Corporations, Kraakman, Fall 2012 Harvard Law School

The Law of Agency

Intro to Agency

Agency is the simplest form of joint economic undertaking and is therefore a foundational concept upon which much of corporate law is built.

Types of Agency

Restatement (3) Agency 1.01: Agency is the fiduciary relationship that arises when a principal manifests assent to an agency that the agent shall act on the principals behalf and subject to the principals control, and the agent manifests assent or otherwise consents to so act. Agent can bind principal in tort, contract, and even criminal lawRestatement (3) Agency 1.02: Usage of the term is not dispositive in determining whether a relationship is one of agency. (See also Jensen Farms v. Cargill)Scope and form of agency:

Rest. (3) Agency 2.02: Scope of authority includes the things that the principal told the agent to do, as well as anything necessary or incidental to it, as a reasonable person would understand that.

Delegation of authority can differ in scope between a:

Special agent, who is only empowered for a particular act/transaction, or

General agent, who is delegated authority over a series of acts/transactions

Rest. (3) Agency 1.04(2): Perception of 3rd parties when dealing with an agent:

Disclosed Principal, where 3rd parties know that the agent is acting on behalf of a known principal,

Partially disclosed Principal, where 3rd parties know they are dealing with an agent, but dont know whom he/she represents, or

Undisclosed Principal, where 3rd parties assume that the agent is the principal.

Level of principals control over the agent can vary, being either:

Employee, wherein the principal exercises significant control (and is vicariously responsible for torts committed within the scope of the employees employment, Rest. 2.04)

Independent Contractor, wherein the principals control is limited and the agent exercises much discretion; e.g. building contractor

TerminationRestatement (3) Agency 306: Agency can terminate based on death or cessation of existence of the principal or agent, loss of capacity, express revocation, or events that lead to the reasonable conclusion that principal no longer assents to agents actions.

Either the principal or the agent can terminate an agency relationship at any time.

If the agency relationship was set up for a term, then actions for breach of contract damages may arise, but in no case will the remedy be specific performance of the agency if one person wants out, there can be no agency. (See Rest. 3.10(1))

Jenson Farms Co. v. Cargill (when is an agency created)

Facts: Cargill contended that it was not the principal for Warren Grain & Seed Co by virtue of its course of conduct, and, therefore, could not be held jointly liable with Warren for Warrens contract defaults with creditors.

Holding: An agency is created through a course of conduct where the facts, taken as a whole, show that 1) one party has manifested consent that another party be its agent; 2) the second party acts on behalf of the first party; 3) the first party exercises control over the second party. An agency requires an agreement, but not necessarily a written contract the existence of an agency may be proved by circumstantial evidence. Warren acted on Cargills behalf in procuring grain for Cargill; Cargill financed this operation; Cargill exercised more than normal control over Warren (making key operating decisions in a way not typical of a normal financier); Cargill loaned money not to benefit from interest but to obtain a source of market grain.

Comment 1: Apparent consent manifestation by actions or by the failure to act of an agreement of the minds (or of the acquiescence by one party to the will of another)Comment 2: Warren was subject to the control of Cargill, as demonstrated by a series of factual findings: Right of first refusal, inability for Warren to assume debt without consent of Cargill, Cargill's right of entry to Warren, criticism by Cargill over Warren's actions, Cargill's determination that Warren needed strong paternal guidance the Court recognizes that these are not inherently more than a debtor relationship individually, but together, in light of all the circumstances, it shows an agency relationship.

Actual and Apparent Authority

Power to bind (Rest. 6.01-6.03): The Agent has the authority to bind the Principal and the 3rd Party together in contract.

Actual authority (Rest. 2.01; 3.01): Actions that the principal delegated to the agent, as the agent reasonably believes at the time of the action.

Can be express, implied, or incidental (Rest. 2.01(1)).

Incidental means that it is necessary or incidental in relation to the task expressly authorized.

Apparent authority (Rest. 2.03): Actions a 3rd party reasonably believes have been delegated to the agent, based on the manifestations of the Principal (but not claims of authority by the agent). See White v. Thomas.

White v. ThomasFacts: White (D) contended that his agent, Simpson, did not have apparent authority to enter into a contract for the sale of land to Thomas (P), and that, therefore, an order of specific performance of the contract was erroneous. Simpson had been authorized only to buy not to sell land.

Holding: In the absence of a principal and any indicia that an agent has authority to engage in a specific action on the principals behalf, the agent does not have apparent authority to engage in such action merely because the agent asserts she has such authority. While the declarations of an alleged agent may be used to corroborate other evidence of the scope of agency, neither agency nor the extent of the agents authority can be shown solely by her own declarations.

Comment: Purchasing and selling are not so closely related that a third person could reasonably believe that authority to do the one carries the authority to do the other.

Apparent Authority: The authority granted to an agent to act on behalf of the principal in order to effectuate the principals objective, which may not be expressly granted, but which is inferred from the conduct of the principal and agent.

Principal can also be bound by estoppel when 3rd party detrimentally relies on expectation of agency relationship and Principal doesnt notify them. (Rest. 2.05, 2.06.) This also works as replacement inherent authority, which Rest. 3rd abolishes.

Inherent Authority Inherent authority is not conferred on agents by principals but represents consequences imposed on principals by the law.

Inherent power gives a general A the power to bind a P, whether disclosed or undisclosed, to an unauthorized K as long as a general A would ordinarily have the power to enter such a K and the third party does not know that matters stand differently in this case. Rest. 2nd Agency 161, 194.

Rest. 3rd Agency does not have provisions exactly matching inherent authority. Instead, Rest. 3rd replaces it with estoppel-type rationales, which lead to similar results in cases like Gallant v. Isaac. Rest. 3rd 2.06.

Gallant Ins. Co. v. Isaac

Facts: Gallant, an insurer, contended that its agent, Thompson-Harris, did not have inherent authority to bind Gallant on an insurance policy issued to Isaac.

Holding: An agent has inherent authority to bind its principal where the agent acts within the scope of its authority, a third party can reasonable believe that the agent has authority to conduct the act in question, and the third party is not on notice that the agent is not so authorized.

Comment: The doctrine of inherent authority gives a general agent the power to bind a principal, whether disclosed or undisclosed, to an unauthorized contract as long as a general agent would ordinarily have the power to enter such a contract and the third party is not on notice that the agent is not so authorized. This theory has been criticized as an unwarranted shift in the traditional balance of monitoring costs between principals and third parties. Inherent authority is extra useful when P is undisclosed (cant look to what the apparent authority is).

Agency Liability in Tort

Rest. 3rd Agency 2.04; 7.07(1): Employers are subject to liability for torts committed by employees acting within the scope of employment, defined in 7.07(2) as subject to employers control (respondeat superior). Principals liability to 3rd party for Agents behavior (7.03) results when:

Agent acts with actual authority (7.04); When Agent acts with apparent authority (7.08); When Principal negligently selected Agent (7.05(1)); When Principal has duty, and Agent does not fulfill it (7.06).Employees as used above are to be contrasted with independent contractors. Independent contractors do not cause vicarious liability for the Principal through their torts; rather, they retain liability themselves.

An independent contract is a party undertaking a particular assignment while retaining control of the manner in which it is executed.

Humble Oil & Refining Co. v. MartinFacts: Martin was injured when a car rolled out of a service station owned by Humble. Martin sought to hold Humble liable for the station operators negligence.

Holding: Although a party is not normally liable for the torts of his contractors, said party may be liable for a contractors torts if he exercises substantial control over the contractors operation. In this case, Humble set the hours of the service station, paid some of the operating expenses, mandated much of the day-to-day operations, etc.

Comments:

When the party so substantially controls the manner of the contractors operations, the contractor relationship breaks down and a master-servant relationship is formed.

According to the R2 Agency, a master-servant relationship is one in which the servant has agreed to work and also to be subject to the masters control. An independent contractor, by contrast, agrees to work but is not under the principals control insofar as the manner in which the job is accomplished. In general, liability will not be imputed to the principal for torts of an independent contractor.

Humble is paying a lot of money they are probably engaged in a lot of supervisory work

Hoover v. Sun Oil Co.Facts: Hoover sought to hold franchisor Sun Oil responsible after he was injured in a fire at a service station franchise operated by Barone.

Holding: A franchisee is considered an independent contractor of the franchise if the franchise retains control of inventory and operations. The test is whether the franchisor retains the right to control day-to-day operations. Here, Barone retained full control of inventory stocked.

Comment: Different courts are split as to which factors would lead to a result of vicarious liability. Barone controls his own costs, is more of a real entrepreneur. He would be the one more able to prevent the accident in this case.

Tort Liability and Apparent Authority

Rest. 3rd Agency 7.08 & Comments. It is also possible to be liable for tort under Apparent Authority doctrine. The classic case of tort liability in agency cases is fraudulent statements to the market about the status of merger talks.

