only has a comment that says absent a contrary agreement, partner does not have a right to receive a current distribution of the profits credited to his account, the interim distribution of profits being a matter arising in the ordinary course of business to be decided by majority vote of the partners. (RUPA § 401, comment 3).

iv. In most partnerships, timing of interim distributions is a matter of either express or implied agreement, and most contemplate some annual distribution.

v. Partners in many operating partnerships make “draws” against their anticipated annual profit share, and at the end of the year they settle up if the partner over/underdraws.

vi. LOSSES: Neither UPA/RUPA specifies timing for loss sharing; typically they just keep track of the losses and it affects what each partner receives when the partnership ends.

12. Liability of Partnership and Partners a. Generally-Liability of the Partnership

i. Partnership liable in contracts for which the partnership was entered into by a partner with actual or apparent authority (UPA § 9, RUPA § 301).

ii. For torts, agency principles are used so that a partnership is liable to third parties for “any wrongful act or omission of any partner acting in the ordinary course of the business of the partnership or with the authority of his co-partners.” (UPA § 13)

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iii. Partnership liable in certain circumstances if a partner misapplies money or property of third party (UPA §14; RUPA §305 generally follows these UPA provisions).

b. Generally-Liability of the Partners i. Each partner in a general partnership has unlimited personal liability for the

obligations of the partnership. (UPA§13-14 calls for joint and several liability for what are basically tort obligations, and UPA § 15 calls for joint liability for all other obligations like contracts).

ii. RUPA eliminates the reference to joint liability; provides that partners are jointly and severally liable for all of the partnership‟s obligations (RUPA § 306(a)).

1. RUPA does allow for creditor to sue the partnership and one or more partners in a single action (RUPA § 307(b)), a judgment creditor is first required to exhaust partnership assets (with some exceptions) before proceeding directly against a partner‟s individual assets. (RUPA § 307(d)).

c. Three issues to consider i. Exhaustion rule: In some UPA jurisdictions, as a matter of case law, a creditor of

a partnership may not pursue individual partners without first exhausting the partnership‟s assets. In RUPA jurisdictions this applies through the statute (RUPA § 307(d)).

ii. Joint Liability and Joint and Several Liability: Distinctions relate not to the extent of liability, but rather the steps a creditor must take. Under both, each partner may be held individually responsible for the full amount of the partnership‟s debt. Under joint and several, the creditor may pursue any of the partners individually; does not need to include all the partners as defendants in the same lawsuit (and release one partner without undermining the claims against the rest). When it is merely joint, creditor must sue all of them, and releasing one releases all.

iii. Relationship of Partners‟ Liability to Third Parties and Partners‟ Inter Se Loss Sharing: Inter se loss sharing has no effect on a third party‟s claim against any particular partner. (i.e., a partner cannot claim that he only owes 60% because that is his percentage of the loss sharing).

d. Binding Partnership through a Partner‟s Wrongful Act (Actions of a Rogue Partner): i. UPA § 13 and RUPA § 305(a) provide a rule for attributing certain wrongful acts

or omissions of a partner to the partnership.

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1. UPA § 13: Arises for any wrongful act or omission in the ordinary course of the business of the partnership with the actual authority of his copartners, and the partnership is liable therefor to the same extent as the partner so acting or omitting the act. ONLY FOR THIRD PARTY CLAIMANTS.

2. RUPA § 305(a): Arises for a wrongful act or omission or other actionable conduct (tort liability), in the ordinary course of business of the partnership or with the actual authority of the partnership, with the partnership liable for loss or injury caused. ATTRIBUTION RULE ALSO AVAILABLE TO PARTNERS.

ii. Wrongful but Ordinary? 1. Proper question under both UPA and RUPA is not whether the specific

wrongful act is “ordinary course” or authorized, but rather whether that type of act, if done rightfully, would be ordinary.

iii. UPA § 13 and RUPA § 305(a) Compared to Respondeat Superior 1. They‟re similar (but UPA does not cover no-fault torts) 2. Claimant need only show that

a. the second person (the partner or the servant/employee agent incurred tort liability)

b. the first and second person stand in a specified relationship to each other (partner/partnership or servant-master/employee-employer); and

c. the tort is sufficiently related to the first person‟s enterprise (“ordinary course of” the partnership or “scope of employment”)

d. One major difference from respondeat superior: UPA/RUPA apply regardless of whether the tortfeasor was subject to the partnership‟s control (because that is more of an agency than a partnership requirement).

iv. Binding the Partnership Through a Partner‟s Breach of Trust (UPA § 14; RUPA §§305(a) and (b))

1. UPA: If partner misapplies a third party‟s money or property, loss is attributed to the partnership if either (1) the partner received the money or other property while “acting within the scope of his apparent authority,”

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(UPA § 14(a)) or (2) the partnership received the money or other property “in the course of its business” and the partner misapplies the property “while it is in the custody of the partnership” (UPA § 14(b)).

2. RUPA: Replicates both prongs of UPA § 14, but has been edited to improve clarity for subsection b (RUPA § 305, comment). For RUPA, makes no mention of whether the misapplication has to occur while the partnership has custody.

v. Core Concern of UPA § 14-Defalcations by Professionals: 1. These are situations where professionals take advantage of their position

(i.e., lawyer gets grieving widow to entrust investments from late husband‟s estate with him).

2. Older leading cases deny recovery because: mere fact of partner status does not constitute “holding out” that partner can accept funds, fund handling not within the course of partnership‟s business, or not within the ordinary course of business.

3. Some newer cases allow recovery because: apparent authority should be determined from client‟s perspective rather than the professional, in modern professional practices handling funds may very well occur in the course of partnership‟s business, and when professionals are involved the need to protect the public and hold professionals to high standards is important.

vi. Rouse v. Pollard (1941), p. 19a in handout 2: Old lady gave money to a law partner and he embezzled; other partners could not be held liable because it was not in the ordinary course of business for law partnerships to conduct such business, the other partners had no knowledge, etc.

e. Indemnification: Partnership must indemnify a partner for payments made and liabilities incurred in the ordinary course of the partnership business. (UPA § 18(b) and RUPA § 401(c)).

i. In an ongoing partnership, indemnification payment reduces the partnership‟s profits like any other payment, so its proportionally taken out of profit shares; on dissolution, this is paid out of the partnership assets like any other obligation so if there is insufficient money the partners must pay in. (UPA §§18(a), 40(b), 40(d); RUPA §§401(b), 807(b), 807(c))

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ii. This means that outside creditors can collect from any partner (under UPA and under RUPA if § 307(d) applies), but between the partners themselves each is only responsible for his share of the partnership obligation.

13. Management Duties a. Duty to Furnish Services to the Partnership

i. Some older cases hold that such duty exists, but neither UPA nor RUPA supports that.

1. Duty may be expressly provided by partnership agreement or implied by circumstances.

2. Partner in breach of that duty may be liable for the cost of hiring someone else to perform the services or for the reasonable value of the services withheld; if the withheld services are crucial to the business, copartners can request dissolution (UPA § 32(1)(d), RUPA § 801(5)(ii).

b. Duty of Care i. Partners‟ standard of care is gross negligence (RUPA §404, comment 3;

generally recognized by courts in UPA jurisdictions). ii. Only negligence for tort liability for the partnership‟s vicarious liability (RUPA §

305, UPA § 13) iii. Partnership agreement may change the duty of care but, at least under RUPA,

may not unreasonably reduce it (RUPA § 103(b)(4). 14. Partner‟s Fiduciary Duty of Loyalty

a. Duty of Loyalty i. Cardozo‟s passage in Meinhard v. Salmon: “A trustee is held to something

stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”

ii. Partner loyalty can be divided into two categories: (1) issues relating to the conduct or interests of the partnership‟s business, and (2) issues relating to differences of interests between or among partners.

iii. UPA/RUPA differences: 1. Duty of Loyalty: UPA=case law, RUPA=codified 2. Limits: UPA=open-ended category, RUPA=codified formulation is

exclusive and exhaustive

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3. Scope: UPA §21(1)=any transaction connected with the formation, conduct, or liquidation of the partnership; RUPA §404(b)=encompasses self-dealing and competition, provides that dissolution ends the restriction on competition, and excludes formation activities from the duty of loyalty.

4. Information: UPA cases=consider partner‟s duty includes volunteering information; RUPA=does not include that duty

5. Good faith: UPA=does not mention good faith; RUPA §404(d)=partner shall discharge duties to partnership and others...consistently with the obligation of good faith and fair dealing.

6. Self-interest: UPA silent, RUPA §404(e)=partner does not violate duty just because conduct furthers the partner‟s own interest.

7. Modifying fiduciary duties: UPA=silent, RUPA § 103(b)=prohibits elimination and provides standards for attempted alterations

8. Most controversial part--RUPA §404(a)=only fiduciary duties a partner owes are loyalty and care set forth in (b) and (c)

iv. Partner versus Partnership Duty of Loyalty 1. Partner may not profit at the expense (direct or indirect) of the partnership.

including competing, taking business opportunities from which it might have benefitted or needed, using partnership property for personal gain, or engaging in conflict-of-interest transactions.

a. Under UPA these begin with formation and end at termination. b. Under RUPA these apply to the conduct of the partnership

business and the noncompete ends when it dissolves, and the others remain until the partnership terminates.

2. Noncompetition: RUPA § 404(b)(3) requires each partner to refrain from competing with the partnership in the conduct of its business before its dissolution; UPA § 21(1) uses broad language and requires that illicit profits be disgorged.

3. Taking business opportunities: Partner cannot take such opportunities unless the copartners consent. Partner may avoid this requirement by submitting it to the rest of the partnership and a majority can accept/reject.

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4. Using partnership property for personal gain: UPA §25(2)(a) and RUPA § 401(g) prohibit a partner from using property for personal gain without copartner consent, but does not apply to minor usage like a phone.

5. Conflict of interest: Partner has conflict of interest when partner causes/allows partnership to do business with: himself, closely related family member, organization in which he has material financial interest. (RUPA § 404(b)(2)

6. Remedies: must disgorge profits gained through the disloyal act, not necessary for the partnership to prove damages (but if it can, partnership may also bring a damage action

v. Obligation of Good Faith and Fair Dealing: UPA does not have this, but RUPA requires partners to exercise good faith and fair dealing. (RUPA §404(d)). This is not a fiduciary duty but it can act as a safety net for improper actions that do not fall under the RUPA‟s list of loyalty duties. Official Comment characterizes it as a contract concept but it is an ambiguous concept.

vi. Differences of Interest Between & Among Partners: 1. Partners cannot use tactics that are appropriate to arms length

transactions but nothing wrong with legitimately pursuing self-interest when partners are on opposite sides of the negotiating table.

a. UPA cases allow this b. RUPA § 404 comment 1: “Arguably, term fiduciary is inappropriate

when used to describe duties of a partner since partner may legitimately pursue self interest.”

2. So, in the inter se context, only excessive self-interest is wrongful. Questions about this fall into two categories

a. Partner-to-Partner transactions (formation of partnership except for RUPA jurisdictions, renegotiation of profit shares, sale or purchase of current partner‟s interest in the partnership)

b. Partners‟ exercise of discretion vis-à-vis copartners (exercise of right created by the agreement to expel a partner without case, rightfully calling for the partnership to end when the end disadvantages one and advantages another). **Under default UPA rules, situation only exists in an at-will partnership, but comparable

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situation is where one partner wrongfully dissolves a term partnership. Under UPA §38(2)(b) the others then have the right to preserve the partnership assets and carry on the business until the end of the original term (if all the remaining partners agree. Under RUPA the situation always exists in an at-will with RUPA §808(1), and often in a partnership for a definite term or particular undertaking with RUPA §801(2)(i).

3. UPA and RUPA differ in approaching this issue a. UPA §21: pertains to partner‟s duty to the partnership so UPA rules

in rules for interpartner duties come from case law b. RUPA § 404: pertains only to duty to the partnership, but because

the RUPA says this is exhaustive, partner-to-partner duties come from other nonfiduciary source, i.e., § 403 (detailing partner‟s rights and duties with respect to information), and § 404(d) (covering the obligation of good faith and fair dealing).

c. Result: When partners‟ interests are potentially/actually adverse, partner is obliged to (1) provide full disclosure, and (2) engage in “fair dealing”

i. Full disclosure: Partner selling or buying partnership interest to/from another partner has an affirmative duty to disclose any material information that (1) relates to the value of the interest or the partnership itself; and (2) could not be learned by examining the partnership books.

ii. Fair dealing: Partner-to-Partner transactions: Process and substance aspects. For process, partners obliged to deal with each other in a candid and noncoercive manner and must avoid arms-length appropriate behavior. Substantively, cases show that partners must provide a fair price, BUT, if the partner made full disclosure and still got an unfair price, the supplement thinks the courts would not overturn because of freedom of contract. Partners exercising discretion vis-à-vis copartners: While partner must give express will to end the partnership (UPA §31(1)(b); RUPA § 801(1) and (2)(i),

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there is no fiduciary duty to consult with them before so doing. Substantive fair dealing does require partners who are expelling others to not end partnership or expel a partner for the malicious purpose of depriving a partner of benefits if he had a right to expect them, they would have naturally accrued to him but for the exercise of discretion, or the exercise of discretion transfers the benefits to the partner or partners exercising the discretion. To succeed on this claim, claimant partner must show conduct amounting to expropriation or unjust enrichment.

d. Remedies: i. UPA-court has broad range of remedies, such as damages,

disgorgement, and recission. ii. RUPA-because partner-to-partner duties are not fiduciary,

courts must use punitive damages and combine other common law concepts.

15. Impact of Agreements on Partner Fiduciary Duty a. Limits on a partnership agreement‟s ability to modify the fiduciary duties

i. This is ambiguous. UPA §21(1) says that all duties can give way with the consent of the other partners, and §18(h) says that the agreement can provide that less-than-unanimous consent constitutes the consent of the other partners.

ii. Under RUPA § 103(b)(3)(ii), all partners or a percentage specified in the agreement may authorize or ratify (after full disclosure of all material facts) a specific act that would otherwise violate the duty of loyalty. (i) says some activities may be specified as not violating the duty so long as they‟re not unreasonable. §103(b)(5) says the agreement may prescribe standards by which the good faith/fair dealing obligation is to be measured so long as they‟re not manifestly unreasonable. Under no circumstances can it eliminate the duty of loyalty or the obligation of good faith/fair dealing (also stated in UPA cases).

iii. What constitutes elimination of duty by agreement is unclear; seems like some degree will be allowed (agreements allowing competition or self-dealing by a managing partner) but others (waiving process fair dealing in partner-to-partner transactions) will not.

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b. Ambiguous, Oral, and Implied Agreements i. Under both UPA/RUPA, agreements purporting to waive/alter duties are strictly

construed. Probably also for good faith/fair dealing obligations under RUPA. ii. No requirement that waivers be in writing, but can be difficult to prove oral

waiver; may be inferred by conduct but can be difficult because courts require clear & convincing evidence.

16. Enforcing Inter Se Obligations a. Action for an accounting: Partnership law provides equitable action for an accounting to

avoid complexity during litigation, and under UPA case law, this is generally a condition precedent to bringing a claim for damages arising out of the partnership‟s affairs/business.

i. RUPA §405(b) has a different approach: partner may maintain an action against the partnership or a partner for legal/equitable relief with or without an accounting in order to:

1. enforce the partner‟s rights under the partnership agreement; or 2. enforce the partner‟s rights under the RUPA; or 3. enforce the rights and otherwise protect the interests of the partner,

including the rights/interests arising independently of the partnership relationship.

b. Partner standing to sue fellow partner for damage to partnership: i. UPA: while it might appear that only the partnership (or a partner acting through

a derivative claim) can sue a partner, the UPA typically uses an accounting to sort this out.

17. Cases a. Meinhard v. Salmon (p. 76): “coadventurers,” the managing one failed to notify the other

of an opportunity and took the benefit for himself. Court held that he had a fiduciary duty to notify.

b. Beasley v. Cadwalader, Wickersham & Taft (handout): Lawyer joined a firm‟s Palm Beach office but the partnership later decided to close that branch. Court decided that there must have been a good faith offer to continue working at the other offices, but that was not the case because (1) he was terminated not transferred, (2) was unreasonable to ask him to move to DC or NY after practicing in South Florida for two decades, so he was wrongfully expelled. So, managing committee had power to open/close branches

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but because the agreement did not grant power to expel, they were in the wrong. Finally, plaintiff‟s lawsuit did not constitute voluntary withdrawal from the partnership because so long as suit for dissolution is not frivolous, does not constitute voluntary withdrawal.

ii. Dissolution 1. UPA: §29 defines it as the change in the relation of the partners caused by any partner

ceasing to be associated in the carrying on of the business a. Does not mean ending the business (that is “winding up” or “liquidation”, instead refers

to changing of the partners); § 30: partnership not terminated with dissolution and continues until the winding up of partnership affairs is completed

b. Some dissolution acts are rightful (i.e., the termination of a definite term or particular purpose partnership, the express will of any partner in an at-will partnership, the express will of all of the partners who have not assigned their interests or had them subject to a charging order, and the expulsion of any partner in accordance with the agreement). Wrongful when the partner decides to withdraw where circumstances do not permit it (i.e., prematurely in a term partnership).

c. Four dissolutions that are neither rightful nor wrongful: (1) any event which makes it unlawful for the partnership to be carried on or for the members to carry it on in partnership, (2) the death of any partner, (3) the bankruptcy of any partner or the partnership, and (4) a decree of court under § 32.

d. Protections for the Dissociated partner i. §§ 33-34 end the actual authority (though not the power) of the continuing

partners to bind the dissolved partnership on obligations related to new business. ii. § 35 limits the power of the continuing partners to bind the dissolved partnership iii. § 36 provides for the dissociated partner, under certain circumstances, to be

discharged from personal liability iv. § 15 imposes personal liability on the dissociated partner only for the debts of the

dissolved partnership (and not of any successor partnership). e. Some at-will dissolutions can be wrongful if (1) implied agreement for a particular term,

or (2) partners have an implied agreement to not injure each other through breach of fiduciary duty.

i. Vangel v. Vangel: Court noted that agreement did not mention term but the borrowing arrangement implied that it was for a particular undertaking.

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ii. Page v. Page: leading case on implying fiduciary duty limit; if it is proved that the dissolving partner acted in bad faith and violated fiduciary duties by attempting to appropriate to his own use the new prosperity of the partnership...

f. UPA § 32 provides several bases for a court to “decree a dissolution: i. § 32(1)(d): application by or for a partner when another partner willfully or

persistently commits a breach of the partnership agreement, or otherwise conducts himself in matters relating to the partnership business that it is not reasonably practicable to carry on the business in partnership with him.

ii. § 32(1)(e): partner can apply for dissolution when the business of the partnership can only be carries on at a loss

iii. § 31(2): purchaser of a partner‟s interest can petition for dissolution (a) after the termination of the specified term or particular undertaking, and (b) at any time if the partnership was a partnership at will when the interest was assigned or when the charging order was issued.

2. Continuation Agreements (fair treatment for the withdrawing interest is primary goal) a. Many questions to be asked

i. Which types of dissolution will trigger the clause? Death, retirement, etc. ii. What happens to the withdrawing interest? iii. Is the disposition of the withdrawing interest to be optional or mandatory? In

other words, may the remaining partners elect to liquidate the partnership? iv. How much is the withdrawing interest to receive? Independent appraiser? Fixed

sum? Book value? v. Should the withdrawing partner‟s share be subject to a minority or marketability

discount? Former decreases value because it lacks control, while marketability decreases because of the established lack of an established market in a closely held business.

vi. Is the payment to be in a lump sum or over time? vii. How will the partnership raise the cash to meet the required payments? viii. May the withdrawing interest compete with the partnership? ix. Should the withdrawing interest have the power to inspect books?

3. RUPA: Allows for partner to leave partnership without dissolution (dissociation). a. § 601: death, withdrawal, bankruptcy, or expulsion of a partner is dissociation.

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b. § 602: distinction between rightful and wrongful remains but § 602(b) has an expanded list of wrongful dissociation events.

c. Switching Provision: Partnership continues despite dissociation, and may continue indefinitely with the dissociated partner becoming entitled to the value of his partnership interest in cash under article 7 (§§ 701-705), or dissolved and wound up under article 8 (§§ 801-807).

d. Dissolution and winding up only required in the limited circumstances set forth in § 801: i. In at-will partnership, any partner who dissociates by his express will may compel

dissolution ii. In a term partnership, if one partner dissociates wrongfully (or if a dissociation

occurs because of a partner‟s death or otherwise under § 601(6)-(10), dissolution and winding up of the partnership occurs only if, within 90 days after the dissociation, ½ of the remaining partners agree to wind up the partnership.

iii. Once an event requiring dissolution and winding up occurs, partnership is bound to do so unless all of the partners (including any dissociated partner other than those wrongfully dissociated) agree otherwise (§ 802).

e. If a partner dissociates but the business continues, he is entitled to receive a buyout price (§ 701(a)), which is defined in § 701(b). If the dissociation was wrongful then damages may be reflected in that price (§ 701(h)). Deferred payment must be secured and bear interest. Unlike UPA, no “loss of goodwill” penalty when valuing a wrongfully dissociating partner‟s interest.

f. Does not continue UPA § 42 election that permitted former partner that did not wind up to take a share of post-dissolution profits. Under RUPA § 701(b), dissociated partner only entitled to interest on the amount to be paid from the date of dissociation to the date of payment.

g. Dissociated partner has apparent authority to bind partnership for a period of time (§ 702) and may be liable for post-dissociation partnership liabilities incurred within 2 years after the dissociation (§ 703). Either the dissociated partner or the partnership may file a public notice to limit this apparent authority and thus limit potential liability (§704).

h. After dissolution, the partnership continues for the purpose of winding up (§ 802(a)), and the apparent authority of partners continues (§ 804), but any partner who has not wrongfully dissociated may file a public statement to give notice that the partnership is winding up (§ 805).

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i. § 807: partnership assets applied to discharge of liabilities and if the assets are insufficient, the partners must pay in to return the balance to zero.

j. 10 events upon which a partner is dissociated, divided into four categories i. Notice: The partnership‟s having notice of the partner‟s express will to withdraw

as a partner or on a later date specified by the partner (RUPA § 601(1)). Notice is defined by § 102(b)

ii. Specified Event: An event specified in the partnership agreement as causing dissociation (§ 601(2)).

iii. Expulsion 1. As provided in the partnership agreement (§ 601(3)) 2. By unanimous vote of the other partners; if

a. it is unlawful to carry on the business with the to-be-expelled partner (§ 601(4)(i))

b. the partner being expelled no longer has an economic stake in the business because there has been a transfer of all or substantially all of that partner‟s transferable interest in the partnership (§ 601(4)(ii))

c. the partner being expelled is a corporation or partnership which has lost its right to take on new business ( § 601(4)(iii))

3. By court order if the partner being expelled has engaged in seriously wrongful conduct (§ 601(5))

iv. Ability to Participate: Partner‟s ability to participate in the partnership affairs comes to an end or his economic stake comes to an end (§§ 601(6)-(10))

1. the partner becoming a debtor in bankruptcy or taking other non-bankruptcy actions which indicate insolvency (§ 601(6))

2. if the partner is an individual, his ability to participate is coming to an end either by

a. death, or b. mental incompetency as indicated either by

i. the appointment of a guardian or general conservator, or ii. a judicial determination that the partner has otherwise

become incapable of performing the partner‟s duties under the agreement (§ 601(7))

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3. if the partner is a trust or estate, its economic stake in the partnership coming to an end by the distribution of the partner‟s entire transferable interest in the partnership (§§ 601(8)-(9))

4. termination of a partner who is not an individual, partnership, corporation, trust, or estate (§ 601(10))

k. Rightful versus Wrongful Dissociation under RUPA (§ 602(b)) i. Wrongful only if:

1. it is in breach of an express provision of the agreement; or 2. in the case of a partnership for a definite term or particular undertaking,

before the expiration of the term or the completion of the undertaking: a. the partner withdraws by express will unless it follows within 90

days after another partner‟s dissociation by death or otherwise under § 601(6)-(10) or wrongful dissociation under this subsection

b. the partner is expelled by judicial determination under § 601(5) c. the partner is dissociated by becoming a debtor in bankruptcy d. in the case of a partner who is not an individual, trust other than a

business trust, or estate, the partner is expelled or otherwise dissociated because it willfully dissolved or terminated

ii. Consequences of wrongful dissociation: 1. wrongful dissociated partner is liable to the partnership and to the other

partners for damages caused by the dissociation (§ 602(c)) 2. in a partnership for a term or undertaking, dissociation creates the

possibility of dissolution, which occurs within 90 days after a partner‟s wrongful dissociation the express will of at least half of the remaining partners is to wind up the partnership business (§ 802 (2)(i)).

3. if the partnership continues the wrongfully dissociated partner is not entitled to any payout until the end of the original term unless the partner establishes to the satisfaction of the court that earlier payment will not cause undue hardship to the business of the partnership (§ 701(h)

4. if the dissociation results in dissolution of the partnership, the wrongfully dissociated has no right to participate in winding up (§ 803(a)).

iii. Power of the Agreement over Dissociation

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1. RUPA § 601 is the default and the agreement can change everything except for two: (1) cannot eliminate partner‟s power to dissociate (§ 103(b)(6)), nor (2) the right of the court to expel a partner (§103(b)(7)).

2. RUPA § 602(b) is also a default rule, so the agreement can modify what constitutes wrongful dissolution and the effects of wrongful dissolution.

l. Nexus Between Partner Dissociation and Partnership Dissolution i. Agreement can sever or modify the effects of dissociation on dissolution ii. Under default rules not every dissociation leads to dissolution; only happens

automatically in two circumstances: 1. in at-will partnership the express will dissociation of a partner who has not

been previously dissociated through some other cause (§ 801(1)) 2. in a partnership for a term or undertaking

a. the express will of at least half of the remaining partners to wind up the partnership business

b. manifested within 90 days after another partner‟s dissociation by death or otherwise under §601(6)-(10) or wrongful dissociation under §602(b)

m. Switching Provision under RUPA: If dissociation results in dissolution, Article 8 applies; otherwise, Article 7 applies. (§ 603(a)).

n. Dissociation that does not cause Dissolution: i. Generally

1. Dissociated partner has no further management role (§ 603(b)(1)) and no further fiduciary duties (§§603(b)(2)-(3)). Does have lingering power to bind partnership and exposure to personal liability.

