BUSINESS ASSOCIATIONS

1. Introductiona. Assets : thing of value to a person to which one has legal title and legal enforcement capability

in the event some other person asserts a contrary claimb. Liabilities : legal obligation of a person to pay another person $ (a.k.a., debt)c. Sole proprietor : no associates; single person. Unlimited liability to fullest extent of indiv’s

wealth.i. As creditors’ claims become liabilities, supersede indiv’s own claim to his wealth.ii. Generates legally valid claims against itself and therefore against its assets

1. Created in many ways, e.g., K or tortd. “fundamental equation”: assets – liabilities = residual net value (net worth)

i. net worth: value of assets exceeds liabilities/capital ownership of any entity1. many ways to value but the uniform system is Generally Accepted Accounting

Principles (GAAP)e. enforceable claims: secured and unsecured

i. unsecured: develop a legal claim against an entity, enforceable after legal proceedings and entry of judgment

ii. secured: enter into a bargain with entity in which by K it grants the secured creditor a specific property interest in an entity’s asset to be exercised if entity does not pay debt obligation

f. creditor : holder of a liability claimg. fundamental rule of creditor legal priority over owners

i. creditors of an entity are always senior in priority of payment over the claims of owners of entity—applies to EVERY enterprise

h. Agent: est’ing linking rel’ship btwn actor & another entity, whereby actor can create liability for other.

i. Establishing agency as a mechanism of suing the larger entity, i.e., the principal.i. Partnerships : co-principals, co-agents, co-owners, whereby each can create joint & several

liability for other. See CA § 16202. Partnerships are unincorp’d associations. Formed by mere association.

i. Note: Conduct only can create agency or partnership.j. State-created enterprises (corps / LLCs): liability limited to a person’s investment. Docs

must be filed w/ the state in order to form the association.k. Goal of every business assoc is reducing amount of liability + increase net worth of

owner.l. Creditors are always senior to owners in terms of getting access to money.

2. AGENCY (a type of fiduciary relationship)a. The engagement and empowerment of others (agent) to act on behalf of any legal person

(principal)i. Principal is liable for agent’s Ks on behalf of principal and torts committed within scope

of agency1. Distinguish from arm’s length contracting, which permits parties to put their

personal interests above othersb. Agent: a person who, by mutual assent, acts on behalf of another and is subject to the other’s

controli. May be general (any reasonably related service to P’s goals) or special (one transaction)ii. Agent has fiduciary duty to principal, which exists to prohibit agent from self-benefit

1. Must act loyally for principal’s benefit in all related matters2. Must not acquire a material benefit from a 3rd party in connection with actions for

principal’s benefitc. Rstmt 3d § 1.01 : An agent is a person who by mutual consent acts on behalf of

another and subject to the other’s control. i. Requires mutual consent that the agent will act on behalf of / subject to control of

principal. Both the principal and agent must manifest assent or otherwise consent (e.g., via conduct).

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1. Objective standardd. Agency relationship may be created although the parties did not call it same and did

not intend legal consequences of the relation to follow. i. Parties labeling and popular usage are not controlling. Manifestation through written or

spoken words, or other conduct is sufficient to create such a relationship. ii. Hence, fact intensive inquiry. Circumstantial evidence, rather than agreement per se, is

sufficient if it shows a course of dealing indicative of agency.iii. Types of principals: (1) Disclosed: 3d pty has notice agent acting on principal’s

behalf, knows principal’s ID. (2) Unidentified: as above but 3d pty does not know principal’s identity. (3) Undisclosed: 3d pty has no notice that agent is acting for principal.

1. Note: When agency disclosed but not ID of principal, both agent & principal liable.a. But fully disclosed agent to third party not liable to 3rd party

e. Actual Agency v. Apparent Agencyi. Distinction between express and apparent authority/agency turns on the person to whom

the communication is madeii. Actual authority: Agent has actual authority if P’s words or conduct would lead a

reasonable person in the agent’s position to believe the P wishes the agent to so act1. Express: P expressly tells A what to do2. Implied: not all of the acts P authorizes are specifically stated but implied

a. Incidental: A has authority to do incidental acts that are reasonably necessary to accomplish an actually authorized transaction, or that usually accompany it

iii. Apparent authority: Agent has apparent authority if manifestations of the principal to the 3rd party would lead a reasonable person in the 3rd party’s position to believe the principal had authorized the agent to act. Refers to how conduct is viewed by a third party (endeavor to protect third parties who may be relying on agent’s representations). See Jenson Farms.

1. APPARENT AGENCY: reasonable belief by 3d person based upon acts of a person (principal) to another (agent) that would give a third person the basis to reasonably believe that there is an existing agency whether there is actual authority.

a. E.g., bank janitor acting as a teller2. Apparent Authority (Rstmt 3d § 2.03): power held by an agent or other actor to

affect a principal’s legal relations w/ third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principal’s manifestations.

a. KEY: Principal’s manifestations . 3d pty’s belief must be traceable to those manifestations. Those manifestations are what create the reasonable belief.

b. Overrides a defense of no express authorityf. Ratification: if A doesn’t have actual or apparent authority, P can still be bound if P either (1)

affirms A’s confudct by manifesting an intention to treat A’s conduct as authorized or (2) engages in conduct that is justifiable only if has such an intention

g. Respondeat Superior: Form of tort liability derived from where agent acts within the scope of the authority conferred on it. Hence, inquiry into scope of employment and whether agent was indeed an agent, i.e., principal must have control or right to control agent, and hence, whether the liability should also be imputed to principal.

i. Note: This doctrine presumes that the agent has been expressly conferred authority by a principal. Not an issue of apparent authority.

1. Liability structure = distinct from contract agency liability, where—whether express or apparent authority—only principal is liable. Here, agent = liable but liability can be imputed to principal if agent acted w/in scope of authority.

ii. Key question: whether principal, who was not involved in transaction that led to tort, has done smthng to allow 3d pty to enforce its right against principal by way of agent’s action.

iii. (Based in phil that industry should bear cost of tort harm. Rough sense of justice; (false) presumption that businesses can always bear the loss better than individuals.)

h. JENSON FARMS v. CARGILL (SC of MN 1981)

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i. Actual authority: not question of farmers’ belief, but rather behavior & reps made by Cargill amounting to Warren’s actual auth’ty—expressions of principal conferring auth’ty on agent.

ii. KEY FACTS1. Ps = various farmers who entered into Ks for sale of grain w/ W Seed & Grain Co.

Ps did not have Ks w/ C, the D. But suing C.2. W’s business = 75% grain; 25% seed.

a. Sold 90% of its grain to C3. C financing W; bank-borrower rel’ship though not actually a bank.4. Key Question: How much of the business is controlled by the principal?

a. Here, critical that C essentially controls main arm of W’s business (90%).b. Just being a buyer or lender does not make out an agency relationship.

5. C also creditor of W, BUT no ordinary creditor. Addit’l rights conferred by security agreement for $175K loan: assets of W’s grain business as security (property right).

a. Note: Monitoring the borrower involves control of the borrower to enhance the probability of repayment, BUT a secured lending arrangement does not automatically create an agency relationship.

b. KEY factors in determining when a creditor becomes a principal and creates an agency relationship = management & discretion.

iii. Actual agency relationship that hinges on what the parties did between themselves that converted a lender-supplier relationship into one of agency.

1. Primary benefit test for distinguishing mere supplier from agent: (1) the one who Ks to acquire property from a 3d person & convey it to another receives a fixed price for the property irrespective of the price paid by him; (2) that he acts in own name & receives title to property which he thereafter is to transfer; & (3) that he has an independent business in buying/selling similar property.

a. Here, C as a buyer of grain buys 90% of W’s grain where grain is 75% of W’s business. Further, C has a right of first refusal. Does W have a business independent of servicing C? Court holds that all portions of W’s operations were financed by C and that W sold almost all of its market grain to C. Relationship not merely one of supplier-buyer.

iv. Further limitations by C the lender on W the borrower’s behavior and how it could use C the lender’s money (elements of control; monitoring / management controls):

1. (1) subsequent K extending W’s credit line; (2) C would provide W w/ annual financial statements; (3) C would keep W’s books or audit would be conducted by independent firm; (4) C had right of access to W’s books for inspection; (5) W not to make capital improvements or repairs w/o lender’s prior consent; (6) W not to become liable as guarantor on another’s indebtedness or encumber its assets w/o C’s permission; and (7) C’s consent req’d before W could declare a dividend / sell & purchase stock. (con’t)

v. Lambert: BUT absence of control. When C reviewed W’s actions & suggested a number of steps for borrower to take, borrower did not act. Control of W’s business? Later, C finds out W was cooking the books and deeply indebted: control? C had no knowledge of borrower’s books.

1. Further, another dealing between the parties indicated that they were aware of how to K for an actual agency relationship.

2. Note: Ultimately, C actually takes control of W by sending in a team.vi. C’s basic argument: mere buyer-supplier of W’s grain or mere lender of money.vii. Security holder merely exercising veto power over debtor’s business acts by

preventing purchases / sales above specified amts DOES NOT thereby become principal.

1. However, if security holder takes over mngmt of debtor’s biz, he becomes principal.

a. KEY: Assumption of de facto control over debtor’s conduct = moment when creditor becomes principal.

viii. Holding: The relationship of C and W was one of agency; C’s conduct, when viewed in sum, esp. of nine specific factors listed, constituted management control and something that went beyond an ordinary debtor-creditor or buyer-supplier relationship.

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1. Lambert’s criticism: The factors to which court points, incl. recommendations, criticisms and need for paternal guidance are not management control.

a. Rt of first refusal, rt of entry, and inability to enter into mortgages, purchase stock & pay dividends = standard lender-borrower terms. Power to discon’t financing = standard lender power.

b. (Even if C’s name imprinted on W’s drafts, not an apparent auth’ty case here.)

2. None of 9 factors signified management control, thus irrelevant there are 9. 9x0=0.

3. Bunge case to which court cites = distinguishable b/c degree of control in Bunge = nearly absolute. At best, Bunge supports proposition that buying most or all of a business’ product est’s more than a mere buyer-supplier relationship.

ix. Note the narrow holding: On the facts of this case, sufficient evidence presented for jury to find presence of agency relationship w/in Rstmt’s definition of agency.

1. (Note: Geographical bias b/c farming community.)x. Classic example of a final exam fact pattern b/c no clear answer re: whether

agency relationship existed and it’s possible to argue for both sides.i. TARNOWSKI v. RESOP (SC of MN 1952): No question about agency here. Clearly established.

i. HOLDING—Breach of fiduciary duty: Agent did merely superficial investigation of the business, made false representations to principal and colluded w/ sellers to get the deal to go through. Essentially, agent took a bribe from the seller and principal found out, and as the seller refused to return the money, principal sued agent.

ii. Agents have fiduciary duty to principals: Duty to deal on principal’s behalf w/ principal’s best interests in mind, i.e., not take advantage of the position as agent. Agent = liable for a breach where agent enriches self. Agent cannot use principal’s property for his own benefit; cannot profit from task given him by principal.

1. Fiduciary duty of agency = distinguishable from arms-length contracting where parties may put their personal interests first. Agent is charged w/ doing what is reasonably necessary to carry out interest/business of principal.

j. Bottom line: Agents cannot personally profit from undertaking principal’s business; any profit obtained must be disgorged.

i. Principal can recover foreseeable damages from agent’s breach of fiduciary duty.1. In Tarnowski, principal does not sue for expected lost profits b/c too speculative

for the law to measure. Here, what principal paid down for coin-operated music machine business and what agent received as secret commission, plus attorney’s fees & expenses of suit directly, foreseeably traceable to harm caused by agent’s breach.

2. In Jenson Farms, principal C could convert case into breach of fiduciary duty for agent W cooking books and misappropriating money C lent, but W has absconded.

3. PARTNERSHIPa. Definition : CA Corp Code § 16202: Association of two or more person to carry on as co-

owners a business for profit forms a partnership, whether the persons intend to form same (except where same is a corporation, an LLP or an LLC).

i. Note: NO FORMAL REQ to form one1. 4 element test for best evidence p’ship created (NOT requirements)

a. agreement to share profitsb. agreement to share lossesc. mutual right of control or management of the businessd. community of interest in the venture

ii. partnership agreements: p’ship Ks can limit/change the applicable law as it applies between them (with limits), but not between them and third parties (except for non-recourse Ks)

1. 3 most important features of p’ship K: 1. How profits divided; 2. How losses shared; 3. What duties and responsibilities of each partner will be

2. p’ship K CANNOT DO THE FOLLOWING:a. eliminate the duty of loyalty—but if not manifestly unreasonable, may:

i. identify specific types or categories of activities that do not violate duty of loyalty

1. CA is stricter than most jx4

a. DE: K theory; can waive duties to fullest extent via K but no fraud and can’t waive GF and fair dealing

ii. all of a % of p’s may authorize or ratify, after full disclosure of material facts, a specific act or transaction that would otherwise violate the duty of loyalty

b. unreasonably reduce the duty of carec. eliminate obligation of good faith and fair dealing

iii. Partners are co-principals and agents to one another 1. Thus, fiduciary duties

a. Duty of care: cannot unreasonably reduce duty by Kb. Loyalty: deals with financial self-interest, i.e., can’t use p’ship business to

further self-interest unless have written exception to loyaltyi. Doesn’t just mean $ but also appropriation of p’ship

opportunitiesii. Can’t wind up stint in p’ship with a party adverse to itiii. Can’t compete with it until entirely dissolvediv. Bottom line: ps must hold p’ship as trustees

c. Good faith and fair dealing: statutorily imposed in every jx2. Actual and apparent authority

a. Acts carrying on ordinary business bind p’ship UNLESS p had no authority and third party actually knew or had notification of this

b. Acts NOT carrying on ordinary business does not bind p’ship unless authorized by other p’s

3. Liable for other ps’ actions if done in course of p’ship business and for a p’s misapplication of a third party’s $ or property

iv. Management:1. re: ordinary course of matters, a majority of p’s can decide (Summers)2. all partners have equal rights in management 3. absent agreement otherwise, every partner must be consulted in decisions

v. Intent is not a factor. Conduct and behavior of the parties determines.vi. Once through § 16202 door, stuck: Entirety of 16000 code governs in absence of

agreement. vii. Nearly all of the Partnership Code can be modified, but only formally.