Agency and Duties

The Agents Duties Duty of care and duty of loyalty

Rest. 3rd Agency 8.01: An Agent has a fiduciary duty to the Principal

Rest. 3rd Agency Comment to 8.01; Remedy for breach of fiduciary duty: Remedies for breach of fiduciary duty can include tort remedies, invalidation of the transaction, and forfeiture of the Agents benefit (both from the real principal and the second, illegal principal. The real principal can claim back both benefits.)

Rest. 3rd Agency 8.02: An Agent has a duty not to acquire a material benefit from a 3rd party arising from actions taken on the Principals behalf. (Tarnowski v. Resop). Duty of loyalty

Rest. 3rd Agency 8.03: An Agent has a duty not to deal with the Principal as or on behalf of an adversary in transactions connected to the agency relationship. (Tarnowski v. Resop) Duty of loyalty

Rest. 3rd Agency 8.06(1): Conduct that would breach the duties stated above is not a breach of duty when the Principal consents, provided that in obtaining the consent the Agent acted in good faith, disclosed all material facts, and otherwise dealt fairly with the Principal and the Principals consent concerns activity that could be expected to arise in the course of the agency relationship.

Rest. 3rd Agency 8.06(2): An agent who acts for more than one Principal in a transaction between them has a duty to deal in good faith with each of them, to disclose to each principal that the agent is acting for the other Principal as well, and all other material facts.

Rest. 3rd Agency 8.09: An agent has a duty to act only within the scope of his actual authority and to comply with all instructions from the Principal.

Tarnowski v. Resop (coin-operated game-machiness case)

Facts: Tarnowski wanted to buy a jukebox business. He hires Resop, who did no research and but told T had discovered a good buy. Actually, the business sucks (but Resop was taking a $2000 secret commission from the business owners to sell their bad business). Tarnowski paid $11,000 down on the business but discovered that Resops representations were false. Tarnowski rescinded the sale and successfully sued the seller for his money. He then sued contending that Resop, while acting as his agent, was liable for the secret commission he collected and for various damages.

Holding:

An agent is liable to a principal for the agents profits made during the course of the agency.

It is not material that no actual injury to principal resulted or that principal made a profit

Also not material that upon discovering the fraud, principal revoked contract and recovered that with which he had parted. Principal has an absolute right to recover all profits made by the agent in the course of the agency. An agent is liable to a principal for the damages caused by the agents breach of his duty of loyalty.

Restatement Agency 407(1): If an agent has received a benefit as a result of violating his duty of loyalty, the principal is entitled to recover from him what he has received, its value, or its proceeds, and also the amount of damage thereby caused.

If the agents wrongdoing requires the principal to sue, the principal is also entitled to attorneys fees.

Comment: An agents primary duty is to make profits for the principal.

In re GleesonFacts: Trust beneficiaries holding real property claimed that Colbrook, the trustee, had to account for profits he personally made as a co-tenant of the trust property.

Holding: A trustee of real property who is also a tenant of the trust property must account to the trust for profits made as a tenant. That Colbrook acted in good faith is unavailing because he should have either chosen to continue as a tenant or to act as a trustee. His choice to act as trustee precluded him from dealing with himself.

Comment: A trust resembles the agency relationship insofar as the trustee has obvious power to affect the interests of the beneficiary. The trust differs from agency insofar as the trustee is subject to terms of the trust.

Joint Ownership and Partnership

Partnership is a way to balance risk and investment to optimize opportunity in some instancesPartnership Formation and Property RUPA 102 (Knowledge and notice) (Corresponds to UPA 12): The only relevant part is subsection (f) in which the partners knowledge is deemed to be knowledge of the partnership immediately. RUPA 103(a): Partnership governed by the partnership agreement and defaults in the RUPA. RUPA 103 (b)(3): Partnership agreement may not unreasonably restrict the right of access to books and records, eliminate the duty of loyalty. The entire partnership or a percentage specified in the partnership agreement may ratify a specific act that violates the duty of loyalty, as long as there was full disclosure. RUPA 103(b)(4): The partnership agreement may not unreasonably reduce the duty of care; RUPA 103(b)(5): The partnership agreement may not eliminate the obligation of good faith and fair dealing, but the agreement may, within reason, specify standards by which the performance is to be measured; RUPA 106 (Governing law): The law of the state where the chief executive offices are located governs relations among the partners and between the partners and the partnership. However, the laws of this state (i.e. RUPA) govern limited liability partnerships. RUPA 201 (Partnership as entity): Partnerships are entities distinct from the partners. RUPA 202 (Formation of partnership) RUPA 202(a): Association of two or more persons to carry on as co-owners forms a partnership, whether or not the co-owners intended that. RUPA 202(c): The following rules apply to determination of whether a partnership was formed (1) Joint tenancy, tenancy in common, etc. do not by themselves establish partnership (2) Sharing of gross returns does not by itself establish partnership, even if the returns arise from commonly owned property. RUPA 202(c)(3) Sharing in the profits of a company leads to presumption of partnership unless its in payment of: debt, services as independent contractor, rent, annuity, interest (UPA 7(4)) RUPA 203 (Partnership property): Property acquired by the partnership is partnership property, not individual property of the partners; RUPA 204 (When property is partnership property): RUPA 204 (a): Property is partnership property when it was acquired in the name of (1) the partnership, (2) partners, with an indication in the transfer instrument that its to partner as partner; RUPA 204 (b): Property is acquired by the partnership if its transferred to the (1) partnership in its name, or (2) partners, with the name of the partnership written in the instrument of transfer; RUPA 204 (c): Property is presumed to be partnership property if purchased with partnership assets; RUPA 204 (d): Property acquired in the name of some of the partners without any of the above indications is presumed to be individual property.Conflict Among Co-OwnersJoint venture = a circumscribed partnership limited to a single investment project

Meinhard v. SalmonFacts: Meinhard and Salmon were co-adventurers in a lease on a hotel. Prior to the expiration of the lease, Salmon without Meinhards knowledge agreed to lease the same and adjacent property.

Holding: So long as their enterprise continues, joint adventurers owe one another the duty of finest loyalty. Salmon here excluded his co-adventurer from any chance to compete and from any chance to enjoy the opportunity to benefit that had come to Salmon by virtue of his agency.

Dissent: There was no intent to renew the joint venture after its expiration

Comments: As remedy, Cardozo awarded Meinhard one half of the shares in the company less one (because Salmon managed it)

On fiduciary duties between partners: Each partner is, roughly speaking, both a principal and an agent, both a trustee and a beneficiary, for he has the property, authority, and confidence of his co-partners, as they do of him. He shares their profits and losses, and is bound by their actions. Without this protection of fiduciary duties, each is at the others mercy.Partnership Formation

The partners need not intend to form a partnership for that relationship to be formed. (UPA 7, RUPA 202) UPA 16(1), RUPA 308 (Partnership by estoppel): If a person represents himself as a partner (or consents to others making such a representation), and a third party reasonably relies on that representation and does business with the enterprise, then the person who is represented as a partner is liable on the transaction, even if not in fact a partner. (UPA restricts to creditors, while RUPA expands to all transactions)

Vohland v. SweetFacts: Sweet contributed labor and expertise into a nursery business, from which he took 20% of the profits.

Holding: For purposes of creating a partnership, one partners contribution may consist of labor and expertise.

Comments:

A partnership may be defined as two or more persons carrying on as co-owners of a business for profit.

Partnership involves mutual contribution. Mutual share of profits creates a presumption and in this case, that presumption could not be rebutted by failure to show mutual contribution. Usually, partners in a partnership intend to create such a relationship. Such an intention is not necessary, however. It is the intention to do the acts creating a partnership, not the intention to create a partnership itself that controls.

Relationship with Third Parties How do claims on personal property of partners get allocated between personal and partnership creditors? UPA 15: Jointly/severally liable for firm torts; jointly liable for firm Ks; partners can enter contracts individually (and pledge their personal assets)

RUPA 306: Joint & severally liable for both firm torts and Ks; BUT under 307(d) firm creditors must exhaust firm assets before pursuing a partners personal assets. When a partner departs, it leads to conflict he is responsible for firm debts but cannot make decisions about firm actions.

UPA 36(2), RUPA 703(c): releases departing partner of partnership debts if court can infer an agreement between the continuing partners and the creditor to release the withdrawing partner

UPA 36(3), RUPA 703(d): releases departing partner from personal liability when a creditor renegotiates debt with the remaining partners after receiving notice of the departing partners exit (passage of time and buyer beware mentality)

In partnerships, assets whose assets are technically private assets. UPA and RUPA address it slightly differently.