2. Unless agreement provides otherwise the partnership must cause the dissociated partner‟s interest to be bought out at a price determined by statute and indemnify him against all partnership liabilities (dissociation does not discharge the dissociated partner from liability for partnership obligations).

ii. Statement of Dissociation 1. Must be filed, stating the name of the partnership and that the partner is

dissociated from it (§704(a))

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2. May be filed by either the dissociated partner or the partnership (§704(a)). If the partner does it, must be executed by him (§105(c)) but if by the partnership, must be executed by at least two partners (§105(c)).

3. To be filed in the office of the Secretary of State (§105(a)) unless the state does not use that as the central filing office

4. To have full effect with respect to real property owned by the partnership, a certified copy must be of record in the office for recording transfers of that property (§303(e)).

a. Once the recording is done, dissociated partner loses all power to transfer real property in the partnership‟s name (§704(b)).

5. With respect to non-real property liabilities, non-partners are deemed to have knowledge after 90 days of filing. (§704(c)).

iii. Lingering Power to Bind 1. Under §702(a) a dissociated partner‟s act binds the partnership if:

a. before the dissociation the act would have bound the partnership under § 301; and

b. at the time the other party enters into the transaction: i. less than two years had passed since the dissociation; ii. the other party does not have notice of the dissociation and

reasonably believes that the dissociated partner is still a partner;

iii. fewer than 90 days have passed since the filing of a statement of dissociation; and

iv. if the transaction involves the transfer of real property owned in the name of the partnership, a certified copy of a filed statement of dissociation is not of record in the office for recording transfers of that real property

iv. Dissociated Partner‟s Liability for Partnership Obligations 1. Dissociation does not discharge liabilities incurred before the dissociation,

but he can be released if a partnership creditor, with notice of the partner‟s dissociation but without his consent, agrees to a material alteration in the nature/time of payment of the obligation. (§703(a) and (d))

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2. § 703(b) creates lingering liability rule; he remains liable as a partner to the other party in a post-dissociation transaction if at the time the other party enters the transaction:

a. the partnership is not an LLP b. less than 2 years have passed since the dissociation c. the other party does not have notice of the dissociation and

reasonably believes that the dissociated partner is still a partner d. fewer than 90 days have passed since the filing of a statement of

dissociation, and e. if the transaction involves the transfer of real property owned in the

name of the partnership, a certified copy of the filed statement is not of record in the office for recording transfers of that real property.

v. Buyout of the Dissociated Partner 1. § 701: default rule is that if dissociation does not cause dissolution, the

dissociated partner is entitled to be bought out (but the partnership can arrange by having a third party purchase the interest, etc.)

2. Determining the price: § 701 (b) and (c) provides the default rule a. assume the partnership was terminated on the day of dissociation b. calculate the amount the partnership would have received for its

assets on that date, both through liquidating those assets piecemeal and through a “sale of the entire business as a going concern”

c. using the higher of those two values, calculate the amount that would have been due the dissociated partner (taking into account all liabilities of the partnership)

d. subtract from that amount any damages for wrongful dissociation/other amounts owing (even if not presently due)

e. add to that amount interest “from the date of dissociation to the date of payment”

3. Timing of and tendering the payment

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a. If the partnership was for a term or undertaking, it is presumptively able to defer the payment to the dissociated partner, though it must be adequately secured and bear interest. (§ 701(h)).

b. In other situations, unless otherwise agreed, the partnership shall pay or cause to be paid, in cash, its estimate of the buyout price 120 days after a written demand for payment (§ 701(e))

i. this must be accompanied by specific financial information to explain how the estimated amount was calculated, and a written notice warning that the estimate becomes final unless within 120 days...the dissociated partner commences an action to determine the buyout price. (§ 702(g)).

ii. same written information must be provided if the payment is going to be deferred (§ 701 (f)).

4. Power of the Partnership Agreement a. § 701 is entirely subject to the partnership agreement, i.e., the

entire section can be modified by agreement. “Indeed, the very right to a buyout itself may be modified, although a provision providing for a complete forfeiture would probably not be enforceable.” (§701, comment 3”

o. Dissociation that Causes Dissolution i. Overview

1. Approach is quite similar to UPA; dissolution commences a period of winding up and once that is completed the partnership is dissolved (§ 802(a)).

2. Default rule is that any partner who did not wrongfully dissociate may participate in the winding up.

3. Each partner‟s duty to refrain from competing with the partnership ends at dissolution (§ 404(b)(3)) but the other fiduciary duties remain in effect.

4. While winding up, (1) the partnership may preserve business/property as a going concern for a reasonable time, pursue legal disputes, etc., and (2) discharge the partnership‟s liabilities, settle and close the business, and marshal the assets to distribute the net proceeds to the partners in cash. (§§ 803(c), 807(a)).

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5. Settling of accounts among partners is similar to UPA except that (1) under RUPA debts owed by the partnership to partners are treated the same as debts to outsiders (§807(a)), and (2) RUPA expressly refers to each partner having an account reflecting his contributions, profit share, etc. (§401(a)) and uses that to describe the “Settlement of Accounts and Contributions Among Partners.” (§ 807).

6. Reversing: § 802(b) permits partnership to undo dissolution at any time before the winding up is completed if there is a waiver by all partners including any non-wrongfully dissociated partners. The partnership carries on business as usual (§802(b)(1)) but the rights of third parties cannot be adversely affected (§802(b)(2)).

ii. Partner‟s Power to Bind During Winding Up 1. §804: partnership is bound by a partner‟s act after dissolution that (1) is

appropriate for winding up the partnership business; or (2) would have bound the partnership under § 301 before dissolution, if the other party did not have notice of the dissolution. This can include a partner‟s act whose dissociation resulted in the dissolution.

2. §805(a): non-wrongfully dissociated partner may file a statement of dissolution.

a. For transactions involving real property, as soon as a certified copy of the filed statement is of record, it has the immediate effect of restricting the authority of all partners to real property transfers that are appropriate for winding up the business (because it is a limitation on authority for the purposes of § 303(e)).

b. Also has the effect of canceling all previously filed statements of partnership authority granting authority (§805(b)). Also, 90 days after filing the statement operates as constructive notice conclusively limiting the apparent authority of partners to transactions that are appropriate for winding up the business. (§ 805, comment 3)

p. Other Causes of Dissolution i. RUPA provides other events that may lead to dissolution that are not related to

dissociation:

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1. in a partnership for a term or undertaking a. the expiration of the term or the completion of the undertaking

(§801(2)(iii) b. the express will of all the partners to wind up the business before

the expiration or completion (§801(2)(ii) c. an event that the partnership agreement establishes as causing

dissolution (§801(3)) d. On application by a partner, a judicial determination that (1) the

economic purpose of the partnership is likely to be unreasonably frustrated, (2) another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with that partner; (3) it is not otherwise reasonably practicable to carry on the partnership business in conformity with the agreement (§ 801(5)

e. on application by a transferee of a partner‟s transferable interest, a judicial determination that it is equitable to wind up the partnership business: (1) after the expiration of the term or completion of the undertaking, if the partnership was for a definite term or particular undertaking at the time of the transfer or entry of the charging order that gave rise to the transfer; or (2) at any time, if the partnership was a partnership at will at the time of the transfer or entry of the charging order that gave rise to the transfer. (§ 801(6)).

2. Grounds for judicial dissolution on application by a partner mirror the grounds for judicial expulsion under § 601(5). Grounds for judicial dissolution on application by a transferee come from UPA § 32(2)

4. Cases a. Adams v. Jarvis: Despite UPA‟s dissolutiontermination presumption, the continuation

provisions in a partnership agreement were able to overcome that presumption and allow the partnership to continue with respect to the remaining partners.

b. Robinson v. Nussbaum: There were many attempts to put in place a formal written partnership agreement but the partners could not agree, so the court used the default UPA provisions, and held that all profits taken in for partnership business after

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dissolution began (though not profits for new business) had to be shared equally among all partners.

b. Limited Partnerships

i. Generally 1. Differ from general partners in seven fundamental ways

a. created by following statutory requirements b. two types of partners (general and limited) c. only general partners are liable for the partnership‟s debts, and limited partners only

personally liable in extraordinary circumstances d. only general partners have right to day-to-day management and power to bind

responsibilities; limited partners have rights in only a few matters ((which can be further restricted by agreement)

e. unless the agreement provides otherwise, the default rule is that the parties share profits in proportion to their capital contributions

f. unless agreement provides otherwise, dissociation of limited partner does not dissolve the partnership and dissociation of general partner only threatens dissolution

g. name of the limited partnership must contain a signifier (i.e., “limited partnership or „LP‟”)

2. Comprised of at least one general partner and at least one limited partner 3. General partner has unlimited liability, but limited partner has none beyond the loss of his

investment (though this is just a default rule; can be changed) 4. General and Limited Partnership statutes have historically been linked so gaps in Limited

statutes are often covered by General statutes a. UPA §6(2): applies to limited partnerships except for where Limited statutes inconsistent

with the UPA b. RUPA § 202(b): association formed under a statute other than the RUPA is not a

partnership for RUPA purposes, but comment to § 101 says that § 202(b) was not intended to preclude RUPA rules to limited partnerships where Limited statutes otherwise adopt General rules

i. Therefore important to note: RULPA § 101(7) of 1976 and 1985 defines limited partnership as a “partnership,” § 403 provides that a general partner in a limited partnership has the rights, powers, restrictions, and liabilities of a partner in a

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partnership without limited partners, and § 1105 indicates that in any case RULPA doesn‟t govern then UPA governs.

ii. ULPA (2001) de-links itself, but that doesn‟t really apply to our class 5. It is a distinct legal entity, rather than an aggregate of its owners.

ii. Formation 1. File certificate of limited partnership with the secretary of state (or equivalent)

a. Skeletal document with basic information about the company including its name and the identity of its general partners (RULPA § 201)

b. Serves to give notice to third parties 2. Does not need to be filed in state where it does most of its business; can choose whichever

state it desires (so as to benefit from its choice of law) but it must maintain an office and an agent for service of process (RULPA § 104).

3. Partnership agreement still used to detail the full set of rights and duties, but is not required a. Does not need to be written (RULPA § 101(9))

4. If the limited partnership plans to do business in other states, it should also file in those states (RULPA 1985 § 902)

5. Defective Formation a. § 201(b) of RULPA (1985): formed at time the certificate is filed if there has been

substantial compliance with the section‟s requirements. b. § 304(a) protects a person who makes a contribution to a business enterprise under the

mistaken but good faith belief that he is a limited partner; such a person is not a general partner and not bound by its obligations if upon ascertaining the mistake, he either

1. causes an appropriate certificate of limited partnership or a certificate of amendment to be executed and filed; or

2. withdraws from future equity participation in the enterprise by executing and filing in the office of the Secretary of State a certificate declaring withdrawal under this section.

ii. if those requirements are met, a mistaken person is only liable as a general partner to any third party who transacts business with the enterprise before either (1) or (2) are accomplished, and even then, liability is only imposed if the third party actually believed in good faith that the person was a general partner at the time of the transaction.

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c. Even if formation was defective but third parties had knowledge of its nature as a limited partnership, the defective formation may or may not matter (case law varies).

6. Partners in a limited partnership are usually required to make a contribution to the venture, and this “contribution” is broadly defined (RULPA 1985 §§ 101(2), 501)

7. RULPA does not address whether limited partnerships can be converted to other entities and vice-versa, but RUPA §§ 902-903 provide requirements for converting a general partnership to a limited partnership (and vice-versa) and § 904 specifies the effects.

8. Limited partnership interests are usually treated as securities under federal and state securities laws and conclude that they are investment contracts because limited partners often lack the right to participate in management and usually depend on general partners‟ efforts (so general partners‟ interests are not securities). The effect of this is that when securities laws apply, it is very difficult to transfer that because there is a complicated transfer process.

iii. General vs. Limited Partners: Role & Liability 1. General partners

a. same rights and powers as a general partner in a general partnership (except for where RULPA provides otherwise). (RULPA § 403(a)).

b. may be removed if the agreement provides a mechanism for limited partners to remove him (§ 402(3): person ceases to be a general partner if he is removed in accordance with the agreement).

i. voting is not the only method by which a partner can be removed, i.e., bankruptcy c. § 405: Agreement can grant to all or certain identified general partners the right to vote

(on a per capita basis or otherwise) on any matter 2. Limited partners

a. Management: RULPA does not explicitly grant or deny management rights to limited partners

b. Several cases have indicated that limited partners cannot take part in management (i.e., Goodman v. Epstein) and partnership agreements tend to deny such rights.

i. helps retain liability since limited partners who participate in control risk liability (RULPA § 303).

c. Agency: RULPA does not address whether a limited partner is an agent who can bind the venture via apparent authority but there is some case law stating that they have no agency authority.

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d. Voting: RULPA § 302: the agreement may grant to all or any set of limited partners the right to vote on any matter

e. Right to inspect: § 305 provides the right to inspect records and to obtain information about the partnership (important because they don‟t participate in the actual management)

iv. Financial Rights and Obligations 1. RULPA §§ 503, 504: unless otherwise agreed in the agreement the profits/losses/distributions

of a limited partnership are allocated on the basis of the value made by each partner to the extent they have been received by the partnership and not returned.

2. There are several provisions designed to prevent partners from abusing their financial rights to the detriment of creditors.

a. § 502: creditor has right under certain circumstances to enforce a limited partner‟s promise to contribute to the venture

b. § 607: distribution to a partner is prohibited if it would leave the firm insolvent c. § 608: makes partners liable to the limited partnership for wrongful distributions and in

some cases for rightful distributions 3. As a practical matter, financial rights of general partners and limited partners are almost

always specified in the agreement. 4. § 601: Except as provided in Article 6, partner entitled to receive distributions before his

withdrawal from the partnership and before dissolution/winding up to the extent and at the v. Entity Status

1. RULPA does not itself specify that limited partnerships are distinct entities from their partners but courts have generally treated them as such--BUT courts might nevertheless ignore this when policy considerations are compelling).

vi. Limited Liability 1. The Control Rule: Under the old ULPA it was unclear how much control was enough to

eliminate the limited liability which is one thing that led to the RULPAs. 2. RULPA 1976 § 303(a): retained control rule and adds second sentence that narrowed scope of

liability so that if the limited partner‟s participation in the control of the business is not substantially the same as the exercise of the powers of a general partner, he is liable only to persons who transact business with the limited partnership with actual knowledge of his participation of control. § 303(b) added a list of “safe harbor” activities that did not constitute participation in the control of the business.

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3. RULPA 1985 § 303(a) kept the control rule and further altered the second sentence so that a limited partner is only liable to persons who transact business with the limited partnership reasonably believing, based upon the limited partner‟s conduct, that the limited partner is a general partner. § 303(b) expands the safe harbor provisions.

4. Special Circumstances where limited partner may be exposed to claims from creditors a. Unfilled promise to contribute: limited partner makes enforceable promise to contribute

to the limited partnership, he is liable for that promise. If the partnership becomes insolvent this liability can be invoked to benefit the partnership‟s creditors. RULPA §502(b).

b. Wrongfully returned contributions: if the limited partnership has returned all or part of a limited partner‟s contribution and the return violated the agreement, then for 6 years afterward the limited partner is liable to the partnership for the amount of the wrongful return, and also to creditors if it becomes insolvent. §§ 608(b) is the general rule and 607 prohibits distributions leaving it insolvent.

c. Properly Returned Contributions: If (1) the limited partnership has returned all or part of a limited partner‟s contribution without violating the partnership agreement and without leaving it insolvent, and (2) the limited partnership cannot pay creditors who extended credit to the partnership during the period the contribution was held by the partnership, then for one year after the returned contribution. §§608(a) and 607.

d. Mistaken Belief in Limited Partner Status: If (1) a person makes a contribution to an enterprise, believing a good faith that the contribution is made as a limited partner, but (2) either no limited partnership exists or the certificate of limited partnership erroneously identifies the person as a general partner, and (3) when the person learns of the problem, he either formally withdraws from the enterprise or has the certificate corrected, then the person is not categorically liable as a general partner in the enterprise. However, if before the partner takes corrective action a third party transacts business believing in good faith that the person is a general partner, then the person is liable on that transaction as if he is a general partner. RULPA § 304(b)

e. Use of a limited partner’s name: If he allows his name to be used in the name of the limited partnership and a third party extends credit to the partnership without knowing that he is not a general partner, then he is liable to that third party on the transaction as if a general partner. RULPA § 303(d). **does not apply if his name is the same as the

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general partner‟s or if the limited partnership had used the name before the limited partner became a limited partner**

f. Participation in Control: If (1) a limited partner participates in the control of the business of the limited partnership, (2) that conduct causes a third party to reasonably believe that the limited partner is a general partner, and (3) with that belief the third party transacts business with the limited partnership then the partner is liable to the third party as if a general partner. RULPA § 303(a)

vii. Management 1. Default management structure-general partners manage and only they have the power to bind

the partnership. **A limited partner may separately be an agent of the limited partnership and in that capacity may have the power to bind the partnership under agency principles**

2. RULPA requires consent of all partners for admission of any new limited or general partner. RULPA §§301(b)(2) and 401

3. Limited partners have the right to information about the business 4. Can bring derivative suits to assert partnership claims (RUPLA §§1001-1004. 5. RULPA does not, as a default rule, empower limited partners to remove general partners (but

the agreement may so allow). viii. Fiduciary Duties

1. General Partners a. RULPA does not explicitly address general partner fiduciary duties but because of the

linkage with general partnership law, UPA § 21 and RUPA § 404 provide guidance for general partner fiduciary duties in a limited partnership.

b. Despite RULPA‟s linkage to general partnership law, the limited partnership context presents its own issues: (1) most legal developments on contractually modifying fiduciary duties have been in the LP context, and (2) when a general partner of a limited partnership is a business entity, managers of the entity may personally owe fiduciary duties to the limited partners and the limited partnership.

c. Partners have broad latitude to contractually modify fiduciary duties i. In Delaware, basic premise is that unless limited by the partnership agreement,

the general partner has the fiduciary duty to manage the partnership in its interest and in the interests of the limited partners. In other words, look first to the operative governing instrument (the agreement). BUT in Delaware, current

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jurisprudence is that statutory language allows modification or restriction of fiduciary rights but not elimination of such duties.

d. RULPA § 403: General Partner fiduciary duties in the limited partnership context, using linkage to general partnership law.

e. General partners may have an affirmative duty to disclose information to limited partners even without a demand for information by the limited partners through case law (because partnership law does not eliminate common law fiduciary duty to disclose all material facts)

f. RULPA § 107 states that except as provided in the agreement, a partner may lend money to and transact other business with the limited partnership and, subject to other applicable law, has the same rights and obligations with respect thereto as a person who is not a partner.

2. Limited Partners a. RULPA does not address this topic, but § 1105 indicates that general partnership law

applies--though they also fail to address this. But since RULPA (1985) § 101(8) defines partner to include limited partners, there is an argument that general partnership fiduciary duties apply to them as well but that results in a poor fit because they do not exercise the same control.

b. ULPA 2001 § 305(a) states that a limited partner does not have a fiduciary duty to the limited partnership or to any other partner solely by reason of being a limited partner. But under § 305(b) he must discharge his duties to the partnership and the other partners or under the partnership consistently with the obligation of good faith and fair dealing.

ix. Profit and Loss Sharing 1. Default rules differ from general partnership rule; RULPA addresses the allocation of profits

and losses separately from the sharing of distributions, though the default rule is the same under both rubrics.

2. §§503-504 hold that profits and losses are allocated and distributed in proportion to the value of contributions made by each partner to the extent they have been received by the partnership and not returned.

x. Transfer of Partner‟s Ownership Interest 1. Default rule is that financial rights are transferable while management rights are not. (RULPA

1985 §§101(10), 702).

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2. § 704: assignee of a partnership (including an assignee of a general partner interest) has the right to become a limited partner “if and to the extent that (1) the assignor gives the assignee that right in accordance with authority described in the partnership agreement, or (2) all other partners consent.” RULPA § 301 addresses the admission of limited partners, while RULPA § 401 addresses admission of general partners.

3. Entity general partners is unusual; transfer of shares of a corporate general partner is distinct from the transfer of a general partner interest.

a. Anti-transfer clauses may alleviate problems associated with this problem (In re Asian Yard Partners held that an agreement prohibiting directly or indirectly prohibited transfer of control through transfer of stock of a corporate entity).

b. A merger involving an entity general partner may also shift control so it could constitute a transfer or assignment in violation of anti-transfer clauses.

4. Keep in mind that RULPA follows the “pick your partner” rule; unless the agreement provides otherwise, no partner (general or limited) may transfer its governance authority to another person without the consent of all the other partners. RULPA § 702. BUT absent a contrary agreement a partner may freely transfer its financial rights. RULPA § 702.

xi. Withdrawal, Dissolution, and Winding Up 1. RULPA § 402: events of withdrawal for a general partner (including voluntary withdrawal,

removal, and bankruptcy). 2. § 602 allows a general partner to withdraw at any time by giving written notice to the other

partners, but if withdrawal violates the agreement, the limited partnership may recover damages.

3. § 604: withdrawing partner, general or limited, is entitled to receive any distribution provided for in the agreement. If the agreement is silent, the section specifies that a partner shall receive within a reasonable time after withdrawal, the fair value of his interest in the limited partnership as of the date of withdrawal based on his right to share in distributions from the limited partnership.

4. § 603 allows a limited partner to withdraw under circumstances specified in a written agreement but if it‟s silent, he may withdraw upon not less than 6 months prior written notice to each general partner.

a. Many states limit the limited partner‟s right to withdraw 5. ULPA (2001) eliminates the right of limited partners to dissociate before the firm‟s termination

but still recognizes the power to dissociate.

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6. Dissolution a. RULPA § 801: limited partnership is dissolved

i. at the time specified in the certificate of limited partnership ii. upon the occurrence of events specified in a written partnership agreement iii. upon the written consent of all partners iv. upon an event of withdrawal of a general partner under § 402 (except when

certain requirements are met); and v. by the entry of a decree of judicial dissolution under § 802

b. § 802 provides that a court may decree dissolution of a limited partnership whenever it is not reasonably practicable to carry on the business in conformity with the partnership agreement

c. Dissociation of limited partner does not cause dissolution because of their nature: they are passive owners so it doesn‟t really cause a substantial change in the business.

7. There are linkage issues for dissolution because with RULPA § 802, UPA § 32(2)/RUPA § 801(6) it‟s unclear if assignees can apply for dissolution, or just partners

8. Dissociation a. RULPA refers to partner dissociation was “withdrawal” (§ 602, 603) and a general

partner has the power to withdraw at any time b. General partner‟s withdrawal threatens but does not necessarily cause dissolution;

limited partnership can avoid dissolution if either (1) the partnership has at least one remaining general partner, the partnership agreement allows the remaining general partners to do so, and the remaining general partners do so, or (2) within 90 days after the withdrawal all the remaining partners (limited & general) agree in writing to continue the partnership. RULPA § 801(4).

c. If general partner‟s withdrawal does result in dissolution its similar to dissolution of general partnership; if partnership continues the former general partner has the right (subject to the agreement) to be paid within a reasonable time the fair value of his interest (RULPA § 604) unless his withdrawal breached the agreement (in which case damages are taken out pursuant to RULPA § 602).

d. Whether limited partners have the right to dissociate depends on the agreement especially if it (1) states a particular term for the partnership, (2) authorizes limited partner withdrawal, or (3) does both.

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i. If the agreement does neither then a limited partner can withdraw by giving at least six months written notice to each general partner (RULPA § 603).

xii. Limited Partnerships with Corporate General Partners 1. If the general partner is a corporate entity and is marginally capitalized, it becomes akin to a

corporation because most of the capital is provided by limited partners, so actual person is personally liable for debts.

2. There is no legal prohibition against limited partners serving as shareholders/directors/officers of the corporate general partner.

3. Using a corporate entity is very common these days, where it basically acts as a shield for the limited partners (99% of financial benefits accrue to the limited partners and they all control the corporation).

4. Corporate general partner differs from an individual in several respects a. Subject to control of somebody else b. Relatively easy to control transfers of managerial authority to third persons when

individuals are involved, but when it‟s a corporation, difficult to do so because the actual corporation does not change

c. Corporation may be entirely acceptable as a general partner even though its assets are nominal, likely where shareholders are also the limited partners; claim of breach of fiduciary duty would need to be against the parties that manage the general partner in order to recover much

d. Even if the corporate partner is reasonably capitalized, subsequent transactions may bleed off those assets to its owners, while greatly increasing the potential risks to the limited partners.

5. Generally courts don‟t frown on use of entity of general partners even when controlled by the other limited partners, but this could still be an issue.

6. Case: In re USACafes, L.P.--directors in control of a corporate general partner have fiduciary duties to the partnership itself, and not merely to the corporation, because they‟re the ones actually in control. I.e., would it make sense to allow the corporate general partner to establish a new corporation and then cause the partnership to convey its assets to the new company at an unfairly low price? No, so the corporate general partner cannot sell its assets to a third party at an unfairly low price either.

xiii. Changes in the ULPA (2001) 1. Stand-alone act that delinks limited partnership law from general partnership law.

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2. Meant to target sophisticated, manager-entrenched commercial deals meant to be for the long term, and family limited partnerships so it assumes that people will want: (1) strong centralized management, strongly entrenched, and (2) passive investors with little control over or right to exit the entity.

3. Provides for a Limited Liability Limited Partnership (“LLLP”), where no partner (general or limited) is liable on account of his partner status for the partnership‟s obligations

4. Gets rid of the control rule for limited partners and provides status-based shield against limited partner liability for entity obligations regardless of whether it is an LLLP.

5. 12 major differences between this and RULPA: a. stand-alone act incorporating many important RUPA provisions b. provides constructive notice, 90 days after appropriate filing, of general partner

dissociation and of limited partnership dissolution, termination, merger, and conversion c. has perpetual duration, which means that the limited partnership continues indefinitely

without a term unless otherwise provided in the partnership agreement and subject to dissolution by partner consent

d. expressly delineates the permissible scope and effect of the partnership agreement e. provides a complete, corporate-like liability shield for limited partners even if the limited

partner participates in the management and control of the limited partnership f. permits a limited partnership to be an LLLP and thereby makes a corporate-like liability

shield available to general partners g. gives limited partners the power but not the right to dissociate before the limited

partnership‟s termination and allows the partnership agreement to eliminate even the power

h. eliminates any pretermination payout to dissociated partners unless the partnership agreement provides otherwise

i. eschews the UPA‟s open-ended approach to general partner fiduciary duties and incorporates essentially verbatim RUPA‟s provision on fiduciary duty and the obligation of good faith and fair dealing

j. provides for judicial expulsion of a general partner though the agreement can negate that provision

k. makes dissolution following a general partner‟s dissociation less likely, replacing RULPA‟s unanimous consent rule with a two-pronged approach:

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i. if at least one general partner remains, no dissolution occurs unless within 90 days after the dissociation, partners owning a majority of the rights to receive distributions as partners consent to dissolve the limited partnership

ii. if no general partner remains, dissolution occurs upon the passage of 90 days after the dissociation, unless before that deadline limited partners owning a majority of the rights to receive distributions owned by limited partners consent to continue the business and admit at least one new general partner and a new general partner is admitted

l. authorizes a limited partnership to participate in mergers and conversions

c. Limited Liability Partnership (LLP) i. Generally

1. LLP is a general partnership that, depending on the relevant statute, provides the partners with limited liability for the firm‟s tort obligations for both its tort and contract obligations.