1. § 16103 permits partners to agree and overcome default rules via p’ship K, w/ some important exceptions

a. one example: p’ship K cannot have provision that permits 2/3 of p’s to take away any minority p’s assets without liquidation because violates covenant of good faith and fair dealing

viii. Jointly held property or sharing of mere gross returns (total $) does not create partnership.

ix. BUT per § 16202(3), a person who receives a share of the profits (revenue – loss (net $)) of a business is presumed to be a partner, unless profits were received for (1) payment of debt, (2) payment for services or for rent, or (3) payment of annuity or interest on a loan.

b. § 16306: Partners are jointly and severally liable.i. Nonrecourse: Where third parties waive right to joint and several liability; agree not to

sue to recover, which limits taking of certain securitiesii. Otherwise, joint and several liability is not modifiable. (Exception where third party

interacted w/ partner/partnership and had actual knowledge of limitation on liability.)iii. Individually liable to p’ship creditors for p’ship obligations but ONLY for share of p’ship

obligations; if one pays more, entitled to indemnification c. Mere employee v. partner. KEY: co-owners in a business for profit. Look for behavior distinct

from mere employee behavior. Has employee put anything into business? Is he acting as a co-owner?

i. Note: When investment in business is merely for services and not for salary, may be a de facto partner and liability may be created as such.

ii. When someone works for and operates w/ other people and shares profit w/o consideration other than sharing in profit, person is a partner and his rel’ship to partnership = governed by 1600 provisions.

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d. Partners can transfer many of their assets but cannot transfer their vote or equal rights in management and conduct of partnership.

i. Partnership interest / economic right to receive distributions is assignable/freely transferable.

ii. Partnership rights / membership & non-economic rights not assignable/freely transferable.

e. Waiver of fiduciary duties: Narrower waiver in CA, see § 16103, than in DE, where fiduciary duties are waivable up to limit of implied covenant of good faith + fair dealing/public policy

f. MARTIN v. PEYTON (NY Ct of Apps 1927)i. Martin = creditor of KNK and sues Peyton only b/c as a creditor of a partnership (KNK),

Martin may sue one or all partners (joint and several liability).ii. Peyton & Co. lend KNK $2.5M liquid securities. KNK gives large # of speculative securities.

1. KNK’s consideration: promise of 40% profits to Peyton & Co. until full return, not less than $100K / not more than $500K.

2. Hence, association here of two or more persons that’s for profit. 3. BUT what’s missing = no agreement to carry on as co-owners.

iii. Holding: Co-ownership = absent here. No control or management (“right to participate in the control of the business,” see Lupien). Not a partnership. Elements of control are insufficient to establish partnership. Mere lending relationship here.

iv. Indicia of control here: 1. Peyton & Co. have resignation of KNK partners in their pocket. If they wish to

exercise, they become partners in name themselves.2. Restrictions on the securities lent by Peyton & Co.3. Collateral on the unliquid securities in the form of KNK securities.4. Close relationship where profits are derived from advanced capital.

a. Court: this control was just to secure safety of loans and make sure business profitable

v. Lambert: Could this have gone other way? Key: No day-to-day control (absolute req’ment?).

vi. Martin Wrap: Case of creditor suing another creditors of debtors on theory of partnership. Holding suggests that when a lending arrangement exists, that’s all it is.

vii. Best argument for partnership: $1M life insurance for Hall signed over to Peyton & Co. Degree of insurance that one of Peyton & Co.’s control mechanisms would not fail. Hall is the key to KNK. If Peyton & Co. control Hall, does that make them partners?

1. However, cannot initiate any transaction like partners may g. LUPIEN v. MALSBENDEN (SC of Maine 1984)

i. Cragin signed an agreement for a specialty auto w/ L in the name of York Motor Mart. If C had signed in his own name, L could not have come after M. Formality as key factor.

ii. M’s rel’ship w/ York MM was well est’d. M’s best argument: Loaned York MM $85K in cash. No loan agreement, no interest. Merely repaid in profits.

iii. L’s best argument: M was co-owner (“right to participate in control of the business is the essence of ownership”).

1. Ownership as rel’ship connoting control. M’s “loan” looked more like a contribution than a loan (M had pooled capital in York MM business).

iv. Holding: M was a partner. Whether M had joint title to York MM, exerted control as a co-owner, evidencing right to participate in the control of the business. M participated in the control of the business on a day-to-day basis: opened the shop many days, remained present for part of each day, had final say in ordering of parts, paid for equipment, paid C’s salary.

v. KEY FACT: Daily basis = control over business. If D just dropping by, arguably not partner.

vi. Key Partnership Facts: Capital & Control Over the Business.1. Summers exemplifies idea of control over partnership decisions. See CA §

16401(j).vii. Lambert: When there is no written agreement, there is no agreement, which leads to

the dangerous situation whereby the whole panoply of 16000 provisions apply.

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1. In absence of written agreement, parties’ conduct is crucial, although it’s unclear how specific must be course of conduct to override default provisions of §§ 16401(a),(b).

h. SUMMERS v. DOOLEY (SC of ID 1971): Clearly partnership.i. Exemplifies control over partnership decisions: equal management rights whereby

differences over ordinary course of business decided by majority (matters outside ordinary course require unanimity). See CA § 16401(f),(j).

ii. P & D equal partners. P approached D re: hiring of addit’l employee. D refused. P decided to hire. Once D discovered, D objected & refused to pay employee out of partnership funds.

iii. Holding: Equal partner in two-man partnership lacks authority to hire new employee in disregard of objection of other partner and then charge partner w/ costs incurred as a result of unilateral decision. Disagreement btwn partners must be decided by majority of partners.

i. RNR INVESTMENTS v. PEOPLES FIRST COMMUNITY BANK (Ct of App FL 2002)i. Suit against partnership on account of general partner’s actions. Lacked actual authority

to borrow money in question, per partnership agreement. BUT bank argues partnership agreement not the law (see § 16301 regarding partner as agent of partnership).

ii. Lambert: Though general partner lacked authority, partnership still bound. Partner is agent for partnership and his acts bind partnership.

1. For partnership to escape liability, partner must act w/o authority and third party must have actual knowledge of partner’s lack of authority, protecting reliance of 3d parties for partners’ acting w/o actual authority in carrying out ordinary course of biz.

iii. Holding: Partners have apparent authority. As bank lacked actual knowledge or was not actually notified of the fact (or had reason to know, given the circumstances) that, even though general partner had apparent authority, he lacked actual authority acc. to partnership agreement, partnership bound to general partner’s K w/ bank.

1. As partnership failed to indicate sections of partnership agreement advising bank of general partner’s lack of actual authority, partnership jointly & severally liable.

iv. RULE: Absent actual knowledge or notification of any limitation on partner’s authority, w/in reasonable boundaries, 3d parties can freely deal w/ partners and bind partnership.

j. MEINHARD v. SALMON (NY Ct of Apps 1928)i. D was manager of P’s real property as part of a partnership. Third party approaches D at

end of partnership term and offers a good deal. D takes the deal w/o consulting P.ii. Issue: Whether D taking deal w/o consulting P violates fiduciary duty of partnership.iii. Holding: D’s business opp came to him w/in scope or performance of partnership.

Clearly, opp was new venture. Yet, D had duty to give P notice of opp and chance to participate.

1. Court awards P 50% share of new venture, but 4-3 decision in 1928. D did not even advise P of acceptance of new venture & P was managing partner. Limited holding.

k. CA §§ 16401(a),(b): critical rules applying in absence of agreement to contrary.i. 2 important things:

1. profit and loss sharing rules: relate to how p’ship calculates how business has made/lost $ over period of time

a. absent agreement otherwise, p’s share equally in profits/losses; share losses in proportion to entitlement to share of profits

2. distribution: payment of cash or property from an entity to an ownerii. § 16401(a): Each partner’s capital account credited w/ amt equal to money plus value of

property, net amount of any liabilities, partner contributes to partnership & partner’s share of partnership profits. Charged w/ amt distributed by partnership to partner & partner’s share of partnership losses.

iii. § 16401(b): Each partner entitled to equal share of partnership profits & chargeable w/ share of partnership losses in proportion to partner’s share of profits, i.e., equal as default.

iv. Accounting for capital = method for keeping ownership score between partners. Gov’d by partnership agreement or § 16401(a),(b) as default (harsh conseq’s where contribs not equal).

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Pertinent Partnership Code Sectionsl. § 16101 (10): Partnership agreement is written, oral or implied.m. § 16103: Partnership agreement. Partnership is governed by the agreement (overrides

terms of RUPA). To extent agreement does not otherwise provide, 16000 provisions function as default.

i. Partnership agreement may not (selections), i.e., what terms agreement may not override:

1. Unreasonably restrict right of access to books/records.2. Eliminate duty of loyalty.

a. If not manifestly unreasonably, it may identify specific types or categories of activities that do not violate duty of loyalty. Partnership may also permit a specific transaction that would otherwise violate duty.

3. Unreasonably reduce the duty of care or eliminate obligation of good faith and fair dealing, though it may prescribe standards for same if not manifestly unreasonable.

4. Vary power to dissociate partner, vary right of court to expel partner, or restrict rights of third parties under the 16000 provisions.

n. § 16202: Formation of partnership. Association of two or more persons to carry on as co-owners a business for profit forms partnership, whether of not the persons intend to form partnership.

i. Common property / part ownership of property does not by itself establish partnership, even where co-owners share profits made by use of same.

ii. Sharing of gross returns, i.e., revenues, does not by itself estab partnership.iii. Person receiving shares of profits from business presumed to be partner, unless

received: In payment of debt by install’s; for services as ind contractor or wage/emp compen; of rent; of retire benefits; of interest/charge as on loan; for sale of goodwill of biz or property by install.

o. § 16301: Partner as agent of partnership. Each partner is an agent of partnership. Act of partner for apparently carrying on in ordinary course of business of kind carried on by partnership binds partnership, unless acting partner lacked same authority and third party knew (or had reason to know in context, see § 16102 definition of knowledge) or received notification of same.

i. Otherwise, partner’s act only binds partnership if authorized by same.p. § 16305: Liability of partnership for act of partner. Partners are agents for partnership,

i.e., partnership = liable for loss/injury caused to person as result of wrongful act or omission of partner acting in ordinary course of partnership’s business or w/ its authority. Partnership is liable for misapplication of money or property by partner acting in same circumstance.

q. § 16306: Joint and severable liability; personal liability. All partners are jointly and severally liable for all obligation of partnership. Partners are not jointly and severally liable for liabilities that arise before they are admitted to partnership.

i. §§ 16306/16307: in enforcement of judgment, partnership must be found liable first and then must not be able to pay judgment before partners may be sued individually for all liabilities.

ii. BUT in reality, action proceeds against partnership and individual partners all at once w/o procedural barriers. Those suing partnerships sue all partners collectively, such that a judgment is won, they can pursue joint and several liability against partners immediately.

r. § 16401: Partner accts; share of profits; conduct of partnership biz; becoming partner.

i. Each partner’s account…1. Credited w/ money + property – liabilities that partner contributes to

partnership and partner’s share of partnership profits.2. Charged w/ money + property – liabilities that are distributed to partner and

partner’s share of partnership losses.ii. Each partner entitled to equal share of partnership profits and chargeable w/ share of

partnership losses in proportion to same.iii. Each partner has equal rights in mngmt/conduct of partnership business. See

Summers.

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iv. Each partner may use/possess partnership property only on behalf of partnership.v. Person may become partner only w/ consent of all partners.vi. Differences arising as to matter in ordinary course of partnership business may be

decided by majority. Act outside ordinary course of biz or amendment to agreement req’s consent of all.

s. § 16404: Fiduciary duties. Partners owe duty of loyalty & care to partnership/partners.i. Duty of loyalty: To account to partnership and hold it as trustee for any property, profit

or benefit derived by partner in conduct of partnership business. To refrain from dealing w/ partnership on behalf of party having adverse interest, or competing w/ partnership.

ii. Duty of care: To refrain from engaging in grossly negligent/reckless conduct, intentional misconduct, or knowing violation of law. Discharge duties owed to partnership w/ good faith + fair dealing. Furthering a partner’s own interest does not necessarily violate this duty.

t. § 16602: Dissociation.i. Partner has power to dissociate at any time, rightfully or wrongfully.ii. Dissociation is wrongful only if

1. Breaches express provision of partnership agreement.2. In a definite-term partnership, it’s before end of term and

a. Partner withdraws by express will; orb. Partner is expelled by judicial determination; orc. Partner is dissociated by becoming debtor in bankruptcy.

3. Partner who wrongfully dissociates = liable to prtnrship for damages.u. § 16701: Buyout of dissociated partner.

i. If partner dissociates, partnership shall purchase his interest for buyout price, which is amount that would have been distributable under § 16807, assuming certain criteria.

ii. Damages for wrongful dissociation shall be offset against buyout price.iii. Bought-out partner is indemnified by partnership of all partnership liabilities.

v. § 16807: Application of assets; settlement of accounts; partner contributions. In winding up, partnership assets applied first to creditor obligations (incl. creditors partners). Any surplus applied in acc. w/ partners’ rights to distribution: (1) settlement of all partnership accounts; (2) profits and losses resulting from partnership asset liquidation are credited and charged to partner accounts; and (3) distribution to partner equal to any excess of credits over charges in partners’ account. Note: Partners shall contribute to partnership any excess of charges over credits in partner’s account.

i. Other partners jointly liable under § 16306 for any obligated contribution a partner fails to make, though the defaulting partner is liable to the other partners.

w. Partnership Accounting (Note: When partnership winds up, creditors are paid first)i. When partnership dissolved, first settle capital accounts (laws of dissolution).

1. § 16807 = partners first paid their capital account, then equal share of profits if any.

2. If losses, shared equally among partners . If partner’s share is negative in to settling of capital accts, partner must pay into partnership to compensate / zero out.

3. Each partner, under § 16807 absorbs profit, loss & distribution equally.x. Partnership Problem Takeaways

i. Initial capital accountsii. Loss, per § 4.2.1(b) = equally sharediii. Draw/distribution, per § 3.2(a) = equally sharediv. Profit, per § 4.2.2(a) = first allocated (equally) to compensate for prior allocation of loss,

then, per § 4.2.2(b), remainder of profit = allocated pro rata acc. to respective % interests

v. If no prior allocation of loss, per 4.2.2(b), profit = allocated pro rata acc. to % interestsvi. Sale of partnership, per § 10.3, initially distributed in acc. w/ capital accounts at time of

sale; then remainder distributed as profit/loss, per § 4.2.2(b), allocated pro rata acc. to % interests

vii. Note: In absence of agreement, CA §§ 16401(a),(b) would govern windup.