UPA 25: partnership property is owned by the partners as tenants in partnership this joint ownership affords to individual partners no power to dispose of partnership property, so it becomes de facto business property (aggregate theory) RUPA 501/502: straightforward entity ownership (gets rid of the aggregate theory that the individual partners own the property); partners rights are transferable. If a partner does not own his partnerships assets in any ordinary sense, he nevertheless retains a transferable interest in the profits arising from the use of partnership property and the right to receive partnership distributions. Selling partnership interest: Both the UPA (26-27) and RUPA (503-503) allow the partners to dispose of their financial interest in the partnership to a buyer, limited to profit rights. RUPA also gives the right to demand judicial dissolution. Since the partner owns those rights, those rights are liable for his personal debt. (RUPA 504, UPA 28). But the interest does not include partnerships other rights.Claims of Partnership Property Creditors to Persons Individual Property Jingle rule (old): Partnership assets to partnership debt first, personal assets to personal debt first. (UPA 40)

New Parity Rule: Partnership creditors get first priority in partnership assets, and are equal in personal assets. (78 Bankruptcy Act 723, RUPA 807(a)).

Partnership Governance

RUPA 301: Partner is an agent of partnership

RUPA 303: Statement of Partnership Authority: a partnership may file a statement of partnership authority to define what partners and agents are allowed to do on behalf of the partnership. RUPA 307: Actions By and Against Partnership and Partners: both partnership and personal assets are liable for partnership liabilities, but partnership assets must be depleted before personal assets can be targeted. RUPA 401. Partner's Rights and Duties: Partners are credited with equal shares of the assets and liabilities, except as otherwise specified. Partners have equal rights in the management of the partnership unless otherwise specified (does not matter what they contributed). Important: differences arising as to everyday business matters are to be decided by a majority of the partnership. Decisions outside the ordinary course of the partnership business or decisions to change the nature of the partnership are to be decided by unanimous vote.

RUPA 403. Partner's Rights and Duties with Respect to Information: Partnerships shall keep their records at the chief executive office. Partners, their agents and attorneys shall have access to the information during ordinary business hours.

Partnership shall furnish basic information necessary for partners rights and duties without demand, and other information regarding the partnerships business on demand.

RUPA 404. General Standards of Partner's Conduct: Duty of loyalty, duty of care.

RUPA 501 and 502. Partner Not Co-owner of Partnership Property: Rather, the only transferrable property he has is the right to the profits. (502) RUPA 503. Transfer of Partner's Transferable Interest: The interest in RUPA 501 is transferrable, but does not carry the right to vote, etc. It only carries the right to distribution, to request judicial determination for dissolution, and accounting upon dissolution, dating back to previous accounting. Partnership agreement can restrict transfer even within those limitations. RUPA 504. Partner's Transferable Interest Subject to Charging Order: The interest that the partner owns, as described above, can be allocated to creditors of the partner.National Biscuit Co. v. StroudFacts: Stroud advised National Biscuit that he would not be responsible for any bread that the company sold to his partner. Nevertheless, National Biscuit continued to make deliveries.

Holding: The acts of a partner, if performed on behalf of the partnership and within the scope of its business, are binding upon all co-partners. Activities within the scope of the business cannot be limited except by a majority of partners. Stroud was not a majority and thus he is bound to Freemans sale of the bread.Comment: In the absence of a contrary provision in the parties partnership agreement, each partner acts as the agent of the partnership and of each other partner. Only acts performed on behalf of the partnership and are consistent with its purposes are binding on other partners.Notes: This case illustrates the majority rule that half of a two-person partnership is not a majority for purposes of making firm decisions within the ordinary course of business. Note: The UPA and RUPA provide default provisions for much of partnership agreements, but allow for specific changes by provision in the partnership agreement. UPA 9(2): If a partner does something not consistent with carrying on the business of the partnership, its not binding on the other partners unless a majority agrees. Third parties should generally ask to see authorization by a majority of partners.Dissolution UPA Dissolution (29): defined as any change of partnership relations, e.g., the exit of a partner. Does not necessarily involve winding up.

Winding up (37): orderly liquidation and settlement of partnership affairs

Termination (30): partnership ceases entirely at end of winding-up

Under UPA, any partner can force a wind-up of the partnership (38(1)). Different from RUPA.

Wrongful dissolution (38(2)): departing partner has no claim on good will value

Limiting partners right to dissolve under UPA 31(1)(b) UPA 31(1)(b): a partnership may be dissolved by the express will of any partner when no definite term or particular undertaking is specified BUT UPA 38(2): even though partnerships are terminable at will (unless a definite term is specified/implied), partners have fiduciary duties to act in good faith when dissolving the partnership. (See Page v. Page). Dissolution RUPA Disassociation (RUPA 601): a partner leaves but the partnership continues, e.g., pursuant to an agreement

Dissolution (RUPA 801): the onset of liquidating partnership assets and winding up its affairs

Under RUPA, disassociation can happen without dissolution. Dissolution here means termination.

Wrongful disassociation (602): can disassociate wrongfully (without an agreement), but are liable for damagesAdams v. JarvisFacts: Adams, Jarvis, and a third doctor entered into a partnership for the practice of medicine. Adams later withdrew and claimed a right to share in the partnerships existing accounts receivable.

Holding: A partnership agreement that provides for the continuation of the firms business despite the withdrawal of one partner and specifies the formula according to which partnership assets are to be distributed to the retiring partner is valid and enforceable.

Comments:

Parties had unambiguously agreed that their partnership would not terminate when one of the doctors withdrew from the firm. Court determines that there is no reason why statutory rules relating to withdrawal should here affect dissolution.

Doctors had agreed that the withdrawing partner would not participate in accounts receivable.

In most jurisdictions, matters pertaining to the distribution of partnership assets and continuation after the withdrawal of one partner are dealt with by statute. However, agreements among partners reached at the outset are generally upheld.

There are three potential ways to divide assets among partners who are dissolving.

Divide the physical property

No longer allowed (UPA 38(1))

Sell the assets to the highest bidder

The only remaining possibility. This is the default provision granted in UPA 38(1). Partners normally buy out dissolving propertyPage v. Page (linen supply business case)

Facts: Page (P) sought a declaratory judgment that the partnership he had with Page (D) was a partnership at-will that he could dissolve.

Holding: A partnership may be dissolved by the express will of any partner when no definite term or particular undertaking is specified.

Comments: Partnerships are ordinarily entered into with the hope that they will be profitable, but that hope alone does not make them all partnerships for a term and obligate partners to continue until losses have been recovered

The power to dissolve a partnership must be exercised in good faith. One partner cannot freeze out another.

A partner holds his dissolution power as a fiduciary

He owes his partners duties of good faith and fair dealing in exercising dissolution rights

General Partnership Features of a general partnership: (1) a dedicated pool of business assets, (2) a class of beneficial owners (the partners), and (3) a clearly delineated class of agents authorized to act for the entity (the partners).

Limited Liability Partnerships: The separation between the partnership as an entity and the investors (partners) who finance it can be further increased by adding limited liability as a 4th element. Limited liability means that business creditors cannot proceed against the personal assets of some/all of a firms equity investors. (Business creditors can only rely on the partnership assets.)The Limited Partnership LPs are made up of at least one general partner, and other limited partners. Limited partners share in profits without incurring personal liability for business debts; general partner has unlimited liability.

Limited partnerships have to be registered (unlike general partnerships)

LPs get pass-through taxation. Distinguishing between general and limited partners: Old test: control test limited partners remain passive so are not liable personally. Rationale: those who can actively shift assets out of the firm, or make risky decisions, should be held personally liable to prevent opportunism against partnership creditors.

Newer test: RULPA 303 (1976) adopted a label and control a limited partner who participates in control is liable only to persons who think hes a general partner.

Newest test RULPA 303 (2001) abandons control test entirely limited partner is not personally liable for partnership liabilities even if the limited partner participates in the management and control of the enterprise. Rationale: status-based liability shield.Limited Liability Partnership

Limited Liability Partnerships (LLPs) allow practitioners such as lawyers and accountants, to have the same benefit of limited liability as other businesses.

Most state LLP statutes protect only negligence by other partners or agents of the partnership (RUPA 1515(b)). Some, e.g. NY and MN, extend it to contracts as well as tort debts.

Many LLP statutes create a capitalization or insurance requirement to offset the limited personal liability of the partners. (to offset the risk of not being able to pay tort creditors)

The Corporate Form

Characteristic

GP

LP

LLC

Corp.Investor ownership

X

X

X

X

Legal personality

X

X

X

X

Limited liability

X

X X

Transferable shares

X

X

Centralized/delegated mgmt.

X

under elected board A corporations legal characteristics have complementary qualities: limited liability makes free transferability more valuable (reduces costs associated with transfers of interest b/c value of shares is independent of assets of owners), free transferability permits development of large capital markets, which are also advanced by the presence of centralized management U.S. corporations are regulated by the law of the state of incorporation, not where they do business.