2. Since it is a “partnership,” general partnership law is applicable to LLPs when it is not explicitly modified by LLP-specific provisions

3. The original LLP was only meant to protect innocent partners from responsibility for malpractice claims, liabilities arising from negligence, or misconduct in which they were not personally involved.

4. In 1996 the ABA concluded that LLPs were OK but disagreed on amount of disclosure about LLP‟s limited liability; minority felt that use of initials was not sufficient, but majority felt that abbreviations place client on notice and encourages them to inquire if they are in doubt as to its implications. When client inquires, ABA says that lawyer must clearly explain the limitation of liability features of his firm‟s business organization--but without such an inquiry lawyers do not have to explain the restriction.

ii. Formation 1. Since LLP is a partnership, formation must fall within the statutory definition of a partnership

but it must also satisfy certain statutory formalities: (1) filing a document (application, etc.) with the secretary of state or other official that has its name/address/statement of its purpose, (2) some jurisdictions require it to provide a specified amount of liability insurance or a pool of funds segregated for the satisfaction of judgments against the partnership.

a. LLP that fails to satisfy the second prong presumably loses its limited liability protection, at least up to the amount that insurance should have provided

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2. Specifically, most LLP statutes reflect RUPA: a. First obtains quantum of consent from its partners and then filing a statement b. Unless the agreement provides otherwise, the consent necessary to approve becoming

an LLP is the same as that required to approve an amendment to the agreement except in the case of an agreement that expressly considers obligations to contribute to the partnership, the LLP approval quantum is the vote necessary to amend those provisions

c. Statement must be executed by at least two partners and be accompanied by whatever filing fee is required, and contain the name of the partnership, the street address of its chief office and its local office, or if not a local office then an address for an agent for service of process, a statement that the partnership elects to be an LLP, and a deferred effective date if any

d. An LLPs name must include designators that show its an LLP e. Must file an annual report with the same official that receives the statement of

qualification, containing minimal information and its function is merely to keep the public record current

f. When a statement of qualification takes effect, a full liability shield for torts, contracts, or otherwise arises (so only the partnership itself is liable).

iii. Dissolution has no effect on the LLP status (RUPA §1001(e)), BUT if the assets/business are transferred to a successor organization, that does not have LLP status unless it gets it on its own (so there could be gaps in the shield).

iv. Shield only applies to acts that occur while a partnership is actually an LLP (and a partner incurs obligations at the time they occur, i.e., when the contract is made or tortious conduct carried out. Unless parties agree, modifications to contract do not reset the incurred date.

v. Contribution Conundrum: if one partner is liable as a result of his negligence and the partnership must indemnify him, then the shield is essentially useless. RUPA § 306(c) affects this

1. RUPA‟s loss sharing provisions remain intact as to capital losses suffered by the partners 2. RUPA‟s contribution provisions will never create a hole in the LLP shield 3. partnership agreement‟s provisions on contribution will jeopardize the shield only if adopted or

reaffirmed after the general partnership becomes an LLP

d. Limited Liability Limited Partnership (LLLP) i. Generally

1. Limited partnership that has invoked the LLLP provisions of its state partnership law

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2. Requires filing with specified public official 3. Completely eliminates the automatic personal liability of each general partner for each

partnership obligation and, under most statutes, also eliminating the “control rule” liability exposure for all limited partners.

4. General partner in an LLLP is liable for the obligations of the business only when a general partner in an LLP would be liable

5. Some jurisdictions hold that limited partners are also granted protection, which in effect means that they‟re protected where ordinarily the control rule might pierce their limited liability shield (unless the conduct would result in liability for an LLP partner).

6. NOTE: All this means that limited partners in an LLLP may only have RULPA § 303(a) protection while general partners have the superior § 306(c) shield.

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III. Limited Liability Companies (LLC)

a. Generally i. It is a noncorporate business structure that provides its owners (also known as members) which

several benefits: 1. limited liability for the venture‟s obligations, even if a member helps control the business 2. pass-through tax treatment 3. tremendous freedom to contractually arrange the internal operations of the venture

ii. Preferred form for many closely held businesses iii. For our class focusing on the RULLCA of 2006 iv. Combines elements of partnerships and companies v. Why would people not use an LLC? Higher fees for LLCs, other taxes may be higher for LLCs, may

require greater detail for operating agreement that is tailored to the founders‟ wishes because of few default rules, professional unfamiliarity with the LLC structure, sparse case law, LLC statutes limit exit rights while partnership default rules provide broad dissociation/dissolution rights, difficulties with LLC merging with corporation

vi. An LLC is distinct from its members (RULLCA 2006 § 104) vii. Operating agreement does not need to be in writing, but LLC statutes usually don‟t provide much

information which is why the freedom of contract is important: agreements generally provide the detail viii. Which controls--the articles of organization or the operating agreement? Some statutes say the

former always controls, while ULLCA § 203(c) say so long as agreement is not inconsistent with the article, it controls as to managers, members, and members‟ transferees while the articles control as to other persons who reasonably rely on the articles to their detriment (RULLCA § 112(d) is substantially the same).

ix. Has full, corporate-like liability shield to protect its owners against automatic, vicarious liability for the debts of the enterprise.

x. LLC may be perpetual, do not have to have a specified term or duration xi. LLC governance structure can be member-managed (like a general partnership) or manager-

managed (like a corporation) xii. Not required that that the LLC form in the state where it does most or all of its business. xiii. “Internal affairs” doctrine: choice of the state of formation is always a choice of law (RULLCA § 106(1)

comment), though that has not really been codified. It is unclear whether this includes claims of liability with respect to outside people because they are outside the LLC.

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xiv. Neither RULLCA nor Delaware use “membership interest” as a defined term, but Delaware does define “limited liability company interest” as only a member‟s share in the profits/losses and his right to receive distributions of the company‟s assets.

1. Not accurate to state that a member necessarily has both economic and governance rights xv. Some generalizations with respect to typical LLC membership and the typical relationship between a

member‟s governance rights and economic rights: 1. When person becomes a member through interaction with the LLC (rather than as transferee),

he typically obtains a membership in return for something he brought that has value (RULLCA § 402: broad form of contribution definition that includes money, services rendered, etc.)

2. An LLC typically has some governance rights; at a minimum rights to information about the company‟s activities and the right to vote on or consent to major issues.

3. An LLC member typically has the right to share in profit distributions, subject to the operating agreement

b. Formation i. Generally

1. File a document usually known as the “articles of organization” or “certificate of organization,” usually skeletal and requiring only basic information.

a. For example, in Delaware: name of the LLC, address of its registered office, and the name and address of its registered agent for service of process

b. ULLA demands more content, e.g., must specify whether its member-managed. 2. Real detail provided in separate document known as an “operating agreement” which is a

nonpublic document that is similar to a partnership agreement or corporation bylaws a. Contains specifics on the rights, duties, and obligations of the LLC‟s members and

managers and on the operation of the LLC as a whole b. Can generally be tailored to suit the particular needs of an LLC‟s members and will

displace most, if not all, of the statutory provisions (in other words: freedom of contract is central to the LLC‟s structure)

3. Some statutes hold that an LLC is created so long as there is substantial compliance with the formation requirements (DLLCA § 18-201(b)), others omit that but provide that filing of the articles is conclusive proof that formation requirements have been satisfied (ULLCA § 202(c); RULLCA § 201(d)(3), (e)(3). This means that an error does not prevent formation.

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a. Unlike limited partnership statutes, LLC statutes do not typically provide any amendment/withdrawal protection for members who mistakenly (but in good faith) believe that an LLC was formed.

4. In the event of improper formation, the underlying agreement is typically enforce with respect to the members (and only impacts cases with respect to third parties)

5. Some statutes have liability for those acting on behalf of an unformed LLC 6. LLC members usually required to make a contribution to the company‟s capital, with

contributions broadly defined (DLLCA § 18-101(3) and ULLCA § 401 and RULLCA § 402) 7. Law of jurisdiction where LLC formed will govern a foreign LLC‟s internal affairs, etc. (DLLCA §

18-901(a)(1); ULLCA § 1001(a); RULLCA § 801(a). 8. LLC statutes used to require at least 2 members (analogous to partnership law) but now they

typically only need one 9. In many jurisdictions, LLCs can be formed by converting existing non-LLC business tructures

into LLCs and statutes typically specify the procedures for making that happen (DLLCA § 18-901(a)(1); ULLCA § 1001(a); RULLCA § 801(a)).

10. Under most statutes, LLC is characterized as a separate legal entity whose entity is distinct from that of its owners (DLLCA § 18-201(b); ULLCA § 201; RULLCA § 104(a)), so it can exercise rights and powers in its own name, But judicial treatment is not always predictable.

ii. Many like to have “shelf LLCs” where it is formed before it has a member but this can be difficult for statutes like ULLCA § 202(a) that presuppose that an LLC has a member upon formation

1. RULLCA permits shelf LLCs but two filings must be made: (1) certificate of organization must be filed and explicitly state that the LLC will have no members when the Secretary of State files the certificate (RULLCA § 201(b)(3)), (2) within 90 days from the filing of the certificate, an organizer of the LLC must file a notice stating that the LLC has at least one member and the date when the person or persons became the LLC‟s initial member or members (RULLCA § 201(e)(1)). If the second filing isn‟t made, then the certificate lapses and is void.

c. Organizers i. Nomenclature: statutes differ as to how they refer to this person ii. Role: sign and submit the document whose public filing will create the LLC; do not need to be a

natural person iii. Member?: Organizer is not a member because his role is preformation--member status for anyone

presupposes the organizer‟s task is finished. Does not need to become a member after it comes into existence but may do so if desired.

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iv. Legal relationship with the LLC: strictly speaking, no legal relationship between an organizer and the LLC--cannot be an agent

v. Legal relationship with the persons who are agreed/destined to become initial members: most statutes are silent but Delaware contemplates that the organizer is acting on their behalf, and REULLCA § 401 contemplates this

vi. Multiple organizers: statutes contemplate this but most are formed by a single organizer d. Articles of Organization:

i. Nomenclature: names vary but articles ii. Contents: name, address, service of process, etc. Most do not require disclosure of members‟

identities but recent controversy has caused some to require articles to assert there is at least one member

iii. Require that name contains language signifying its LLC status and must be distinguishable in the records from other entities.

iv. Optional contents: all statutes allow for other information but unclear what effect this has v. Notice: a few state that filing articles are constructive notice that it‟s an LLC, but some cases hold that

it‟s ineffective to change common law agency principles. e. Taxation

i. Original “Kinter” regulations sought to avoid corporate similarities ii. In 1997 replaced them with new “check the box” regulations

1. LLC can simply elect whether to be taxed as a partnership (pass through) or a corporation (double taxation)

2. Certain entities must be taxed as corporations: (1) entities organized under a federal or state statute that refers to the entity as “incorporated” or a “corporation”; (2) certain foreign entities that are specifically listed in the regulations as per se corporations; and (3) business entities that are taxable as corporations under other provisions of the Internal Revenue Code such as publicly traded firms and regulated investment companies. Result: federal income tax treatment is now determined by a simple taxpayer choice.

f. LLC is now the most popular form of new business entity g. Because the LLC is a mishmash of business entities, courts often analogize to existing structures for other

forms h. LLC as a juridical person

i. Separate entity

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ii. Modern trend is to permit LLC to have any lawful purpose, so it does not have to be just a business purpose.

iii. Tax-exempt Single Member LLCs: must (1) be organized for one or more nonprofit purposes, (2) be classified as a corporation, comply with stringent limitations on governance, operations, and use of assets, (3) and apply for and obtain a tax-exempt status but “checking the box”. Corporations are likely to do this within its own organization to carry out a nonprofit mission.

iv. Powers of an LLC: Almost all LLC statutes expressly address the powers issue; those derived from corporate law contain a detailed list of powers if an LLC, but those based on partnership law are more simple and provide for any power necessary to carry on activities. (RULLCA § 105). Result: an LLC is a person with the attendant powers necessary to pursue its lawful objectives.

v. Capacity to sue, etc.: 1. authorized and required to sue and be sued in its own name 2. not able to be represented in court by a non-attorney member 3. subject to particular service of process requirements 4. not an agent for service of process on any of its members

vi. Property matters: contribution of property is a transfer from one entity to another, so it: 1. can trigger a deed tax even if the contributor is the LLC‟s sole member unless the tax statue

provides otherwise; 2. can entitle a real estate broker to commission for the “sale” from the member to the LLC 3. means that the former owner of property contributed to an LLC lacks standing to contest

zoning activities pertaining to the property/LLC members cannot sue to partition land contributed to the LLC

4. Puts land out of reach of member‟s creditors i. Operating Agreement:

i. Broad flexibility ii. Can supplant default rules iii. Might address membership, governance, finance, dissolution iv. Generally not required but defined so broadly that as soon as LLC has members it typically has an

agreement v. Single member LLCs may have an operating agreement despite its contractual nature in some

jurisdictions because it may be of interest to third parties and under some statutes binds the LLC vi. Mechanics of Adoption

1. Initially must be agreed to by allpersons who are members at the moment of its adoption

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2. A few require them to be in writing but most define it as oral or written and even allow for terms to be implied (RULLCA § 110(13).

vii. Articles of Organization as Part of the Agreement: articles can be a part of the agreement but where articles can be amended with less than unanimous consent, it would be wise to have the agreement expressly determine whether the articles are part of the agreement.

viii. Amending the Agreement: Requires consent of all persons then members, whether or not an LLC is member- or manager-managed, though the agreement itself may provide for nonunanimous amendments (in fact RULLCA § 110(a)(4) provides this as a default rule); it is common for agreements to specify consent in terms of profits interest held by members. Agreements can specify several types of amendments to allow for different levels of consent.

1. Depending on jurisdiction, “good faith and fair dealing” and fiduciary duties may be applied to member-to-member transactions

2. Where agreement must be in writing, amendments must also be in writing. 3. In jurisdictions where oral/implied agreements are permissible, unclear whether written

agreements can preclude such amendments. ix. Relationship of Operating Agreement to New Members: Under RULLCA, person becomes a member

and is deemed to assent to the agreement (§ 111(b)). If the relevant statute is silent there is a reasonable argument that new members are deemed to consent.

x. Resolving Conflicts Between Articles and Operating Agreement: What if the Articles and Agreement conflict? Most statutes are silent on this, but a few take the corporate approach and subordinate the agreement to a publicly filed document.

1. RULLCA carries forward the original ULLCA‟s approach and gives priority to the agreement in inter se matters and to the articles when third party interests are involved. (RULLCA § 112(d)); absent statutory mechanism, court might approach this as a matter of common law.

j. Capital Structure: Economic Rights/Roles of Members i. Overview

1. “Capital Structure” is a fancy way to label the economic rights of an entity‟s owners vis-à-vis each other and the entity. Basic rules derive from partnership law.

2. LLC statutes are fairly similar in the substance although the language can vary a bit. They all: a. conceptualize a member‟s financial rights as separate from the member‟s governance

rights, providing a label for the financial rights such as a “transferable interest” or “membership interest”

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b. provide default rules for allocating distributions among members and transferees of a member‟s financial rights, both for operating distributions and liquidating distributions

c. contemplate a person acquiring economic rights either: (1) directly from the LLC by buying into the company and becoming a member, or (2) acquiring economic rights from a person already a member (and either becoming a member or remaining a “mere” transferee)

ii. Member‟s Contribution (“Buying In”) 1. Person can become a member of an LLC either

i. by acquiring another person‟s membership and being admitted to the LLC in connection with that acquisition; or

ii. through a transaction with the LLC b. In the former instance, new member does not make contribution because the original

member‟s consideration passes to the seller and his original contribution is chalked up to the new member. In the latter instance it is usual for the person to make a contribution in return for membership.

2. LLC statutes put almost no limits on possible forms of contribution 3. Some statutes contain a statute of fraud provision applicable to promised contributions; most

expressly permit a person to become a member without making any contribution. k. Management Structure; Agency, and Fiduciary Duties of Members and Managers

i. General Governance 1. Most statutes assign, as a default rule, all management functions to members. (DLLCA § 18-

402, ULLCA §§ 101(11), (12), 203(a)(6); RULLCA §§ 102(10), (12), 407). This resembles a general partnership.

a. A few statutes default to manager-managed structure 2. Default rules for voting differ among statutes; half default to members voting on a per capita

basis (one vote per person) while the other half defaults to a pro rata basis (by financial interest or other contribution to the firm).

a. For ordinary matters, majority rule carries the decision b. For extraordinary matters, some require a specified supermajority c. In manager-managed LLCs, decisions are usually made by a majority vote of the

managers (by number) although certain extraordinary decisions will often require a specified vote of the members as well (ULLCA § 404(c); RULLCA § 407(c)).

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3. Deviating from the default rules must usually be stated in the articles but some allow the specification to be made in the operating agreement (ULLCA § 203(a)(6) - articles, RULLCA § 407(a) - operating agreement).

4. Some statutes allow for management functions to be divided between managers and members, and this might occur even without explicit statutory authorization

5. Default rule for allocation of financial rights among members follows a similar split as to voting (i.e., can be per capita or pro rata).

6. Some statutes allow for creation of multiple classes of ownership interests with different rights and privileges

7. LLC statutes typically do not include formalities provisions like in corporate statutes (with respect to elections, meetings, etc.)

ii. Authority 1. Under most statutes, members in member-managed LLCs have partnership-like agency

authority to bind the LLC and same for managers in manager-managed LLCs. 2. Members in manager-managed LLCs usually have no statutory authority to bind the venture

(ULLCA § 301(a), though Delaware allows it unless otherwise provided in the agreement DLLCA § 18-402)

3. Authority for One of Several Managers to Act Unilaterally: when LLC has more than one manager, look to whether the agreement definitely addresses this issue. If it doesn‟t, the answer must be inferred as a matter of agency law and actual authority from any relevant language in the LCC statute and the operating agreement, and from other circumstances that manifest the principal‟s (LLC‟s) intent.

4. “Manager” is an ill-defined term iii. Discerning the management structure is difficult because of the number of ways in which LLCs have

been structured but there is a general approach: 1. Begin by identifying the relevant statute under whose authority the LLC has been created 2. Look for references to “management” and “members” within that statute 3. Consider following issues

a. what is the statutory default setting (member- or manager-managed) b. which document can change that setting (only articles or also the agreement?) c. what does the relevant document provide?

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d. what means may be used to alter the management rules of the relevant template--are some rules subject to change only in the articles, agreement, etc. Are some rules mandatory?

4. For member-managed LLC set up by modifying the statutory template with the operating agreement:

a. is each member expressly authorized to participate in the LLC‟s activities? b. rule for determining when a member may make a unilateral decision? c. for what issues is member consent required...? d. what sort of majority is required and how is it measured e. are formal meetings of the members contemplated or required to make decisions

effective? f. is acting by proxy authorized/prohibited g. where consent/voting power allocated according to some form of economic rights and a

member has transferred some or all of the economic rights, what is the consequence to the member‟s consent/voting rights?

5. Manager-managed LLC set up by modifying the statutory template with the agreement: a. how many managers are provided for? b. how are they selected, removed, replaced c. does the LLC have a separate management agreement with the managers? d. With respect to the scope of the managers‟ authority, how is the scope generally

delineated/which if any decisions are within the managers‟ authority? e. if the LLC has more than one manager, how is authority divided among them/rule for

when a manager may make a unilateral decision/are meetings required/proxies allowed f. with respect to matters reserved to the members, is member decision-making

contemplated to be by consent, voting, or both (and what majority is required?) iv. Fiduciary Duties of those who manage:

1. Overview a. LLC management authority primarily comes with duties of care and loyalty b. these are internal affairs and therefore analyzed under the law of the LLC‟s state of

organization 2. Who Owes the Duties?

a. Under two-template statutes, any stated duties switch according to whether the LLC is member-managed or manager-managed.

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b. In a manager-managed LLC, members who are managers owe fiduciary duties qua managers, and nonmanaging members are therefore not fiduciaries.

i. Many statutes negate any fiduciary duties for nonmanaging members in a manager-managed LLC

1. Applies by its terms to a member‟s exercise of consent or voting rights within a manager-managed LLC, so even though the nonmanaging member has power over governance matters, there are no fiduciary duties

2. Does not apply to liability for conduct that is wrongful regardless of a person‟s status as a member

3. If a nonmanaging member effectively controls the manager(s), this does not immunize his exercise of that control

c. Member-managed LLCs: may be fiduciary duties because operating agreements can reserve particular management functions to only some of the members

i. RULLCA §110(f): agreement may relieve member in a member-managed of some duties, and may also relieve that person of fiduciary duties that would have pertained to the responsibility.

3. To Whom are the Duties Owed a. Generally, governance duties are owed primarily to the LLC as an entity and not to the

individual members i. major exception: under law of most states, members obliged to not use

managerial power to oppress or unfairly prejudice a fellow member (concepts are vague, but at the core is a concept of unfairness). In this case, the damage is to a member and the duty runs directly from member to member.

4. The Duty of Care a. Some statutes set a low bar for the duty of care, requiring only that those with

management authority avoid gross negligence and intentional wrongdoing. b. Others borrow from a prominent corporate law formulation and require the exercise of

ordinary care. c. RULLCA recognized this was difficult and codified a hybrid standard: ordinary care

subject to the business judgment rule (RULLCA § 407(c)). i. Generally

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1. applies when an entity or those seeking to enforce an entity‟s rights challenges a decision made by those persons having top governance within the entity

2. presumes that those persons made the challenged decision in good faith without any breach of the duty of loyalty and using the requisite degree of care; and

3. requires the court not to second guess the decision unless the complainant can rebut some aspect of the presumption of proper conduct

5. The Duty of Loyalty a. Not all statutes codify this duty; some leave the question to case law if they use a

corporate-like approach b. Those that directly address it have some language derived from UPA § 21 or RUPA §

404, and RULLCA falls into this category i. § 409(b): duty of loyalty includes duties to account to the company and to hold as

trustee for it any property, profit, or benefited derived by the member (a) in the conduct of winding up the company‟s activities; (b) from a use by the member of the company‟s property, or (c) from the appropriation of a limited liability company opportunity. Also, to refrain from dealing with the company in the conduct or winding up of the company‟s activities as or on behalf of an interest adverse to the company; and also to refrain from competing.

6. Duty to Provide Information: a. Those with managerial authority have an obligation to provide information to those on

whose behalf they manage. b. RULLCA follows the 2001 ULPA and includes a detailed provision on the informational

rights of members, dissociated members, and transferees (§ 410). c. Delaware also has a detailed provision d. Even though statutes have detailed provisions the courts will fill in any gaps as a matter

of fiduciary duty especially for member-to-member and member-LLC transactions. 7. Obligation of Good Faith and Fair Dealing:

a. Implied as a nonwaivable part of any contract (R.2d Contracts § 205), and since operating agreement is a contract, the principle is applicable here.

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b. RULLCA codifies this at § 409(d): member in a member-managed LLC or manager-managed LLC shall discharge their duties under the act or agreement consistently with the contractual obligations of good faith/fair dealing.

i. RULLCA apparently takes a narrow approach to this to emphasize the contractual obligation so that it‟s not a fiduciary duty--in other words, to protect the contract that the parties bargained for, not to restructure it.

8. Altering Fiduciary Duties by Agreement: a. LLC law permits fiduciary duties to be delineated or modified by agreement b. Delaware law even allows elimination of duties, but RULLCA takes a more complicated

approach; subject to a manifestly unreasonable standard, the agreement may alter the duty of care except to authorize intentional misconduct or knowing violation of law (RULLCA § 110(d)(3)), restrict or eliminate the core fiduciary duties of loyalty (RULLCA § 110(d)(1) and (2); 110(e)), or alter any other fiduciary duty, including eliminating particular aspects of that duty (RULLCA § 110(d)(4)).

c. RULLCA approach in sum: i. Operating agreement might eliminate duty or otherwise permit the conduct,

without need for further authorization or ratification (§ 110(d)(1) and (2)) ii. Conduct might be authorized or ratified by all the members after full disclosure (§

409(f)) iii. Operating agreement might establish a mechanism other than the informed

consent for authorizing or ratifying the conduct (§ 110(e)) iv. In the case of self-dealing the conduct might be successfully defended as being

or having been fair to the LLC (§ 409(e)). l. Right and Power to Bind of Members and Managers

i. Actual Authority 1. Depends on the operating agreement (RULLCA § 301(b)) and on the rules provided by

whatever management template might be applicable. ii. Statutory Apparent Authority

1. Almost all two-template statutes provide for apparent authority for members in a member-managed LLC and managers in a manager-managed LLC

2. Most statutes negate any authority for a nonmanager in a manager-managed LLC

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3. RULLCA rejects notion of statutory apparent authority: leaves authority of members and managers to the law of agency (RULLCA § 301(a), comment). Nature of LLC needs flexibility so it doesn‟t make sense to use rigid statutory apparent authority.

iii. RULLCA Statements of Authority: allows an LLC to publicly file a statement of authority for a position (and not just a person) to enable LLCs to provide reliable documentation of authority to enter into transactions without having to disclose to third parties the entirety of the operating agreement. (§ 302).

iv. Power to Bind for Acts of Negligence: Most LLC statutes have no language to impute to the LLC torts of negligence committed by the members or managers. RULLCA specifically contemplates that doctrine of respondeat superior might make an LLC liable for a member‟s tortious conduct but under nonuniform LLC statutes there is no guidance.

m. Case: Taghipour v. Jerez (pg. 1193): While manager of manager-managed LLC exceeded the authority granted to him by the agreement by entering into a loan agreement, the LLC could not hold the third party liable because, while there was 2 statutes (one allowing managers to have such power and another allowing operating agreements to limit that power), the former was more specific and the third party had no notice of the operating agreement provision that limited the manager‟s authority.

n. Distributions and Financial Rights i. LLC statutes tend to provide either a partnership-like equal allocation or a corporate/LP-like pro rata

allocation based on contributions to the firm (though these are only default rules so the operating agreement can get around them)

ii. Like general partnership partners, LLC members usually establish capital accounts and specify the allocation of financial rights in their operating agreement

iii. Many statutes allow third parties (creditors) to hold a member liable for unpaid contribution even if the other members have decided to waive that obligation (RULLCA § 403)

iv. Many statutes indicate that members may have liability for receiving distributions that render the LLC insolvent (RULLCA §§ 405-406).

o. Liability of Members, Managers, and LLC (other than for improper distribution) i. Fiduciary duties (see above) ii. ULLCA states that the only fiduciary duties owed by members and managers are those of loyalty and

care (ULLCA § 409(a)), and loyalty is limited to circumstances described in the statute. RULLCA changes this by removing the “only” and “limited to” phrases (RULLCA § 409(a), (b)).