4. Corps, LLCs, limited p’shipsa. Features of these state-created entities

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i. 1. Limited liability: creditor legal recourse limited to assets of the entity for its debts, NOT the owner-investors

ii. 2. Passive investment: owner-investors do not have control over business decisionmaking of the entity, which is managed by the managers

1. owner-investors have right to vote for managers and approve/reject proposals, major transactions

iii. Board of Directors: plenary discretion for managerial decisions but owe fiduciary duty to investors of due care, loyalty, good faith

1. Business judgment rule: presumption BoD acts lawfully and in good faith; insulates from lawsuits from investor-owners that are just second-guessing decisions

a. Thus, may reject any interference by investor-owners even if legitiv. All of these strictly require filings with the gov’t for their creation—no filing = no entity =

personal liability for pre-incorp transactionsb. legal entities in corporate structure

i. Shareholders: owners/investorsii. BoD: ultimate governing bodyiii. Creditorsiv. Agents: CEO, pres, CFOv. Note: individual can have AT THE SAME TIME the role of each of these positions

c. Terminologyi. Unincorp’d entities/p’ships promoters formation incorp’d entity

1. Corporationa. Mgmt.: BoDb. Owners: SHs

2. LLCa. Mgmg: manager(s)b. Owners: members

3. Limited p’shipsa. Mgmg: general partner(s) (agentsb. Owners: limited partners

5. LLCsa. Members are owners; equivalent of partners / shareholders; management = managers

i. All owners can be managers, thus can participate in mgmt. and control with little or no risk of general liability as partners

b. Operating agreement = constitutive document, defines how it will operatec. Articles of organization = doc to file to form

i. Similar to arts of incorp except it needs to state whether all members = managersd. LLCs have the flexibility of partnership (operating agreement) and limited liability of corporation

(provided LLC plays by rules and does not engage in wrongful conduct that amounts to injustice).

e. Option to be managed by members or professional manager; some mixture of the two also permitted. Default: managed by members. Otherwise, it must be stated in Articles of Org, § 17151.

i. Have similar authority to bind the LLC like partners in p’shipsii. May transfer right to receive distributions but cannot transfer rights to mgmt./participate

unless K says so or all members consentf. Default voting rule: absent agreement, votes in proportion to participation in profits, §

17103.g. Fiduciary duties: owed by managers to members only, unless all managers are members.

Same fiduciary duties as partners: duty of care / loyalty. (Waivablility same as partnership, § 16153).

h. KAYCEE LAND v. FLAHIVE (SC of WY 2002): equitable remedy of piercing the corporate veil available remedy in action against LLC.

i. Target of litigation here managing member of LLC in question.ii. Parallel corporation provision: § 17101(b). Absolution from liability of shareholder in

corporation; equivalent applies in LLC, as does alter ego liability of corporations.Pertinent statutory provisions

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i. § 17001: definitions of fundamental terms / constituents of LLCi. (d) capital account: unless agreement provides otherwise, member’s original

contribution, as (1) increased by any additional contributions & by that member’s share in the profits and (2) decreased by any distribution to that member and by that member’s share in the losses.

ii. (n) economic interest: right to share in income, gains, losses, deductions, credit, etc. of the LLC and to receive distributions from same, but does not include any other rights of a member, incl. right to vote or participate in management.

iii. (w) manager: person elected by members to manage; if not provided for by articles of incorporation, each of the members is a manager (default)

j. § 17005: articles of organization / operating agreementi. govern relations among and between members; fiduciary duties of managers may only

be modified in writing w/ informed consent of members, see § 17153, which imports duties and limitations of waivers of LLCs from the partnership code.

k. § 17050: requirements of formation; beginning of existencei. formation occurs on execution & filing of articles of org w/ sec of state, plus oper agreement.ii. existence begins upon filing of articles of organization.

l. § 17051: contents of articles: if not all members are managers, must be stated as req’d by § 17151(b)

m. § 17101: liability of membersi. personal liability of members is limited; veil of LLC can be pierced just like a corporation:

liability under corporate rules for disregarding LLC form and providing of personal liability of members, except failure to observe formalities does not militate against members of LLC as it does in corporate context.

n. § 17103: voting: if no provision otherwise, members vote in proportion to interests in current profits.

o. § 17150: management by members unless articles provide otherwisep. § 17151: management by one or more members

i. (a) articles of organization may provide that LLC’s business and affairs shall be managed under authority of one or more members who may, but need not be, members.

ii. (b) if LCC to be managed by one or more members and not all its members, articles of organization shall contain statement to same effect. (protects 3d pty reliance)

q. § 17153: fiduciary duties: owed by manager to LLC same as partnership duties, § 16404 / 16103(b)

r. § 17200: capital contributions of membersi. articles of organization or operating agreement may provide for capital contributions of

members, which may be made in money, property or services, or any other obligation. s. § 17202: profits and losses; allocation among members

i. unless provided, profits & losses allocated among members in proportion to each contributions.

t. § 17250: distributionsi. unless provided, distributions that are return of capital shall be made in proportion to

contribution; distributions that are not capital shall be made in proportion to allocation of profits.

u. § 17254: prohibited distributions (compare CA § 500/501 for corporations)i. no distributions shall be made if after same: (1) LCC would not be able to pay debts as

due in usual course of business; or (2) LLC’s total assets would be less than sum of total liabilities, plus liabilities represented by members’ rights that would be preferential to those of the members receiving present distribution.

ii. distributions must be returned if member had actual knowledge of impropriety of same and if after distribution all liabilities of LLC exceed FMV of assets.

v. LLC Problemi. Original capital contributionsii. Losses decrease capital accounts according to sharing ratiosiii. Distributions decrease capital accounts according to sharing ratiosiv. Profits increase capital accounts according to sharing ratios; if losses previously

sustained, profits are first allocated to extent of any previously allocated losses

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v. Net proceeds from sale of assets, i.e., profits, are allocated according to sharing ratios, unless there are previously allocated losses to offset

6. Basic corporations lawa. Fundamental rule of creditors: When corporations are being liquidated, creditors have first

priority on corporation’s assets, before assets are paid out to shareholders.b. CA § 200: Formation; articles; commencement and perpetuity of existence. One of

more persons, incl. any legal entity, can form a corporation. Corporation begins upon filing of articles of incorporation, the basic constituting document, and continues perpetually.

i. KEY = corporation begins upon date on which AIC are filed. Corporate existence does not begin until filed w/ sec of state. Intent not a factor.

1. If you no act filing, de facto partnership and subject to the 16000 provisions.c. CA § 300: confers all power w/ the Board; enormous authority, ultimate responsibility. Duty of

care, loyalty and good faith: shareholders are true owners; right to be treated acc. to fiduciary duties.

i. Key provision: “Business and affairs of the corporation shall be managed and all corporate powers shall be exercised by or under discretion of the Board.”

d. Lambert’s Introductory Conceptsi. Basic traits of a corporation

1. Liability for shareholders in corporation is limited.2. Passive ownership w/ management undertaken by others (except for

fundamental right to vote for Board and for extraordinary transactions)3. Free transferability of ownership interests; Continuity of existence;

Centralized management; Status as an entity.4. Generally, corporation must follow the law of the state of incorporation.

a. CA § 2115: if are essentially a CA corporation, governed by CA law, even if incorporated in DE. BUT DE SC struck down as violating Commerce Clause.

e. Promoter Liability, Pre-incorporation Transactions & Ksi. Ks made by individual promoters pre-corp formation create personal liability for

promoter.1. Exception: if party that K’d with promoter knew the corp was not in existence at

time of K but said would look solely to corp for liability explicitly or impliedly, then promoter is not liable

ii. GOODMAN v. DARDEN (WA 1983)1. P proposed to renovate building owned by D. P informed D that he was forming a

corporation to limit personal liability.2. K said it was btwn D and “Building Design and Development, Inc. (In Formation)

John A. Goodman, President.” Fact that D knew corp was not yet in existence does not mean D did not intend to make P personally pty to K. Ks are made btwn real parties.

3. KEY: Checks were written out to corporation and P as an individual. Does not show by reasonable certainty or explicitly that D intended to K only w/ corporation.

4. Holding: D failed to assent to P’s intention to limit personal liability.5. Note: When K signed, law expects at that time a party will be bound. Hence,

where agent of corporation-to-be-formed signs K on behalf of same, agent is bound to the K.

a. If pty knows corp non-existent does not indicate agreement to release promoter; opposite: corp is non-existent, can’t hold liable; need recourse against promoter.

b. Promoters seeking to get out of personal liability have a significant burden. Cts tend to hold promoter liable pre-incorp if promoter signs in indiv capacity.

c. In Goodman, P could have formed corporation before signing K.iii. Bottom line: Corporation, just like real person, not bound to K until it can sign it. As

such, when promoter enters into K w/ another party on behalf of corporation-to-be, same

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K will stick, absent crystal-clear terms that K is between corporation-to-be and the other party.

1. Best way to avoid this problem: No Ks until K = in existence.iv. Defective incorporation: Misleading. Either a corporation = in existence under § 200(c)

or it’s not. In vast majority of cases, no de facto incorporation. But see Sunshine (not law in CA), where incorporators sent certificate to wrong address and entered into K before certification processed, and court did not hold individuals liable.

7. Allocation of Power Between Directors and Shareholdersa. Bottom line: BoD makes all business decisions but cannot meddle with SHs’ voting rightsb. §§ 300, 309 define division of control btwn shareholders & directors, and duties directors owe

SHs.c. CHARLESTOWN BOOT & SHOE v. DUNSMORE (NH SC 1880)

i. Ds are elected directors. Shareholders unhappy w/ directors and wished to liquidate. Elected one Osgood to rep their interests and act w/ directors to “close up” corporation’s affairs.

ii. CA § 300(a): general conferral of authority to Board equivalent to statutory provision at issue here. Business of corp shall be managed by directors, subject to bylaws and SH votes. Only limitation on judgment or discretion of directors is that of bylaws or by SH vote.

1. § 300(a): “business and affairs of corporation shall be managed and all corporate powers shall be exercised by or under the direction of the Board.”

iii. If SHs wish to take issue w/ Board, must exercise voting rights to change corp leadership.iv. BUSINESS JUDGMENT RULE: rebuttable presumption that directors act with due care,

good faith, and loyalty and their decisions are informed and rationally undertaken. SHs must overcome presumption to make out case. Otherwise, directors’ decisions stand, unless rest on no rational basis whatsoever. (con’t)

v. BJR = “presumption that in making a business decision the directors of a corp acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”

1. (a) business decision/judgment; (b) made by disinterested and independent directors; (c) made with due care on an informed basis; (d) made in good faith in the honest belief it is in the best interests of the corporation and its SHs; and (e) made with no abuse of discretion

vi. Applied in Charlestown : Statute here does not authorize shareholders to join another officer w/ directors, nor compel directors to act w/ one who is not a director. Directors are bound to use ordinary care & diligence in managing the corporation and answer for failure to do same.

vii. When statute provides that powers granted to corporation shall be exercised by directors, such powers can only be exercised by same. Thus, here, shareholders’ attempt to exercise power through Osgood that the charter lodged in the directors alone is void.

viii. Board has an incredible power of oversight & presumption of loyalty, care and good faith.ix. Bottom line: Directors run the corporation and they have the ultimate responsibility

and authority for the corporation, subject to fiduciary duties. Shareholders do not get in boardroom, but as corp’s owners, they have power to vote to put directors in the boardroom.

BJR Standard on Board Decisionx. (1) Decision; (2) Directors must have fully informed selves and utilized a reasonable

decision-making process, under negligence standard (due care);xi. (3) Decision must have been made in good faith, although this has not been much

litigated.1. Disney suggests loyalty & good faith are separate, although Ritter suggests

otherwise.2. Good faith = different connotation than loyalty. Good faith = reckless disregard,

or knowingly or internationally bad act, which could include lack of good faith in Board’s exercise of its monitoring responsibilities, whereas loyalty = $$$ interest.

xii. (4) Director must not have a financial interest in subject matter of decision (loyalty)d. BJR: KAMIN v. AMERICAN EXPRESS (Sup Ct NY 1976)

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i. Key facts: D corporation paid $29M for shares in a stock. Now, stock is worth $4M. If D does not declare a dividend, it will have a capital loss, but a tax benefit equivalent to an $8M cash benefit for the corporation. Instead, D issues SH dividend whereby corporation gets no tax or cash benefit, and SH pay taxes. SHs sue w/ contention of breach of duty of care.

ii. Holding: Court will not inquire into business items of Board’s actions, absent fraud, nonfeasance, or malfeasance. Court will not look at Board’s ultimate decision, but instead will look at the steps Board took in making its decision. Court will examine the level of the Board’s inquiry and whether it discussed the merits. Here, procedural regularity.

iii. Lambert: If instead of 4 of 20 directors, closer to a majority had compen tied to corp revenue / stock price (diminished if corp took loss as capital loss & tax benefit), stronger argument.

1. Note: As Board did not interfere w/ SH voting process, Blasius does not apply.iv. If Board is careful in making decision & procedural regularity present, BJR diff to

overcome.e. NO BJR: SCHNELL v. CHRIS-CRAFT INDUSTRIES (SC of DE 1971)

i. Facts: P is SH bringing suit against corp & its directors. Directors see that shareholders seek to replace them and, using specific authority to amend bylaws, they move up annual Board meeting by a month. Take action 2 days after shareholders file notice for a proxy fight.

ii. Entrenchment: Directors’ action is legal on face, but clear attempt to act in own self-interest & head off SHs’ attempt to replace them. Inequitable action not permissible simply b/c legal.

1. Board may be acting technically legally but improper purp of entrenching itself. Inequitably employing valid source of its power under DE law (amending bylaws).

iii. Critical fact: proxy fight. Inequitable purposes, contrary to principles of corporate democracy, underlie director’s actions. Directors are using corporate machinery and DE law for purpose of perpetuating themselves in office & obstructing legitimate efforts of dissident stockholders exercising their rights to undertake proxy contest against management.

iv. When Board bylaw amendment impacts voting (here, making meeting sooner), it calls into question possibility of interference w/ shareholders’ fundamental right in corp.

v. Directors’ best arg: legitimate biz purp; date changed, still time for SHs to pursue proxy fight.

vi. Bottom line: Board’s ultimate authority does not extend to the elective process. When Board interferes w/ sacrosanct shareholder voting franchise, bad faith & prohibited.

f. UNOCAL CORP. v. MESA PETROLEUM CO. (SC DE 1985)i. Board sees Mesa’s tactic whereby Unocal’s SHs will get bad deal. Mesa will offer to

double share price of remaining shares needed to get majority control of Unocal to then merge it w/ Mesa. Under Mesa’s tactic, remaining Unocal SHs get subordinated debt for their shares.

ii. Board views Mesa’s proposal as amounting to buying corporation at price below its true worth as a going concern and concludes transaction is unfair and coercive to SHs. Hence, Unocal’s Board moves to block Mesa w/ better proposal to its shareholders that will greatly leverage value of Unocal, but will prevent Mesa from getting at Unocal’s assets.