Public corporations vs. closely held corporations

Closely held corporations have few SH; tend to incorporate for liability purposes rather than capital raising purposes; may drop features of corporate form; Public corporations tend to incorporate to raise capital in public capital markets; adopt all characteristics

Controlled corporations vs. corporations w/o controlling SH

Controlled corporations: a single SH or group exercises control through its power to appoint the board Corporations w/control in the market: no single SH/group exercising control; but anyone can purchase control in the market by buying enough stock; while control is in the market, practical control resides with the existing management of the firm Process of Incorporating, RMBCA (2.01-2.06; DGCL 102, 106, 108):

(1) A person, the incorporator, signs documents and pays fees; (2) The incorporator drafts/signs the articles of incorporation (RMBCA)/certificate of incorporation (DGCL) also known as the corporations charter. Document states the purpose and powers of the corp. and defines all its special features (3) The charter is then filed with the secretary of state, along with a filing fee; (4) The secretary of state issues the corporations charter, signed by the secretary (5) The first acts of business are electing directors, adopting bylaws, and appointing officers (at an organizational meeting)

Articles of incorporation: state codes set out baselines and defaults, but leave freedom to the Corporation itself to be set up how it wishes.

Articles of incorporation MAY contain any provision that is not contrary to law, but MUST provide for voting stock, board of directors (incorporators elect initial board), and SH voting for certain transactions; name the original incorporators; state corporations name & business; set capital structure

Transactional freedom is the overriding concept articles of incorporation can set out any customized features you want, e.g., classes of voting stock

The charter MAY establish the size of the board or include other governance terms, like procedures for removing directors from office

Shareholders' Agreements (primarily concern of closely held corporations) Agreements among shareholders are important in close corporations, but not in widely held public corporations.

Shareholder agreements include restrictions on holding shares, buy-sell agreements, voting agreements (DGCL 218), etc. Courts enforce these agreements when the corporation and its shareholders are all party to the suit relating to the agreement, but not if its only some shareholders. That is why widely held corporations dont deal with this much.

Limited Liability

Limited liability is a fundamental part of the Corporation Advantages: Makes shares fungible, allowing modern markets. Investors can deal better with risk, which lowers transaction costs of finance.

Transferable Shares

Transferability is a default all corporate statutes allow for agreements that bar transfers. But often, there must be a clear warning to that effect on the actual stock. (See DGCL 202)

Centralized Management

Centralized management leads to economies of scale, but also shareholder disconnect. Disconnected shareholders cant police the firm. Leads to challenge what can the law do to make the management accountable and the shareholders involved?

Shareholders elect Board of Directors, which by strong default appoint management. (E.g. DGCL 141(a)). Board of directors, then, has the responsibility to oversee management, and make decisions that management puts into practice. Board is the Holder of Primary Management Power: The board of directors holds the primary power of the company, not the shareholders. In that sense, the corporation is like a representative democracy rather than a direct democracy.

Automatic Self-Cleansing Filter Syndicate Co. Ltd. v. CunninghameFacts: A 55% majority group (P) of the shareholders of Automatic contended that the companys board of directors could not override the groups vote (made at an ordinary shareholders meeting) to sell the companys assets, notwithstanding that the companys charter required a 75% vote to limit the boards decision-making power.

Holding: Where a companys charter requires a 75% vote of the shareholders, made as an extraordinary resolution, to override a boards decision, a mere majority resolution made at an ordinary shareholders meeting may not override the boards decision.

Comments: Governing statute in this case gives power to directors to do all things other than those expressly reserved to shareholders

Directors are agents to all shareholders not just the majority (and the charter is here providing certain protections to the minority). If the board thwarts the will of the majority, dissatisfied shareholders can attempt to remove it.Structure of the Board

DGCL 141 sets forth the structure and duties of the Board of Directors.

Corporate Charter sets structure of the board in general terms. There are necessary terms, default terms, and allowed changes in the structure and function of the Board of Directors.

Charter can set different classes of stock to elect different proportions of the Board of Directors. Once elected, Directors have duty to all stockholders equally.

Board has power to establish standing committees for effective organization, and may delegate to these committees. Advisory committees can include non-directors, but decision-making must be done by directors. (This comes up in the context of Special Litigation Committees and Independent Committees in transactions later in the course). Boards are only empowered when they meet as boards. Often, that involves having a quorum, issuing proper notice, etc. see, e.g. DGCL 141(b), which sets the default quorum as a majority of the board.

The essential point of this is that Directors are not agents of the Corporation, the board as a group is. Corporate Officers, Agents of the Corporation

Unlike the directors, the Corporate officers that the Board appoints are the agents of the Corporation. They usually include a president, vice president, treasurer, and secretary, although titles are not important.Jennings v. Pittsburgh Mercantile Co.Facts: Pittsburgh Mercantile Co. contended that Egmore, Mercantiles VP and treasurer-comptroller, did not have apparent authority to accept an offer for a sale and leaseback, and that, therefore, Jennings, a real-estate broker, was not entitled to commissions for a sale and leaseback transaction that Egmore seemed to accept, but which the board did not.

Holding: A corporations executive officer does not have apparent authority to accept an offer for a transaction that, for the corporation, is extraordinary. Egmores office does not, in itself, indicate that he has been endowed with apparent authority to act on behalf of the corporation regarding an extraordinary transaction.

Comments: Apparent authority is defined as authority that, although not actually granted, the principal 1) knowingly permits the agent to exercise or 2) holds him out as possessing. Such authority emanates from the principal not the agent.

Extraordinary nature of the transaction should have placed Jennings on notice to inquire as to actual authority

The Protection of Creditors

Hierarchy of claims on a corporations cash flow(More Junior)Common Stock

Equity

Preferred Stock

Equity

Subordinated Debt Debt

Bank Debt/Notes Debt

(More Senior)Mortgage Debt (secured) Debt Dangers of limited liability: Owners may misrepresent assets (incentivized by ownerships ability to walk away) There are three basic strategies that Corporate Law can pursue in order to protect creditors (1) Mandatory disclosure rules (2) Rules regulating corporate capital (3) Creating duties/remedies on Corporate actors like directors, creditors, and shareholders. Mandatory disclosures help protect creditors insofar as they protect against misinformation. In fact, Federal securities law requires extensive disclosures for other agency-related problems in corporate law. But state law does not rely much on disclosure. Of course, voluntary creditors can require disclosure as a precondition to lending to the Corporation. Capital Regulations

Some definitions: Shareholder equity: The difference between the assets and liabilities on the balance sheet. The sum of the liabilities and the shareholder equity must equal the assets.

Stated Capital: The value of the shares that the stockholders contributed to the company. By Delaware and NY law, the company can deplete the stated capital amount, so it is of limited use as a protective implement.

Capital Surplus: Equity that the company has that is not accounted for in the original shareholder stock value. This can result from the company issuing stock at a par value lower than the actual issuance price. (If I understand this correctly, the company can also add to this account by designating operating profits to become capital surplus.)

Financial Statements

The difference between the (lower) value of liabilities and the (higher) value of assets is Shareholder Equity, so that the liabilities together with the Shareholder Equity equals the value of the assets. The distribution constraints use the figures on the balance sheet to restrict payment of dividends. Distribution Constraints

Basic concept: creditors lend money on the basis of corp. having a certain amount of assets, so corp. should keep those assets available for the creditors. Three main dividend tests used as constraints:

Nimble dividends test (DGCL 170; NYBCA 510) You can choose to pay dividends either from Capital Surplus or from Net Profits in the current/preceding year. The motivation for the Net Profit provision is to allow companies on the rise to pay a dividend even absent a Capital Surplus. Not much protection for creditors because in addition to flexibility choosing either capital surplus or net profit, the Corporation can (1) manipulate balance sheet to avoid losses, (2) Add money to the surplus account from no-par stock equity, or (3) (with shareholder vote) lower the par value of stock to create an equity surplus. New York adds the requirement that the corporation not be insolvent and that the dividend not render the company insolvent. (Note: if either of these were true, would that invoke the fraudulent conveyance doctrine?) Modern test (RMBCA 6.40) No distribution that renders corp. insolvent; liabilities cannot exceed assets; corps may use the real value of the corp. if book value is too low. This tends to undermine creditor protection.Minimum Capital and Capital Maintenance Requirements

Minimum capital requirements- (at startup of corporation).