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iii. Many LLC statutes protect members and managers from liability if they rely in good faith upon the information, opinions, reports, or statements of accountants/lawyers/other experts (RULLCA § 409(c)).

iv. While a member/manager may not be liable in that capacity when he exceeds his authority, he will still be liable for breach of the warranty of authority (agency law) or his tortious conduct.

v. Liability shield only pertains to claims by third parties and is irrelevant to claims by an LLC against a member or manager, and vice cera.

p. Conveyance of Member‟s Interest in an LLC i. Member (1) has the right to receive distributions and to share in the profits/losses (financial rights),

and (2) the right to participate in the management and control of the business (management rights). All LLC statutes provide that assignment of an LLC ownership interest transfers a member‟s financial rights but not his management rights.

1. Assignee can acquire management rights only with consent of all the nontransferring members.

2. This is just a default rule that can be modified through the agreement ii. Most statutes provide a charging order remedy that creditors can use against a member‟s interest

(i.e., creditor obtains any payments/distributions the member would have received) without becoming a member or being involved in management

q. Dissociation and Dissolution i. LLC statutes typically state that a member dissociates from a venture upon the occurrence of certain

acts such as withdrawal ii. Until recently, dissociation resulted in either a buyout of his interest or dissolution iii. With check-the-box regulations there was no longer a tax-driven need for dissociation to trigger

dissolution; many jurisdictions have eliminated this form of dissolution iv. Under all statutes, LLCs have perpetual duration unless articles or agreement provide otherwise v. Two types of dissociation:

1. voluntary-member always has the power to dissociate by expressing the intent to do so, but the agreement can constrain or eliminate the right to do so (making it wrongful)

2. involuntary-death, bankruptcy, sale of all financial rights, expulsion (by unanimous consent upon occurrence of specified grounds or as provided by the agreement)

vi. Consequences of dissociation: trend is to eliminate governance rights but to lock in the financial rights subject to a different deal made in the agreement.

r. Cases

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i. Elf Atochem North America, Inc. v. Jaffari: operating agreement contained an arbitration clause that was signed by the two members of the LLC; one member sought to avoid arbitration by bringing a derivative action on behalf of the LLC (because the agreement was not signed by the LLC itself). Court found the LLC was bound by the agreement, because in Delaware the agreement is any one that is written or oral “of the member or members as to the affairs of the LLC and the conduct of its business.” It is the members who are the real parties in interest. The LLC is simply their joint business vehicle. This is because LLC operating agreements are given a wide latitude with respect to freedom of contract, and courts will not often overturn them unless they are inconsistent with mandatory statutory provisions.

ii. Poore v. Fox Hollow Enterprises: non-attorney individual tried to represent LLC himself because he thought he could do so since it wasn‟t a corporation. Court found that LLC is more analogous to corporation than partnership for the most part (and mostly partnership for federal tax purposes), so Delaware courts could restrict who can represent LLCs to lawyers.

iii. Meyer v. Oklahoma Beverage Laws Enforcement Comm‟n: At issue was a regulation prohibiting liquor licenses from being issued to corporations (or really, any business entity beyond proprietors/partnerships). Court found that the LLC has elements of corporations so it‟s a hybrid and concluded that since the purpose of the regulation was to ensure personal responsibility for compliance with the liquor laws, so the LLC does not provide such an opportunity.

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IV. Corporations

a. Generally i. Formation (corporate existence/”corporateness” begin with the filing of articles of incorporation or, in

some states, when official issues a certificate of incorporation 1. Prepare articles of incorporation as required by state law 2. one or more incorporators sign the articles 3. submit the signed articles to the state‟s secretary of state

ii. Lawyer who acts during the organizing period may be held to represent the corporate entity, not the individual investors

iii. Choosing Where to Incorporate 1. Internal Affairs Doctrine permits parties to fix the law that applies to their corporate relationship

with respect to those affairs relating to the legal relationships between the traditionally regarded corporate participants

a. Some states have tried to implement their own regulations for foreign corporations when it has substantial ties to the state

2. Foreign corporation may conduct intrastate business if it is qualified to do business; to qualify it must file a certified copy of its articles, pay a filing fee, and appoint a local agent to receive service of process (MBCA § 15.01).

a. If not qualified, corporation and its officers may be fined; could be treated as unincorporated (and subject to individual liability)

3. Foreign corporation conducting only interstate business need not qualify iv. Setting up the Corporation

1. Delaware really only attractive to large national corporations because it would be too expensive for small closely hell organizations to incorporate there and qualify in their local state.

2. Corporate existence begins when the articles are filed unless a delayed effective date is specified (MBCA § 2.03)

a. Filed when: it is delivered to the secretary of state and satisfies the requirements of MBCA § 1.20

3. MBCA Chapter 1 is fairly restrictive with respect to the Secretary of State‟s powers: may not prescribe mandatory form for the articles, his filing duty is ministerial, and he is expressly commanded to file so long as the articles satisfy 1.20

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4. Names a. Must contain the word “corporation” or another similar indicator (MBCA § 4.01) b. Must be distinguishable upon the records of the secretary of state from other corporate

names (§ 4.01(b)), and does not mean it cannot be deceptively similar for competitive purposes. (Trans-Americas Airlines, Inc. v. Kenton (Del. 1985): rejecting the competitive formula). Note: many statutes still use the “deceptively similar” standard but unclear to what extent states actually follow that

c. Corporations may generally conduct business under an assumed or fictitious name to the same extent that an individual may (§ 4.01(e))

d. By applying to the secretary of state just for a name and address, including a fictitious name for a foreign corporation whose corporate name is not available, and if the name is available the Secretary will reserve it for 120 days. Owner of reserved name may transfer the reservation to another person by delivering a signed notice of the transfer stating the name/address of the transferee (§ 4.02)

e. Registered names are similar except that the corporation is definitely already in existence elsewhere, and is not committing to actually qualifying in the jurisdiction at hand--basically just saving its right to do so at a later time (§ 4.03).

f. Registered office and registered agent: i. Ensure that every corporation has publicly stated where it may be found for

service of process, tax purposes, etc. (MBCA §§ 5.01-5.04) 5. Great deal of customization may be necessary (MBCA §§ 2.01-2.03) 6. Initial Directors and Incorporators:

a. § 2.05 gives drafter of articles of incorporation an option as to how the organization of the corporation is to be completed

7. Number of incorporators, directors, or shareholders a. Modern trend is to only require one incorporator b. Not really minimum requirements for number of shareholders/directors

8. Initial Capital a. There used to be a requirement for $1,000 of initial capital but that requirement has

largely disappeared 9. Bylaws are the internal set of operating rules for the corporation (§ 2.06) 10. Capital Structure

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a. Articles must specify the securities the corporation will have authority to issue, describing the various classes/number of shares/privileges rights and limitations. Cannot issue more than are authorized unless articles are amended.

11. Purpose and Powers: a. Articles may (but do not need to) state the corporation‟s purposes and powers, but not

as important as it once was because ultra vires is not as important these days. 12. Optional Provisions: articles can use a broad range of other provisions to customize the

corporation (MBCA § 2.02(b)): voting, membership requirements, management provisions, indemnification provisions

13. Organizational Meeting a. Creates working structure, and is named in the articles; called upon written notice. Does

not need to take place in person. b. Closely-Held corporations do not require actual meetings of incorporators, directors, or

shareholders (MBCA §§ 2.05, 7.04, 8.21) 14. Bylaws

a. Bylaws are important, and typically describe functions of each office, how meetings are called, formalities of voting, etc. State law does not require them to be filed but they must be consistent with the articles (MBCA § 2.06). They are not enforceable if they stray too far from the traditional corporate model.

15. Directors a. MBCA § 8.01

i. Each corporation must have board of directors ii. All corporate powers exercised by or under the authority of the board, and the

business affairs shall be managed by or under their direction and subject to its oversight, subject to any limitation set forth in the articles or agreement authorized under § 7.32

1. Oversight responsibilities include attention to: business performance, major risks to which it may be exposed, etc.

b. MBCA § 8.02 i. Qualifications of Directors: Articles or bylaws may prescribe qualifications for

directors, but he need not be a resident of the state or a shareholder of the corporation unless the articles/bylaws so prescribe

c. MBCA § 8.03

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i. board must have at least one individual with the number specified by the articles or bylaws; the number may be increased/decreased from time to time by amendment to, or in the manner provided in, the articles/bylaws

ii. Directors elected at the first annual shareholders meeting and at each annual meeting thereafter

d. MBCA § 8.04: if articles divide shares into classes, they may authorize election of all or a specified number of directors by the holders of one or more authorized classes of shares. Class of shares entitled to elect one or more directors is a separate voting group for purposes of the election of directors.

16. Officers: a. MBCA § 8.40

i. Corporation has the offices described in its bylaws or designated by directors in accordance with the bylaws

ii. Board may elect individuals to fill one or more offices, and an officer may appoint officers if so authorized by the bylaws or the board of directors

iii. Bylaws or board of directors shall assign to one of the officers the responsibility for preparing minutes of the directors and shareholders meetings and for maintaining/authenticating the records of the corporation required to be kept under §16.01(a) and (e).

iv. One individual may hold more than one office in a corporation b. MBCA § 1.40(d0): “Secretary” is the officer to whom the directors has delegated

responsibility § 8.40(c) for custody of the minutes of the meetings of the board of directors and of the shareholders and for authenticating records of the corporation.

c. MBCA § 8.41: Each officer has the authority and must perform the functions set forth in the bylaws or, to the extent consistent with the bylaws, the functions prescribed by the board of directors or by direction of an officer authorized by the board of directors to prescribe the functions of other officers.

i. Officers may also have implied authority (i.e., CEO) for ordinary business transactions

ii. Apparent authority by reason of corporate conduct on which third persons reasonably rely

iii. Board can also ratify unauthorized acts 17. Dissolution

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a. Note: MBCA § 3.02: all corporations are for perpetual term b. Terms

i. Dissolution is formal extinguishment of corporation‟s legal life ii. Liquidation is process of reducing the corporation‟s assets to cash iii. Winding up is the process of liquidating the assets, paying off creditors, and

distributing what remains to shareholders c. Dissolution is subject to majority rule d. Voluntary dissolution is subject to only two levels of protection (MBCA § 14.02):

i. approval by the board ii. approval by the shareholders

e. Process of Winding Up i. Corporation must pay all known claims to creditors

1. MBCA § 14.07: unknown claims may be brought against the dissolved corporation for five years

ii. If corporation does not retain sufficient assets after distribution, some statutes permit claimant to seek satisfaction from former shareholders who received distributions.

1. MBCA § 14.07(d)(2): each shareholder who received distribution is required to pay a pro rata share of the claim up to the amount that was distributed.

2. If creditors cannot satisfy their claims against the dissolved corporation or its former shareholders, they can assert claims against entity that acquired assets under successor liability doctrine.

18. Ultra Vires a. Historically corporations were extremely limited in their purposes, today it is very broad

unless the articles has a narrow purposes clause (for purposes of state regulations, persons being uncomfortable with lack of useful information about its purpose, etc.)

b. Powers are similar but distinct, and today all statutes contain a list of general powers analogous to those in MBCA § 3.02, along with a general phrase that conveys all the same powers as an individual to carry out its business and affairs.

c. Decline of Ultra Vires: i. Courts have avoided it by broadly construing purposes clauses and finding

implied purposes.

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ii. Many statutes allow corporations to take into consideration the best long term and short term interests of its employees, and other constituencies.

d. Modern approach: i. Neither corporation nor any party doing business with it can avoid contractual

commitments by claiming the corporation lacked capacity (MBCA § 3.04(a)) ii. If articles state a limitation, MBCA protects expectations arising from limitation

and specifies three exclusive means of enforcement 1. shareholder suit: to enjoin corporation from entering into or continuing an

unauthorized transaction; court may only issue it if equitable and if all the parties are present in court. Equitable if the third party knew about the corporate incapacity

2. Corporate suit against directors and officers: 3. Suit by the state attorney general

iii. Distinguishing from Corporate Duties 1. Corporation acting illegally is not acting ultra vires 2. Breaching fiduciary duties is not acting ultra vires

iv. Charity 1. Courts have generally held that corporations have implicit powers to make

charitable gifts that in the long run arguably benefit the corporation; must me for proper purpose and in reasonable amount

2. Note: corporate altruism may be attacked as corporate waste (a fiduciary breach)

v. To Whom are Fiduciary Duties Owed? 1. They flow from theory of shareholder wealth maximization; where other

constituents (i.e., creditors) have interests inconsistent with those of shareholders, the shareholders prevail.

19. Premature Commencement and Promoter Liability a. Promoter=person who, acting alone or in conjunction with one or more other person,

directly/indirectly takes initiative in founding and organizing the business or enterprise of an issuer. (or who in connection with the founding/organizing of the business, directly or indirectly receives consideration of services or property or both, 10 percent or more of any class of securities of the issuer or 10 percent or more of the proceeds from the sale of any class of such securities.

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b. Promoter owes significant fiduciary duties to the other participants in the venture (both to the entity and the members)

c. Who may attack transactions between promoter and corporation? i. subsequent investors ii. general creditors of the corporation or their representatives iii. co-promoters iv. the corporation itself

1. Old Dominion Copper Mining & Smelting Co. v. Bigelow: Fiduciary duties violated because new subscribers to corporation were meant to be brought in, even though at time of wrongful conduct the promoters and shareholders were the same

d. Stanley J. How & Assoc., Inc. v. Boss: i. Three possibilities for interpreting contracts signed by promoter before

corporation is actually formed: 1. Other party making a revocable offer to the nonexistent corporation which

will result in a contract if it is formed and accepts the offer prior to withdrawal. This is the normal understanding.

2. They may understand that the other party is making an irrevocable offer for a limited time, and consideration to support he promise to keep the offer open can be found in an express or limited promise by the promoter to organize the corporation and use his best efforts to cause it to accept the offer.

3. They may agree to a present contract by which the promoter is bound, but with an agreement that his liability terminates if the corporation is formed and manifests its willingness to become a party--no ratification by the corporation possible since it was not in existence when the agreement was actually made.

4. They may agree to a present contract on which, even though the corporation becomes a party, the promoter remains liable either primarily or as surety for the performance of the corporation‟s obligation.

ii. Promoter was held liable because when he signed as “Edwin A. Boss, agent for a Minnesota corporation to be formed who will be the obligor,” it was not clear

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enough that the to-be-formed corporation was the sole guarantor--so the promoter remains on the hook.

e. Restatement of Agency shows that purported agent acting for nonexistent P becomes a party, and so is personally liable for contractual obligations, unless otherwise agreed, and Comment b to § 326 shows some relationships they could have agreed to:

i. Nonrecourse agent: A is a mere messenger, and no contract exists unless the corporation is incorporated and adopts the contract; no recourse against the A even if the company does not accept the offer.

ii. “Best Efforts” agent: A agrees to use his best efforts to bring the corporation into existence and have it accept O‟Rorke‟s offer, but there is no contract until the company is created and accepts it. A is liable only if he fails to use his best efforts to incorporate/have it accept.

iii. Interim contracting party: A accepts liability under the contract until company is incorporated, adopts the contract, and is substituted in the A‟s place. This is called novation and the other party discharges the A.

iv. Additional contracting party: A is liable under the contract even if the company later adopts it, and the A is severally liable along with the company.

f. How can promoters show intent? Often they sign contract “for the corporation to be formed” but they will need to show other things:

i. Negotiations: i.e., where salesman agrees to look only to the corporation, such as where he‟s eager to close a sale. (found promoter not liable)

ii. Postcontractual actions: Other party started to perform before the promoter formed the corporation and accepted the contract (found the promoter liable)

iii. Corporation‟s actions: Promoter liable where, even though it was formed, did not accept the contract

g. Corporation‟s Adoption of Contract: Not automatically liable for contracts made by promoters before incorporation; must adopt it. Binding adoption is most clearly demonstrated by formal corporate resolution by the board of directors but this is not necessary; can be implicit if the officers/directors with authority to adopt knew of and acquiesced in the contract. Later acts by the corporation consistent with or in furtherance of the contract also indicate adoption.

h. Third Party‟s Liability on Contract: Promoter liability goes both ways; if promoter is liable to the third-party outsider, the same is true vice versa.

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20. Liability for Defective Incorporation: a. De Facto Corporation and Corporation by Estoppel: Courts impute attributes of

corporate limited liability when the circumstances suggest the parties intended a “no recourse” relationship (this mostly happens in contract creditor cases). Whether courts can use these two approaches depends on whether the state statute permits judicial imputation of limited liability when there is no incorporation, and if so, when do the circumstances justify such action?

i. De facto corporation: requires (1) some colorable, good-faith attempt to incorporate, and (2) actual use of the corporate form, such as carrying on the business as a corporation or contracting in the corporate name. State can challenge corporation‟s existence but outsiders cannot; to them, it has all the attributes of a rightfully formed corporation, including limited liability.

ii. Corporation by estoppel: Arises when parties have dealt with each other on assumption a corporation existed even though there has been no colorable attempt to incorporate. Outsiders relying on representations or appearances that a corporation exists and act accordingly are estopped from denying that existence even with respect to limited liability.

b. Modern Abolition of the De Facto Corporation and Estoppel Doctrines? i. Some courts have abolished the theories because these days it‟s so easy to form

a corporation. Most courts, however, continue to use these doctrines. c. Current MBCA § 2.04: all persons purporting to act as or on behalf of a corporation,

knowing there was no incorporation...are jointly and severally liable for all liabilities (so, liability if outsiders are intentionally deceived but no liability if it was a good faith mistake as to whether formation was effective). But probably does not turn just on the insider‟s belief--also take into account the outsider‟s perspective.

d. Case: Robertson v. Levy: Person personally liable because there was no corporation since the articles were defective, and pre-1984 MBCA said that persons assuming to act as a corporation without authority are personally liable.

21. Liability for Nonsignatory Participants a. When there is an incorporation defect and the doctrines imputing limited liability are not

available, courts impose liability on the promoter on a variety of theories: i. Statutory: MBCA § 2.04 liability for those purporting to act for corporation they

know does not exist

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ii. Breach of warranty (either of his authority or of the existence/competency of principal): R.2d Agency § 329, R.3d § 6.10)

b. Courts reluctant to impose partnership-like liability on participants who thought they had corporate limited liability even though a defectively incorporated business bears all the hallmarks of a partnership; many limit liability to active participants, rather than on passive investors who did not act on behalf of the business.

22. Administrative Dissolution: a. Statutes provide for dissolution if the corporation (though properly formed) does not pay

state franchise taxes and fees, to report a change in registered agent, or to file an annual report (MBCA § 14.20)

b. If corporation not reinstated, those who knowingly act on its behalf become personally liable even if creditors had not relied on personal assets

c. If it the corporation is reinstated, modern corporate statutes provide that the reinstatement relates back to the date of administrative dissolution as though revocation of corporate status never happened (MBCA § 14.22); even in states without reinstatement, some courts impose liability only on those acting for a dissolved corporation without knowledge of the dissolution.

v. Disregard of the Corporate Entity 1. Piercing the Corporate Veil

a. In a piercing case: (1) the business has been properly incorporated, it is obligated to the creditor, and distributions to shareholders have been statutorily proper.

b. No single test exists for when piercing will be allowed but there are some situations where courts are more likely to do so:

i. business is closely held ii. plaintiff is an involuntary (tort) creditor iii. defendant is a corporate shareholder iv. insiders failed to follow corporate formalities v. insiders commingled business assets with individual assets vi. insiders did not adequately capitalize the business vii. the defendant actively participated in the business viii. insiders deceived creditors

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c. Closely Held Corporations: No reported cases of piercing with shareholders of a publicly traded corporation, but the fact that‟s closely held is not sufficient--other factors must be present.

d. Involuntary Creditors: courts recognize that voluntary creditors (suppliers, employees, etc.) have an opportunity to contractually protect themselves; so long as they‟re not deceived they can anticipate corporate limited liability. Once again, this factor is not in itself sufficient.

e. Enterprise Liability Doctrine: Courts use this to disregard multiple incorporations of the same business under common ownership. Does not cover individual managers‟ or owners‟ assets; applies where risky operations are placed within control of a separate subsidiary corporation, and so will look to the parent corporation‟s assets. This is more likely when the same managers run the two branches.

i. Bartle v. Home Owners Co-Op.: Home Owners had a wholly owned subsidiary, Westerlea, that went bankrupt; creditor sought to pierce the veil to get at the parent corporation‟s assets. Court refused to do so because while the parent controlled the subsidiary‟s affairs, the outward inidicia of these two separate entities was at all times maintained when creditors extended credit: creditors were not misled, no fraud, and D performed no act causing injury to the creditors of Westerlea by depletion of assets or otherwise. Dissent argued that parent ran the subsidiary to its benefit by running it for insolvency to obtain cheaper homes, so the veil should be pierced.

ii. Walkovsky v. Carlton: Carlton set up 10 wholly owned cab corporations in which he was the controlling/dominant shareholder. Each owned two cabs and employed its own drivers. But, difference between corporation that is a fragment of a larger corporation, and one that is a dummy for its individual shareholders (either could justify piercing but would lead to different results: personal vs. corporate liability). There was even some evidence of undercapitalization and comingling of funds among the several subsidiary corporations, but the defendants were not perverting the corporate form for individual benefit.

1. But see Goldberg v. Lee Exp. Cab Corp.: Similar facts but the plaintiff alleged that all the corporations, which were owned by one person, were mere shams because the defendant individual operated all of them and commingled their finances and assets, and that none of the separate

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corporations had their own existence (though this was not a merits decision, merely a motion to dismiss).

iii. Parent-Subsidiary Piercing: Simply isolating assets in a subsidiary does not justify piercing; courts require showing that the parent dominated the subsidiary so that they acted as a “single economic entity” and recognizing corporate separateness would be unfair or unjust.

f. Failure to Observe Corporate Formalities: Look to whether individuals used the corporation as their “alter ego” or “conduit” for their own personal affairs. In other words, were outsiders confused about its status, or did insiders disregard corporate obligations?

g. Commingling Assets and Affairs: Shareholders fail to keep assets separate; using a corporate bank account to pay for personal expenses is an example. In parent-subsidiary enterprise liability, were the different business assets commingled?

h. Undercapitalization and Purposeful Insolvency: Courts more likely to pierce where the corporation was formed or operated without capital adequate to meet expected business obligations, or where there is nominal capitalization. Courts will usually give some leeway with respect to this, however.

i. DeWitt Truck Brokers v. W. Ray Flemming Fruit Co.: Defendant was a close, one-man corporation. Was initially capitalized at $5,000 and eventually, $2,000 worth of shares was retired. At the times involved in the case, Flemming (the sole shareholder) owned about 90% of the corporation‟s outstanding stock. The company did not observe many of the corporate formalities. He received money each year but was not really a formal distribution, even though the company was not really capitalized (it was reduced to the $3,000 capital). In fact, it appeared the company often operated on non-corporate assets. Thus, the court pierced the veil.

ii. Baatz v. Arrow Bar: No piercing; occasional neglect of corporate formalities, personally guaranteeing corporate loans, lack of evidence that the corporation was the defendants‟ alter ego, and no evidence that capitalization was insufficient for the business at issue.

i. Active Corporate Participation: Piercing the veil does not necessarily pierce for all participants: shareholders who are not active in the business and have no acted to

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disadvantage creditors are less likely to be personally liable than those whose actions resulted in a depletion of assets.

j. Deception: Perhaps the most critical factor; where there is misrepresentation. In other words, if a creditor is deceived into believing that the corporation is solvent or that the creditor is otherwise protected, then piercing is a near certainty.

k. Cases: i. Radaszewski v. Telecom Corp: Under Missouri law, three elements to prove in

order to pierce the veil: (1) complete domination of finances, policy and business practice in respect to the transaction attacked; (2) such control must have been used by the defendant to commit a fraud or wrong; (3) aforesaid control and breach of duty must proximately cause the injury/unjust loss complained of. Insurance can be used to show proper capitalization because the whole purpose is to determine its financial responsibility; doesn’t matter if through insurance or otherwise.

ii. Fletcher v. Atex, Inc.: Atex was a subsidiary of Kodak. Court found that control where parent had to approve and participate in transactions did not justify piercing because that is typical of a majority shareholder or parent corporation. Also, no alter ego liability simply because parent used a cash management system. While there was some overlap in the boards, it was not of a negligible amount (with sometimes only one or two in common). Use of Kodak logo on Atex brochures was not sufficient to show single economic entity. Moreover, there was no evidence of injustice or unfairness.

l. NON-PIERCING LIABILITY--Distinguishing Direct Personal Liability: Many cases that hold shareholders liable are not piercing cases at all; liability can arise when shareholder has personally obligated herself for debts of the corporation; in cases of oral contracts the courts might use piercing doctrine anyway as a safety valve to avoid problems of enforcing the contract. Similarly, if a shareholder/manager commits a tort in the course of corporate business, she is liable under traditional tort and agency rules and piercing is not necessary.

b. Financial Matters and the Closely Held Corporation

i. Definitions; Authorized Shares; Common vs. Preferred Shares 1. Debt and Equity Capital

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a. Capital may be obtained from several sources: (1) borrowing funds, (2) capital contributions from the owners, (3) capital contributions from outside investors who either remain inactive or become active co-owners, (4) retaining earnings of the business rather than distributing them to owners.

b. Critical distinction between “equity capital” and “debt”. Debt is from borrowing so it must be repaid with interest, and its repayment is not contingent on the business‟ success. Equity on the other hand, means a piece of property of the business which values the market value of that property minus the market value of the debts that are liens against the property.

c. Equity securities are authorized when the articles permit board to issue them; issued when sold to shareholders; outstanding when held by shareholders. (MBCA § 6.03)

d. To issue new shares, corporation must have sufficient authorized unissued shares; if not, articles must be amended. (MBCA § 10.02 for amendment by board before shares issued, MBCA § 10.03 for amendment proposed by board and approved by shareholders).

i. MBCA § 6.21(f): must be shareholder approval for issue of shares for cash consideration if, after the issuance, the shareholders will hold voting power equal to more than 20 percent of the voting power that existed prior to the issuance.

e. Articles may give Directors a “blank check” to specify rights and powers of a series or class without further shareholder action, filling blanks left by the articles. (MBCA § 6.02).