1. Key: Board acts on advice of outside counsel, both re: rejecting Mesa and re: defensive tactics; further, Board compromised by majority of outside directors.

2. Key (2): Only way plan works, however, is excluding Mesa. Otherwise, Mesa will still benefit at cost of Unocal leveraging itself. (con’t)

iii. Holding: Unocal Board’s tactics to block Mesa = valid, based on Mesa’s reputation as a “greenmailer.” Corporation’s self-tender for its own shares that excludes from participation stockholder making hostile tender offer for company’s stock is valid.

iv. Not typical BJR case, where if Board properly exercises its BJ, its decision stands whether or not shareholders agree. Here, a change-in-control is threatened, which raises concern Board may act for own interest to remain entrenched, rather than acting in corp’s interest.

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1. Court scrutinizes transaction more carefully: Board must reasonably perceives threat & use a proportionate response for there to be no violation of fiduciary duty to SHs.

a. Here, Unocal’s Board acted in good faith and, after reasonable investigation, found Mesa’s tender offer = inadequate/coercive. As such, Board had power & duty to oppose bid it perceived to be harmful to corporate enterprise.

b. Device Board adopted is reasonable in relation to perceived threat; proper exercise of Board’s BJ, per Sinclair Oil’s “rational business purpose” test.

2. Essentially, no reason Board cannot exclude greenmailers b/c it’s what greenmailers seek to do. An any or all cash offer difficult to defend against other than w/ same.

v. Key: Board perceived coercive deal not available to all shareholders. Court’s test for Board’s response: (1) Does Board rsnably perceive threat harmful to corp enterprise? (here, rsnable b/c only % of stockholders will get reasonable deal) and (2) Is Board’s response proportionate? (here, fight fire w/ fire). If so, as here, entitled BJR protection.

vi. Bottom line: Not voting case or change in bylaws or addition of directors to Board, but biz transaction. If Board has legitimate view of corporate danger and it responds rsnably, Board can engage in conduct to protect corporation, even if it includes excluding shareholder.

g. BLASIUS INDUSTRIES v. ATLAS CORP. (Ct of Chancery 1988)i. P, as 9% shareholder in D, sees opp in making moves to leverage D, whereby SHs

become SHs, bondholders & holders of cash in hand that flows equally across the SH population.

ii. P offers consent solicitation to all SHs, incl. appting 8 directors to remaining 8 Board vacancies.

1. Note on consent solicitation: get approval of any action SHs may take at meeting without actually having by sending out form asking for their consent—need 51%

iii. P takes offer to Board, which immediately counters by appointing two additional directors to Board vacancies, thereby shutting off P’s potential for getting Board majority.

iv. Board thinks P’s deal is a bad one b/c it gets shareholders (incl. P as 9% shareholder) cash right away by greatly leveraging corporation and putting its future in jeopardy.

v. Board’s argument: mere exercise of BJ; rsnably perceives threat & response is proportionate.

vi. P’s argument: Schnell, not Unocal, applies here. Case of Board entrenchment. Perhaps not in bad faith, BUT this is a voting case.

1. By interfering w/ SH voting rights, Board invades fundamental integrity of corp. NOT covered by BJR & NOT covered by Unocal b/c here concerns SH voting rights.

vii. Holding: Board is acting in good faith. Believes, perhaps fairly, that P’s proposal is a bad one for shareholder. However, not for Board to substitute its judgment for SHs’ judgment on matter that involves SH vote. SH vote involves underlying legitimacy of corp. Primary purpose of Board, here is preventing / impeding exercise of SH vote (to elect new directors).

1. Board may fight proxy vote using other methods, but ultimate decision is w/ SHs. (con’t)

2. Board can’t interfere w/ shareholders’ voting power , see Schell. Here, by filling two vacancies on Board, Board effectively cutoff opportunity for voters to vote on P’s consent solicitation. Unlawful interference w/ voting franchise.

a. Integrity of shareholder voting process involves considerations not present in any other context where directors exercise delegated power.

3. Here, Board does not meet compelling justification test for its interference w/ shareholders’ voting franchise. No Board has ever met this test (Lambert).

viii. “A Board’s decision to act to prevent the SHs from creating a majority of new board positions and filling them does not involve the exercise of the corporation’s power over its property, or with respect to its rights and obligations; rather, it involves allocation, between SHs as a class and the board, of effective power with respect to governance of the corp.”

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ix. If no direct interference w/ voting franchise, Unocal applies; if interference, Blasisus applies.

1. Lambert: No matter how coercive the conduct to which Board is responding, Board must utilize some tactic other than interference w/ SH vote.

x. Lambert Wrap: Schnell was an easier case than Blasius because in Schnell, bad faith was present, whereas in Blasius, it was absent. In Blasius, the Board had a plausible defense against the consent solicitation that the Board perceived as bad for the corporation, BUT the Board cannot use the device it chose, i.e., interfering w/ the shareholder voting franchise. Consent solicitations are not per se illegal. Bottom line: The Board can counter-solicit and can argue its case that it’s crazy, but ultimately, it’s up to the shareholders.

h. BJR v. UNOCAL V. BLASIUSi. Three tests for SHs challenging Board conduct: (1) BJR; (2) Elevated scrutiny under

Unocal; (3) Compelling justification under Blasius.ii. Where Board exercises its traditional corp power, BJR presumes due care, loyalty & good

faith. BJR is a powerful form of deference. Difficult burden on SHs to overcome. iii. Unocal requires that any defensive measure engaged by Board be reasonable and

proportionate in relation to threat posed. In Unocal Board implemented defensive measure to prevent what it perceived to be bad change-in-control. (Elevated scrutiny b/c entrenchment)

iv. Blasius ’ compelling justification standard applies where primary purpose of Board’s action is impeding/interfering w/ effectiveness of shareholder vote. Such situations call for enhanced judicial scrutiny where Board bears heavy compelling justification burden.

i. MM COMPANIES v. LIQUID AUDIO (SC DE 2003)—Basically, ignore this case i. Key fact: In face of MM’s efforts to force a shareholder vote that would expand the size

of the Board and result in MM having a majority, Liquid’s Board amended bylaws to increase size of Board by two additional members, which it appointed.

ii. KEY: Director conceded at trial level that primary purpose of Board’s conduct = cutting off ability of P shareholder to get additional directors appointed to Board and gain control.

iii. Holding: Here, Unocal applies b/c Board’s action touches upon issues of control, not merely matter of BJ. Blasius ’ compelling justification standard applied w/in Unocal standard of reasonableness and proportionality b/c involved primary motivation of interference w/ shareholder vote (minimizing impact/diminishing influence of any MM elections to Board).

1. Board action invalid. Defensive measure of adding two members to Board compromised SH voting franchise. As action was taken on eve of contested election, Board had to demonstrate compelling justification for its action, which it failed to do.

a. Note: Board may retain power under bylaws to expand # of directors & DE / CA codes permit same, though not dispositive re: validity of Board’s actions.

2. Incumbent Board not permitted to adopt defensive measures to change size & comp of Board where same actions taken for primary purpose of impeding shareholders’ right to vote effectively in an impending election for successor directors.

8. Piercing the corporate veil (Creditor Doctrine)a. Recall limited liability is a method for protecting owners’ equity from creditors.

i. Lose protection / expose to personal liability by acting inconsistently w/ sep’ness of corp entity.

b. SH conduct disregarding separateness of corporation, its assets and the integrity of its existence (esp. in financial sense). When same conduct is inequitable, SH gives rise to creditor claim that it can sue corporation & SH, one and the same.

i. Mere domination is not sufficient to pierce the corporate veil.ii. Mere lack of formalities is not sufficient on its own, though it may help.iii. Mere inadequate capitalization not necessarily sufficient; fact intensive.

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1. Arnold (CA Ct App 1972): Inadeq capitalization merely a factor.2. Slottow (9th Cir 1993): Under CA law, inadeq capitalization may alone be basis.

iv. Facts to determine if acting as single corporate entity: undercapitalization, solvency, corporate formalities, commingling of funds, fraud, whether corp is simply a shell corp

c. Piercing disregards limited liability nature of corporate entity; severe result and as such, requires showing of severely inequitable conduct.

d. DE Rule (applied in Fletcher v. Atex): (1) unity of interest: parent and subsidiary operated as a single economic entity (separateness of entities was ignored) & (2) observing the separateness would lead to an inequitable result: overall element of injustice / unfairness was present. (CA Test equivalent) Note: Strong presumption against piercing.

i. Designed to break limited liability b/c unjust harm to creditor & unjust enrichment of wrongdoer.

e. Inequitable result: failure to do things necessary and proper for running a corporation.f. Difficult to disregard corporate entity & override rule keeping SH separate from corporate

entity.g. What conduct? Where SH has done something wrong w/ corp’s assets, hurting creditors.

i. Key Factors: (1) capitalization & (2) whether dominant SH siphoned corporate funds.

1. One measure of capitalization: appropriate amt of insurance. Where corp lacks sufficient assets, it can protect its creditors by purchasing insurance.

a. Inadequate capitalization can be determinative in CA, though not necessarily.

ii. Unity of interest: indicator that attention should not be paid to corporate form. When a corporation has no assets, failing to fulfill its fiction as a separate entity. When owners treat corporation’s assets as own/personal bank account, e.g., add/withdraw capital from corp at will. Where owners fail to provide for legitimate & foreseeable expectations of creditors.

h. “One ball of wax” = different theory.i. FLETCHER v. ATEX (2nd Cir 1995): Employee of Atex sues Kodak as single entity w/ Atex.

i. Atex has its own cash resources, though may be in Kodak’s bank account, Kodak is still liable for those funds. Likewise, Kodak paid consideration for Atex’s assets.

ii. Some of Board & some of managers = same at Kodak as at Atex, and Kodak exerted control over Atex’s major transactions, but this is fairly common and not, of itself, determinative of unity of interest.

iii. Question is whether the managers of Kodak, through operation of Atex and ownership of all its equity, did something that crossed the line and created unity of interest.

1. Here, however, Kodak’s cash-management system = vehicle to manage cash, not to enrich self or co-mingle corporate funds.

iv. Parent-subsidiary rel’ship : even though Kodak may have dominated its subsidiary Atex by using it for its financial interest as sole shareholder, it did not cross the line; sustained something akin to arms-length and fair dealing.

v. Holding: Applying DE test of (1) single economic entity & (2) overall element of injustice, although Kodak did engage in conduct treating Atex as part of its own corp, Kodak did not disregard separateness of Atex. In light of ind factors cited by Kodak, e.g., Atex’s observ of formalities, its maintenance of its own financial records, and its employment of its own employees/managers responsible for day-to-day business, requisite degree of domination not met for “single economic entity.” Likewise, no showing of req element of overall injustice.

vi. Analytical approach re: whether parent-subsidiary operate as single economic entity: adeq capitalization, solvent, dividends paid, corp records kept, officers & directors function properly, formalities observed, dominant SH not siphon corp funds / corp not façade.

j. MINTON v. CAVANEY (SC of CA 1961): Swimming pool case. Example of using corporation for own personal benefit; allows P to disregard corporation and sue shareholder in personal capacity.

k. Key: No attempt to provide adequate capitalization and no assets. Though it was formed as a corporation and represented itself as such, it never functioned as a corp.

i. Terminology = less important than behavior.

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ii. D = owner b/c held multiple offices, corporate records were kept in his office and he was in line for 1/3 of corp’s shares whenever issued (though never never were).

iii. Generally, however, inadequate capitalization alone is insufficientl. D’s “corporation” engaged in activities where liability would be foreseeable, i.e., swimming pool

business, but it did not have adequate capital to cover same foreseeable liabilities.i. Corp must be able to cover legitimate + foreseeable expectations of creditors.

m. “Reverse Piercing” – SEA-LAND v. PEPPER SOURCE (7th Cir 1993)i. Unjust enrichment / injustice case: Marchese, owner of Pepper Source & other corps,

giving creditors the run-around to avoid paying bills. Marchese: distinct intent not to pay creditors.

1. No corp meetings, no AICs or bylaws, all corps run out of same office w/ same phone line and expense accts. M borrows $ from corps; corps borrow from each other.

ii. Reverse piercing: Here, M involved w/ multiple corps. Thus, P is suing Pepper Source the corp and M individually. In suing M individually, and in seeking to pierce Pepper Source’s corp veil, P is seeking to get at any and all of M’s assets, incl. M’s assets in his other corps.

1. Reverse piercing = misnomer b/c question is still whether P can pierce Pepper Source’s corporate veil and get at Marchese’s personal assets, whether held in those other corporations or not. Either way, P cannot get at the other corporations’ assets that are separate from Marchese. Those corporations have their own creditors who have their own rights superior to P’s rights.

a. (Perhaps if all of corporations in questions are “one ball of wax” w/ an indiv at the center of all, perhaps the creditor who is trying to get at the assets of the individual at the center is on same level w/ other corporations’ creditors.)

b. Reverse piercing incorrectly implies that once shareholder pierces corp veil, shareholder can elevate himself above shareholder status.

iii. Bottom line: Here, once P pierces D’s corporate veil due to M’s inequitable conduct, P gets whatever assets M has. Non-M assets in any corps in which Marchese also has assets are not exposed in a corporate veil piercing case.

1. Just b/c M’s conduct = inequitable does not give creditor of Pepper-Source right to reach into assets of M’s other corps w b/c as concerns those corps, whether same are one ball of wax at all, their creditors are superior to Pepper-Source’s creditors.

n. KINNEY SHOE v. POLAN (4th Cir 1991)i. Key facts: P leased building to D’s corporation, which turned out to have no assets.ii. Rule: Court applies WV law, which incl. a permissive, 3rd prong to piercing, whereby

under circs where it would be reasonable for party (e.g., bank or lending institution) entering into K w/ a corporation to conduct financial due diligence investigation of corp prior to entering into K, such party will be charged w/ knowledge that rsnable credit investigation would disclose.

iii. Holding: Here, court does not charge P w/ this responsibility. Court does not insist that P should have known better. One reason here is that D’s conduct was so bad it would create an inequitable result to charge P w/ this responsibility.

9. Duties of Due Care & Loyaltya. Recall Charlestown Boot & Shoe: Shareholders not permitted to get involved w/ running of corp.