Neither DGCL nor RMBCA has a minimum capital requirement

Not effective because even if corps cannot dip into minimum capital to pay dividends, normal business activity can deplete the capital; the money is only required when corporation is incorporated, and then it is immediately invested so no longer available to creditors

Pros and cons of these requirements: (+) attempts to protects creditors and thereby opens up investment opportunities. (-) creditors can protect selves through K; the amount is arbitrary; it constrains corp. creation Capital maintenance requirement: This requires that Corporations not only have minimum capital, but that they keep a certain amount of capital around to cover expenses. But the essential effect of this is to accelerate bankruptcies because Corporations suffering from cash flow difficulties have to enter insolvency as soon as the required reserves are depleted.

Director Liability

Uniform Fraudulent Transfers Act sets up guidelines for the duty that directors have to ensure that assets remain available to creditors.

Duties to Creditors: Delaware law says that once a company is entering insolvency the Directors have a duty to the creditors in addition to the shareholders, since at that point there arise conflicts of interest between the two groups. (E.g. Shareholders are comfortable with even massive risk, since they have little to lose, but creditors want safety more than anything at that point.)

Credit Lyonnais Bank Nederland v. Pathe Communications Corp

Holding: When near insolvency, board cannot consider SH welfare alone but should also consider the welfare of the community of interests constituting the corp.Note 1: As a matter of policy we always want to be maximizing the value of the corp. But here, maximizing the firm value does not maximize what the SH get. Three conflicting interests: SH, creditors, and firm as a whole. By making the board think about the creditors, we are making them think more about long-term value than short-term SH interests (even though their duty is usually with the SH).Note 2: Another case, North American Catholic Educational Programming (also from Delaware) specifically held that a solvent corp. operating in the zone of insolvency could not be sued by creditors asserting a direct claim to their interests as creditors, since the Directors duties were to the Shareholder rather than the creditors. They did, however, have standing to sue in a derivative capacity. This case might contradict the Credit Lyonnais holding, or it could be interpreted to mean that Directors have a duty to the Corporation qua Corporation rather than to specific constituency groups. Creditor Protection: Fraudulent Transfers

Fraudulent transfer law: creditor remedy that obligates parties contracting with an insolvent or soon to be insolvent corp. to give fair value for assets they receive from the debtor. Relevant acts create causes of action for creditors against transactions on either of two grounds actual intent or constructive intent. Actual intent: Present or future creditors can attack transfers made with actual intent to hinder, delay, or defraud a creditor (UFTA 4(a)(1))(UFCA 7) Even without actual intent: Pre-conveyance creditors can attack a transfer that was made for value that was not reasonably equivalent and left the debtor with remaining assets unreasonably small in relation to its business. (Or when the debtor should reasonably have seen that he wouldnt be able to pay his debts following the transfer). (UFTA 4(a)(2), 5(a) and (b)). Compare UFCA 4-6. US Bankruptcy law is the source for most such lawsuits today, and the approach is substantially similar to the UFTA/UFCA (Section 548) and invokes local state law (Section 544(b)). Future Creditors who knew or should have known about the conveyances cannot void them. (Kupetz v. Wolf)Fraudulent transfers in Leveraged Buy Outs (LBOs)

LBOs involve a liquidation-type takeover funded by massive borrowing. Acquiring group has to borrow so much, that they often declare bankruptcy shortly thereafter. In a way, the target and its management have engaged in fraudulent transfer because shareholders take full payment for securities in what is becoming a debt-ridden company. Thus, creditors can sue the original board for letting the companys cash go for inadequate consideration. Potential remedies People who attempted to profit by pillaging of near-bankrupt company will have to give back all that they profited. Spin offs: Another arguably fraudulent transfer is companies (tobacco/asbestos) spinning off the tort-debt-laden sectors into separate corporations, to avoid having to pay in full. Prof notes (as with Sea-Land v. Pepper Source) that diversification is appropriate in allocating risk, but should it work ex-post facto, when the liability is impending?Shareholder Liability

There are two doctrines under which shareholders can be liable for corporate misappropriation of creditors funds. Equitable subordination and Corporate veil piercing

Equitable subordination (SH Liability in a way)

Equitable subordination protects unaffiliated creditors by moving them up on the debt hierarchy as compared to shareholders/insiders who are also corporate creditors.

U.S. Bankruptcy Code 510(c)(1): permits subordination of a debt claim under principles of equitable subordination. The principle is usually invoked only in the bankruptcy context

Two requirements to invoke this doctrine: (1) the creditor has to be an equity holder and typically an officer of the company, (2) The insider-creditor must have behaved unfairly or wrongly toward the corp. and its outside creditors.

Policy: We dont want to use equitable subordination as a default rule and we dont want to discourage controlling SH from lending money to corporations when the loan is legitimate, since they are often in better position than third parties to make loans.Costello v. FazioFacts: The trustee in bankruptcy for the bankruptcy estate of Leonard Plumbing and Heating Supply, Inc. contended that claims against the estate of the companys creditors, Ambrose and Fazio, who were also its controlling shareholders, should be subordinated to those of general unsecured creditors because Ambrose and Fazio had converted the bulk of their capital contributions into loans and left the company grossly undercapitalized to the determinant of the company and its creditors.

Holding: Where, in connection with the incorporation of a partnership, and for their own personal and private benefit, partners who are to become officers, directors, and controlling stockholders of the corporation convert the bulk of their capital contributions into loans, taking promissory notes, thereby leaving the partnership and succeeding corporation grossly undercapitalized, to the detriment of the corporation and its creditors, their claims against the estate of the subsequently bankrupted corporation should be subordinated to the claims of general unsecured creditors.

Comments:

Claims of controlling shareholders will be deferred or subordinated to outside creditors where a corporation in bankruptcy has not been adequately or honestly capitalized, or has been managed to the prejudice of creditors.

Equitable Subordination is a means of protecting unaffiliated creditors by giving them rights to corporate assets superior to those of other creditors who happen to also be significant shareholders of the firm. The critical question is what circumstances will permit a court to impose this subordination? The first requirement is that the creditor be an equity holder (and typically an officer or director). In addition, the creditor must somehow have behaved inequitably to outside creditors.Piercing the Corporate veil is an equitable form of shareholder liability. The Courts assert that they will not allow the corporate form to be used to perpetrate a fraud in order to avoid contract or tort liabilities.

Different jurisdictions have different tests for determining whether the corporate veil should be pierced, but most tests have two components (1) Evidence of lack of separateness between shareholder and corporation, and (2) Unfair/inequitable conduct (which is the wild card in these cases)

Criteria for veil piercing: the criteria for evidence of lack of separateness are vague, but include some factors such as: Disregard of corporate formalities, Mingling of corporate and personal assets, Thin capitalization, Small numbers of shareholders, Active involvement of shareholder(s) in management

Different formulations of the test from different jurisdictions:

Van Dorn Test (7th Cir., applied in Sea-Land): (1) unity of interest or ownership such that separation between the corp./ownership cease to exist, (2) allowing the corporate fiction would be to sanction fraud/promote injustice.

Laya test/Kinney Shoe: (1) unity of interest/ownership such that separation of personalities between corporation and ownership dont exist; (2) inequitable result would occur if the acts were attributed to the corporation alone. But theres another optional element (that court can choose to apply), which is that the defendant might still prevail if he can show that the plaintiff assumed the risk. Sea-Land Services, Inc. v. Pepper SourceFacts: When Sea-Land could not collect a shipping bill because Pepper Source had been dissolved, Sea-Land sought to pierce the corporate veil to hold Peppers sole shareholder personally liable.

Holding: The corporate veil will be pierced where 1) there is a unity of interest and ownership between the corporation and an individual and 2) where adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice.

Comments: In this case there was little doubt that the first prong was satisfied.

Corporate formalities were not maintained. Funds and assets were intermingled with other holdings of the shareholder. Pepper was undercapitalized. Shareholder moved and borrowed corporate assets between various corporations without regard for their source.

The second part of the test is more difficult as an unsatisfied judgment is not, in itself, a sufficient injustice. The test requires a showing short of fraud but greater than an unsatisfied judgment.

Notes: On remand, the court found that Marchese had committed tax fraud, and he had used the corporations to move money around and avoid liabilities for various things. The veil was pierced. Prof. K says that this case was decided wrongly and could have been decided under fraudulent transfer.

Kinney Shoe Corp. v. PolanFacts: After a corporation owned by Polan defaulted on a building sublease with Kinney, Kinney sought to hold Polan personally liable because his corporation was inadequately capitalized and Polan had not observed any corporate formalities.

Holding: In a breach of contract, the corporate veil will be pierced where 1) a unity of interest and ownership blends the two personalities of the corporation and the individual shareholder and 2) where treating the acts as those of the corporation would produce an inequitable result.

Comments:

In this case, Industrial (the corporation that held the sub-lease) had no paid-in capital (its only asset was its re-subleasing of the building to Polan Industries, a second corporation owned by Polan) and Polan did not observe any corporate formalities.