2. Types of Equity Securities a. Shares Generally

i. MBCA § 1.40(22): “units into which the proprietary interests in a corporation are divided.”

ii. MBCA § 1.40(2), 6.01(a): corporation may create and issue different “classes” of shares with different preferences, limitations, and relative rights. Each class must have a “distinguishing designation” and all shares within a single class must have identical rights.

1. Different classes and their accompanying rights must be set forth in the articles of incorporation (MBCA § 6.01)

iii. MBCA § 6.01(b): two rights of holders of common shares: (1) they are entitled to vote for the election of directors and on other matters coming before the shareholders, and (2) They are entitled to the net assets of the corporation after

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debts are taken care of, when distributions in the form of dividends or liquidating distributions are made.

1. These characteristics may be placed in different classes of shares in whole or in part, but one or more classes with these attributes must always be authorized.

2. § 6.03(c): at least one share of each class with these characteristics must always be outstanding.

b. Common and Preferred Shares i. Not defined in MBCA but some commonly accepted meanings ii. Common shares

1. Common shares are those with the essential attributes (or some of them) required by § 6.01 (b), and they have some non-financial rights as well--inspect books and records (MBCA § 16.02), right to sue on behalf of the corporation to right a wrong committed against it (MBCA §§ 7.40-7.47), a right to financial information (MBCA § 16.20), and more.

2. May be defined in several ways but the Supreme Court identified several characteristics that are usually associated with them: (1) right to receive dividends contingent upon an apportionment of profits, (2) negotiability, meaning being able to be transferred by delivery or endorsement when the transferee takes the instrument for value, in good faith, and without notice of conflicting title claims or defenses, (3) ability to be pledged or hypothecated, meaning the ability to be pledged as security or collateral for a debt without delivery of title or possession, (4) conferring of voting rights in proportion to the number of shares owned, and (5) capacity to increase in value.

3. Value is open-ended since they‟re residual, and depend on the profits at the end minus debts.

iii. Preferred shares 1. Entitle holders to a priority in payment with respect to common

shareholders, either in the payment of dividends or making of distributions out of the capital of a corporation, or both.

2. Scope of their rights typically defined by detailed provisions in the articles that create the class; called the “preferred shareholder‟s contract” and

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cannot be amended without consent of holders of some statutorily designated fraction of that class

iv. Funds may be distributed to either class in the form of dividends or distributions 1. dividend: distribution from current or retained earnings 2. distribution: payment to shareholders out of capital

v. MBCA sets forth rules for distributions generally, but not for dividends (§ 1.40(6), 6.40).

vi. Typically, common shareholders have no legal basis for complaining if distributions or dividends are omitted over extended periods of time.

3. Special Rights of Publicly Traded Preferred Shares a. Cumulative Dividend Rights: Dividend preference may be cumulative, noncumulative, or

partially cumulative. Cumulative simply means that if a preferred dividend is not paid in any year, it accumulates and must be paid (along with the following years‟ unpaid cumulative dividends) before any dividend may be paid to the common shares in a later year.

i. Noncumulative: not carried over from one year to another, so if no dividend is declared during the year, the preferred shareholder loses the right to receive a dividend that year. It simply disappears.

ii. Partially cumulative: cumulative to the extent that there are earnings in the year, and noncumulative with respect to excess dividend preference.

b. Voting: Preferred shares are usually nonvoting, but in order to provide protection it Is customary to provide that nonvoting preferred shares obtain a right to vote for the election of a specified number of directors if preferred dividends have been omitted for a certain period.

c. Liquidation Preferences: preferred shares usually have a liquidation preference, often at a fixed price per share, payable upon dissolution before anything paid to common shares. This is usually a fixed amount so it is not affected by appreciation in value of the corporation‟s assets, and its not a debt of the corporation.

d. Redemption Rights: may be made redeemable at the option of the corporation, usually at a fixed price according to the articles at the time the class of shares was created, meaning it has the right to buy it back. When a corporation redeems, it “calls” the stock for redemption, and usually may be exercised only after a specified period of time has elapsed, and the price is usually somewhat in excess of the share‟s liquidation

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preference. There may be preferred classes where shares are redeemable at the holder’s demand, but this may be limited in some jurisdictions with respect to common shares. Moreover, most statutes prohibit the issuance of callable common shares (but MBCA eliminates this restriction on the theory that fiduciary duties are sufficient protection, § 6.01).

e. Conversion Rights: May be made convertible at the option of the holder into common shares at a fixed ratio specified in the articles of incorporation; typically ratio is established so that the common shares must appreciate substantially in price before it is profitable to convert the shares. Convertible shares are usually redeemable but typically the privilege to convert continues for a limited period of time after the redemption call; a conversion is “forced” when shares are called for redemption when the market value obtainable on conversion exceeds the redemption price. Most statutes forbid conversion from common to preferred shares (but MBCA eliminates this restriction on the theory that fiduciary duties are sufficient protection, § 6.01).

f. Protective Provisions: Certain financial protections, such as sinking fund provisions, which require corporation to set aside certain amount to redeem a specified portion of the preferred stock issue. Also, protections for the conversion privilege in the event of share splits.

i. Preemptive rights: i.e., allow shareholders to acquire shares when the corporation issues new shares in order to preserve its voting position. (MBCA § 6.30). In MBCA jurisdictions, they do not exist unless the articles provide for them. NOTE: These rights do not exist when shares issued for management services or noncash property (MBCA § 6.30(b)(3)).

g. Participating Preferred: nonparticipating shares are entitled to the specified dividend payment and specified liquidation preference, as described above, but nothing more. “Participating preferred” shares are entitled to the specified dividend and, after the common shares receive a specified amount, share with the common in additional distributions on some predetermined basis.

h. Classes of preferred: there can be different classes with different privileges i. Series of Preferred: MBCA § 6.02(a)(2) refers to multiple series within one or more

classes 4. Classes of Common Shares

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a. MBCA § 6.01 authorizes creation of classes of common shares, which may vary in rights: some are nonvoting, some have multiple votes per share, etc.

b. Not to much stock should be put in the name; MBCA is very general and avoids “common” and “preferred” in order to give drafters some flexibility.

c. Common shares can be used as incentive compensation for company employees: i. Employee Stock Ownership Plans: employer sets up trust for benefit of

employees and makes payments to the trust so it can purchase company shares; gives employees a stake in the company.

ii. Stock Options: Contractual right to purchase shares (usually common shares) at a specified date in the future at a specified price

ii. Share Subscriptions; Payment for Shares; Par Value 1. Share Subscriptions and Agreements to Purchase Securities

a. Persons agree to purchase specified number of shares contingent upon a specified amount of capital being raised. Issues relating to these are now usually addressed by statute (MBCA § 6.20). They declined in importance with rise of modern banking that allowed for large capital to be raised.

b. May be used to a limited extent in connection with capitalization of a closely held business, but modern practice is to use simple contractual agreements to purchase securities rather than a formal subscription agreement.

2. Authorization and Issuance of Common Shares Under the MBCA a. Does not matter how many shares are issued to satisfy a class (i.e., $10,000

authorized--can be 1 share for $10K, 2 for $500, etc.). BUT the shares must be for the same price if they‟re the same class, and the number of shares authorized must be at least equal to the number of shares the corporation plans to issue.

3. Par Value and Stated Capital a. “Par Value” = arbitrary dollar value assigned to shares which, after being assigned, is

the minimum amount for which each share may be sold (from corporation to shareholder?). Generally no minimum or maximum that must be assigned; in most states, shares may also have no par value, meaning the directors will assign a value to the stock below which the shares cannot be issued.

i. MBCA has eliminated par values. b. “Watered Stock” occurs where the corporation has not received the property for which

the share was issued; “discount shares” are the same where it has not received

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sufficient cash. “Bonus shares” occur when nothing at all was paid. These are generally lumped together under the “watered stock” term.

c. Hanewald v. Bryan‟s Inc.: 100 shares for $100,000 were issued but consideration was not paid to the corporation; after it dissolved (and satisfied some of its debts) a creditor brought suit against the company and its shareholders. Court found that shareholders are usually not liable beyond their contribution because that is their capital investment, but as here, where the investment was not actually made, they can be personally liable for the corporation‟s debt. In other words, shareholder liability to pay for shares can be directly enforced by a creditor of the corporation.

d. Generally, watered stock only applies to initial issuance of shares; if corporation reacquires them it may resell at any price, since they are still “issued” even though they are held by the corporation. There is some contrary authority for this, but it remains the general rule.

4. Eligible and Ineligible Consideration for Shares a. Only actual receipt of certain types of property or services will support issuance of

shares b. Can be for combination of past and future services; not all jurisdictions allow for only

future services. c. Cannot be issued for promissory note d. MBCA allows GREAT flexibility for what constitutes consideration for issuance of shares

(see MBCA § 6.21), including reduction of liability, release of a claim, etc. i. Board must determine the consideration is adequate; shareholders must be

advised before the next shareholders meeting if shares are issued for future services or promissory notes

5. Par Value in Modern Practice a. Today, practice most often followed is to use “nominal” par value that is one cent, etc. b. One significant carryover: to avoid watered stock liability the issuance price for shares

of stock with par value must always be equal to or greater than par value. iii. Inspection Rights and Other Rights to Accurate Information

1. MBCA § 16.01(a) requires corporation to keep a minimum set of core documents that reflect decisions made by the directors and shareholders, and that a set of copies be kepy at the principal office of the corporation.

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2. At common law, shareholders had qualified right to inspect; at one time this usually revolved around list of shareholders

3. Today, most statutes permit virtually automatic right of inspection of list of record shareholders entitled to vote at a scheduled meeting shortly before and during the meeting; at other times the list may only be inspected if the shareholder qualifies under the general shareholder inspection statutes.

4. Right to inspection reflects a balance between shareholder‟s right to information, and corporation managers‟ right to fealty; thus, there is no general right to inspect records because of suspected wrongdoing

a. But if generalized purposes are not acceptable, many cases state that a “proper purpose” is to examine in order to determine the value of one‟s own shares

b. Delaware § 220 allows owners of record and beneficial owners to inspect books and records for “any proper purpose,” which is obviously broad.

5. Financial Reports a. MBCA, but not Delaware, requires corporation to provide shareholders with annual

financial information including an end-year balance sheet, income statement, and statement of changes in shareholders‟ equity. (MBCA § 16.20). Must be audited by a public accountant or include statement that it was prepared on the basis of generally accepted accounting principles and explain any deviation from those principles.

b. For close corporations, these reports are the only periodic disclosure mandated by law; SEC filings not publicly disclosed.

6. Inspection of Corporate Books and Records a. MBCA § 16.02 codifies right to inspect books; subsection (f) extends right to beneficial

owners; makes articles of incorporation, bylaws, minutes of shareholders meetings available as of right (MBCA §§ 16.01(e), 16.02(a)), and makes other records such as board minutes, accounting records, and shareholder lists available for inspection upon a showing of a “proper purpose.” (MBCA §16.02(b), (c)).

i. Proper purpose: valuing assets; improper: competitive advantage, seeking to advance a political agenda unrelated to the investment.

7. Enforcement of Shareholder Rights a. Shareholders can enforce the corporation‟s rights in derivative proceedings (MBCA §

7.40-41).

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b. Shareholders can enforce voting powers in direct actions against corporation or directors

i. In some cases there may be expedited judicial review and summary orders (MBCA § 7.03, 16.04(a), 16.04(b)).

8. Malone v. Brincat: Fiduciary duty for directors to disclose material information to shareholders; duty of loyalty and good faith to not knowingly disseminate false information about the company‟s financial condition. In this case, directors conveyed false information that caused the corporation to lose bout $2 billion in value, and held that the plaintiffs could refile in order to make it a derivative claim.

iv. Debt Financing; Debt vs. Equity 1. Debt Securities

a. Bond: secured by a lien or mortgage on corporate property b. Debenture: unsecured corporate obligation

2. Debt financing is more important than equity financing; it‟s what corporations usually use 3. Concept of Leverage

a. Leverage favorable where the borrower able to earn more on borrowed capital than the cost of the borrowing. (Attractive during periods of high inflation).

4. Tax Treatment of Debt a. In a C corporation there are usually tax advantages for individuals who lend to the

corporation a portion of their investment rather than making a capital contribution. b. Corporation with a high debt/equity ratio=thin corporation c. Courts use a number of factors to distinguish real debt from equity masquerading as

debt i. Failure to repay obligations as they mature risks losing debt characterization ii. Variable payments are a sure sign of equity since debt is fixed iii. Debt must be paid regardless of whether there are earnings; dividends on equity

are paid from earnings iv. Inside debt tends to be viewed as at the risk of the business v. The higher the debt-equity ratio, the more likely that some of it will be

recharacterized as equity 5. Debt as a planning device

a. In a closely held corporation, can allow person to contribute a lot but in the form of a loan so that it‟s not at risk from creditors

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6. Corporation‟s directors do not owe fiduciary duties to debtholders 7. Debt securities do not have voting rights but it is possible to incorporate them into a debt

security, and it is not uncommon for a corporation to issue bonds that are convertible at the holder‟s option into specified equity securities (though this is merely a contractual matter).

c. Distributions and Freeze-Outs i. General

1. Dividends: periodic payments usually made in relation to past or current earnings; decision to pay is generally within the board of director‟s discretion and is protected by the business judgment rule.

a. may be paid in cash or property b. Once the board declares a cash dividend, shareholders obtain rights as creditors for the

amount as of the record date specified by the board. c. Once declared, board has no discretion to rescind.

2. Capital Distributions: Payment made in relation to capital, not earnings a. MBCA does not distinguish between dividends and cash distributions

3. Stock dividends: pro rata distribution of additional shares; does not distribute assets, so it is not a distribution--simply divides ownership among more shares. Still, the new shares must be authorized but unissued.

4. Stock splits: outstanding shares are converted into (and replaced by) additional new shares. a. Board usually allowed to authorize this on its own initiative.

ii. Corporation repurchasing shares 1. Types

a. Redemption: forced sale usually initiated by the corporation b. Repurchase: voluntary buy-sell transaction

2. In practice: preferred because public corporations use it to distribute cash and each shareholder can then choose whether to participate in selling shares back; any resulting gain is a capital gain, which may be taxed at a lower rate than receipt of dividends.

3. Think of it as a distribution, not acquiring assets; the shareholders continue to own 100 percent but the number of assets is reduced by the amount of the payment used to reacquire shares.

a. Under most state statutes, the reacquired shares are called treasury shares; viewed as being held in some sort of limbo until permanently retired or resold to someone else. They are not an asset even though they are salable (same as every share of authorized but unissued stock).

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4. Can avoid some tax liability; if the corporation issues dividends to the shareholder that is taxable, but if it redeems (being a constructive dividend) that is taxable to the departing shareholder.

5. Corporate statutes treat redemptions as distributions subject to the legal restraints on dividends and distributions.

iii. Legal Restrictions on Distributions 1. MBCA § 6.40: standard test for the legality of distributions, dividends, and redemptions.

a. Requires that no distributions be made if, after doing so, (1) the corporation would not be able to pay its debts as they become due in the usual course of business (equity insolvency prong), or (2) the corporation‟s total assets would be less than the sum of its total liabilities plus (unless the articles state otherwise) the amount that would be needed, if the corporation were to be dissolved, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution (balance sheet prong)

iv. Timing of Distributions 1. MBCA § 6.40(e): measures legality of a distribution on its authorization date, unless it is to be

paid more than 120 days after authorization v. Close Corporation Disputes

1. Freezeouts and Forceouts a. Forceouts: majority manipulates corporation‟s structure and eliminates minority interests

(for example, selling its assets or merging with another corporation controlled by the majority). Or it could recapitalize the corporation and amend the articles to eliminate minority shares.

b. Freezeouts: isolate minority shareholders from participation, forcing it to sell to (or buy from) the majority; can be done by removing minorities from office, denying them compensation, not issuing dividends, etc.

2. Minority Shareholder‟s Options a. Market Out: No real market; cannot force the majority to purchase shares, unless they

enter into a contractual buyout arrangement or statute provides buyout right. b. Dissolution: Generally cannot not dissolve, or at least not as easily as in a partnership. c. Involuntary Dissolution: Can ask court to dissolve, with final distribution granted after

affairs wound up. Court may do so if: i. Board deadlock (MBCA § 14.30(2)(i))

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ii. Shareholder deadlock (MBCA §14.30(2)(iii)) iii. Misconduct--conduct that is illegal/oppressive/fraudulent (MBCA § 14.30(2)(ii)),

or assets are being misapplied/wasted (MBCA § 14.30(2)(iv)), or is reasonably necessary for the protection of the complaining shareholder (not MBCA).

d. Fiduciary Challenge: courts have inferred heightened fiduciary duties by recognizing the partnership-like qualities of a close corporation

vi. Judicial Protection of Minority Shareholders 1. Involuntary Dissolution

a. Courts are cautious with this in nondeadlock situations and try to distinguish between genuine abuse, and acceptable tactics in a power struggle. (MBCA § 14.30, comment).

b. Some courts look at whether the majority‟s actions have a legitimate business purpose, others at whether the majority‟s actions harm the minority‟s interests

c. Majority may avoid dissolution by electing to buy out the minority‟s shares at a fair value (MBCA § 14.34). Purchasing shareholders must give notice to the court within 90 days of the petition and then negotiate with the petitioning shareholder; if after 60 days the negotiations fail, the court may award the petitioner “fair value.”

d. Fair Market Value: (1) Value determined for a 100 percent interest, looking at the asset value based on liquidation value of the business, the market value by looking at sale of similar businesses, or income value by looking at the earnings, then the minority‟s proportional interest is calculated, then (2) that value is discounted to reflect the lack of control, and (3) minority shares are further devalued to reflect their lack of liquidity. However, most courts say that control and marketability discounts are not appropriate for close corporation contexts -- they look to the undiscounted full value of the proportionate

vii. Fiduciary Protection 1. Used in jurisdictions without oppression statute, and where minority does not necessarily want

liquidity but things like employment or distributions 2. Majority is protected if it can show some rational business purpose for its action, negating a

finding of bad faith. 3. Some courts have fashioned a direct cause of action for minority shareholders, abandoning the

idea that corporate fiduciaries owe duties to the corporation; minorities can sue and recover from the controlling shareholders directly.

viii. Cases

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1. Dodge v. Ford Motor Co.: Ford had a huge surplus but planned to reduce price of car and expand manufacturing, all without paying dividends. Found that given the huge profits the board had a duty to distribute a large sum to the shareholders.

2. Wilkes v. Springside Nursing Home, Inc.: Equal Opportunity rule; if majority shows a legitimate business purpose and the minority shows the objective could have been achieved in a manner less harmful to their interest, the court must balance the legitimate objective against the practicality of the alternative.

3. Gottfried v. Gottfried: Close corporation distributions. No dividends were paid upon common stock, although dividends were paid regularly upon the outstanding preferred stock and intermittently upon another class; claim is that the decision was animated by considerations other than the best welfare of the corporations or their stockholders. No single distinguishing ear mark of bad faith but the following may be indicative: exclusion of the minority from employment, high salaries or bonuses for the officers in control, the fact that the majority may be subject to high personal income taxes if substantial dividends are paid, and the existence of a desire by the controlling directors to acquire the minority stock interests as cheaply as possible. Essential test is whether the directors policy is dictated by their personal interest rather than the corporate welfare. There was evidence of dissension, substantial compensation for the D‟s, and exclusion from employment, but court did not find bad faith because: there had been retirement of some outstanding stocks that led plaintiffs to actually get some money that was substantial, and dividends were finally paid after the commencement of the action (in the amount of 44% of the preceding year‟s earnings).

4. Wilderman v. Wilderman: Ex-wife and husband each owned half of a corporation, and wife asserted that he caused excessive and unauthorized payments to be made to himself out of the corporate earnings, and that they must be returned to the company and treated as profits. Court looked at the success of the corporation, what the IRS would allow them to deduct as compensation, amounts previously received as salary, whether increases in salary are geared to increases in the quality of services rendered, etc.

5. Donahue v. Rodd Electrotype Co.: Holds close corporations to partnership-like fiduciary duties. When corporation reacquires its own shares, purchase is subject to additional requirement that the stockholders who caused the corporation to purchase them must have acted with the utmost good faith and loyalty to the other stockholders. This means that if the stockholder whose shares were purchased was a member of the controlling group, the controlling stockholders must cause the corporation to offer each stockholder an equal opportunity to sell

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a ratable number of his shares to the corporation at an identical price. This is because otherwise it creates an exclusive market to which minority shareholders do not have access, and without an equal opportunity to sell, the controlling shareholder has a preferential distribution of assets.

6. Zetlin v. Hanson Holdings, Inc.: Plaintiff had 2% of corporation, defendants had 44%--defendants sold their share at a premium ($15, vs. $7 market price) to Flintkote Co which gave Flintkote a controlling interest. This was not in bad faith though because controlling shares do command a premium, so the transaction made sense, and the minority shareholder plaintiff cannot inhibit the legitimate interests of other shareholders--including the right to obtain a premium for valuable shares.

d. Traditional Roles of Shareholders and Directors i. Generally

1. Shareholders: The corporation‟s electorate; elect directors annually and vote on fundamental corporate transactions. While they are nominal owners, they do not participate in managing the corporation‟s business or affairs--even a majority cannot act on behalf of the corporation.

2. Board of Directors: The corporation‟s legislative organ; all corporate powers shall be exercised by or under the authority of the board of directors, as well as the business and affairs of the corporation. (MBCA § 8.01(b)). Board is not an agent for the shareholders but has independent status--directors have fiduciary duties to the corporation and shareholders (as a group).

3. Officers: The corporation‟s bureaucracy; delegated the day-to-day management of the corporation and are answerable to the board. All authority to act for (and to bind) the corporation originates in the board.

ii. Fiduciary Duties 1. In Closely Held Corporations

a. Some courts have implied fiduciary duties in this setting because of the lack of marketability and degree of control.

b. Frequent issue is whether these duties can be modified by agreement. While partnerships can often do this, courts are reluctant to allow close corporations to do so.

2. In Modern Public Corporations a. Management has three principal functions: (1) enterprise decisions concerning

operational and business matters, (2) ownership issues such as initiating mergers or constructing takeover defenses, (3) corporate oversight.

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b. Degree of fiduciary standards vary when control markets are available (relaxing scrutiny when control markets are available to discipline poor management and tightening scrutiny when the board attempts to insulate itself from these markets).

c. Note on the “Imperial CEO”: CEO has so much authority and influence so, presumably, they have greater fiduciary duties.

3. Validity of Management Agreements a. Modern Statutes for Close Corporations

i. Depends on the corporate statute; older statutes mandated exclusive board management, but modern statutes have special close corporation provisions that authorize agreements limiting directorial discretion.

ii. MBCA authorizes shareholders agreements that govern the “exercise of corporate powers or the relationship among the shareholders, directors, and corporation.” (MBCA § 7.32) It is authorized if approved by all of the shareholders, whether in the articles or bylaws, or in an agreement signed by all then-current shareholders and made known to the corporation (MBCA § 7.32(b)).

b. Common Law i. Early decisions imposed a strict rule that any restraint on the board violates

public policy and is unenforceable ii. Over time, cases have adopted an increasingly more relaxed approach that allow

such restraints if the agreement: 1. relates to a close corporation 2. does not adversely affect interests of nonparty shareholders or of creditors 3. deviates only slightly from the statutory norm that directors “manage the

business of the corporation” c. Effect of Invalidity and Enforcement

i. Early cases held that entire agreement would be null if only part was invalid ii. Modern courts often sever or rewrite troublesome provisions

iii. Historic Cases 1. McQuade v. Stoneham: There was an agreement among the shareholders to use their best

efforts to continue to be directors and officers. Despite this, two of the three abstained from voting for an office and the four outside directors voted in a new treasurer (displacing one of the parties to the agreement). But Stockholders may not, by agreement among themselves, control the directors in the exercise of the judgment vested in them by virtue of their office to

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elect officers and fix salaries. But: stockholders may combine to elect directors, though this is limited to that election and does not extend to contracts limiting the directors‟ power to manage the business of the corporation by the selection of agents.

2. Clark v. Dodge: Clark owned 25 percent and Dodge owned 75 percent of the stock of 2 corporations. They entered into a written agreement that Clark would manage the business and in that connection, would disclose a secret formula to Dodge‟s son that was necessary for the business‟ success. In return, Dodge agreed that he would vote his shares and also vote as director to ensure Clark would be retained as general manager, receive ¼ fo net income either by way of salary or dividends, and no unreasonable salary would be paid to reduce the net income so as to materially affect Clark‟s profits. Court allowed this limit on director discretion because here, where the contracting shareholders/directors are the sole shareholders there should be no objection to enforcing the agreement.

3. Long Park, Inc. v. Trenton-New Brunswick Theaters Co.: All shareholders of theater company entered into an agreement giving one shareholder full authority and power to supervise and direct the operation/management of certain theaters. He could be removed as manager only by arbitration among the shareholders. This limits Clark v. Dodge‟s holding because here, the action completely sterilized the board of director‟s power to manage the business and control its affairs--definitely against public policy.

iv. Transition to the Present; Special Rules for Close Corporations 1. Cases

a. Galler v. Galler: Dealt with problems interpreting a shareholder agreement in a close corporation (widow vs. brother-in-law & wife). Court recognized that it could not fail to distinguish between close and publicly-traded corporations, especially since courts had long ago begun to relax their attitudes with respect to statutory compliance for close corporations, allowing slight deviations to give legal efficacy to common business practice. This case was important because of its call for special legislative treatment of close corporations that deviate from the traditional corporate model envisaged in McQuade.

b. Zion v. Kurtz: Delaware case. All stockholders agreed that, except as specified in their agreement, no business activities would be conducted without the consent of a minority stockholder; court held the agreement is enforceable as to the original parties, even though all the formal steps required by statute were not taken. This is because the agreement required nothing that was prohibited by law, and as a close corporation,

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state law grants some flexibility. Moreover, they intended to be bound as a close corporation.

c. Nixon v. Blackwell: Delaware Supreme Court refused to apply close corporation statute to a corporation because Delaware law already provided a very specific statute for close corporations, and in order to qualify for that section a company needed to elect to be governed by it at the inception; court would not give it the benefit of the doubt.