Recall Kamin: Shareholder not permitted to sue Board for decision merely disagree w/.b. Shareholders’ derivative action is procedural remedy for SHs to sue Board when allegedly

harms corp by violating its duties of care, loyalty & food faith. Allows SH to bring case in name of corp. against the BoD for breach of a fiduciary duty

c. SL&E, Talbot & Cookies: Cases where alleged personal benefit ran to the director (and sometimes, the officer, which raises separate agency and Tarnowski issues). Director enjoys protection of BJR.

d. Duty of Care: Procedural integrity in directors’ decision-making process. If Board sustained its procedural integrity, then BJR kicks in and Board’s decisions must be baseless for suit to succeed.

i. DE § 102(b)(7) exempts / exculpates Board for money damages from breaches of duty of care; does not permit same exemp for breaches of duties of loyalty or good

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faith. Where provision exists as part of corporate charter, SHs are limited to duties of loyalty or good faith. For this course, CA § 204(a)(10) = DE § 102(b)(7).

1. If directors have no financial interest in transaction, then Ps must show conscious disregard (i.e., bad faith) of directors’ duties in order to prevail.

ii. Duty of Care standard : negligence, not gross negligence, e.g., w/o in-depth examination or consideration of other offers, and sloppy (as in Transunion, where Board failed to uncover hidden asset that merging corporation sought to capitalize on).

iii. CA § 309 defines directors’ performance of duties as “with such care, incl. reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circs.” Therefore, Board req’d to act carefully, applying standard of reasonably prudent person.

iv. In Kamin, Board’s decision is immune from SH attack b/c no disloyalty or fraud or waste alleged. Under BJR, presumption Board complies w/ its duties in making business decisions. SH simply argued Board’s decision was nuts; not sufficient to overcome presumption.

1. Question limited to whether Board inquired, monitored & considered relevant facts.

2. Rsnable care in Board’s decision-making behavior w/ presumption Board is careful.

v. Therefore, in derivative suit against Board, must be alleged that Board was not careful.1. BJR insulates Board from legal substitution of BJ of the Court for its own.

vi. To get past BJR, P must plead limited / no inquiry into circs, or sloppiness, or undue haste, or failure to see rsnable need for addit’l investig, & must point to objective facts intends to prove.

vii. If BJR presumption = overcome, burden shifts to Board to prove that, in spite of sloppiness, haste, etc., it exercised entire fairness (fair price & fair dealing) in the transaction. If not overcome, then P must show no rational basis for Board’s decision. Difficult to show decision = irrational if P cannot show transaction = unreasonable.

1. Note: Burden shifting = fulcrum of shareholder litigation.viii. Bottom line: Duty of care goes to manner in which Board prepares for making

important decisions. Must use careful procedures and must be fully informed in arriving at decisions.

1. Directors need a hard, paper trail showing the procedures they went through in making their decision in order to protect against violation of duty of due care.

2. Most directors insist on a DE § 102(b)(7) provision in AIC, guarding them against personal liability for breach of duty of due care. This provision allows directors to make on-the-spot, Transunion-type deals w/o fear of personal liability.

e. Duty of Loyalty: Req’ment directors not be financially interested in any transaction; cannot have competing financial interests. If interested, BJR presumption overcome & burden shifts to directors who then must show none of their own interests were conflated w/ those of the corp.

i. See CA § 309: Director must perform in good faith, in a manner such as director believes to be in best interests of corporation and its shareholders.

f. CA § 310: Financial Interest of Director: Where director has material financial interest in transaction w/ corporation on whose Board director sits. (Ways to validate / cleanse)

i. (a) No K / transaction btwn corp & director is void/voidable b/c director is a party if…1. material facts were fully disclosed to shareholders and they ratify, absent fraud.2. as (1) but Board & the Board, excl. interested directors, approves in good faith

a. Note: Burden on challenging party to establish transaction not fair to corp. Heavy burden, esp. if ind directors scrutinize fairness carefully pre-approval.

3. in Ks/transactions not approved as above, person asserting validity has burden of proving that K/transaction = just and reasonable.

ii. Where director merely sits on two Boards as common director (b) Transaction validated in if approved by independent board in good faith (w/ common director abstaining).

1. Note: w/o disclosure + common director abstention, transaction must be just + reasonable to both corporations, if common director votes in both capacities.

g. Summary: In breach of fiduciary duty case, whether CS or Board, entire fairness is starting point & burden rests on breaching party, i.e., party standing on both sides of trans. However, breaching party can ventilate or cleanse before they initiate transaction with an independent committee found to be independent and employing independent procedures (or a majority vote of the minority shareholders with full disclosure; or Cookies fair & reasonable). In

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NY (Auerbach) or CA (§ 800), such a cleansing ends inquiry because BJR applies to the action of the breaching party. In DE, even w/ such a cleansing, the ct may still substitute its own BJ for that of the breaching party (Zapata). If it’s an extraordinary transaction (see Kahn, i.e., sale of the entire corporation), cleansing or ventilation shifts the burden of entire fairness to the P minority SHs, which gives a small window to prove that transaction lacked entire fairness (which P does not get to do in both instances where BJR applies).

h. LEWIS v. SL&E (2nd Cir 1980)i. Donald, the P = shareholder of SL&E only; owed fiduciary duty from SL&E Board. ii. Not creditor of SL&E, corp veil pierce case (e.g., Donald lent $ to LGT / empl filing suit).iii. Donald has agreed to sell his SL&E stock to LGT, but does not like book value price

offered b/c believes LGT’s lease w/ SL&E not fairly valued.iv. Alan, Leon and Richard, the Ds = sitting on Boards of SL&E and LGT. LGT controls SL&E.

Taking salaries as officers of LGT. Sitting in every conflicted position possible.1. BUT argue LGT is losing money and cannot pay rent bill to SL&E.

v. Alan, Leon & Richard viewed SLE as existing purely for benefit of LGT (disregarded separateness); only a shell to protect LGT; no formal meetings.

vi. Holding: Burden on Alan, Leon and Richard to show entire fairness, i.e., fair, just and reasonable, of rent payments to SL&E. As cannot meet burden, Donald’s shares will be purchased, per agreement, on basis of FMV of LGT’s lease w/ SL&E.

1. Ds failed to prove fairness. No indep approval of lease in question & directors who approved it were directors of corporate lessee, i.e., self-dealing (breach of loyalty).

i. COOKIES FOOD PRODUCTS v. LAKES WAREHOUSE (SC of IA 1988)i. BBQ and Taco Sauce case. Receipt by Speed, president of D corporation, of profits for D

corporation while serving as director of P corporation.ii. No disclosure / specification authorization from directors or SHs, for Speed to make profit

off transaction w/ P corporation. iii. Holding: Though no specific authorization, P corporation still got good deal (fair &

rsnable).1. Inconsistent w/ Talbot: Speed dealing w/ corp for which serves as director w/o

specific approval from Board. Does Speed really meet the burden that transactions were fair and reasonable to corp, and prices/services were negotiated at arms-length?

2. Dissent: Majority too loose w/ Speed and the fact that it was good deal for the corporation. Accounting Speed provided does not show it was necessarily a good deal. It’s Speed’s own accounting. Further, where’s full disclosure?

j. CA requires either (disinterested) shareholder approval w/ full disclosure (after which transaction cannot be attacked) or, if disinterested Board approves a transaction w/ full disclosure, the burden shifts to party contesting same.

i. Otherwise, party seeking to uphold transaction bears burden of proving “entire fairness,” i.e., “just and reasonable” to corporation.

10. Duty of Good Faitha. Due care and loyalty cases involve actual decisions and actual financial interests, as well as

burdens of proof and duties of directors in context of actual decisions. Duty of care, likewise, implies Board’s exercise of some monitoring function to assure relative safety of the assets and prospects of the corporation. Cases are sparse on Board’s liability for inaction.

i. Caremark: “Only a sustained or systematic failure of Board to exercise oversight, such as an utter failure to attempt to assure a reasonable information and reporting system exists, will establish lack of good faith, a necessary condition to liability.”

b. Hence, director’s obligation includes duty to attempt in good faith to assure an adequate corporate information and reporting system exists.

i. Records must sustain that Board either lacked good faith in exercise of their monitoring responsibilities or conscientiously permitted occurrence of a known violation of law by corp. Board must know / should have known corp’s methods of oversight = insufficient.

ii. Sustained and systematic failure to exercise oversight is breach of duty of good faith b/c equivalent to conscientiously allowing harm to come to corp.

c. IN RE DISNEY (SC of DE 2006)

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i. Alleged breach of fiduciary duty by Board in hiring & then terminating Michael Ovitz, friend of Michael Eisner (Chairman of Board), who was recruited from lucrative career at CAA.

ii. Though Disney’s certificate of incorp contained a DE § 102(b)(7) provision exculpating directors from personal liability for breach of duty of care, Ps pleading interpreted to allege behavior excepted from § 102(b)(7)’s reach, i.e., breach of good faith and loyalty.

1. Due care here is w/in exculpation provision in Disney’s charter.iii. Holding: Good faith and due care are distinct. Board’s conduct may have fallen short of

best practices, but it did not rise to level of breach of good faith duty.1. “Good faith”: breach of good faith involves subjective bad faith, i.e., actual

intent to do harm or intentional dereliction of duty. Conscious disregard for responsibilities.

d. STONE v. RITTER (SC of DE 2006)i. Issue: To prevent SH abuse of derivative action, i.e., as exception to Charlestown Boot,

special pre-conditions exist, incl. SH must demand Board take action to vindicate corp right in ?.

1. As Board will not sue itself for its misbehavior, exception for demand futility.ii. Holding: Validation of Caremark and Disney articulation of requirement of good faith.

Here, complaint does not sufficiently allege behavior on part of Board to render it so interested, i.e., likely conflicted as to its liability, that corporation could not take action on its own to vindicate shareholder’s claim.

iii. Bottom line: Demand required on Board. Here, derivative Ps do not make same and do not show reasonably that directors were interested or lacked BJ. Did not show directors’ conduct was so suspect it could not have taken action against self. No colorable claim of breach of good faith duty. Thus, demand not excused as futile. Therefore, case dismissed.

iv. Note: Dynamic of derivative litigation = (1) contemporaneous ownership and (2) demand on directors. When derivative Ps cannot create rsnable doubt of interestedness of directors or integrity of BJ, then directors can refuse to take action and refusal has BJR protection.

1. Decision to not take action in those circumstances must be wrongful, per Zapata, to overcome BJR (equivalent to where Ps fail to shift BJR burden in duty of care case).

e. ● Lyondell v. Ryani. πs allege breach of duty of loyalty: BoD failed to act in good faith in selling the company

in a merger because it was a bad deal, ∆s were self-interested; ∆s blew the negotiations and terms of deal

ii. held: no evidence to infer BoD knowingly ignored their responsibilities, thus could not breach good faith; ∆s entitled to MSJ

1. ∆s’ charter had 102(b)(7) exculpation for breach of duty of care2. only liable if knowingly and completely failed to understand responsibilities3. not doing all that they could have done is only breach for duty of care, which is

exculpable

11. Stock Optionsa. Derivative Suit Summary: Procedural law of derivative suit inextricably tied into substance of

law governing allocation of power between SHs and directors, and basic fiduciaries duties.i. Derivative action is exception to traditional deference afforded to Board’s decisions.

1. Allows SH to bring suit on behalf of corp & get monetary recovery to flow to corp.ii. Requisite elements of derivative action (to prevent vexatious and harassing litigation):

1. Must have been shareholder at time of alleged wrong2. Must have made a demand on Board to act, giving them means of avoiding the

lit.3. When demand not excused, Board may decide, under BJR protection not to take

requested action and dismiss derivative suit. Demand stage = crucial.a. Demand is excused when P creates reasonable doubt as to (1) Board’s

disinterestedness, i.e., independence and (2) possibility that transaction could have been valid exercise of BJ. (Aronson and Rales).

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b. If excused or deemed futile, suit moves forward subject to proof of underlying claim (derives from Aronson, Rales and others).

iii. When Board’s interestedness cannot be questioned, demand cannot be excused & P is stuck, Zapata. BJR applies & if Board does not take up P’s allegations, P must then overcome BJR.

12. Fiduciary Claims in Context of Exculpatory Provisionsa. DE § 102(b)(7): Corporate charter may eliminate or limit personal liability of director to

corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit liability of director (i) or any breach of director’s duty of loyalty to corporation or its stockholders, (ii) for acts or omissions not in good faith, or (iii) for any transaction from director derived an improper personal benefit. CA § 204(a)(10) is equivalent. EMERALD PARTNERS (SC DE 1999): Where claim solely implicates violation of duty of care, DE § 102(b)(7) provision’s protections may be invoked and applied. Where claim of breach of duties of loyalty or good faith has been properly pled, P is arguing something outside scope of § 102(b)(7) and burden rests on directors to show loyalty or good faith.

b. MALPIEDE v. TOWNSON (SC DE 2001)i. Key fact: Board of Frederick’s was not conflicted or controlled by conflicted member,

thus claim is breach of due care (negligence) & not one of breach of loyalty / good faith.ii. Holding: Where complaint is incapable of being interpreted as claim of breach of duties

of loyalty or good faith, it must be dismissed in the face of DE § 102(b)(7). Here, claim amounts to breach of duty of care, thus DE § 102(b)(7) bars continuance.