A third prong may be added to the test where a complaining party may be deemed to have assumed the risk of gross undercapitalization (where it would be reasonable for the party to protect itself by making a credit investigation).

Though inadequate capitalization is not, in most jurisdictions, considered to be in itself an injustice, here, Polan had attempted to protect his assets by placing them in Polan Industries, then interposing Industrial, a shell corporation, between Polan Industries and Kinney.

Veil Piercing and Tort Creditors Tort creditors do not rely on creditworthiness of a corp. when placing themselves in a position to suffer a loss. They have no opportunity to negotiate ex ante for contractual protections from risk General rule remains that thin capitalization alone is insufficient grounds for veil piercing (but that makes tort claims difficult)

Walkovsky v. CarltonFacts: Walkovsky was run down by a taxi owned by Seon Cab Corp. Walkovsky sued Carlton, a stockholder of ten corporations, including Seon, each of which had only two cabs registered in its name.

Holding: Whenever anyone uses control of a corporation to further his own rather than the corporations business, he will be liable for the corporations acts. Upon the principle of respondeat superior, the liability extends to negligent as well as commercial dealings. However, where a corporation is a fragment of a larger corporate combine that actually conducts the business, a court will not pierce the corporate veil (so long as the corporation has some hope of functioning independently of parent corporation).Dissent: In requiring the minimum liability insurance of $10,000, the legislature did not intend to shield those individuals who organized corporations with the specific intent of avoiding responsibility to the public.

Comments:

The corporate form may not be disregarded simply because the assets of the corporation (and its liability insurance) are insufficient. If insurance requirements are inadequate, the remedy is with the legislature. It is not fraudulent for the owner of a single cab corporation to take out no more than minimum insurance.

NOTE: Courts often justify disregarding the corporate entity by way of an estoppel argument if its shareholders do not respect the entity, why should the court?

The corporate veil may be pierced even in instances where there has been no reliance on the companys representations such as in cases of tort. As a consequence, whether or not creditors have been misled is not of primary importance.

Instead, the court will look at the degree to which the corporation is treated as a separate formal entity (as well as the degree to which the corporation could function as a separate entity from the parent).Successor Liability

Since shareholders are not personally liable for corporate torts, firms might capitalize themselves sparsely so that when something goes wrong, they just dissolve to avoid liability. Corporate law addresses that. After Corporate dissolution and the payment of liquidating dividend to SH, SH remain liable for suits arising during the corp.s life as follows: DGCL 278, 282: SH remain liable pro rata on their liquidating dividend for 3 years; RMBCA 14.07(c)(3): same as DGCL, provided that corp. published notice of its dissolution Going concerns/product lines: Buyers will either negotiate for indemnification or just buy the assets but not the going concern. Substantive consolidation (horizontal veil piercing) used in bankruptcy. Its commonly used, but there are some shortcomings to its use. Its federal law, because its used in bankruptcy, so its an example of federal law trumping state corporate law. While it may seem right to make the entire corporate family suffer, rather than abandon the creditors of one company, there is also merit for the ability of a company to partition its assets in order to allocate risk strategically. Close CorporationsA Note on Close Corporations: Closely held corporations have different characteristics than widely held corporations. Since the 1960s, state law has dealt with this by allowing latitude in the setup of close corporations. These laws often have a different structure characterized by a unified corps statute, which explicitly permits planners to K around statutory provisions through general opt-out clauses (Using language like unless otherwise provided in the charter (see RMBCA 8.01(b)).

Donahue v. Rodd Electrotype Co.Facts: Donahue, a minority stockholder in a close corporation, sought to rescind a corporate purchase of shares of the controlling shareholder. The CS sold his shares back to the corporation at $800/share. The corporation only offered to pay $200 per share for the shares of minority holders.

Holding: A CS (or group) in a close corporation who causes the corporation to purchase his stock breaches his fiduciary duty to the minority stockholders if he does not cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price.

Note 1: Minority SH are seen as vulnerable b/c their exit opportunities are limited. This case was an example of judicial activism. Delaware later rejected this holding b/c there may be good business reasons for repurchases and we dont want to regulate them too heavily.

Note 2: There was no allegation here that the price being paid to Rodd was too high. Donahue wanted out b/c there was no way her stock would ever get dividends; the Rodds had better ways (salary) to get money out of the co.

Smith v. Atlantic Properties Inc.Facts: Wolfson, a minority stockholder acting pursuant to a provision in the articles of incorporation, was able to prevent the distribution of dividends, as a result of which the corporation, Atlantic, had to pay a penalty tax for accumulated earnings. Atlantic. Wolfson had arranged for the charter to require an 80% SH vote for any corp. action to prevent the other three SH from ganging up on him. Wolfson continually vetoed dividends. Other SH sue to remove Wolfson as a director and force him to reimburse the penalty taxes and related expenses.Holding: Where a closed corporations articles of incorporation include a provision designed to protect minority stockholders, the minority stockholders have a fiduciary duty to use the provision reasonably. Here, Wolfson took risks inconsistent with a reasonable interpretation of his duty of utmost good-faith and loyalty (UGFAL).

Comment 1: The question is whether the veto power possessed by a minority may be exercised as its holder wishes w/o a violation of UGFAL duties. The answer is no.Comment 2: After Donahue and this case, many courts feared that UGFAL, if left to grow unrestrained, could decrease the value of the corporate form.Easterbrook and Fischel: Close Corporations and Agency Costs: Goals of Fiduciary Law The goal of fiduciary duty analysis is to determine what the parties would have done if they had the low-cost opportunity to address this eventuality in negotiations. In closely held corporations, incentives for management action are different in kind from public corporations, and the danger of conflict is greater. Example firing an employee is not necessarily a legitimate management decision in a closely held corporation, it is more likely to be a way to cut a shareholder out of the benefit of owning a share.Part II

The Limited Liability Company

General contours: Internal relations between investors (members) governed by general or limited partnership law;

Members may operate the firm themselves (agency like in GPs) or elect managers (as in LPs or corps); The resignation of a member may or may not lead to dissolution; Members must file a copy of their articles of organization with the secretary of state (like LPs) Unlike limited partners, members of an LLC enjoy limited liability even if they exercise control over the business in much the same way that a GP would.

The rise of LLCs was largely tax-driven. Up until 1997, IRS regulations said that LLC would be taxed like a corp. if it had 3 or more of the following: (1) limited liability for the owners of the business, (2) centralized management, (3) freely transferable ownership interests, and (4) continuity of life. During this era, LLC drafters tried to fail the corporate resemblance test by lacking both free transferability of interests (putting restrictions on transfers) and continuity of life (by setting LLC for a term, or requiring dissolution with exit of any member).

Since 1997: check the box regulations. All new unincorporated businesses (GPs, LPs, LLCs, LLPs) may choose whether to be taxed as partnerships (pass-through) or corporations (two-tier taxation).

IRS Reg. 7704(a): publicly traded partnerships are treated as corporations.Pappas et al. v. Tzolis

Facts: plaintiffs (Pappas and Ifantopoulos) and Tzolis formed Vrahos LLC (Delaware) for the purpose of entering into a lease. The operating agreement (governed by NY law) provided that Tzolis would have a right to sublease (subject to additional payments to Vrahos) and that any member of the LLC may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC. After a year Tzolis bought plaintiffs interests in the LLC (allegedly to avoid additional rent payments), making them sign a handwritten certificate representing that they were not relying on any representation by Tzolis and that Tzolis owed no fiduciary duties to them. 6 months later Tzolis assigned the lease for a considerably superior price. Plaintiffs allege breach of fiduciary duty and fraud arising out of Tzolis failure to disclose, prior to buying them out, that he was arranging a lucrative sale of the leasehold interest.

Holding 1: Under Delaware law, unless the LLC agreement in a manager-managed LLC explicitly restricts or eliminates fiduciary duties, managers owe those duties to the LLCs members (6 Del. C. 18-1101(c)). Holding 2: Despite the certificate in which plaintiffs acknowledged performing their own due diligence and waived Tzolis fiduciary duties in relation to the assignments, Tzolis had an overriding disclosure duty ( duty of loyalty) until the moment the buy-out transaction closed. The case cited in the dissent (Centro) does not support the position that the certificate effectively released Tzolis, because in Centro plaintiffs knew that the information provided to them was incomplete (i.e., they were lax in protecting themselves).

Normal Governance: The Voting System

The Role and Limits of Shareholder Voting (Powers of Board v. Powers of Sharheolders) Very few public companies restrict the boards managerial power in their charters.

Default powers of shareholders: right to vote (board + some fundamental transactions), right to sell, right to sue.

The most important factor affecting shareholder voting is the collective action problem. Attempts to create a more active shareholder democracy:

1934 Securities and Exchange Act: forced disclosure of information to shareholders (SEA 14);

Institutional shareholder activism: boost in the 1990s.