2. Two Types of Close Corporation Provisions a. MBCA

i. No close corporation category so opt-in is not necessary, but any shareholder agreement modifying the control structure must be conspicuously noted on share certificates--moreover the agreement must be approved by all shareholders

ii. All shareholders must agree to any amendment to the agreement; the agreement ends automatically after 10 years unless the parties agreed otherwise, or if the corporation‟s shares are traded in a national stock market

iii. Comprehensive list of kinds of provisions permitted in shareholder agreements, but requires that all the shareholders approve it

iv. Shareholders are left to their regular statutory deadlock remedies b. Delaware

i. Close corporation is one that has less than 30 shareholders of record, whose stock is subject to transfer restrictions, and that has not publicly issued any stock. To elect close corporation status the articles must originally state (or be amended to state) that it is a close corporation, and an amendment opting in to that status requires a two-thirds majority vote.

ii. Amendment to the articles voluntarily terminates close corporation status; must be approved by a two-thirds majority vote. Close corporation status terminates when it files the charter amendment or if any condition of close corporation status is breached

iii. Shareholders holding a majority of voting shares can enter into written agreements restricting or interfering with discretion or powers of the board of directors; certificate of incorporation can also provide that the business will be managed by the shareholders rather than by a board of directors.

iv. If shareholders manage the business and become deadlocked, or if they have the right under the articles to dissolve the corporation, a shareholder may petition

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the court for the appointment of a custodian. Court may also appoint a provisional director--who is neither a shareholder nor creditor--if it is deadlocked.

3. Vote-Pooling Agreements a. Purpose: important in electing directors

i. Under straight voting, candidates who obtain plurality are elected ii. Under cumulative voting, the votes necessary to elect one or more directors is

fixed by formula (Number of directors X (total number of shares authorized to vote) divided by the (number of directors + 1) PLUS fraction (or 1)

b. Validity: Generally valid if they relate to a matter on which shareholders may vote; most statutes require that they be in writing, and some require a maximum duration/notice of the agreement.

i. Governed by regular contract rules; may be of indefinite duration, subject to change, etc.

c. Enforcement: Agreements are generally specifically enforceable because of the difficulty in calculating money damages from a diminution of control.

v. RMBCA‟s Allocation of Power 1. Shareholder Meeting and Voting Provisions; Election, Terms, and Resignation of Directors

a. Purposes of Shareholder Voting i. Gives self-help remedies to the majority, allowing them to protect their position

as residual claimants of the corporation‟ b. Shareholder Voting in Public Corporations

i. In public corporations, shareholders typically participate less fully than the model assumes--they generally vote their proxies for a slate of directors and transactions proposed by incumbent management.

ii. Proxy Process 1. Management sends to shareholders at corporate expense a voting

package containing an annual report, proxy disclosure document, proxy card, and a return envelope. SEC now allows companies to send notice that these materials are available online.

2. COMPLICATION: most shareholders are beneficial, not record owners. Under SEC rules the corporation must send proxy materials or notice of online access either to (1) the record owner for distribution to beneficial

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owners, or (2) to beneficial owners who do not object to having their nominees furnish their names and address.

3. After receiving this notice, shareholders can go online or use regular mail to vote their proxies.

4. The meeting takes place; difficult to overcome incumbent wishes because unless the new person/slate has solicited proxies, they will not stand a chance

c. History of Public Shareholder Voting i. Separation of Ownership and Control

1. Berle & Means: famous thesis that shareholder voting was ineffective where ownership is so widely distributed that it can‟t really form a ruling bloc, so management is able to be self-perpetual and keep itself going or nominate its successors.

ii. Institutional Shareholders 1. 1980s: public shareholders began to use their latent control over

managers, by exercising ability to exit and sell shares. 2. 1990s: institutional shareholders became important because with their

large blocs of shares they overcame the collectivization obstacles that discouraged a single shareholder from taking the initiative to solicit proxies, etc.

iii. Institutional Activism: Institutional Investors have fiduciary obligations to manage/vote their shares for the exclusive benefit of their beneficiaries. Regulatory pressure has led them to take this responsibility seriously

iv. Voting Incentives for Public Shareholders: Whereas individual shareholders will have little profit from expending huge amounts of effort, institutional investors can be more efficient (think of it as an example of economies of scale).

1. If insurgent loses, cannot seek contribution from other shareholders or corporation; if he wins, may be able to obtain reimbursement from the firm, but any gains will be shared with all the shareholders (according to their pro rata rights).

v. Shareholder Voting in Close Corporations 1. Majority shareholders exercise their voting power to control the company,

and since they often rely on the company for their livelihood, are far more

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active than in a publicly-held model. For minority shareholders, voting is usually not a meaningful protection, but they cannot sell shares in a public market--instead they need to negotiate for special voting rights.

2. Voting Structure: Basic core principles: shareholders must have voting rights; elections of directors must occur with regularity; shareholders must approve any fundamental corporate transactions; shareholders must have access to particular information; shareholders meetings must comply with minimal procedures; and shareholders can remove wayward directors.

a. Shareholders‟ Governance Role i. They vote ii. They cannot act on the ordinary business and affairs/bind the corporation/select

and remove officers/fix compensation/pay dividends/etc. iii. Election and Removal of Directors

1. MBCA § 8.03(d): power to elect at first meeting and annually thereafter 2. MBCA § 8.08: shareholders can remove directors before term expires--for

cause or without cause depending on the statute and articles of incorporation

iv. Approval of Board-Initiated Transactions 1. Fundamental Corporate Changes

a. Shareholders must vote here, for things like amendments to the articles of incorporation (MBCA § 10.03), mergers with other corporations (MBCA § 11.04), sales of substantially all of the corporate assets not in the regular course of business (MBCA § 12.02), and voluntary dissolutions (MBCA § 14.02).

2. Conflicting Interest Transactions a. Shareholders can vote on transactions where directors have a

conflict of interest (MBCA § 8.63). Furthermore, they can vote to approve indemnification of directors/officers/other agents against whom claims have been brought because of their relationship to the corporation (MBCA § 8.55(b)(4).

v. Shareholder-Initiated Changes 1. Amendment of Bylaws

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a. Shareholders have the power to adopt, amend, and repeal bylaws (MBCA § 10.20). Even if the board shares that power, its power is coterminous with that of the shareholders.

b. Scope of Power to Amend Bylaws: i. Oklahoma case held that powers that were not the exclusive

province of board of directors could properly be restricted/regulated by the shareholders

ii. Delaware case: bylaw unlawful that would prevent directors from exercising their full management powers, because their fiduciary duties could have prevented them from following the bylaw (which was to require reimbursement for successful short slate dissidents).

2. Amendment of Articles a. A few statutes allow amendments to the articles, and others

describe the procedure without specifying who initiates it. Most statutes vest the initiation power exclusively in the board. (MBCA § 10.03(b)).

i. Similarly, most statutes do not permit shareholders to initiate other actions even though they must approve them (i.e., mergers); they are entitled only to approve or reject (MBCA § 11.04 (merger), § 12.02 (sale of all assets), § 14.02 (dissolution)).

3. Nonbinding Recommendations a. Shareholders can make nonbinding recommendations about

governance structures and management of the corporation, including matters entrusted entirely to the board.

b. Leading case: Auer v. Dressel, court reasoned that shareholders can express themselves to put directors on notice before the next election.

3. Enforcement of Shareholder Rights a. Can use direct actions against the corporation or directors

4. Mechanics of Shareholders‟ Meetings a. Annual and Special Meetings

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i. Annual: Directors elected, other regular business is conducted (MBCA § 7.01); Special where unusual circumstances require shareholder action (MBCA § 7.02).

ii. Annual rules 1. Bylaws usually specify timing and location of the annual meeting 2. All statutes require an annual meeting 3. Many allow shareholders to compel a meeting to take place if one is not

held within a specified period (e.g., MBCA § 7.03(a)(1) -- within 6 months of end of fiscal year or 15 months of last annual meeting).

iii. Special rules 1. Must be specially called by the board, the president (if allowed by statute

or bylaws), shareholders with enough shares (as specified by statute/bylaws), or other persons designated in the bylaws. (MBCA § 7.02))

iv. Shareholders meeting conducted by chair as designated in bylaws or by board 1. chair has wide latitude to decide order of business/rules (MBCA § 7.08) 2. Robert‟s Rules not needed 3. Corp. can have bylaws requiring advance notice of shareholder

nominations/resolutions b. Notice

i. Record Date 1. Board sets record date before shareholders meeting to determine which

are entitled to vote. (MBCA § 7.07 -- may not be more than 70 days before meeting).

2. Only record owners as of that date are entitled to vote ii. Contents of Notice

1. Generally, requirements are minimal 2. Must describe time and location. (MBCA § 7.05). 3. Under some statutes, if extraordinary matter to be discussed, the notice

must specify the purpose as well. (MBCA § 7.05(c)). iii. Timing of Notice

1. Notice must arrive in time for shareholder to consider matters on which they‟ll vote, but not so early that it become stale

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2. Many statutes require notice be given at least 10 days but no more than 60 days, before a meeting. (MBCA § 7.05(a)).

iv. Defective Notice 1. Shareholders can waive notice before, at, or after meeting. (MBCA §

7.06). 2. Many statutes hold that attendance at meeting waives notice. (MBCA §

7.06(b)). 3. If notice is defective and not waived by all affected shareholders, meeting

is invalid and any action taken there is void. c. Quorum

i. Quorum necessary for action to be valid ii. Statutes typically set this as a majority of shares entitled to vote. (MBCA §

7.25(a)). iii. Prevents minority from acting at a meeting without the presence of a majority iv. Some statutes allow quorum to be reduced in the articles or bylaws to one third

(though MBCA § 7.25(a) allows it to be reduced without limit). v. Most hold that once quorum is achieved, cannot be broken if a faction walks out.

(MBCA § 7.25(b)). d. Appearance in Person or by Proxy

i. Can appear either in person or proxy. (MBCA § 7.22(a) ii. By proxy, statutes only require that proxy appointment be in writing and signed,

including by electronic transmission. (MBCA § 7.22) iii. Proxy creates an agency relationship in which the shareholder is the P for the P‟s

shares; so can grant proxy specific instructions or broad authority. 1. Proxy can be revoked by P at any time by (1) submitting written notice

with corporation of intent to revoke, (2) appointing another proxy holder in a subsequently dated proxy, or (3) appearing in person to vote

iv. Proxy generally lasts 11 months (long enough for one meeting). (MBCA § 7.22(c)).

5. Voting at Shareholders‟ Meetings a. Who Votes

i. Record shareholders cast votes ii. Generally, each share = one vote (MBCA § 7.21).

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iii. Articles can deviate and create supervoting shares or voting caps for any shareholder with a specified percentage (MBCA § 6.01(c)(1)).

iv. Statutes prohibit a majority-owned subsidiary from voting the shares of the parent corporation (MBCA § 7.21(b)).

b. Majority Vote i. Board-Initiated Transactions usually requires absolute majority of outstanding

shares entitled to vote. Abstentions and no-shows count against the proposal as a result.

ii. Other statutes require approval only by a majority of shares represented at a meeting at which a quorum is present (simple majority) (MBCA § 7.25(c)).

c. Election Inspectors i. Corporation appoints inspectors to inspect proxies and votes (MBCA § 7.24). ii. Inspector‟s actions subject to judicial rule, usually deferential though to his good

faith judgment. iii. Inspectors may not resort to extrinsic evidence to decide validity of proxies. iv. Corporation and inspectors not liable in damages for accepting/rejecting proxies

in good faith. (MBCA § 7.24(d)). d. Action by Consent

i. Usually, shareholders can act without a meeting by giving written consent. Same effect as action at an actual meeting.

ii. Some statutes allow this require shareholder consent to be unanimous (MBCA § 7.04(a)).

iii. Most states, including Delaware, only require that consents represent minimum number of shares required to approve an action if the meeting were actually held.

iv. To determine which consents are required, corporation must set record date; if it doesn‟t, the record date is just the first day that written consents are delivered to it.

6. Election of Directors a. Qualifications and Number of Directors

i. Directors need not be shareholders, residents of the state of incorporation, or have any other special qualifications (MBCA § 8.02).

ii. Only need to be individuals (at least 18 years old) who meet qualifications prescribed in the bylaws or articles.

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iii. Number of directors specified in the articles or bylaws (MBCA § 8.03(c)). iv. Articles often specify variable range with the actual number fixed in bylaws;

range can only be amended with shareholder approval, but the number of directors within the range can be set by the board.

v. Most statutes now permit a board of one director. (MBCA § 8.03(a)). b. Voting Methods

i. General Rule--Annual Election by Straight Voting 1. Generally, all directors face election at each annual meeting (MBCA §

8.03(d)) 2. Plurality is the usual method 3. To ensure greater minority representation, some statutes require

cumulative voting. (MBCA § 7.28 allows it if adopted in articles). c. Staggered Board

i. Exception to one-year election cycle 1. only some of the directors are elected at each annual meeting 2. must be specified in the articles or, in some states, the bylaws (MBCA §

8.06 requires articles). d. Class Voting

i. Board structure can be built into capital structure (MBCA § 6.10(a)), meaning that different classes elect their own directors.

ii. Majority can use this to undermine minority‟s rights, by amending articles to create a new class and assuming ownership of the new class, it can elect a greater proportion of directors than had been the case under cumulative voting (MBCA § 8.04).

e. Holdovers i. Director holds office until successor is elected and qualified (§ 8.05(e)). ii. This is a temporary solution for shareholder deadlock (though shareholder

deadlock can lead to involuntary judicial dissolution). 7. Removal of Directors

a. Most statutes allow shareholders to remove directors during their term with or without cause (MBCA § 8.08(a)).

b. Also, some states allow directors to be removed in judicial proceeding brought by the corporation or by shareholders holding a specified percentage of shares (MBCA § 8.09).

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c. Procedures i. Shareholders must give specific notice that removal will be considered at a

meeting (MBCA § 8.08(d)). ii. Directors to be removed for cause have due process rights to be informed of

reasons for removal and to answer the charges. d. Removal Under Cumulative Voting

i. To prevent majority from circumventing minority rights, nearly all state statutes state that director elected under cumulative voting cannot be removed if any minority faction with enough shares to have elected him by cumulative voting, votes against his removal (MBCA § 8.08(c)--comment indicates this is for removal for cause or without cause).

e. Filling Vacancies i. Generally, board or shareholders can fill vacancies created by the removal,

death, or resignation of directors or the creation of new directorships (MBCA § 8.10).

ii. Shareholders can only exercise this power at annual or special meeting (MBCA § 7.21)

iii. Under some statutes, any mid-term replacement must stand for election at the next annual meeting (even if filling for a staggered term director). (MBCA § 8.05(d)).

iv. Some statutes limit board‟s authority to fill vacancies, especially when they‟re removed or new directorships are created.

8. Control Devices in Close Corporations a. Shareholder-Level Controls: supermajority requirements and vote-pooling agreements,

multiple classes of shares, irrevocable proxies, transfer restrictions and buy-sell agreements

i. Supermajority Provisions 1. Purpose: give minority participants a veto power; can be only for specified

matters, or for all matters coming before the shareholders/directors 2. Creation: Majority rule is default, so under most statutes, the charter must

specify supermajority quorum or voting requirements for shareholder action either when drafted or by amendment (MBCA § 7.25(a) and (c)).

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a. MBCA § 7.27(b): same vote required to take action under voting requirements in effect or proposed to be adopted, whichever is greater

b. Supermajority requirements for director voting may be incorporated in the articles or the bylaws if not inconsistent with the articles (MBCA § 8.24).

c. Supermajority requirements can be included in the agreement (MBCA § 7.32).

d. Validity: Statutes generally permit supermajority requirements (MBCA § 7.27). Note: supermajority quorum requirement allows a party to cast veto by absenting himself; if shareholder and shows up at meeting that cannot be broken (MBCA § 7.25(b)) but if it‟s director at director meeting than he can just leave and break quorum (§ 8.24(c)).

i. Some courts have refused to respect these. b. Board-Level Controls: Compensation guarantees, dissolution stipulations, limits on

business operations, dividend policies 9. Classes of Stock (Classified Board): voting power disproportionately allocated to financial

interests a. Purpose: can solve problem where one person has disproportionate capital

contributions b. Creation: must be authorized in articles c. Validity: subject to few if any statutory or common-law limitations

10. Case: Humphrys v. Winous Co.: corporation‟s majority enacted three classes for minority shareholders with each class having one director, and each class for one shareholder. This diluted the effects of cumulative voting. Court upheld the matter because it found statute only granted right to cumulative voting, and not necessarily to actual minority representation.

vi. Directors‟ Compensation, Conduct, Liability, and Tenure; Board Committees 1. Delegating Board Functions to Committees

a. Statutes allow board to delegate many of its functions to committees composed of some (but less than all) of the directors. (MBCA § 8.25).

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b. Some refer to specific powers that cannot be delegated, such as authorizing distributions or shares, approving mergers, amending articles or bylaws, and making other fundamental corporate changes. (MBCA § 8.25(e)).

c. Committees have become particularly important in public corporations i. Executive Committee acts on matters coming up between regular board

meetings, makes presentations to the board; full board adopts or ratifies its actions

ii. Audit committee reviews financial position with the company‟s outside auditor iii. Compensation committee negotiates and sets executive compensation iv. Nominating committee selects directors to be nominated for election by the

shareholders d. Often committees are comprised of outside directors to provide element of

independence in matters involving potential conflicts e. Sarbanes-Oxley Act of 2002: all members of audit committee of publicly traded

companies must be independent; at least one must be financial expert, and committee must have complete authority to hire/fire/supervise the company‟s outside accountants and auditors.

2. Corporate Authority: a. Sources of authority for corporate officers, like any agent, exist along a continuum. b. Board is the corporate principal and the officers are its agents; thus, whether the

corporation is bound brings in normal agency questions (actual, apparent, and inherent authority).

e. Share Transfer Restrictions; Remedies for Oppression, Dissension, or Deadlock i. Generally

1. Share transfer restrictions constitute contractual obligations that limit the power of owners to freely transfer their shares (MBCA §§ 1.40(3), 6.27).

2. MBCA § 6.27 provides a number of possible restrictions. 3. Closely held corporations: buy-sell agreements, and option agreements.

a. Option does not guarantee the shareholder a specified price, whereas a buy-sell agreement does.

4. Two basic types of buy-sell agreements a. Cross-purchase agreement: each shareholder agrees to personally purchase his

proportionate share of the other shareholders stock in the event of their death, and

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binds his estate to sell the shares he owns to the surviving shareholders in proportion to their respective holdings. Capitalization remains unchanged.

b. Stock-redemption: corporation becomes a party to the agreement as well as the shareholders; corporation would agree to redeem or purchase the shares of the first shareholder to die, and each of the two shareholders would bind his estate to sell or tender for redemption the shares he owns. Upon the death of the first shareholder, the corporation buys his shares using corporate funds.

5. Traditional view is that these constitute a restriction on alienation and are strictly construed, but this is changing. So, terms should be clear--is purchase mandatory, etc.

6. When drafting buy-sell agreement, method of valuation is very important: can retain an outside expert to appraise, refer to the corporation‟s book value, or to set a value subject to periodic reevaluation.

7. Many cases hold that restrictions are valid even if it compels a shareholder to sell shares at an arbitrary price that may not reflect the real value of the shares

ii. Share Transfer Rights 1. Shares are freely transferable and this is so clear that its not actually described (MBCA § 6.27

describes limited circumstances where transfers can be restricted). 2. Restrictions cannot be imposed by majority action; only apply to shareholders who purchased

subject to the restriction or who are parties to a restriction agreement. 3. Any restrictions on share transferability must be for “reasonable purposes.”

iii. Transfer Restrictions and Contractual Liquidity Rights (Close Corporation) 1. Transfer limits combine with contractual outs to create a “private market,” in place of the

liquidity that public shareholders enjoy. 2. Creating Transfer Restrictions and Liquidity Rights

a. Can be placed in the articles, bylaws, a shareholders‟ agreement, or an agreement between the corporation and its shareholders.

b. In some states, any agreement for transfer restrictions must be filed with the corporation and available for inspection.

c. Notice i. Certificates must note conspicuously that the shares are subject to restrictions

(MBCA § 6.27(b)). This means italics, bold, contrasting color, CAPITALS, or underlined (MBCA § 1.40(3)). Even if not conspicuous, still enforceable against transferee with knowledge. (MBCA § 6.27(b)).

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d. Drafting Issues i. Planner must be specific when drafting

e. Validity of Transfer Restrictions i. Restrictions must be reasonable under the circumstances, which balances two

conflicting corporate tenets: free alienability of shares, and structuring to meet the participants‟ needs.

1. Flat prohibition: likely invalid unless there is a legitimate purpose (i.e., shares in a professional medical corporation only transferable to doctors). MBCA § 6.27(d)(4).

2. Prior Approval: many allow this if not manifestly unreasonable. MBCA § 6.27(d)(3).

3. Purchase Option: Courts have enforced first option contracts where corporation gets chance to buy at a specified option price. MBCA § 6.27(d)(1). If it refuses so that a controlling shareholder can purchase, that may be self-dealing subject to review.

4. First refusal: Similar to purchase option but offered to corporation at the price and terms offered by outsider, this is usually upheld.

5. Mandatory buy-sell: valid, provided the corporation has sufficient legal capital to redeem the shares.

ii. Generally, failure of corporation to purchase frees the shareholder to transfer the shares.

iii. No statutory limits on how long restrictions can last (regular contract rules apply). iv. Fiduciary duties in buy-sell agreements: some courts don‟t infer that and instead

seem to say, “caveat emptor,” while others infer duties, especially where there is an unexpected hardship.

iv. Oppression, Dissension, and Deadlock 1. Duties of Controlling Shareholders

a. They have fiduciary duties that generally parallel those of directors b. Who are Controlling Shareholders?

i. Has sufficient voting shares to determine the outcome of a shareholder vote. 2. Cases

a. Gearing v. Kelly: Deadlock situation. Appellant owning 50% of stock intentionally stayed away from a shareholder meeting to avoid quorum to prevent a director‟s election. The

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election happened but the absent party wanted to have it overturned; the court refused to do so because the 50% controlling shareholder was the one who caused the wrong.

b. In re Radom & Niedorff, Inc.: Two equal stockholders; one filed for judicial dissolution to dissolve the corporation because they did not get along. Even though 50% of the shareholders, the one guy, wanted dissolution, the court would not grant it because despite the feuding, the corporation itself was flourishing. Instead, court notes that when majority stockholders file a petition for dissolution due to internal corporate conflicts, order is granted only when the competing interests “are so discordant as to prevent efficient management” and the “object of its corporate existence cannot be attained.” In other words, will judicially-imposed death be beneficial to the stockholders or members and not injurious to the public. Thus, they would not dissolve the corporation. Dissent points out that despite the profits, it is the management that is in a deadlock, and that if dissolution not granted and the managing shareholder/director quits, it may result in a greater loss to all parties than if dissolution is granted.

c. Davis v. Sheerin: “Modern Remedies for Oppression, Dissension, or Deadlock.” Two shareholders, with a 45/55 split in ownership. 55 denied 45‟s right to inspect the corporate books unless he produced a stock certificate: 55 claimed that 45 had gifted him the 45 interest 30 years before. Trial court found that 45 did in fact have a 45% interest, and ordered 55 to buy him out. On appeal, court found that buy-outs may be used in an appropriate case where less harsh remedies are inadequate to protect the parties‟ rights. Here, the alleged conduct was “oppressive conduct,” which is sometimes described as “burdensome, harsh and wrongful conduct,” “a lack of probity and fair dealing in the affairs of a company to the prejudice of some of its members,” or “a visible departure from the standards of fair dealing, and a violation of fair play on which every shareholder who entrusts his money to a company is entitled to rely.” Thus, conspiracy to deprive minority shareholder of his interest, together with acts of willful breach of fiduciary duty, and undisputed evidence indicating that 45 would be denied a future voice in the corporation, are sufficient to support conclusion that oppressive conduct would continue. So, buy-out was appropriate.

d. Abreu v. Unica Indus. Sales, Inc.: Two shareholders with 50% split ownership of Ebro Foods, Inc. One of the shareholders was a corporate entity, and one of that entity‟s directors started up another business to compete with Ebro. Trial court removed the bad director, holding there was oppressive and fraudulent self-dealing; put in place a

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provisional director to stabilize the competing factions. This was meant to be an alternative remedy to dissolution. This happened to be one of the party‟s sons, but the court didn‟t find a strict requirement for impartiality for the provisional director: the court looked at the director‟s experience, understanding of corporate history, experience, true interest in viability and advancement of the corporation as an entity.

f. Action and Authority of Directors and Officers i. Authority to Bind the Corporation

1. Emanates from the board of directors 2. Board Decision Making

a. For transactions requiring board approval, outsiders must be sure the proper procedures were followed.

b. Board Meetings- Notice and Quorum i. Notice: board meets at regular and specially called meetings. Generally, bylaws

dictate whether, when, and how much notice is required. MBCA § 8.22(a), (b). Board action taken at a meeting at which all directors did not receive required notice is invalid. Directors can waive notice in writing or by attending and not promptly objecting to the meeting. MBCA § 8.23.

ii. Quorum: Prevents board minority from meeting and taking action the majority would not have. Exists when a majority of authorized directors are present at the meeting, unless the articles or bylaws specify a greater number. MBCA § 8.24(a). Some statutes permit them to reduce the quorum but generally set a floor of one-third. MBCA § 8.24(d). Many statutes require quorum when voting happens, allowing directors to break a quorum by not attending or walking out. MBCA § 8.24(c).

ii. Board Action-Majority Vote at a Meeting 1. Action by directors at a properly convened meeting is generally decided by a majority vote of

those present unless the bylaws/articles impose a supermajority requirement. MBCA § 8.24(c). Each director has one vote and cannot use a proxy.

2. Generally, directors cannot vote separately; must act together at the meeting. a. Many statutes now allow boards to take action by separate written and signed consent

of the directors, if the consent is unanimous. MBCA § 8.21, as well as by electronic transmission in some cases.

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b. Many also allow directors to occur over the telephone or other means where all directors can hear each other. MBCA § 8.20(b).

c. In some situations courts have accepted that directors (even without a meeting) can ratify the act of a corporate officer or agent through acquiescence.

iii. Delegating Board Functions to Committees: see above. iv. Cases

1. Baldwin v. Canfield: Deed was executed by the directors of a corporation for purposes of a conveyance to another party, but they did it separately and at different times--court found this conveyance was therefore illegal, because the directors had authority as a board, not individually, so they only have authority to act when assembled at a board meeting. Strict Meeting Rule.