13. Fiduciary Duty of Controlling Shareholdersa. Lambert: Exception to usual rule that passive investors have no duties. Analogy to fiduciary

duty owed to shareholders by directors who control corporation. CSs occupy similar position of power. As such, transactions w/ CSs’ controlled corporations receive similar scrutiny.

b. CS = 50+% of shares or have enough stock to essentially control the corpc. General rule of duty: CS has fid duty to min SHs and cannot receive any benefit to their

exclusion or detriment, which includes creating an opportunity for oneselfi. E.g., cannot sell corporate asset because this belongs to all SHs

d. Entire fairness: fair price / fair dealing. Burden on CS in case of transaction for which it receives a benefit to detriment or exclusion of minority shareholders.

i. Fair dealing: when transaction timed, how it was initiated, structured and disclosed to the directors, and how the approvals of the directors were obtained.

ii. Fair price: economic and financial considerations.iii. Note: CS owe duty directly to minority shareholders. Sometimes P minority

shareholders do not sue directors in order to avoid derivative trap in favor of class suit.e. Ways to cleanse interested transaction: (1) majority vote of the minority SHs with full and

fair disclosure of the CS; or (2) convene special committee that is independent, i.e., not at the behest of controlling shareholder, and uses a procedure that approximates arms-length dealing.

i. In Kahn, as it was an extraordinary transaction, though committee that evaluated the CS’s action was found to be independent and employing independent procedures, the P shareholders still have opportunity to meet shifted burden of entire fairness. The inquiry did not end with the independent committee’s determination that the transaction was fundamentally fair because it was an extraordinary transaction (sale of entire company).

ii. Summary: In a breach of fiduciary duty case, whether it’s CS or Board, entire fairness is the starting point and burden rests on breaching party, i.e., party standing on both sides of trans. However, breaching party can ventilate or cleanse before they initiate transaction with an independent committee found to be independent and employing independent procedures (or a majority vote of the minority shareholders with full disclosure; or Cookies fair & reasonable). In NY (Auerbach) or CA (§ 800), such a cleansing ends inquiry because BJR applies to the action of the breaching party. In DE, even w/ such a cleansing, the ct may still substitute its own BJ for that of the breaching party (Zapata). If it’s an extraordinary transaction (see Kahn, i.e., sale of the entire corporation), cleansing or ventilation shifts the burden of entire fairness to the P minority

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SHs, which gives a small window to prove that the transaction lacked entire fairness (which P does not get to do in both instances where the BJR applies).

f. SINCLAIR v. LEVIN (SC DE 1971)i. Key fact: Sinclair owns 97% of Sinuven stock. Parent-subsidiary situation.ii. Rule: CS bears entire fairness burden when receives special benefit, i.e., self-dealing,

not available to minority SHs. Look for special benefit that triggers CS’ entire fairness burden.

1. Bottom line: CS cannot do something w/ its control that operates as benefit to self only and as a detriment to minority shareholders. If so, it’s self-dealing.

iii. Analysis: (1) Payment of dividends here goes to all shareholders, so no special benefit to CS; (2) denial of expansion opps to Sinuven: no proof that opps were w/in Sinuven’s scope, so no special benefit to CS (further, no obligation or affirmative duty as parent to deploy subsidiary resources in any particular way outside area in which subsidiary operates); BUT (3) causing breach of K btwn CS as the parent corporation and Sinuven as the minority shareholder was a benefit to CS that hurt minority shareholders of Sinuven.

iv. Holding: (1) & (2) subject to BJR, BUT (3) subject to entire fairness b/c CS self-dealing. Sinclair cannot meet the burden.

1. When parent controls subsidiary and fixes the term of its controlling transactions dealing with subsidiary, entire fairness test applies

v. Recall Perlman, where source of steel itself was corporate asset and minority SHs awarded share of premium received by majority SH in his sale of control. Sale occurred during Korean War, thus CS enjoyed premium for selling control over corp asset during wartime.

1. Perlman distinguishable b/c here, not a sale, but exercise of, control.2. NOTE: Very misleading that, in sale of control for premium, CS must share

premium w/ minority. Not law. Sale of control is completely irrelevant to fiduciary duty claim.

g. KAHN v. LYNCH COMMUNICATIONS (SC of DE 1994)i. Class action b/c direct harm to minority SHs forced out for cash at lesser price than FMV.ii. Key fact: Cash merger. CS proposes merger of corp into entity CS controls w/ minority

receiving cash in exchange for their shares, a forced cash-out of minority.iii. Special comm appointed by CS not independent. Even if it was, inquiry not necessarily over

b/c in special case of acquisition of controlled corp, question whether exercise of control = approp.

iv. Holding: In acquisition of controlled corporation by CS, as CS stands on both sides of the transaction, exclusive test is entire fairness to minority SHs. No room to argue BJR. Burden on CS, though it may be shifted with approval of truly disinterested Board committee or approval of majority of minority SHs.

1. Note: Distinguishable from CA § 310 in director loyalty case where disinterested SH approval (w/ full disclosure of all material facts) ends case against interested director.

2. Better argument for CS here than in Ahmanson b/c benefit of merger transaction is shared, i.e., all minority SHs get cash equivalent for their shares.

h. JONES v. AHMANSON (SC of CA 1969)i. Key: Trans by which CS group appropriates to itself benefit not available to P minority

SHs.ii. Facts: CS group creates new corporation. Exchanges their Association shares for shares

in new corporation. New corporation becomes 85% holder of Association.iii. New corporation makes public offering, creating public market for new corporation’s

stock only for CS group and not for P minority SHs of Association.iv. Moreover , new corp pledges assets of Association to leverage its bond sale. This

offering permits CS group to have a public market for their Association shares, as well as cover the bond offering and get a return of capital, i.e., profit from the new corporation, both of which are paid by the debt component of its offering (the debt being back by assets of Association).

1. CS pledged assets of all shareholders for benefit only it received.

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v. P minority SHs = frozen into illiquid investment b/c no trading market for their shares. Further, P minority SHs not offered opp and not provided notice. CS group merely offers to buy P minority SHs’ shares for a below-book value.

vi. Holding: CS group’s actions benefit themselves, i.e., it’s a pattern of self-serving conduct, to the absence of benefit or cause of detriment to P the minority shareholder. Entire fairness standard applies. CS group cannot meet it. Breach of fiduciary duty.

1. Exclusion of control: Minority denied opp to participate in transaction. CS group here used their control “to obtain an advantage not made available to all SHs” and did so w/o regard to resulting detriment to minority stockholders.

2. No possible fairness to which CS group can point; Lynch is better arg b/c benefit of merger transaction is shared, i.e., all minority SHs get cash equivalent for their shares.

3. To meet entire fairness standard, CS needed to give minority notice, full disclosure and opportunity. Needed to give minority right to do everything majority did.

14. Sale of Controla. Exercise of control v. sale of control: In exercise, CS must not exercise control to benef

themselves to exclusion of minority. A well-pled complaint w/ factual assertion of proof of exclusive benefit for CS shifts burden to CS to prove entire fairness, i.e., fair dealing / fair price.

i. Sale of control commands a premium b/c CS has capability an ordinary shareholder does not, incl. opp to deal to his benefit w/ corp, provided arm’s length & fairness.

1. NOTE: CS can sell controlling interest at premium and minority SHs do not have a right to share in it so long as no looting, conversion, fraud, bad faith, etc.

b. ZEITLIN v. HANSON HOLDINGS (NY Ct of Apps 1979)i. RULE: CS = free to sell control and purchaser free to buy CS’ controlling interest at a

premium price over prevailing market price, absent bad faith, fraud, looting of corporate assets, or conversion of corporate opportunities. In such a legal sale of control, premium does not have to be shared w/ minority.

1. Illegal sale of control: If CS exercises power through Board to sell an asset of corporation, but consideration is paid in cash directly to the CS, that’s outright stealing or looting from corporation, i.e., if CS causes sale of corp asset at profit to CS directly = breach of fiduciary duty.

ii. Duty of CS = not to benefit self at expense of minority but right of CS to sell at premium over market price reconciled in sense that CS has duty to investigate circs of sale of control, incl. character of buyer, + seek K assurances that buyer will not use control to detriment of remaining minority SHs.

1. Selling CS may be liable for buyer’s conduct; not guarantor but high standard of due diligence for assurance that buyer will not loot assets of corporation by use of control purchased from CS at a premium.

a. CS protection from liability = placing K restrictions in form of representations and warranties re: buyer’s use of control.

b. Also, indemnification from buyer if CS held liable for buyer’s misconduct.2. Zeitlin rule for selling CS liability for buying CS’ action: Not whether selling

CS received premium, but whether wrongdoing of buying CS in form of breach of fiduciary duty = foreseeable to reasonable CS seller. As such, e.g., selling control to a known corporate raider will likely create liability for selling CS.

3. Where buyer of control breaches fiduciary duty, first question = whether seller did due diligence to protect shareholders from same.

15. Distributions to Shareholders (Creditor Protection Doctrine)a. In all limited liability forms of doing business, limitations exist for distributions to equity

participants, i.e., those w/ claims to residual owners’ equity.i. Distributions law exists to protect creditors from depredations of equity

owners.b. DE § 170: dividends may be paid upon shares of capital stock either:

i. Out of its surplusii. If no surplus, out of its net profits for the fiscal year in which dividend declared

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c. CA § 166: Distribution to shareholders is a transfer of cash or property by corporation to its shareholders without consideration, whether by dividend or otherwise.

d. CA § 500: effective Jan. 1, 2012i. Dramatically changes law to reflect DE’sii. (a) shall not make any distribution to corp’s SH UNLESS BoD has determined in good

faith either:1. retained earnings immediately prior to dividends exceed distributions plus

dividends OR2. immediately after distro, value of the corp’s assets would equal or exceed sum of

its total liabilitiese. KEY: Distribution to shareholders incl. purchase / redemption of corporation’s shares

for cash/property (repurchase of corporation’s own shares).i. When corporation repurchases its own shares, it gets no tangible or intangible

consideration b/c share itself has no value to corp. Repurchase of stock is mini-liquidation of owners’ equity, which can compromise rights of creditors in exactly same way as a dividend. If it bought all its own shares, a corporation would have liquidated, i.e., bought out all its ownership interests w/o providing for creditors.

1. Hence, to legally repurchase its own shares, a corp must pay its creditors first or leave enough money in corp to cover superior claims of the creditors to corporate assets.

2. Purpose of distribution law = protection of creditors.ii. Corporation’s repurchase of its own shares is equivalent to a dividend, except that, after

the dividend transaction, shareholder remains a shareholder.f. Transfer to shareholders of property in form of dividend = distribution to shareholders b/c

reduces assets of corporation for which corporation receives nothing in return. Such a distribution reduces owners’ equity by paying SH claimants and reducing value of their ownership interest in corp.

g. Vigilance that corp does not delete its assets in favor of its owners if same compromises ability of corporation to pay its creditors, who have priority of payment of their claims against corp assets.

h. KLANG v. SMITH’S FOOD & DRUG (SC of DE 1997)i. Evidences how DE allows distribs to SHs from any source of surplus, incl. revaluation

surplus.ii. Sale of control orchestrated in part via repurchase of corp’s stock (a leveraged

recapitaliz’n not greatly different from Blasius), which means the corporation is less capitalized.

1. Uses up corporate assets in a way benefiting shareholders w/o likewise benefiting creditors. May leave corporation w/ too little in assets and too greatly leveraged.

iii. Buyer bought out majority portion of outstanding shares, but not all; leveraged buyout of all preferred stock and portion of common stock.

iv. Issue: Whether buyout transaction made from available source of surplus.1. KEY: Integrity of valuation that determined a sufficient surplus existed. Here, ind

valuator assured Board that transactions would not endanger corporate solvency.2. Board permitted to rely on such independent, expert advice.

v. Holding: Repurchase of shares valid distrib b/c revalued asset creates surplus considerably in excess of amount paid to shareholders. Court defers to Board’s determination of surplus; no violation of DE law in corporation’s self-tender. Ct may defer to Board’s measurement of surplus unless P can show directors failed to fulfill duty to eval assets based on acceptable data & by standards which they are entitled to believe reasonably reflect present values.

1. D convinced court that its revaluation of surplus reasonably reflected its value.2. Directors have reasonable latitude to depart from balance sheet to calculate

surplus so long as they evaluate assets / liabilities in good faith, on basis of accepted data, by methods they reasonably believe reflect present values, and arrive at determination of surplus close enough to value so as to not constitute actual or constructive fraud.

3. Repurchasing shares impairs capital only if funds used in repurchase exceed amount of corporation’s surplus, i.e., net assets minus par value of corporation’s issued stock.

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vi. Klang likewise applies where distribution is a dividend, rather than repurchase of stock.

16. Direct and Derivative Litigationa. Derivative action exception to general governance power of Board

i. Derivative suit when Board steals money; direct where Board frustrates SHs’ voting power.

b. Derivative suit allows SHs to sue on behalf of corporation to enforce rights of corporation that were otherwise unlikely to be enforced, e.g., directors’ embezzlement or violation of fiduciary duties.

i. Embezzlement is a derivative action b/c directors are taking away something that is the property of the creditors, i.e., an asset goes out of corporation subject to priority of creditors, thus it should not be returned to the shareholders’ pockets.

ii. Rationale for requiring that corporate claims be brought on behalf of corporations = protection of priority of creditors to corporate assets.

iii. However, in order to curb indiscriminate use of derivative suits, protective procedural rules exist, e.g., contemporaneous ownership, demand requirement, etc.

c. Direct v. Derivative: Derivative where wrongful act depleting corp assets and affects SH only by reducing stock value; direct where wrongful act that does not deplete corp assets and interferes w/ ownership rights (e.g., voting).

i. If harm is suffered by both π AND corp priority to creditors derivative actionii. If harm is direct injury to SH and independent of any injury to corp direct action

(because duty was breached to SH, e.g., interfering with voting rights)d. W/ advent of class action, shareholders seek to avoid characterization of derivative status b/c

same obviates compliance w/ procedural barriers & class suit = direct shareholder recovery. Direct suits allow shareholders to sue for violation of their rights as distinct from those of the corporation.

i. Note: Pro rata inquiry is undertaken at conclusion of derivative action.e. CA § 800: Requirements for bringing a derivative suit.

i. Contemporaneous ownership: At the time of the transaction or any part thereof, P must be a shareholder (incl. if the shares thereafter devolved to P by operation of law from shareholder meeting same req’ment); if not, P must meet five listed req’ments.

1. Five req’s: Strong prima facie case, no other similar action exists, P acquired shares before corp informed public of / P knew of wrongdoing, D stands to retain gain from willful breach of fiduciary duty, & requested relief will not lead to unjust enrichment.

ii. Demand requirement: P alleges w/ particularity P’s efforts to secure from Board such action as P desires or reasons for not making same, i.e., demand on the Board or necessity to say why no demand was presented to Board, incl. considerations of futility and excuse.

Lambert’s Approach to Derivative Processf. Derivative or direct/class action? (1) Who suffered harm & (2) Who would receive benefit of

any recovery or remedy?g. Contemporaneous ownership of shares at time of wrongdoing, § 800 (“any part thereof”)?

i. Rifkin: Exception to rule. Where purchase price reflected knowledge of seller’s wrongdoings, buyer not permitted to recover in a derivative suit b/c buyer would receive double benefit of lower price plus share of derivative recovery.

h. Demand on Board required and, if so, excused b/c of Board’s interestedness or lack of BJ? (Serves to protect from SH suing for smthg Board can itself address & correct, see p. 949).

i. Test for excuse and futility? See Marx v. Akers (NY Ct of Apps 1996) on p. 952, quoting from Aronson: allege particularized facts which create reasonable doubt that (1) directors are disinterested & independent (financial interestedness: whether the Board had competing interests, i.e., duty of loyalty) or (2) challenged transaction was otherwise product of valid exercise of BJ (whether the decision was product of integrity). Once interest established, BJR inapplicable & demand futile.

ii. If P cannot make out case of reasonable doubt re: Board’s interest, then P must show extreme defect in business decision, i.e., an extreme deviation from care or procedure. In that instance, Board has enormous latitude to dismiss the shareholder action.

iii. Demand requirement stage = crucial for shareholder. 26

iv. Bottom line: W/o showing of Board’s interestedness or that it was not careful, or that it was disloyal, or that it acted in bad faith, demand is required. If demand is req’d, Board’s decision to reject demand will be treated under BJR and same rejection will have to be wrongful to be overcome.