Amendment of SEC proxy rules in 1992.

Conclusion: we no longer live in a world of extreme cases in which collective action costs are either nonexistent (because the corp. has a controlling shareholder) or preclusive (because stockholding is highly diffuse).

Electing Directors

Every corporation must have a board of directors (1 or more natural persons) (DGCL 141(a)) and at least one class of voting stock. Unless the charter provides otherwise, each share of stock has one vote (DGCL 212(a)).In public corps, most equity takes the form of voting common stock (the right to appoint the board is more valuable to common stock investors than to any other class of investors (e.g., bondholders)).

Annual election of directors (another mandatory feature). Boards can be staggered (classified) or formed of a single class of directors (DGCL 141(d)). Corporate law facilitates the election of directors by creating a flexible framework for holding the annual meeting: minimum and maximum notice period (DGCL 222(b)), quorum requirement (DGCL 216), minimum and maximum period for the board to fix a record date (DGCL 211(c)). This prevents the incumbent board from manipulating so that only a small number of shareholders can attend. Cumulative voting increases the possibility for minority shareholder representation on the board: each shareholder may cast a total number of votes equal to the number of directors to whom she is entitled to vote, multiplied by the number of shares that she owns, with the top overall vote getters getting seated on the board (opposite of cumulative voting is sequential/normal voting)Removing Directors

At common law, shareholders could remove a director only for cause. What is a good cause for these purposes is unclear: fraud and unfair self-dealing certainly are, but what about abysmal business judgment? DGCL 141(k): Any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at an election of directors (there are exceptions for cumulative voting (k)(2) and staggered boards (k)(1)). PROBLEM: THE UNFIREABLE CEO (p. 159). In a staggered board, directors can only be removed for cause. Directors can propose amendments to corporate charter (DGLC 242) (but that doesnt help much). Voting stockholders (not board) can always change bylaws (DGCL 109) (and increase size of board but board might be able to fill seats by default). Board typically cannot remove directors in the absence of express shareholder authorization, but can petition a court of competent jurisdiction to remove for cause.

Shareholder Meetings and Alternatives

In addition to the election of the board at the annual meeting, shareholders may also vote to adopt, amend, and repeal bylaws; to remove directors; and to adopt shareholder resolutions.

Special meetings are called for special purposes (e.g., to vote on fundamental transactions). In most jurisdictions, it is the only way that shareholders can initiate action (therefore, it is of considerable importance who may call a special meeting):

Revised Model Business Corporation Act (RMBCA) 7.02: (i) board of directors or a person authorized in the charter or bylaws; (ii) Holders of at least 10% of all votes entitled to be cast.

DGCL 211 (d): only the board or persons designated in the charter or bylaws (no mandatory 10% provision).

Shareholder Consent Solicitations: alternative to special meetings. DGCL 228 (majority of outstanding shares); RMBCA 7.04(a) (less liberal: unanimity).

Proxy Voting and its Costs

Each stockholder entitled to vote may authorize another person (signed proxy card or electronic communication) to act for such stockholder by proxy (DGCL 212(b)).

Proxies are revocable unless the holder has contracted for the proxy as a means to protect a legal interest or property.

Proxy voting does not remedy shareholders collective action problem: (i) costs of soliciting proxies are borne by the corporation, but the fact that the board may expend corporate funds on its own re-election seems to permit a kind of self-dealing. (ii) Expenses of insurgent shareholders are not reimbursed unless they are victorious in their proxy fight (so the incumbent board has a financial advantage).

SEC eProxy Rules (2007) aimed at reducing the cost of soliciting proxies. Rule 14a-16.

PROBLEM: ONLY INCUMBENTS AND WINNERS GET FREE PROXIES (p. 162).

Rosenfeld v. Fairchild Engine and Airplane Corp.

Facts: Stockholders' derivative action against corporation to have returned to the corporation money paid by corporation to reimburse expenses of rival factions in proxy fight.

Holding (Judge Froessel): (i) In a contest over policy, as compared to purely personal power, corporate directors have the right to make reasonable and proper expenditures from the corporate treasury to persuade stockholders of the correctness of their position and to solicit their support for policies which the directors believe, in all good faith, are in the best interests of the corporation. (ii) The stockholders have the right to approve reimbursement of successful contestants for the reasonable and bona fide expenses incurred by them in any such policy contest. No reimbursement if:

(i) money spent for personal power, individual gain, etc. (ii) fairness and reasonableness of the amounts allegedly spent are successfully challenged.

Comment: Judge Froessels rule: win or lose, incumbent managers are reimbursed for expenses that are reasonable in amount and can be attributed to deciding issues of principle or policy. Insurgents stand a good chance of being reimbursed only if they win. But does this rule fix right incentives?

Class Voting

Its a protection against exploitation by the majority: in order to be authorized, a transaction needs to be approved by the majority (or such higher proportion as may be fixed) of the votes in every class that is entitled to a separate class vote.

Can occur in the normal governance context (special classes electing designated seats on the board) or in voting on fundamental transactions (which raises more interesting class voting problems).

PROBLEM: WHEN THE PREFERRED STOCK PREFERS NOT.

Avonex has two classes of stock (5 million no par common stock and 500,000 6% cumulative preferred stock with a par value of $10 million). Wants to issue a new class (11% senior cumulative preferred stock).

According to NYBCL 804, preferred have a separate vote when an amendment either subordinates their preference or authorizes a superior preference. Under NY law, Avonex can issue 1 million additional 6% cumulative preferred shares at a large discount and preferred would have no action.

Under Delaware law, preferred can vote if (i) their preference over common is being subordinated or (ii) the aggregate number of shares of their class is being increased. They do not get a separate vote simply because an even more senior preferred class is being issued. (DGCL 242(b)(2)).

Shareholder Information Rights

State law mandates neither an annual report nor any other financial statement. Federal securities law and SEC rules require extensive disclosure for publicly traded securities.

Modern statutes codify shareholders right of access to information for a proper purpose.

Delaware: two types of requests:

Request for a stock list: does not contain proprietary information and is easy to produce, thus proper purpose is broadly construed (burden is on company to prove improper purpose). The order will often require the company to also furnish a non-objecting beneficial owners list.

Inspection of books and records: more expensive; may jeopardize proprietary and competitively sensitive information. These requests are reviewed with care: (i) Delaware plaintiffs must show a proper purpose which will be carefully screened; (ii) New York shareholders have a statutory right to access information, unless the company can show that the shareholder lacks a proper purpose.

Techniques for Separating Control From Cash Flow Rights

Although it is ordinarily good policy to align control (voting rights) with residual returns, this policy is frustrated in capital structures (e.g., dual-class voting) that misalign incentives.

Circular Control Structures

DGCL 160(c): Shares of its own capital stock belonging to the corporation or to another corporation (if a majority of the shares entitled to vote in the election is held, directly or indirectly, by the corporation) shall neither be entitled to vote nor be counted for quorum purposes.Speiser v. Baker (Circular Structures Case)

Facts: Theres a single operating business, Chem, with four classes of shareholders: public (40%), Speiser (10%), Baker (8%), and Health Med (42%). Health Med itself is owned by Chem, Speiser, and Baker. Chem, through a wholly owned subsidiary (Medallion), owns an issue of Health Med convertible preferred stock which carries the right to only 9% of Health Meds vote, but if converted into common stock, would represent 95% of Health Meds vote. While the preferred stock is not converted, Speiser and Baker control Health Med. If the stock was converted, Chem would control Med and Baker and Speiser wouldnt be able to use their control of Med (through Chem) to vote on Chem under 160(c).

Holding 1: Where a corporation has failed to hold an annual stockholders meeting for the election of directors, in contravention of statutory law, such a meeting must be held even if it means that one of two directors will be removed.

Holding 2: Where a statute (like DGCL 160(c)) prohibits the voting by a corporation of stock belonging to the corporation, stock held by a corporate subsidiary may belong to the issuer and thus be prohibited from voting even if the issuer does not hold a majority of shares entitled to vote at the election of the directors of the subsidiary.Vote Buying

Traditionally, a shareholder could not sell her vote other than as part of a transfer of the underlying share. Now, vote buying is voidable but not void per se. Why limit the separation of control rights (the vote) over cash flow rights (the dividends)?

Easterbrook and Fischel: Voting in Corporate Law

Someone who wants to buy a vote (almost always) must buy the stock too; by attaching the vote firmly to the residual equity interest, these rules ensure that an unnecessary agency cost will not come into being. Transactions in votes would present difficult problems. Legal rules tying votes to shares increase the efficiency of corporate organization.

Schreiber v. Carney

Facts: Texas International lends over $3 million to Jet Capital (which held 35% of Texas Internationals common stock) in return for voting in favor of reorganization merger. Plaintiff (i) alleges vote-buying and (ii) asserts that the loan was corporate waste.