2. Mickshaw v. Coca-Cola Bottling Co.: Action where claimant wanted to get bonus pay that he was promised as a result of being conscripted for service in the 1940‟s. One director had made the promise by publishing an ad in the newspaper to tout the policy, even though there were three directors of the corporation. One of the directors testified that he knew about the announcement on the day it appeared, and did not object to it. While it may be inferred the third director knew about it, that is not necessary because the first two (one who took out the ad + one who acquiesced in it) constituted a majority, and the court thus found the board had ratified the act. Court mentioned that it would be unjust to require a claimant to prove case by formal corporate records. Example of relaxed meeting rule.

v. Actual vs. Apparent Authorization 1. Whether corporation is bound raises the usual agency questions (actual, apparent, inherent

authority) 2. Actual Authority--Internal Action

a. Express Actual Authority: clearest method i. Arises when the board, acting by a requisite majority at a proper meeting,

expressly approves the actions of a corporate agent ii. Binds the corporation so long as the statute/corporate documents do not limit

board‟s authority iii. Most transactions are not specifically approved for day-to-day transactions, but

rather, board delegates categories of authority to officers so look to: the corporate statute, articles, bylaws (most common source), and board resolutions.

b. Implied Actual Authority

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i. Two techniques for inferring: within the penumbra of the express actual authority (acts incidental to the open-ended grant of authority), and when the board‟s reaction indicates acquiescence/already knowing of the act.

c. Ratification: i. Board can create ex post facto express actual authority retroactively by ratifying

a prior act if the board has the power to authorize it. ii. This can also be implied

3. Apparent Authority--External Appearances a. If board induces an outsider to rely on officer, even though he has no actual authority,

the corporation may be bound b. Different than inherent authority c. How it is created depends on the officer‟s position in the corporation

i. President/CEO: can bind as to matters in the usual course of business, but not as to extraordinary matters (in which case outside party is on notice to demand proof of actual authority).

ii. Vice President: Can only bind as to matters within his area iii. Secretary: Normally does not bind, only keeps/certifies records iv. Treasurer: Normally does not bind, just keeps books, receives payments, makes

authorized payments d. Thus, whether apparent authority exists often turns on whether it is ordinary or

extraordinary i. Extent of corporation‟s business interest can determine this/indicate the result ii. Theory focuses on protecting outsiders‟ reasonable beliefs, so entire discussion

negated if outsider actually knows the officer has no authority iii. Case: Lee v. Jenkins Bros.: President‟s promise to new executive that

corporation could provide a pension at age 60, which it assumed became vested after a reasonable period of time, was not an extraordinary transaction because it did not implicate future managerial policy nor did it expose the corporation to significant liabilities.

4. Inherent Authority a. Some courts follow this approach, especially for CEOs/Presidents b. Under this theory, corporation can become bound regardless of any actual or apparent

authority as normally understood; if officer‟s actions relate to transactions he is normally

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authorized to conduct and the third party reasonably believes he is authorized and has no notice to the contrary, the corporation is bound.

c. Particularly strong if the binding agent is also a significant shareholder. 5. Cases

a. In the Matter of Drive-In Development Corp.: Apparent authority; board did not actually pass resolution to guarantee a loan from bank to its parent corporation, but the corporation‟s secretary provided such a resolution (though actually unauthorized), certified with the corporate seal affixed, and the “Chairman” of the organization was the person who originally signed the guarantee. Court found (apparent) authority and estopped the corporation form denying its officers‟ representations, since it is the duty of the secretary to keep corporate records and make proper entries of its actions, so it was within Dick’s authority to certify that a resolution was adopted.

b. Black v. Harrison Home Co.: Two shareholders; mother (502 shares) and daughter (498 shares); daughter died intestate, and two weeks later her mother entered a contract to sell real estate owned by the corporation. The corporation refused to obey the contract, and the court upheld this because (1) the mother was not the sole shareholder; she only has rights as to what remains of the daughter‟s shares after creditors are satisfied, etc., and (2) the board is the sole source of power, not shareholders or officers, and there was nothing in the record to suggest that the president ever had power to bind corporation for disposition of its real estate.

g. Duty of Care/Business Judgment Rule (I)--Background; Merits of the Decision i. Generally

1. Addresses attentiveness and prudence of managers in performing their decision-making and oversight functions

2. Business Judgment Rule presumes that they carry out functions in good faith, after sufficient investigation and for acceptable reasons

ii. Standards of Care 1. Statutory

a. MBCA § 8.30(a): each director must discharge duties in good faith and in a manner he reasonably believes to be in the corporation‟s best interests.

b. MBCA § 8.30(b): collectively, the board must become informed in performing their decision-making and oversight functions with the care that a person in like position would reasonably believe appropriate under similar circumstances.

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c. MBCA § 8.42(a): officers with discretionary authority have similar standard 2. Common law

a. Very similar b. Delaware: party challenging business decision must show directors failed to act (1) in

good faith, (2) in the honest belief that the action taken was in the best interest of the corporation, or (3) on an informed basis.

iii. Facets 1. Good faith

a. Requires that directors (1) be honest, (2) not have a conflict of interest, and (3) not approve or condone wrongful or illegal activity.

b. Fraudulent or self-dealing activity is subject to scrutiny under director‟s duty of loyalty 2. Reasonable belief

a. involves substance of director decision making b. board decision must be related to furthering the corporations interests c. embodies the “waste” standard, under which board action is invalid if it lacks a rational

business purpose 3. Reasonable care

a. informed basis and ordinary care standards relate to process of board decision-making and oversight

b. directors must have at least minimal levels of skill and expertise c. “like position” establishes an objective standard recognizing that risk taking decisions

are central to director‟s role d. “similar circumstances” takes into account the complexity and urgency of board‟s

decision making iv. Directors are rarely held liable without breaching their duties (findings of bad faith, illegality, fraud, or

conflict of interest) v. Business Judgment Rule:

1. Rebuttable presumption that directors are honest and well-meaning, and decisions are informed and rationally undertaken (in other words, do not breach duty of care).

2. Not statutorily codified but is assumed to be present (MCBA § 8.30, comment). 3. Shields directors and officers from personal liability and insulates board decisions from judicial

review 4. Two aspects: (1) substantive standard of review, and (2) procedural burden of proof

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5. Reliance Corollary: Off shoot that allows directors to rely on information and advice from other directors, competent officers/employees, and outsider experts; can also rely on others to whom board has delegated its decision-making or oversight functions (MBCA § 8.30(c)-(e)). May also extend to officers.

a. Must have become familiar with the information or advice, and reasonably have believed that it merited confidence.

b. Because “reasonable,” directors cannot hide their heads in the sand 6. Overcoming the Business Judgment Presumption

a. Courts place burden on challenger to prove either (1) fraud, bad faith, illegality, or a conflict of interest; (2) lack of a rational business purpose; (3) failure to become informed in decision making; or (4) failure to oversee the corporation‟s activities. MBCA § 8.31(a) largely follows this.

b. Lack of good faith (first method) i. Fraud: director misled shareholders in connection with voting, knowingly

disseminate false/misleading information to public or directors ii. Conscious disregard: disregarding responsibilities; can be liable for failing to call

board meetings/acting as stooges for controlling shareholders iii. Illegality: intentionally approving/disregarding illegal behavior iv. Conflict of Interest: Personally interest in an action because he stands to receive

personal/financial benefit, or if an action is approved because he is beholden to another person interested in the action

c. Waste (rational business purpose) i. Rational Basis: cannot be merely unwise; must be “imprudent beyond

explanation.” Only when board approves transaction in which the corporation receives no benefit--issuance of stock without consideration or use of corporate funds to discharge personal obligations--have courts found waste.

ii. Case: Shlensky v. Wrigley: the case about installing lights at the stadium; court dismissed, found there could be a rational basis because lights could deteriorate the neighborhood, leading to decline in attendance or drop in Wrigley Field‟s property.

iii. Safety Valve Case, where good faith action but so imprudent: Litwin v. Allen: bank affiliate repurchased options after the 1929 crash with risky option where it bought them back below par, and the seller could repurchase at par value 6

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months later if it desired. Court found this was way too risky--even if the prices rose dramatically, the seller could call and reap a windfall. Some see this as a case demonstrating that fiduciary duties may be heightened for directors of financial institutions.

7. Remedies a. Personal Liability for Directors

i. If Board action violates duty, each director voting for the action, acquiesced in it, or failed to object becomes jointly and severally liable for all damage the decision caused

1. Where director attends the meeting, this is presumed unless minutes reflect dissent or abstention--some allow director who has not voted to register dissent or abstention by delivering written notice at or immediately after the meeting (MBCA § 8.24(d)).

ii. Court might require showing of proximate cause iii. MBCA §8.31(b)(1): directors breaching care duties liable in damages only if the

violation proximately caused harm to the corporation or shareholders. b. Enjoining the Flawed Decision

i. Courts can enjoin or rescind board action h. Duty of Care/Business Judgment Rule (II)--Decision-Making Procedure; and, Additional Insulations for

Directors and Officers i. The Two Contradictory Senses of “Oversight”: Monitoring vs. Inattention

1. Directors‟ Duties to Monitor Corporate Operations a. Potential Liability for Directorial Decisions

i. May arise in two situations: (1) board decision resulting in a loss that was ill advised or negligent, or (2) unconsidered failure of the board to act in circumstances in which due attention could have prevented the loss.

1. First situation is subject to business-judgment rule 2. Second situation, failure to monitor, is a good faith situation.

ii. Being uninformed (second situation)--governed by this rule: director‟s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may render him liable for losses caused by non-compliance with applicable legal standards. Absent reasons to believe

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otherwise, does not mean they should assume officers/employees are dishonest or wrongdoers. Show:

a. directors knew or b. should have known that violations of law were occurring and, in

either event, c. that the directors took no steps in a good faith effort to prevent or

remedy that situation, and d. that such failure proximately resulted in the losses complained of,

although this last element may be an affirmative defense. iii. Courts more likely to hold director liable for inattention to management abuse, as

opposed to mismanagement. b. Case:

i. Smith v. Van Gorkom (Trans Union Case): Shareholders sought rescission of a cash-out merger of the corporation into a defendant corporation. Court found there was no informed business judgment as to the price per share for the merger because simply comparing it to the market value was erroneous; did not take into consideration the intrinsic value of the company as a going concern, no valuation study, etc. Here, the board did not request a valuation from its CFO and instead relied on the officer‟s statement that the price was “within a fair range.” Does not mean outside valuation/etc. required, only that there needs to be sufficient information; simply asking the CFO without any evidence to inform themselves is not an informed decision. Moreover, could not rely on the oral presentation about the merger because never asked the basis for the presentation. Thus, board as a collective group are subject to liability. This rejected a number of arguments that normally carry the day under the business judgment rule; this was harshly criticized.

c. Older cases i. Bates v. Dresser: Bank president/director held personally liable for money stolen

by a young bookkeeper at the bank because he knew of the missing deposits, and was told the young man was the likely culprit, but did nothing.

ii. Francis v. United Jersey Bank: Sons of corporation‟s founder siphoned large sums of money in the form of shareholder loans, and the corporation became insolvent; the founder‟s wife (and a director) was held liable because she did

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nothing in her role as director, instead drinking herself silly, so she was found grossly negligent and that this negligence was the proximate cause of the improper shareholder loans.

d. Sarbanes-Oxley: federalized a large swath of fiduciary duties by requiring that corporate officers of reporting companies certify annual and quarterly reports with the SEC, that he review the report and to his knowledge it does not contain false/misleading statements, and it fairly represents the company‟s financial condition.

ii. Exculpation; and the Relationship of “Good Faith” to the Duty of Loyalty 1. Right after Van Gorkom, Delaware added a provision that allows certificates of incorporation to

have a “raincoat provision” that eliminates or limits director personal liability for breaches of fiduciary duty as a director provided that it does not do so with respect to breaches of duty of loyalty, acts or omissions not in good faith or which involve intentional misconduct, or for any transaction from which the director derived improper personal benefit.

a. The mechanics of this are controversial; do directors only have to show at motion to dismiss stage? Or is it part of the merits?

b. Emerald Partners v. Berlin: Delaware Supreme court said, “when entire fairness is the applicable standard of judicial review (as it is whenever a plaintiff/shareholder can show a violation of the directors‟ duty of care, the duty of loyalty, or the duty to act in good faith) a determination that the director defendants are exculpated from paying monetary damages can be made only after the basis for their liability has been decided).

i. Thus, Delaware‟s raincoat provision no longer results in automatic, instantaneous dismissal of claims against individual directors

ii. Instead, when a plaintiff adequately pleads conduct that falls within the statutory exceptions, directors charged with both care and loyalty/good-faith violations must go through a full trial on both claims before interposing their affirmative exculpation defense--which one presented presumably wipes clean any damages claims based only on care violations.

2. MBCA § 2.02(b)(4): no liability for money damages to corporation or shareholders, except liability for (1) financial benefits he received to which he is not entitled, (2) intentional infliction of harm on the corp. or shareholders, (3) approving illegal distributions, or (4) an intentional violation of criminal law. This can be included in articles or amdned and placed there.

3. These have been held to not cover disclosure duties. 4. Case:

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a. Stone v. Ritter: Derivative suit by shareholders against directors, seeking personal liability for failure to implement a monitoring system required by law. Court declined to do so, because while the system the bank did implement was insufficient to catch the wrongdoing, they established one that was sufficient to provide information on compliance with the law‟s requirements. Holding directors liable for employee failures is one of the most difficult theories in corporate law.

b. McCall v. Scott: Shareholders sought liability against directors for failure to discover and prevent ongoing and systemic health care fraud over a period of years committed by the company‟s agents. Court found that exculpation provision does not bar liability for intentional or reckless conduct.

c. In re Abbott Laboratories Shareholder Derivative Litigation: Almost identical exculpation provision but directors could not claim ignorance of their company‟s failure to comply with FDA regulations; they had been sent four notices and the Wall Street Journal had written about it.

d. In re The Walt Disney Company Derivative Litigation: Deliberate indifference and inaction in the face of a duty to act is clearly disloyal to the corporation. Three different circumstances of bad faith: (1) subjective bad faith, when director acts with intent to harm, (2) gross negligence but with something more than just that, (3) director consciously disregards responsibilities to inform himself and act.

e. In re Citigroup Inc. Shareholder Derivative Litigation: Business judgment rule insulated directors from liability for failure to reduce a bank‟s exposure to risks from subprime mortgage lending market; in essence, distinguishing overseeing business risks from monitoring business risks.

iii. Indemnification 1. Generally

a. MBCA § 8.58(a): makes enforceable provisions that advances for defending litigation are mandatory to the maximum extent possible

b. Corporation should consider whether expense advance is only for direct suits, or derivative suits as well.

2. Corporate Reimbursement a. Rights continue even after director has left the corporation b. Right to indemnification depends on whether he was successful in defending the action

or, though unsuccessful, was justified in his actions.

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c. Generally fixed by contract or the corporation‟s constitutive documents (articles/bylaws). d. Generally, corporation may also indemnify nondirector officers, employees, and agents

to the same extent as directors (MBCA § 8.56). 3. Mandatory Indemnification for Successful Defense

a. If director sued because of his corporate position and is successful, indemnification is obligated under all state statutes. (MBCA § 8.52).

b. Success on the merits: deemed “successful” whether on the merits or procedurally, but not if the claim is settled out of court.

4. Indemnification to the Extent Successful: a. Some statutes require indemnification where defendant is only partially successful b. MBCA § 8.52 makes mandatory indemnification “all or nothing” and limits it to

defendants who were “wholly successful.” 5. Permissive (Discretionary) Indemnification for Unsuccessful Defense

a. Corporation may indemnify only if it is approved by certain corporate actors or a court, under certain specified criteria; depends on whether the action was brought by a third party or on behalf of the corporation

b. Third Party Actions i. Unsuccessful director must be deserving to be entitled to indemnification

1. Criteria: allow it only if director (1) acted in good faith, and (2) reasonably believed her actions were in the corporation‟s best interests. (MBCA § 8.51(a)(1). Often the findings implicit in a final court judgment will be inconsistent with this criteria, so a director increases chances by settling or plea bargaining. MBCA § 8.51(c) allows this and states that such an action is not conclusive as to whether he meets the criteria.

2. Coverage: Reasonable litigation expenses and any personal liability, out-of-court settlement, or imposition of penalties or fines. (MBCA § 8.51, 8.50(4)).

3. Procedures: Statutes specify who determines whether the criteria are satisfied; under MBCA § 8.55(b) it is done by legal counsel; the finding is subject to judicial review.

c. Actions by or on Behalf of the Corporation i. Most statutes do not allow indemnification for director adjudged liable to the

corporation if the action was brought by the corporation or shareholders in a

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derivative action. (MBCA § 8.51(d)(1). BUT, it can do so for a director who settles a suit for litigation expenses if he meets the criteria for permissive indemnification. (id.). Court can also order such litigation expenses to be indemnified (MBCA § 8.54(a)(3)), and can even do so for settlement amounts if fair and reasonable (id.).

d. Court-Ordered Indemnification i. If the corporation refuses to or cannot indemnify under its discretionary authority,

some statutes allow a court to order indemnification of an unsuccessful director who does not meet the criteria for permissive indemnification (§ 8.54(a)).

ii. If adjudged liable to the corporation or for personal gain, it can only do so for litigation expenses. (MBCA § 8.54(a)(3)).

6. Advancement of Litigation Expenses a. Most statutes allow corporation to advance litigation expenses during the proceeding.

(MBCA § 8.53). b. MBCA § 8.53(a) requires the director to:

i. affirm his good-faith belief that he would be entitled to permissive indemnification or indemnification under a charter provision, and

ii. undertake to repay the advances if he is not entitled to indemnification. c. MBCA then requires corporation‟s disinterested directors or shareholders to authorize

the advancement of expenses, subject to the standards that govern board actions. d. Director need not give security for his repayment obligation; corporation can also accept

the repayment obligation. e. In Delaware, two factors are important: (1) likelihood the defendant will reimburse the

corporation if indemnification is determined to be inappropriate, and (2) whether the advancement would serve the corporation‟s interests.

f. This is discretionary, but corporation can bind itself by contract or can make advancement on an ad hoc basis.

i. MBCA § 8.58(a): corporation that obligates itself to indemnify to the fullest extent permitted by law must do so unless the provision specifies a limitation

ii. When advancement is not required, corporations not to advance expenses is evaluated pursuant to the business judgment rule

7. Exclusivity of Statutory Indemnification

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a. MBCA‟s provisions are exclusive, so indemnification is permitted only to the extent that the statute allows

b. Delaware is more open ended iv. Insurance

1. Policies a. Claims Made: provides coverage for claims first made against an insured during the

policy period--this is what director & officer insurance typically uses these days b. Occurrence: provides coverage for injuries that take place during the policy period

regardless of when the claim is asserted 2. Exclusions

a. Three general categories i. Conduct: seek to eliminate coverage for certain conduct which is deemed to be

sufficiently self-serving or egregious that insurance protection is considered inappropriate

ii. Other insurance: implements the concept that D&O insurance is a backstop, not the line of first defense; if the corporation can purchase other insurance to cover a specific risk, the D&O insurer expects that it will do so. (I.e., bodily risk, libel, etc.)

iii. Laser: intended to address specific risks unique to the insured corporation which the insurer has identified as inconsistent with its underwriting principles.

b. Loss is typically defined to exclude penalties imposed by law or matters uninsurable under the law pursuant to which the policy is construed (such as punitive damages, treble damages, taxes, etc.)

c. Virtually all D&O policies now exclude damages from cases brought by corporation (except for derivative suits brought without the solicitation or assistance of the insured, and for wrongful termination/contribution/indemnity claims).

d. Endorsements: custom provisions i. pending/prior litigation; look to which party is the subject of the litigation ii. regulatory exclusion: added to policies where there is concern that a financial

institution (or other similar company) may be taken over by regulators e. Premium payments for D&O policies are additional executive compensation authorized

as such or by statute (MBCA § 8.57)

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f. Corporations can buy insurance even for claims that it could not indemnify (on theory that directors could have gotten it by themselves anyways).

i. Duty of Care/Business Judgment Rule (III)--Shareholder Derivative Suits i. Generally

1. Two Suits in One a. Court must have personal jurisdiction over the individual defendants b. Many statutes hold that acceptance of directorship acts as consent to jurisdiction in that

state 2. All Recovery to Corporation

a. Any recovery goes to the corporation, so shareholders only benefit indirectly b. BUT: Shareholders can recover directly in proportion to their holdings in some situations

where the corporation is no longer in existence, or there are new owners. Similarly, close corporation derivative suits may allow for direct recovery so long as the corporation is not unfairly exposed to multiple claims, creditors not materially prejudiced, and recovery can be fairly distributed

3. Reimbursement of Successful Plaintiff‟s Expenses a. Corporation pays successful plaintiff‟s expenses, because he produced a benefit to the

corporation (MBCA § 7.46(1)). b. Effect of Rule

i. Leads to bounty hunter attorneys c. Method of Fee Calculation

i. Attorney fees generally calculated using either a percentage-of-recovery or lodestar method. Under former theory, attorney receives 15-35 percent of the recovery; lodestar, based on hours spent on suit multiplied by prevailing rate for similar legal work by similar attorney.

4. Derivative suit plaintiffs have a duty to be a faithful representative of the corporation and other shareholders

5. Shareholders who were not a part of a derivative suit may appeal even though they did not intervene/object in the trial court.

6. Some courts apply a 2-3 year limitations period for tort claims 7. In cases where the facts seem to indicate both a direct and derivative claim, the plaintiff‟s

choice usually controls, but the plaintiff cannot escape procedural restrictions of a truly derivative claim by using direct claim-like injuries.

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8. Close corporations: Many courts allow an exception where shareholders can vindicate otherwise derivative claims as direct action.

9. Class action: direct claim but also suing on behalf of others (but not the corporation). 10. Procedural requirements

a. Courts seek to avoid “strike suits” that are purely malicious b. Contemporaneous Ownership Requirement: plaintiff must have been a shareholder

when the wrong was committed (MBCA § 7.41(1)), though an exception might be allowed where an undisclosed wrong was continuing when the plaintiff acquired his shares.

i. New owners cannot sue for wrongdoing that occurred before the ownership change.

ii. Exception: shareholders of parent corporation want to sue to claim parent failed to take action against subsidiary

c. Some statutes require plaintiff to have a continuing interest, though Delaware recognizes a narrow exception where plaintiff leaves after a fraudulent or illegal merger

d. Equity shareholders usually have standing, but some statutes also allow holders of options or convertible securities

ii. Role of the Special Committee 1. Boards use “special litigation committee” comprised of disinterested directors to decide

whether suit should go forward 2. Originally, their decisions were subject to the business judgment rule 3. Cases:

a. Gall v. Exxon Corp.: SLC‟s decision to dismiss was not quite overturned; just that the plaintiff deserved discovery to determine whether the decision was in violation of the rule.

b. Cuker v. Mikalauskas: Court might stay a derivative action while it determines the propriety of the board‟s decision; might order limited discovery to look at whether: the SLC was disinterested, whether it was assisted by counsel, whether it prepared a written report, whether it was independent, whether it conducted an adequate investigation, and whether it rationally believed its decision was in the best interests of the corporation.

iii. Zapata and Aronson Tests (Delaware Caselaw)

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1. Aronson: Prevailing judicial approach: board of directors can decide fate of derivative litigation if a pre-suit demand on the board is required.

a. If the board receives a demand and refuses to act or settle the charges, its response/nonresponse receives deferential review under business judgment rule.

i. are the directors disinterested? ii. did the directors follow their duty to inform themselves prior to making a business

decision, with all material information reasonably available to them? b. Shareholder must show the board‟s response was self-interested, dishonest, illegal, or

insufficiently informed c. Demand is excused if it would be futile; directors cannot then block the suit.

2. When is demand excused as futile (Aronson)? a. Delaware has adopted two tests for demand futility; it is excused if the shareholder can

allege with sufficient particularity facts that create a reasonable doubt for either of the two:

i. doubt that a majority of the current directors on whom demand would have been made are disinterested and independent, or

ii. doubt that the challenged transaction was protected by the business judgment rule (by showing a conflict of interest, bad faith, grossly uninformed decision-making, or a significant failure of oversight).

b. Aronson: Independence not sufficiently overturned where defendant owned 47% of the outstanding stock, maybe because it was less than a majority, but even if there is a majority the directors‟ independence is not necessarily overturned--must actually be controlling the directors. Moreover, nominating a director isn‟t enough--it is the care, attention, and sense of individual responsibility to the performance of one’s duties, not the method of election, that generally touches on independence.

3. Once a shareholder makes a demand, he cannot bring a derivative suit unless he can show the board‟s rejection was wrongful (was not made in good faith after a reasonable investigation, Spiegel v. Buntrock), and a shareholder who makes a demand cannot later assert that demand should have been excused ( Levine v. Smith). Thus, making a demand effectively places fate of derivative suit in the hands of the board.

4. Levine also shows that judicial review of a decision rejecting demand is subject to the same pleading standard established in Aronson for whether demand was excused.

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5. Zapata: When Demand is Excused as Futile, Courts listen to the SLC but with suspicion; court has two-party inquiry into whether the recommendation to dismiss would be respected; this test has limited scope because Aronson made demand required in a large number of cases.

a. Procedural Inquiry: defendants must carry burden of showing the committee members independence from the defendants, their good faith, reasonable investigation, and the legal and factual bases for the committee‟s conclusions. If there is a genuine issue of material fact as to any of these counts the derivative litigation proceeds (In re Oracle Corp. Derivative Litigation, where there was lack of independence despite being composed of unnamed board members/reputable outsiders because of long-standing professional/academic relationships with the principal defendants--“our law should not ignore the social nature of humans...our law cannot assume that corporate directors are generally persons of unusual social bravery...”).

b. Substantive Inquiry: Even if SLC‟s recommendation passes the first stage, the trial judge may apply his own independent business judgment as to whether the suit should be dismissed.

iv. RMBCA Solution to Delaware‟s Gordian Knot 1. Demand Requirement--Exhaustion of Internal Remedies

a. Many statutes require demand in all cases b. MBCA § 7.42: shareholder must wait 90 days before filing suit, unless the board rejects

the demand or waiting would result in irreparable injury to the corporation. i. Gives board a chance to take a corrective action, and avoids difficult question of

whether demand is excused ii. Does not answer what substantive effect is given to board‟s rejection or refusal to

bring suit c. If board rejects demand, the plaintiff must plead with particularity that either the board‟s

rejection of the demand was not disinterested or the rejection was not in good faith or not informed (similar to the Delaware Aronson approach)

2. Board Rejection: MBCA § 7.44(a), (b)(1): board can move for dismissal if independent directors constitute a quorum and a majority of independent directors determine in “good faith” and after a “reasonable inquiry” that maintaining the suit is not in the corporation‟s best interests.

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a. Independence is defined similar to the courts‟ approach; MBCA § 7.44(c): director not disqualified merely because he is named as a defendant, was nominated or elected to the board by defendants, or approved the challenged transaction.