1. If Board is the true D ( not merely nominal), demand will be futile & excused.i. When Board is interested and demand will be excused, how does Board preserve its right to

argue for dismissal of suit? Creation of independent special committee w/ all the power of the Board. Same committee reviews merits of demand and reaches decisions as to whether it’s in corporation’s best interests to pursue derivative action.

j. When so-called independent committee advises dismissal of derivative suit as in best interests of corporation, what’s the court’s review standard? See Auerbach v. Bennett (Ct of App NY 1979) and Zapata v. Maldonado (SC of DE 1981).

i. CA § 800: If integrity of independent committee itself and its process = valid and vetted, its BJ cannot be questioned & case / inquiry = over.

ii. Zapata: In DE, burden of proving independence, good faith and care of committee is on corp. Even if that burden is met and independent committee is truly independent, DE court req’d to use its own BJ to determine if suit should be allowed to proceed.

iii. Summary: In a breach of fiduciary duty case, whether it’s CS or Board, entire fairness is the starting point and burden rests on breaching party, i.e., party standing on both sides of trans. However, breaching party can ventilate or cleanse before they initiate transaction with an independent committee found to be independent and employing independent procedures (or a majority vote of the minority shareholders with full disclosure; or Cookies fair & reasonable). In NY (Auerbach) or CA (§ 800), such a cleansing ends inquiry because BJR applies to the action of the breaching party. In DE, even w/ such a cleansing, the ct may still substitute its own BJ for that of the breaching party (Zapata). If it’s an extraordinary transaction (see Kahn, i.e., sale of the entire corporation), cleansing or ventilation shifts the burden of entire fairness to the P minority SHs, which gives a small window to prove that the transaction lacked entire fairness (which P does not get to do in both instances where the BJR applies).

iv. If case goes forward & damage proved, only then is pro rata issue of damage raised.1. Lambert: Problem w/ pro rata recovery: takes assets belonging firstly to creditors

as superior claimants to owners’ equity out of corp, circumventing creditors, and gives assets directly to the wronged SHs. If the minority SH has really absorbed the wrong, however, should be able to sue directly & not get foxholded into derivative box.

k. TOOLEY v. DONALDSON (SC of DE 2004)i. Rejection of “special injury” rule: old DE rule that SHs seeking to prosecute direct

action against directors req’d to allege harm to SHs distinct from corp and distinct from other SHs.

ii. RULE: Direct v. derivative inquiry: (1) Who suffered the harm, the corporation or the shareholders individually? and (2) Who will receive the benefit of recovery, the corporation or the shareholders individually?

1. In general, favorable Ks, interested transactions and abdication of director responsibility are harms to corporation, i.e., causes for derivative suit.

2. Grimes, which is discussed in Tooley is an exception to rule. There, where directors showed continued and relentless disregard of fiduciary duties, court held it to be direct action b/c SHs sought mere declaratory relief (w/o seeking monetary damages) in way of a declaration of the invalidity of certain agreements on the ground that Board has abdicated its responsibility to the SHs.

3. In general, only if directors affect personal voting right of SHs = direct action.

iii. Lambert: Play in the joints of Tooley exists; phrasing of complain = important. Particularly, where both the shareholders and the corporation are harmed.

iv. Holding: Court should look to nature of the wrong and to whom relief should go. SH’s claimed injury must be ind of any alleged injury to corp. SH must demonstrate that the duty breached was owed to SH and that SH can prevail w/o showing an injury to corporation.

1. Here, not a derivative claim asserting injury to corporate entity. No relief that would go to corp. No basis to hold that complaint states a derivative suit.

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2. BUT it does not necessarily follow that complaint therefore states a direct claim. In fact, it states no claim at all. Complaint assets no rights of Ps that have been injured.

3. Rights at issue have not yet ripened b/c K claim here is nonexistent until ripe and same claim will not be ripe until terms of merger are fulfilled.

l. BAGDON v. BRIDGESTONE/FIRESTONE (7th Cir 1991)i. Holding: Corporation is a corporation; partnership is a partnership. Consequences

follow from organizing as either entity. Rejects Barth and follows DE law. Derivative claims are paid to corporations, direct claims to claimants.

1. Note: DE strict view corps, whether closely held, are different entities from prtnrshps.

ii. Holding (2): Claim is derivative if injury mediated through corp. SH may litigate directly if wrong to the corp inflicts distinct & disproportionate injury on the investor.

m. Beam v. Stewarti. aff’d d. ct. dismissing π’s derivative suit because failed to make presuit demand on corp’s

BoD and failed to demonstrate demand futilityii. π alleges ∆ (Martha Stewart) breached fid duty of loyalty by illegalling selling stock and

mishandling media attn afterwardiii. d. ct. dismissed because did not demonstrate presuit demand futility

1. ∆ Stewart was an interested party due to potential civil and criminal liability; ∆ Patrick interested due to officer and director and makes $ from company; therefore both unable to consider a demand

2. issue therefore is the subject BoD’s director ∆s’ independence3. π only needed to show one of 3 director ∆s wasn’t independent because already

determine Stewart and Patrick aren’t independent4. π alleged ∆s Martinez and Moore weren’t independent because of friendship with

Stewart5. held insufficient: need a bias-producing relationship

a. Stewart has 94% voting poweriv. π alleged ∆ Seligman not independent because in the past S called company whose BoD

he was also on at Stewart’s request to prevent unfavorable publication reference to Stewart

v. held: S’s actions were as much to benefit the company as to benefit Stewartn. Rales v. Blasband

i. holding: demand on the BoD is excused because facts create reasonable doubt that a maj of the BoD would be disinterested or independent in making a decision on a demand

ii. B = SH of D corp and E corp; entered into merger between the 2 where E became wholly-owned sub of D

iii. R = Rales brothers; directors, officers, or SHs of E and D; directors and 52% owners of E prior to merger; 44% owners of D and prez and CEO of D, resigned in early 1990 but still served on BoD

iv. π’s complaint1. re: alleged misuse of E BoD proceeds of the sale of E’s Notes2. π alleges ∆s did not invest in “gov’t and marketable securities” but in junk bonds

of Drexel corp, which π alleges ∆s were trying to help outa. these investments have declined substantially, causing E to lose $14milb. π also alleges E and D’s BoDs haven’t complied with his requests for info

3. to get over BJR, must give reasonable doubt BoD are disinterested and independent or the transaction was a product of valid BJR

v. in these situations, must analyze whether the BoD that would be addressing the demand can impartially consider its merits without being influenced by improper considerations

vi. here, no demand was made, so must consider whether could have been disinterested and independent

1. held: not disinteresteda. decision by BoD to bring suit against E’s BoD would have financial

consequences, so ∆s have disqualifying financial interest that disables them from impartially considering a response to a demand by π

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2. held: reasonable doubt could act independentlya. others on BoD are beholden to ∆s; must demonstrate the ∆s here could

exert influence so much that others don’t have discretiono. RIFKIN v. STEELE PLATT (CO Ct of Apps 1991)

i. Holding: On claim of breach of fiduciary duty, if buyers knew of breach and priced it into their acquisition, not permitted to recover damages for same from sellers.

1. Arguably, no derivative claim b/c fails to satisfy requirement of contemporaneous ownership at time of wrongdoing.

2. Likewise, inequitable to see a corporation’s wrongdoing, acquire it and then turn around and sue directors for same wrongdoing. Double-dipping.

3. Buyers can make a K claim and sue on sellers’ misreps BUT cannot also sue on behalf of corp for sellers’ alleged breach of fiduciary duty for harm caused to corp.

ii. Note: Untainted, contemporaneous-ownership SH would have a strong derivative suit argument (may present a pro rata issue, though it’s corp’s—and the creditor’s—money).

p. GLENN v. HOTELRON (Ct of App NY 1989)i. Addressing appealing nature of pro rata recovery; raises issue of alignment of Ps and Ds,

conspiring to avoid money going to the creditors.1. Reason to not allow it is priority of creditors.

a. But note: Priority of creditors did not persuade Perlman court.2. Argument in favor: award of damages to corporation does not provide sufficient

deterrent to potential wrongdoer where same is shareholder of injured corporation.

ii. Holding: In spite of concern that potential wrongdoer is not deterred in a derivative recovery where wrongdoer is SH does not require different damage rule for closely held corporations.

1. Fruits of corporate injury are properly corporate assets; awarding them directly to shareholders could impair superior rights of creditors, even though direct damage awards to innocent shareholders seem equitable in certain circumstances.

a. But see pro rata examples on p. 933.

17. Accountinga. Basics

i. Fundamental equation: In every transaction, two accounts are impacted.1. Key questions: (1) What has happened? (2) Which accounts are affected? (3)

In which direction are the affected accounts moving, i.e., plus or minus?ii. Balance sheet = point in time. Assets, liabilities and owners’ equity.iii. Net income = net increase in owners’ equity (diffs btwn revenues and expenses during

reporting period). Consists in closing out income statement, adjusting it up or downward, accounting for increases or decreases in owners’ equity. (Income statement = one year of company’s financial picture.)

1. Note: Amount of net income in income statement equals amount of increases in owners’ equity in balance sheet.

iv. Income revenue: Seeks to match all revenue and expenses, whether or not received/paid for.

v. GAAP = consistent and accountable system of reporting.1. Provides abstract characterization of net worth not limited to cash.2. Concerned w/ tracking income (difference btwn revenue and expense) and

changes in equity (resulting from income).vi. Separate entity assump: entity being reported on distinct from those who own it,

whether separate entity for legal purposes. NOT TRUE. Generally, corps are one ball of wax.

vii. Going concern assumption: company is solvent.viii. Time period assumption: division of entity’s activities into discrete time periods, e.g.,

balance sheet and income statement.ix. Financial transactions principle: transaction to be reported must be capable of

measurement in concrete, monetary terms based on some actual transaction.x. Realization principle: transactions to be reported must be completed transactions

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xi. Matching principle: redundancy of time period principle, i.e., during a period, record actual revenues and actual expenses, whether or not received/paid for (should be allocated to period in which revenue/expense f/x generation of revenue).

xii. Conservatism and cost principles: assets are reported at historical cost; can only be written down, not up; preference for understating earnings, values and cash flows.

b. Balance Sheet: lists assets; set of permanent accounts, as of moment in timei. Assets: things of value, i.e., properties, resources and claims owned/controlled

1. Current assets: cash or cash equivalents (liquid)ii. Liabilities: amounts owed by entity to another, i.e., debts, accounts payable, etc.

1. Current liabilities: current debts payableiii. Owners’ equity: net of assets and liabilitiesiv. Working capital: net of current assets and current liabilities

1. Measure of relative ability to pay debts in near futurec. Income Statement (picture of corp’s financial health over one year, comp’d to other yrs): lists

expenses; set of period accounts for a particular, limited stretch of time.i. Revenues: increases in equity resulting from asset increases and/or liability decreases

from delivering goods or services or other activities that constitute entity’s ongoing major ops. Amounts generated by entity upon sale of goods it is in business of selling and fees from rendition of services it is in the business of rendering.

ii. Expenses: decreases in equity from asset decreases and/or liability increases from as above. Costs incurred by entity in order to generate its revenue and for which entity does not receive in return any equivalent asset.

iii. Expenses and Revenues represent what the business generates in terms of financial resources either owed to it or paid to it during a particular period. Earnings + losses = net income, which increases/decreases owners’ equity.

d. Accrual and Deferrali. At end of year, total revenue (what business gets paid for) matched against total

expenses (what business pays to run business) = business’ bottom line, i.e., profit or loss / increase or decrease in owners’ equity.

ii. Lambert: When paid for something in cash not yet done, it cannot be recorded as revenue and owners’ equity is not increased; obligations not yet done are charged against cash.

1. Recorded as a liability; deferral of cash = deferred revenue. Once service performed, liability comes off books and revenue is recorded.

2. Flipside = pre-paying for something. Lose the cash and slowly accrue the asset. Once asset is fully utilized, recorded as an expense.

iii. Accrual and deferral apply to transactions involving receipt or payment of cash but which are not complete in a certain sense.

1. Completed transaction = where desk purchased or wages paid.2. Not completed transaction = where receipt of cash or payment of cash for

some benefit/service company obligated to provide or for which it is entitle to receive later.

a. e.g., prepaid rent. Pay in advance for 6 mos. Cannot record an expense but company is out cash and, accordingly, it must reduce cash. BUT new asset: prepaid rent, i.e., obligation owed to company:

b. As time goes by and landlord earns rent, company incurs the expense. Thus, company reduces asset account of prepaid rent (b/c no longer an asset) and records rent expense in account for income statement.

iv. Prepayments: receipt of prepayments for services or goods, on the one hand, and prepayments for goods or services that we are due in future, on the other. In GAAP…

1. One component of balance sheet = expense incurred or revenue recognized, which must be recorded in the accounts that form the basis for the income statement, which will be closed at year’s end to reflect a net increase/decrease in owner’s equity.

a. e.g., corp pays personnel every 6 mos. At end of mo 1, record liability for wages payable + an expense on income statement. At end of mo 6, when pay in cash, reduce cash & remove liability of wages payable. Six mos of expense for labor = recorded & will become a part of income statement (reduction of owners’ equity).

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v. Flipside of prepayment transaction1. e.g., receive retainer for future legal services that company agrees to perform.2. Company has cash and, therefore, it increases cash. BUT cannot record revenue

yet on income statement b/c income not yet earned and, therefore, not recognized.

a. Company has legal oblig’n to perform service in order to recognize revenue.

b. As such, service = liability b/c if company does not perform, it must return the cash. Record as liability of deferred revenue.

c. Once company performs services, it can increase revenue and eliminate liability of deferred revenue b/c it has earned it.

vi. Revenue recognition: increases in equity as through revenue only recognized when reasonably certain; decreases in equity recognized when reasonably possible.