Holding: Corporate vote-buying is permissible if it does not work to the prejudice of other stockholders. The loan constituted vote-buying, but it had no purpose to defraud or in some manner disenfranchise other stockholders.

Two principles that appear in Delaware cases dealing with vote-buying:

Vote-buying is illegal per se if its object or purpose is to defraud or disenfranchise the other stockholders.

Vote-buying is illegal as a matter of public-policy. Each stockholder should be entitled to rely upon the independent judgment of his fellow stockholders.

In this case, however, the agreement was entered into primarily to further the interests of Texas Internationals other stockholders, hence the public policy rationale ceases to exist. An agreement involving the transfer of stock voting rights without the transfer of ownership is not necessarily illegal and each arrangement must be examined in light of its object or purpose.Today, many types of derivative financial contracts are available in more or less standard forms that allow the legal owner of shares to trade away the economic risk of an investment while maintaining legal title.

Portnoy v. Cryo-Cell International, Inc. (Going further than Schreiber)Facts: Agreement between board of directors and stockholder, to add stockholder to the management slate in exchange for his support in proxy fight. Another dissident shareholder who loses the proxy fight sues for illegal vote-buying.

Holding: It was vote-buying, but not illegal. The Court declines to apply the Schreiber test considering that it would result in creating litigable factual issues about a large number of useful compromises that result in the addition of fresh blood to management slates.Crown Emak Partners v. Kurz (Separation of financial rights from voting rights)Facts: The insurgents bought from a former corporate employee the economic interest (future cash flow rights) and the right to vote just enough shares to win a proxy contest. The seller retained bare legal title.

Holding: There was no fraud in the transaction, because the economic interests and the voting interests of the shares remained aligned. Both were transferred by the Purchase Agreement. No need to apply Schreiber (because the votes were bought along with the economic interest)Controlling Minority Structures

Other ways to separate control rights from cash flow rights: controlling minority structures or (CMSs)- permit a shareholder to control a firm while holding only a fraction of its equity.

Bebchuk, Kraakman, Triantis: Stock Pyramids, Cross-Ownership, and Dual Class Equity

Dual-class share structures (most common in the U.S.)- single firm issuing two or more classes of stock with differential voting rights. Cash flow and control rights may be easily separated by attaching all voting rights to the fraction of shares assigned to the controller.

Stock pyramids (most popular worldwide)- in a pyramid of two companies, a controlling minority shareholder holds a controlling stake in a holding company that, in turn, holds a controlling stake in an operating company (not popular in US because of taxation at each stage).

Cross-ownership ties- horizontal structures. Voting rights used to control the corporate group are distributed over the entire group rather than concentrated in the hands of a single company or shareholder.

Pyramids and cross-ownership are unpopular in the U.S. due to tax reasons and reporting requirements under the Investment Company Act of 1940.

Dual-class share structures are rare among public companies (in fact, historically NYSE would not list common stock that did not possess equal rights), although sometimes they might be desirable (e.g., newspapers).

Currently, NYSE proscribes securities that limit the voting rights of existing securities, but permits IPOs of low-vote or no-vote stock that do not control the rights of existing stock.

The Collective Action Problem

A collective action problem exists in any voting system where an informed vote is costly.

Recently, some commentators have pointed to hedge funds as a solution to the collective action problem.

Kaban and Rock: Hedge Funds in Corporate Governance and corporate Control

Incentives for hedge funds to monitor portfolio companies: (i) maximizing returns to fund investors (and at the same time increasing the fund managers fees); (ii) maximizing absolute returns.

Unlike mutual funds, hedge funds benefit directly and substantially from achieving high absolute returns.

General Judicial Superintendence of Shareholder Voting

Fundamental nature of shareholder voting + wide and flexible power of management recognition of broad general powers of courts of equity to supervise the voting process under a fiduciary standard of good faith.

Schnell v. Chris-Craft Industries

Facts: The incumbent board strung along the dissidents who were negotiating up to the last minute; then with only a couple of months left before the annual meeting the board amended the bylaws to advance the annual meeting date by one month and moved it to a small town (excuse: avoid the Christmas mail rush).

Holding: Management has attempted to utilize the corporate machinery and the Delaware Law for the purpose of perpetuating itself in office; and, to that end, for the purpose of obstructing the legitimate efforts of dissident stockholders in the exercise of their rights to undertake a proxy contest against management. Given these inequitable purposes, the advancement of the by-law date of a stockholders meeting cannot stand. Inequitable action does not become permissible simply because it is legally possible.

Comment: The above expresses a most fundamental rule of fiduciary duty: legal power held by a fiduciary may not be deployed in a way that is intended to treat a beneficiary of the duty unfairly.The Federal Proxy Rules

Originate with the provisions of the Securities Exchange Act of 1934 ( 14(a)-(c)). Four major elements:

Disclosure requirements and a mandatory vetting regime.

Substantive regulation of the process of soliciting proxies.

A specialized town meeting provision.

A general antifraud provision.

Rules 14a-1 through 14a-7: Disclosure and Shareholder Communication

Section 14(a) of the SEA made it unlawful for any person to solicit any proxy to vote any security under 12 of the Act without abiding by a long list of SEA regulations. The broad interpretation of this rule in Regulation 14A resulted in actually discouraging proxy fights as risky and expensive.

Amendment of the rules in 1992: limitation of the term solicitation and new exemptions under Rule 14(a)-2 (releasing institutional shareholders, in limited circumstances, from the requirement to file a disclosure form before they could communicate with other shareholders about a corporation).

Rule 14a-3: no one may be solicited for a proxy unless they are, or have been, furnished with a proxy statement containing the information specified in Schedule 14A.

Rule 14a-1: proxy- any solicitation or consent whatsoever.

Rule 14a-2(b): exemptions: solicitation to less than 10 shareholders; ordinary shareholders who wish to communicate with other shareholders but do not themselves intent to seek proxies.

Rules 14a-4 and 14a-5 regulate the form of the proxy and the proxy statement, respectively.

Rule 14a-6: formal listing requirements.

Rule 14a-8 Shareholder Proposals (the town meeting rule)

Entitles shareholders to include certain proposals in the companys proxy materials.

Regulation 14A provides thirteen specific grounds to permit corporations to exclude shareholder-requested matter from the corporations proxy solicitation materials. Companies that wish to exclude a shareholder proposal generally seek SEC approval (no-action letter). To be eligible to submit a proposal, a person must hold $2,000 or 1% for one-year (14(a)(8)(b)(1)). Most proposals fall into one of two categories:

Corporate governance. To what extent can shareholders enact bylaws that limit the range of options open to the board in managing the firm? SEC will not mandate access to the companys proxy statement if, inter alia, the matter on which shareholder action is sought is not a proper subject of shareholder action under state law. Matters that fall within the ordinary course of business may also be excluded. Less controversial proposals (which are more likely to be included) are bylaw amendments imposing structural reforms on the board.

Rule 14a-8 request by the Carpenters Pension Fund to Hewlett Packard, requesting that the HP directors initiate a process to amend the charter and bylaws so that directors are elected by majority (rather than plurality) vote (p. 196-200).

NOTE ON THE RISE AND FALL OF RULE 14A-11, THE SHAREHOLDER PROXY ACCESS RULE. August 2010: SEC announced the adoption of a Rule 14a-11(proxy access at all U.S. public companies) any shareholder or shareholder group that held more than 3% of a U.S. public companys shares for more than three years would be eligible to nominate candidates for up to 25% of the companys board seats on the companys proxy form. July 2011: D.C. Circuit Court of Appeals struck down Rule 14a-11. April 2012: SEC announced that it would permit shareholders to propose proxy access on a company-by-company basis.

Corporate social responsibility: shareholders opposition to lawful (but disapproved) activities of the firm. Generally, Regulation 14A permits management to exclude matters that fall within the ordinary business of the corporation.

Employment-related proposals cannot automatically be excluded under the ordinary business exclusion.

Case-by-case, analytical approach. A 14a-8 proposal must focus on significant social policy issues and must not seek to micromanage the business in order to avoid running afoul of the ordinary business exclusion.Rule 14a-9 The Antifraud Rule

Proxy Rule 14a-9: general proscription against false or misleading proxy solicitations. Key elements (established by Supreme Court decisions): (i) Materiality; (ii) Culpability; (iii) Causation and reliance; (iv) Remedies: injunctive relief, rescission, or monetary damages. See Scotts StuffNormal Governance: The Duty of Care

Introduction to the Duty of Care

Duties of a fiduciary:

Duty of obedience: important in agency, but not in corporate law.

Duty of loyalty: requires that corporate fiduciaries exercise their authority in good-faith attempt to advance corporate purposes.

Duty of care: requires officers and directors to act with the care