3. SLC: Committee of at least two independent directors may seek dismissal after shareholder makes obligatory pre-suit demand; if the committee was appointed by a majority of independent directors, MBCA requires court to dismiss action under the same standards as board dismissal: requires SLC to dismiss in “good faith” after a “reasonable inquiry” that maintaining the suit is not in the corporation‟s best interest. MBCA § 7.44(a), (b)(2)

a. Defendant not unqualified merely because he is named as a defendant, was nominated or elected to the board by defendants, or approved the challenged transaction. (MBCA § 7.44(c)).

4. Court Approval of Settlement--A Clean Solution a. MBCA § 7.45: require judicial approval before a derivative suit can be settled,

discontinued or dismissed. i. Proponents of the settlement have burden to show it is fair and reasonable to the

corporation. b. Court has broad discretion to consider:

i. terms of the settlement, including corporation‟s recovery and reimbursement of expenses to the shareholder-plaintiff/individual defendants; and

ii. the outcome that might have come from trial, discounted by the inherent uncertainty of litigation, costs caused by the delay of trial, additional litigation expenses the corporation might be required to pay, etc.

iii. MBCA § 7.45: court required to notify nonparty shareholders and solicit their comments; in large public corporations it may do so through a sampling of shareholders

j. Duty of Loyalty--Self-Dealing i. Generally

a. Fiduciaries cannot serve two masters b. Corporate fiduciaries breach their duty of loyalty when they divert corporate assets,

business opportunities, or proprietary information for personal gain c. Flagrant Diversion: simply stealing tangible corporate assets, since the diversion was

unauthorized and corporation received no benefit in the transaction. Corporation can disaffirm the transaction as unauthorized and sue for breach of fiduciary duty and in tort.

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d. Self-Dealing: When fiduciary enters into a transaction with the corporation on unfair terms, the effect is the same as if he had appropriated the difference between the transaction‟s fair value and the transaction‟s price.

i. Parent corporation that controls a partially owned subsidiary can breach its duty to the minority shareholders of the subsidiary if the parent prefers itself at the expense of the minority.

e. Executive Compensation: when director/officer sells his executive services to the corporation, diversion can occur if his compensation exceeds a fair value

f. Usurping Corporate Opportunity: When corporate fiduciary seizes a desirable business opportunity that the corporation may have taken and profited from and the diversion denies the corporation to expand profitably.

g. Disclosure to Shareholders: When directors/officials provide false or deceptive information on which they rely to their detriment that undermines corporate credibility/transparency, and frustrates shareholders‟ expectations of fiduciary honest and accountability. Disclosure duties arise when directors seek a shareholder vote.

h. Trading on Inside Information: When fiduciary is aware of confidential corporate information, such as the impending takeover of another company, and he buys the target‟s stock, diversion can occur if the fiduciary‟s trading interferes with the corporation‟s takeover plans. Similarly, where fiduciary diverts to himself information belonging to the corporation.

i. Selling Out: Corporate official accepts a bribe to sell her corporate office breaches a duty to the corporation; also applies to controlling shareholder who sells his interest to new owner who diverts assets to himself.

j. Entrenchment: manager uses corporate governance machinery to protect his incumbency effectively diverts control from the shareholders to himself. Can be flatly prohibited (insider trading), others receive searching judicial fairness review (squeezeouts), and others are subject to internal corporate safeguards (executive compensation).

2. Fiduciary Duties are owed to the corporation and not to particular shareholders (so must be enforced in the name of the corporation--DERIVATIVE).

3. Independent Directors (see Palmiter 223-227) ii. Duty of Loyalty Under Delaware Corporate Law

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1. Statutory Safe Harbor if: (1) disclosure to disinterested directors, approved in good faith by a majority of disinterested directors; (2) shareholders entitled to vote and approved in good faith by a majority (if disinterested--business judgment rule, if not disinterested then prove fairness under Fleigler), (3) transaction is fair (3) intrinsic fairness test.See Delaware § 144 (pg. 604) if necessary.

2. Fliegler v. Lawrence: Ratification by majority of shareholders not legitimate if a majority is comprised of interested directors (and no proof of disinterested shareholders voting with the directors), thus burden of proof remains with the defendants. However, defendants did offer enough proof that the transaction was fair. In other words, legitimate shareholder ratification can switch the burden of proof back to a plaintiff to prove the transaction was not legitimate; can therefore reset the standard back to the business judgment rule.

3. Marciano v. Nakash: § 144 is not the only way to validate a self-interested transaction; if there is shareholder deadlock then it‟s subjected to the intrinsic fairness test. Suggests that the statute does in fact create a safe harbor if approved by fully informed, disinterested, and independent directors or shareholders.

iii. Treatment of Self-Dealing Transactions Under the RMBCA 1. Nature of Self-Dealing

a. Direct Interest: MBCA § 8.60(1)(i): Corporation and director are parties to the same transaction.

b. Indirect Interest: When corporate transaction is with another person or entity in which the director has a strong personal or financial interest

i. MBCA § 8.60(1)(i), (3): with the director‟s close relatives, defined as spouse/child/grandchild/sibling/parent/family trust

ii. MBCA § 8.60(1)(i), (ii): with an entity in which the director has significant financial interest (or in which he is a director/partner/agent/employee)

iii. MBCA § 8.60(1)(ii): between companies with interlocking directors (but in the case of parent-subsidiary relationship, duties are subsumed in the question of duties of the controlling shareholder).

c. Judicial Suspicion of Self-Dealing Transactions: i. Modern corporate law allows self-dealing when fair to the corporation ii. Substantive and Procedural Tests

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1. Substantive: focuses on the transaction‟s terms and measure whether the interested director advanced his interests at the expense of the corporation.

2. Procedural: focuses on the board‟s decision-making process to measure whether the approving directors are disinterested in the transaction and independent of the influence of the interested director.

iii. Burden of Proof: Once challenger shows existence of director‟s conflicting interest in a transaction, burden generally shifts to the party seeking to uphold it to prove the transaction‟s validity. (MBCA § 8.621(b)(3).

iv. No Business Judgment Presumption: Deals normally subject to it are subject to intense judicial review, but it still applies to disinterested, independent directors who approve a self-dealing transaction in good faith.

v. Self-Dealing by Officers and Senior Executives: Subject to the same standards as directors, and may even be held to a higher standard.

d. Judicial Fairness Tests i. Substantive “Fairness”

1. Examines whether director‟s interests won out over the corporation‟s interests, courts accept fairness of self-dealing if the court concludes the transaction was in the corporation‟s best interests. Two aspects:

a. Objective test: the transaction must replicate an arm‟s-length market transaction by falling into a range of reasonableness; courts carefully scrutinize this.

b. Value to the Corporation: transaction must be of particular value to the corporation, as judged by its needs and the scope of its business.

2. Some cases suggest the degree of review shifts according to the degree of self-interest

3. MBCA §§ 8.60(1)(ii), 8.61(a): treats interlocking-director transaction as a “director‟s” conflicting interest transaction only if so significant that it would normally require board approval.

ii. Procedural Fairness--Three major elements: 1. Disclosure to the Board:

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a. Even when a self-dealing may be fair on the merits, courts have invalidated if there was outright fraud in connection with its approval.

b. When there is no fraud, only inadequate disclosure, courts have used a number of approaches: some require full disclosure as a factor bearing on its fairness, others require there to be disclosure only of the conflict of interest to put the board on notice, others require full disclosure of all material information including the profit the interested director stood to make in the transaction.

2. Composition of the Board that approved the transaction: a. Some courts have upheld self-dealing transactions approved by

disinterested directors with a less exacting standard of fairness that approximates the business judgment rule.

b. Others have held a presumption of fairness and shifted the burden of proving unfairness to the plaintiff, if the self-dealing is approved by a majority of disinterested directors.

c. Directors approving the transaction must be both disinterested and independent (Orman v. Cullman). Disinterested if no direct or indirect financial interest that would affect his judgment; independent if neither beholden to nor dominated by the interested director.

d. MBCA § 8.60: “qualified director” is one who is not a party to the transaction and does not have beneficial financial interest that would influence the director‟s judgment, and no relationship that would influence his vote on the transaction.

3. Role of the Interested Director a. Generally, interested director is allowed to

negotiate/participate/vote without necessarily undermining the transaction‟s validity. (MBCA § 8.31).

b. It may, however, evidence that the interested director dominated the other directors, undermining the advantage of disinterested approval.

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c. Many modern statutes facilitate disinterested approval by easing quorum requirements for self-dealing transactions; some dispense with the requirements if the transaction is approved by a majority of (but at least two) disinterested directors. (MBCA § 8.62(c), former § 8.31(c)).

iii. Shareholder Ratification 1. Courts have shown deference to self-dealing transactions

approved/ratified by a majority of informed/disinterested shareholders 2. Majority Ratification

a. Most courts do not require fairness showing where a majority of the shares are cast by informed shareholders who neither have an interest in the transaction nor are dominated by those who do.

b. Instead, courts review under the business judgment rule and shift the burden to the plaintiff to show the transaction was wasteful

c. Delaware courts have followed this where the self-dealing was by a noncontrolling shareholder. (In re Wheelabrator Technologies Litigation). When it‟s a controlling shareholder, ratification is less cleansing and only shifts the burden to show unfairness to the challenger. (Kahn v. Lynch Communication Systems).

3. MBCA § 8.63(b): shares voted by an interested shareholder are not counted for purposes of shareholder ratification.

4. Unanimous Ratification: if the transaction is ratified by all shareholders, courts will not set aside the transaction even under a waste standard so long as there is no injury to creditors. But depends on whether there was full disclosure of the conflicting interest.

e. MBCA Subchapter F i. MBCA § 8.61(b) validates a director‟s conflict-of-interest transaction if

1. disclosed to and approved by a majority (but not less than two) of qualified directors (MBCA § 8.62), or

2. disclosed to and approved by a majority of qualified shareholders (MBCA § 8.63), or

3. established to be fair, whether or not disclosed (MBCA § 8.61)

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ii. Judicial review of this is limited to the “care, best interests, and good faith criteria” of MBCA § 8.30, which may be less deferential than business judgment; original comment suggested asking whether the transaction was manifestly unfavorable to the corporation.

iii. Judicial review is limited to the approval process--not a substantive review. iv. Not all states include this subchapter.

f. ALI Principles i. ALI Principles § 5.02: Also adopt a safe harbor approach, under which director

self-dealing is valid if after full disclosure: 1. a court finds the transaction was fair when it was entered into, or 2. a majority of disinterested directors (not less than two) approved or ratified

the transaction, or 3. a majority of disinterested shares approved or ratified the transaction

ii. Diluted judicial review of the substance of a self-dealing transaction validated by disinterested directors; must conclude the transaction “could reasonably be believed to be fair to the corporation.” Burden is on the challengers.

g. See pages 273-74 for a summary chart h. Remedies for Self-Dealing

i. General Remedy--Rescission 1. returns parties to their position before the transaction 2. normally, corporation cannot seek to renegotiate the terms of the

transaction by retaining the transactions benefits but at a lower price ii. Exceptions to Rescission:

1. May be entitled to damages, since rescission may not right the wrong 2. Where director takes a corporate opportunity that belonged to the

corporation, forcing it to choose between disaffirming the opportunity or accepting it (and forgoing a claim for the director‟s profits) would allow him to take a profit that belongs to the corporation.

a. Corporation can require that director account for any profits he made in the deal.

b. New York Trust Co. v. American Realty Co.: director resold to the corporation at a significant profit timberland he had purchased only a few months before. Corporation chose not to rescind, court held

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that the director could be liable on an “agency” (or “corporate opportunity”) theory without the transaction being rescinded.

iv. Challenges to Payments to Executives 1. Forms of Executive Compensation

a. Salaries and bonuses: usually set annually, provide compensation for current services b. Stock plans: based on stock value, create incentives for executive performance;

purpose is to align management and shareholder interests by pegging compensation to the stock price

i. Stock grant: provides shareholding stake but dilutes other shareholding interests ii. Stock option: gives executive the option during a specified period to buy a

specified amount of the company‟s stock at a fixed price. iii. Phantom stock plans/stock appreciation rights: similar but corporation does not

have to issue stock; executive is credited with units on the corporation‟s books, and the value of the units rises or falls with the market price

c. Pension plans: deferred compensation. 2. Judicial Review

a. Dilemma of Executive Compensation: i. Compensation must be authorized

1. Shares for stock-based compensation must be authorized in the articles (MBCA § 2.02)

2. Transactions involving corporation‟s stock require board approval (MBCA § 6.24).

3. May require shareholder approval for stock options if, when exercised, would result in substantial dilution of existing shareholders (MBCA § 6.21(f)).

4. Large corporate boards often delegate compensation tasks to a compensation committee of outside directors (MBCA § 8.25(d)).

b. Disinterested Approval Avoids Fairness Review i. Compensation not subject to fairness review if informed, disinterested,

independent directors approved the compensation. (MBCA § 8.62(a)). ii. Board must be aware of all material information related to the compensation, and

interest executive cannot dominate board‟s decision making.

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iii. Modern cases hold that ratification cleanses the transaction and shifts the burden to the shareholder challenger to show waste

iv. In closely held corporations, often turns on ratification by a majority of informed, disinterested shareholders.

c. Prevailing Standard--Waste i. If compensation approved by disinterested and independent directors, courts

invoke the business judgment rule; challenger must show either that the board was grossly uninformed or that the compensation was a waste of corporate assets--that it had no relation to the value of the services promised and was a gift. (Beard v. Elster).

d. Fair and Reasonable Compensation i. When compensation is subject to fairness review, judicial scrutiny is substantial;

court assumes the function of the board and assesses whether the challenged compensation is fair and reasonable to the corporation, taking into account the relation of the compensation to his qualifications, corporation‟s complexities/revenues/earnings/etc., likelihood incentive compensation would fulfill its objectives, compensation paid in similar circumstances.

ii. This scrutiny arises mostly for compensation in close corporations. 3. Directors‟ Compensation: Fees authorized by disinterested shareholders are reviewable only if

they constitute waste (MBCA § 8.61). 4. Case: Heller v. Boylan: example of high executive compensation, but the court would not

impose its own limitations on it because (1) the amount was approved by an overwhelming amount of shareholders in a bylaw, and (2)

v. Treatment of Parent-Subsidiary and Squeeze-Out Transactions Under Delaware Law 1. Dealings with Wholly Owned Subsidiaries

a. Parent has great control over what it can do with the subsidiary, though it does have duties to corporate creditors and, to a limited extent, future minority shareholders.

2. Dealings with Partially Owned Subsidiaries a. Statutes provide little guidance b. Most conflict-of-interest statutes covering transactions where director has a relationship

to another situation do not include parent-subsidiary situations 3. Judicial Review of Parent-Subsidiary Dealings

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a. Most courts (including Delaware) agree that parent corporation should be able to exercise its control: dealings in the ordinary course of business are subject to fairness review only if the minority shows the parent has preferred itself at the minority‟s expense.

i. If that is the case, court presumes the parent dominates the subsidiary‟s board and places burden on parent to prove the transaction was “entirely fair” to the subsidiary.

ii. If there is no preference for the parent, transaction is subject to the business judgment rule and the minority must prove the dealings lacked any business purpose or that their approval was grossly uninformed.

b. Sinclair Oil v. Levien: Minority shareholders of Sinven, a partially owned (97 percent) Venezuelan subsidiary, challenged three dealings. (1) High dividend policy argument was unsuccessful because court found the minority received their proportionate amount and, therefore, it was subject to the business judgment rule. (2) Parent‟s allocation of projects to other wholly owned subsidiaries were not corporate opportunities and had no obligation to share them. (3) Court did find self-dealing where Sinven did not enforce contracts for sale of oil to other Sinclair subsidiaries, and that Sinclair failed to show this was fair.

i. Levien rule: assumes the propriety of parent-subsidiary dealings, and the burden is on the minority shareholders to show the dealings were not those that might be expected in an arm‟s length relationship.

c. Exclusion of Minority i. Controlling shareholders have fiduciary duties to minority shareholders (and thus,

subject to business judgment rule). d. Approval of a majority of informed, disinterested shareholders insulates a parent-

subsidiary transaction; thus, if the parent discloses the conflict and terms of the transaction, it is subject to review only under a waste standard

e. Remedies: Parent-Subsidiary Transactions: rescission is the general remedy unless that‟s no longer possible; Controlling shareholders: minority shareholders can sue directly and seek equal treatment in the transaction or recovery based on what it would have received absent the breach.

4. Squeeze-Out Transactions--Eliminating Minority Interests a. Squeeze-Out Mechanics

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i. Can use mergers, liquidation, or reverse stock split ii. Beneficial because it allows the parent to use subsidiaries‟ assets as it pleases,

consolidate for taxes, etc. b. Business Purpose Test

i. Some Courts require that the transaction not only be fair, but the parent also have some business purpose for the merger--other than eliminating the minority.

ii. This test has been criticized for being too weak; Delaware has abandoned it and uses “Entire Fairness” test

c. Entire Fairness Test i. Weinberger v. UOP: In Delaware, squeeze-out mergers are subject to a two-

prong entire fairness test: 1. Test

a. Fair Price: characterized fair price as the preponderant consideration, and held that valuation must take into consideration “all relevant factors,” including discounted cash flow: looks at anticipated future cash stream and, after making some assumptions, figures how much present cash would produce that future stream.

b. Fair dealing: relates to when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors were obtained. Court strongly recommended the subsidiary board form an independent negotiating committee of outside directors to represent the minority shareholders.

2. Court faulted the cash out merger procedures because the parent went for $21 per share despite having studies indicating that $24/share would be a good investment (and not disclosing that information to the outside directors).

ii. Post-Weinberg fair dealing cases: 1. Court has clarified some aspects of the “fair dealing” test:

a. Negotiation by a team of the subsidiary‟s outside directors significantly buttresses procedural fairness, particularly when the

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directors are well informed and negotiations are adversarial. (Rosenblatt v. Getty Oil Co.)

b. Approval by a committee composed of independent directors shifts the burden to the challenger to show lack of entire fairness. (Kahn v. Lynch Communication Sys., Inc.).

c. Committee members must be independent and become fully informed, actively participate in deliberations, and appropriately simulate an arm‟s-length negotiation. (Kahn).

d. Parent need not disclose internally prepared valuations (its reservation price) unless directors or officers of the subsidiary prepare them; only when executives have overlapping roles must the parent do so. (Rosenblatt).

e. Approval by minority shareholders, after full disclosure, buttresses (but does not guarantee) procedural fairness and shifts burden to the challenger to show a lack of entire fairness

f. Squeeze-out merger, even if share price is within range of fairness, may not be purposely timed by the parent to avoid an obligation to pay a higher contract price.

2. Post-Weinberger “Fair Price” Cases a. Price paid to minority shareholders, if supported by outside fairness

opinion and asset valuations by experts, can be calculated using old Delaware block method if so desired. (Rosenblatt).

b. Fair value can be based on opinions of the parent‟s investment banker, even though the subsidiary‟s committee has received opinions of higher value from other investment bankers. (Kahn).

c. Price fairness must take into account all relevant factors; speculative elements are not considered, but projections susceptible of proof may be considered.

iii. Remedy in Squeeze-Outs: rescissions often not possible 1. Appraisal Exclusive: shareholders not necessarily entitled to damages

even if they can prove the squeezeout was unfair; appraisal rights may be the remedy when merger is challenged on the basis of price.

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2. Consolidated Proceedings: Plaintiff limited to single remedy but can bring new suits based on new evidence

3. Director Liability: directors with greater financial expertise bear a higher fiduciary duty to recognize and oppose a transaction they have strong reasons to believe is financially unfair.

iv. Fairness in Parent Tender Offer: for a parent tender offer not to be coercive, it must (1) be subject to a “majority of minority” tender condition, (2) include a promise to engage in a prompt back-end merger at the same price as the tender offer, and (3) not involve retributive threats.

k. Duty of Loyalty--Corporate Opportunity and Competition: corporate opportunity doctrine (subset of duty of loyalty) balances the corporation‟s expansion potential and the managers‟ entrepreneurial interests

i. Corporate Opportunity Doctrine 1. Prohibition Against Usurping Corporate Opportunities

a. Rule: manager (director or executive) cannot usurp corporate opportunities for his own benefit unless the corporation consents

b. Plaintiff has the burden of proving the existence of a corporate opportunity c. Remedies: Director must share the fruits of the opportunity as though the corporation

had taken it. Remedies include (1) liability for profits realized by the director, (2) liability for lost profits and damages suffered by the corporation, and (3) imposition of a constructive trust on the new business or the subject matter of the opportunity. Rescission is not available unless the third party had notice of the insider‟s wrongdoing.

2. What is a Corporate Opportunity? a. Use of Diverted Corporate Assets

i. Fiduciary cannot develop business opportunity using assets secretly diverted from the corporation. Real evil is not that the director took opportunity for himself, but rather that he took something that belonged to the corporation to do it. (Guth v. Loft, Inc.).

1. Some courts, however, have refused to impose a constructive trust if the opportunity was one in which the corporation did not have an interest or expectancy. (Lincoln Stores v. Grant).

b. Existing Corporate Interest--Expectancy Test i. Corporate Expectancies do not rise to the level of an ownership interest;

expectancy exists if corporation is negotiating to acquire a new business or an

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exec. learns of a business offer directed to the corporation (Thorpe v. CERBO, Inc.).

ii. For example, look for manager keeping an opportunity a secret (suggesting the corporation would have had an interest).

iii. Expectancy also covers opportunities of special/unique importance to the corporation for which there is a presumed expectancy; for example, corporation‟s avowed interest in finding a new headquarters site or in acquiring patents necessary for its business.

iv. Directors may also be liable for misappropriating soft assets (goodwill/confidential information), but if the opportunity came to the manager in his individual (not corporate) capacity, courts may be reluctant to find the opportunity was corporate. (Broz v. Cellular Information Systems, Inc.).

v. Case: Northeast Harbor Golf Club, Inc. v. Harris: Corporate opportunity when country club president acquired for herself property adjacent to club‟s golf course, which real estate agent had offered to her in capacity as president on the assumption the club would be interested.

c. Corporation‟s Existing Business i. Some courts use broad “line-of-business” test to measure the reach of

corporation‟s expansion potential. (Guth v. Loft, Inc.); courts compare the new business with the corporation‟s existing operations.

ii. Corporation need not learn of the opportunity in his corporate capacity; if the project is functionally related to the corporation‟s existing or anticipated business, he must obtain consent before exploiting it.

iii. Functional relation exists if there is a competitive or synergistic overlap suggesting the corporation would have been interested in taking the opportunity. (Miller v. Miller).

d. Eclectic Approaches i. ALI Principles: comprehensive approach; begins with definition combining the

narrower expectancy test and the line-of-business test. 1. ALI: corporate executives are subject to line-of-business and expectancy

restrictions, while outside directors are subject only to expectancy restrictions.

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ii. Fairness Test: Some courts go beyond the two prevailing standards and add a flexible “fairness test.” (Lewis v. Fuqua). In this context, “fairness” focuses on the fairness of holding the manager accountable for his outside activities.

1. For instance, in Miller v. Miller, fairness test recognized that no harm came to the corporation and the new business game the corporation a captive market for its products

iii. Multiple Boards: Courts have shown sensitivity to problems of serving on two boards

1. Consider Broz v. Cellular Information Systems, Inc.: director had his own cell company that served Michigan, and was an outside director for another company that served the Midwest. Opportunity came up to buy a license from a company in Michigan, Broz offered it to CIS but they declined it; soon thereafter, CIS was bought out and bid on the license but Broz upped his bid and won. Court found no taking of corporate opportunity--no expectancy (third-party license holder had not considered CIS a viable candidate for the license); CIS was wholly aware of Broz‟s duties to his own company.

3. Corporate Rejection and Incapacity a. Even if there is an opportunity, that is negated if the corporation rejects it. b. Corporate Rejection:

i. Corporation can relinquish its interest by generally renouncing any interest in categories of business opportunities or by rejecting a specific deal.

ii. MBCA § 8.70: permitting qualified directors or shareholders to disclaim corporation‟s interest in opportunity

iii. Corporation‟s rejection of a specific deal can be a self-dealing transaction because of the possible conflict between the manager‟s and corporation‟s interests; some courts subject rejection to a fairness review and require rejection by informed, disinterested directors (Telxon Corp. v. Meyerson).

iv. Other courts have held that informal acquiescence to the taking constitutes rejection

v. Courts have sometimes folded together questions of corporate consent and the existence of an opportunity. Burg v. Horn: part-time managers of a closely held firm acquired other properties with the tacit consent of the co-shareholder; since

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there was acquiescence and the properties hadn‟t been offered to the firm, there was no usurpation.

c. Corporate Incapacity: i. Many courts allow defendants to argue that corporation could not have taken the

opportunity because it was financially incapable or otherwise unable to do so. ii. Does not matter if the director failed to inform the board; question of incapacity is

left to the court. 1. slippery argument: corporation can always argue that it could have found

funds somehow 2. Because of this speculative nature, some courts have rejected this

approach 3. Delaware does follow this, however; Broz was a Delaware case.

iii. ALI Principles: disclosure-oriented approach, mandates informed corporate rejection: (1) manager must have offered the opportunity to the corporation and disclosed his conflicting interest, and (2) the board or shareholders must have rejected it. (ALI § 5.05(a)).

1. If disinterested directors rejected the opportunity, board‟s action is subject to the business judgment rule.

2. If disinterested shareholders reject it, subject to the waste standard. 3. If rejection is not disinterested, or challenger shows lack of business

judgment or waste, defendant must prove the taking was fair to the corporation (ALI § 5.05(a), (c)).

4. Klinicki v. Lundgren: court applied this standard to the president of a closely held air transport company who secretly took for himself a contract for a new air charter business. Court refused to consider that the corporation lacked the financial ability to undertake the contract because it had never been presented to the corporation.

d. Competition with the Corporation i. Subject to special treatment; in general, managers may not compete with the

corporation unless there is no foreseeable harm caused by the competition or disinterested directors (or shareholders) have authorized it.

1. Applies regardless of whether the competing business is set up during the manager‟s tenure or was preexisting

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ii. Goes beyond duties of corporate opportunity doctrine; can be violated because of preexisting businesses, and can be done without violating the misappropriation or expectancy theories.

iii. Remedy: manager may be liable for damages for any competitive losses suffered by the corporation, but the manager need not share the competing business unless setting it up usurped a corporate opportunity

1. Other liability theories: (1) breach of contractual covenant not to compete, (2) misappropriation of trade secrets, (3) tortious interference with contractual relationships if the manager induces the corporation‟s customers/employees to follow him.