1. Revenue recognized in period when goods/services = delivered (realization principle) & costs assoc’d w/ revenues of period = expenses of that period (matching principle).

vii. Accrual accounting: burdens income statement w/ all expenses that were incurred to generate revenue on a period-by-period basis and benefits income statement w/ revenues earned on period-to-period basis (w/o regard to when paid for in cash).

1. Accruals = revenues that have been earned and expenses that have been incurred by end of accounting period, but will not be collected or paid until subsequent period.

viii. Deferral accounting: seeks not to benefit income statement of period unless work is done in that period, even though cash in respect of that event is paid or received in that current period.

1. Note: Formally, assets, liabilities, revenues or expenses must be adjusted at end of accounting period to reflect earned revenues or incurred expenses.

18. Securities lawa. Different purpose than corporations law

i. Corp: e.g., questioning the authority of the board to issue a dividendii. Securities: e.g., questioning whether board gave full and fair disclosure to a new SH it’s

giving newly issued stock tob. What is a security?

i. Act of 33 and Act of 34: security = any note, stock, bond, debenture … investment K1. VERY broad on purpose

ii. “note” = any obligation to pay $1. test for whether it is a security: Reeves v. Ernst & Young

a. rebuttable presumption every note is a security; rebutted by showing it has a “family resemblance” to one of the notes on a list of non-security notes, which is shown through 4 factors:

i. Motivation for issuance of note1. If the seller’s purpose is to raise $ for the general use of a

business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be called a “security.”

ii. Plan of distribution of the notesiii. Expectation of the public as to whether are securities: here,

advertised as an investment1. L: this is very vague and hard to tell what a public

perception would be—no one knowsiv. Alternative risk-reducing factors, i.e., whether some factor such as

the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the securities act unnecessary

c. Insider tradingi. Based on fraud: conduct with respect to affirmative misstatements of fact or partially

misleading statements that exist by omission of material facts

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1. 5 elements: (1) intent to mislead a (2) specific person by intentionally making a (3) materially false statement or partially false statement (4) on which the person relied (5) the reliance on which proximately caused person specific damage

ii. deceit: silence when there is a duty to speak1. if have no duty to persons who will be harmed by remaining silence = no liability

d. ’34 Acti. §10(b): It shall be unlawful for an person to use or employ manipulative or deceptive

practices in contravention of such rules and regulations as the Commission may prescribe.

ii. §10(b)(5): It shall be unlawful for any person to 1. (a) employ any device, scheme, or artifice to defraud,2. (b) to make any untrue statement of a material fact or to omit to state a

material fact necessary to make the statements made not misleading, or a. Material “an omitted fact is material if there is a substantial likelihood

that a reasonable SH would consider it important in deciding how to vote.” (TSC Industries)

3. (c) engage in any act, practice, or course of business which operates or would operate as a fraud or deceit on any person

4. (d) in connection with the purchase or sale of any securitya. absolutely MUST be re: a purchase or sale of a security to violate

(a), (b), or (c)iii. Blue Chip : to have standing to bring § 10 claim, π must either be purchaser or seller of

stockiv. Ernst & Ernst v. Hochfelder: must have scienter to bring 10(b) claim

1. Negligence is insufficient—cannot be frauda. Though some insinuation gross negligence/recklessness can be fraudulent

i. Every single court of appeal to consider issue has held recklessness is sufficient for scienter

v. Reliance1. Requirement that person subject of material false statement has taken action on

basis of it (“transaction causation”)a. Must also have loss causation, i.e., loss was caused by the reliance on

false statement2. “fraud on the market”: in a fully developed market, reliance is rebuttably

presumed once it’s established the false statements had been disseminated in the securities markets

e. silence—failure to disclosei. bottom line: CANNOT be liable unless have a fiduciary duty to discloseii. O’Hagan : violation occurs when use non-public info gotten through a breach of duty to

the source and then trade using that information1. A.k.a., “fraud on the source”

iii. Dirks : mere “tipping” of info doesn’t constitute a securities violation but if the tipper gives information in breach of duty and the tippee knows that, then it’s a violation

1. A tippee will only be deemed to have derivatively assumed and breached a fiduciary duty when he knows or should have known that the insider would benefit in some fashion for disclosing information to the tippee

Basic, Inc. v. Levinson o issue of whether may rely on integrity of the price set in the marketo misleading statements made on market will defraud purchasers even if do not rely directly on themo to invoke fraud on the market presumption, π must allege and prove all 5 of these elements:

1. ∆ made public misreps 2. misreps were material 3. shares were traded on an efficient market 4. misreps would induce a reasonable, relying investor to misjudge the value of the shares 5. π traded the shars between the time the misreps were made and the time the truth was

revealedo rebut presumption by showing that severs the link between the alleged misreps and either the price

received or paid by π, or his decision to trade at a fair mkt price

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e.g., ∆ could show the “market makers” were privy to truth about subject transaction (here, a merger) and thus the mkt price would not have been affected by their misreps because the price would not have gone through market

or, e.g., if merger talks info went into market, thus affecting mkt prices

requirement of loss causationo hypo: investor in ship transportation; ship owner says it’s 100ft long but also uninsured; ship sinks and

investor loses everything π might allege would not have invested if knew true length of ship; ∆ could argue it’s irrelevant

because π knew investment was not insured; π could also argue it wouldn’t have invested as much, or the price should have been less, thus causation est’d

Dura Pharma v. Broudo (SCOTUS 2005)o rev’d 9th cir holding a π can est. economic loss caused by ∆’s mireps by saying the price of the security

on the date of purchase was inflated because of the repo πs (Broudo et al) bought ∆ stock on public securities mkt, suing for securities fraud

most important aspect of complaint was that they reliance on integrity of mkt and paid artificially inflated prices for ∆’s securities, which caused πs damages

o 2 main claims: 1. that drug sales would be profitable (“drug profitability claim”) 2. spray device would get FDA approval (“spray device claim”)

o d. ct. dismissed complaint, holding: 1. drug profitability claim had no allegation of scienter 2. spray device claim did not adequately allege loss causation

o 9th cir rev’d on re: spray device claim, holding: πs est’d loss causation if show price on date of purchase was inflated because of misreps

injury occurs at time of transactiono securities fraud action elements:

1. material misrep 2. scienter 3. connection with the purchase or sale of a security 4. reliance--fraud on the market/transaction causation 5. economic loss 6. loss causation, i.e., causal connection b/t misrep and loss

o ∆ alleges π’s complaint fails the last 2 elementso held: 9th cir incorrectly held the price on the purchase date was inflated

an inflated purchase price itself ≠ causation of relevant economic loss π has suffered no loss at moment of purchase; inflated purchase payment is offset by ownership

of a share that at that instant possesses equivalent value could also buy, then immediately share before truth comes out in general, longer time between purchase a sale, more likely that other, normal economic

factors have caused the drop in price R2d: when make misreps, liable for the relying purchaser’s losses when the facts

become generally known and as a result the share value depreciates objectives of securities law is to protect investors against economic losses misreps cause

o allowing nonreliance would turn 10b-5 into investor’s insurance 9th cir approach would allow recovery where a misrep leads to an inflated purchase price but

nonetheless does not proximately cause any economic losso πs failed to prove proximate causation and economic loss

failed FRCP 8(a)(2) because no allegation that ∆’s share price fell significantly after the truth became known

suggests πs considered the allegation of purchase price inflation sufficient, but artificially inflated purchase price is not a relevant economic loss

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B. silence and deceit: req to disclose material non-public info or abstain from trading securities based on info obtained (1) in course of performing fid duties of employees to employer/SHs (2) in the course of performing fid duties to any source

no “generaly duty” to the marketplace by possessors of wrongly obtained material nonpublic info Chiarella v. United States

o issue: whether a person who learns from confidential docs of a corp that it is planning an attempt to secure control of a second corp violates 10b-5 if fails to disclose the impeding takeover before trading the target company’s securities

held: NOo ∆ is a printer who came across docs about corp takeover bids and without disclosing the knowledge he

gained from them he bought stock in target companies and sold the shares immediately after the takeover attempts were made public--gained $30k in 14 mos

o ∆ made no statements at all in connection with his purchase of the stock--was totally silent d. ct. held jury could find him guilty if he willfully failed to inform sellers of target co securities that

he knew of a forthcoming takeover bid that would make their shares more valuableo corp insiders have duty to abstain from trading unless disclose all material inside info because by virtue of

their position they know material info others do not commit fraud for failing to disclose ONLY IF HAVE DUTY TO DISCLOSE

only have duty to disclose if other party is entitled to know because of fid duty or some rel’ship of trust and confidence

here, π was not corp insider and received no confidential information from the target company--only related to plans of acquiring the company

o NO duty at all to disclose to anyoneo Only have duty to disclose when have info “that the other party is entitled to know

because of a fiduciary or other similar relation of trust and confidence between them”

securities fraud when inside “tips” material nonpublic information and the “tippee” trades on the basis of ito liability for traders who receive info directly or indirectly from a corp source

Dirks v. SEC : someone who receives material nonpublic information from a corporate fiduciary will commit a violation of the antifraud prohibitions of the ‘34 Act if he or she trades on the basis of such information with the knowledge that the information was wrongfully obtained and with the knowledge that the information is materially nonpublic in nature

o ∆ received material nonpublic info from insiders of a corp with which he had no connection and disclosed it to investors who relied on it in trading shares of the corp

issue is whether ∆ violated antifraud provisions of securities lawso ∆ received info that assets of Equity Funding (EF) were vastly overstated as a result of fraudulent corp

practices ∆ investigated and corroborated allegations of fraud; openly discussed his findings with clients

and investors, which then sold their holdings in EF securities, which caused in 2 weeks shares to drop from $26 to $15/sh

EF eventually got taken over by SEC and then investigated ∆’s role in exposure of the fraud

o whether tippee is under obligation to disclose or abstain requires whether the insider’s tip was a breach of the insider’s fiduciary duty

test: whether the insider tipper personally will benefit, directly or indirectly, from the disclosure--no breach to SHs unless personal gain

o held: ∆ could not be liable because he has no fiduciary duty to SHs because not an agent of EF and he did not do anything that would induce EF or its SHs to have trust/confidence in him

no expectation from ∆’s sources that he would keep the info confidential tippers received no monetary or personal benefit by revealing EF’s secrets--they were motivated

by desire to expose the fraud thus, ∆ could not have been an after-the-fact participant in insiders’ breach of a fid duty

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fraud on the source as a violation of section 10b and 10b-5 United States v. O’Hagan

o issue: is a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fid duty to the source of the info, guilty of violationg 10b and 10b-5?

YESo ∆ was lawyer for firm who rep’d Grand Met (GM) in a potential tender offer for common stock of another

company, but ∆ did not work on the case firm then stopped rep and a month later GM publicly announced its tender offer in the meantime, ∆ began purchasing call options, and price for stock almost doubled when

tender offer announcedo ∆ charged with defrauding law firm and GM by using nonpublic information re: offero 10b makes unlawful using any deceptive device in connection with the purchase or sale of securities, i.e.,

is not confined to deception of a purchaser or sellero fiduciary’s undisclosed, self-serving use of a principal’s info to purchase or sell securities, in breach of a

duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the info “misappropriation theory”: premises liability on a fiduciary-turned-trader’s deception of those who

entrusted with access to confidential info

occurs when person commits fraud “in connection with a securities transaction” when he misappropriates confidential info for securities trading purposes, in breach of a duty owed to the source of the info

fraud is consummated when use confidential info to purchase or sell securities because the breach of duty and securities transaction coincide

only need “purchase or sale of any security”--not identifiable purchasers or sellers of securities

BJR: to be eligible for the protection of the basic business judgment rule, a director's business decision must satisfy all requirements of the rule. The board's decision must have been made with due care, in the good faith belief that it is in the best interests of the corporation and its shareholders, and the directors must have been disinterested and independent when they reached the decision. Since directors' self-interest -- or entrenchment interest -- is always implicated by a decision affecting the future control of the corporation, there is reason to question the directors' ability to reach a completely disinterested decision in the corporation's best interests, as the rule requires. Therefore, the Delaware courts have modified the rule to provide for enhanced judicial scrutiny in many such cases.

Flipping house scenarioX contributes $140kY contributes $10kPurchase price of $350kY puts labor into fixing houseHouse sells for $800kX pays bills of $20kP’ship owes $30k for property taxes and other bills

$30k to creditors $770k left of $800k proceedsPaying back X’s $20k $750kReturn capital contributions ($140k, $10k) $600k which are the profits, divided equally between the 2

Initial Capital AccountsP contributes $100k (cash)D contributes $150k (cash)

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M contributes M’s name

2008: $3mil profits—split evenly ($1mil to each partner)P: 1,100,000D. 1,150,000M: 1,000,000

Distributions: $500k to P and D, $1mil to MSubtract distributions from 2008 profitsP: 600kD: 650kM: 0

2009: $150mil in losses—split evenly ($500k loss each)P: 100kD: 150kM: -500k

2010: all assets sold, $3mil profit; all debts paid off except disputed $1mil distribution loans (ignore for question 1)M repays the $500k so $3.5mil - $250k (total value of capital accounts) net proceeds will be divided evenly amongst the partners

At the conclusion of the partnership, any negative capital, first, must be paid in by the negative partner in cash and thus its capital account temporarily becomes zero. The amount paid in by the negative partner increases total cash net proceeds. Those proceeds are compared with the total capital accounts (obviously the now zero partner's account is zero). If the total proceeds exceed the positive capital accounts (of course of the other non zero partners), then there is a profit that is shared equally among all the partners and enhances their capital accounts, including the zero partner, who shares in the net profit allocation. This makes the total proceeds equal to the adjusted capital accounts. Those proceeds are paid to all partners according the final adjustment. (MADONNA HYPO)

What about when capital accounts, even after the pay-in by the negative capital partner still are less than the total capital? In this altered scenario, where the negative partner pays cash to bring his capital account to zero, the same computation must be made. But after this payment, if the total net proceeds are still less than the total capital accounts (again negative partner has raised its capital account to zero, so the total capital is the positive partners), then the loss, like the profit, is shared equally and the zero partner (like the other positive partners) will absorb the loss on sale and drive his capital account to negative a second time. He, of course, must pay in again to bring his account to zero. Then the total proceeds, including his payment, will be shared according to the adjusted positive capital accounts, understanding, just to be redundant, that the partner (whose account has been brought up tozero) will not receive anything, and the positive capital accounts will be paid in those respective amounts. The regime always results in the positive capital accounts being paid in full, and the proceeds will always equal the total finally adjusted capital accounts. This result is arrived at by causing the negative accounts to be brought to zero whether it is from operations, or net profit and loss on sale of the partnership.

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