LAW 611 Corporations (Westbrook)Exam Outline – Spring 2004

Joe Ippolito

(Note: Braces {} in the text denote my own commentary, provided in some places for explanatory purpose only)

I) INTRODUCTION TO BUSINESS ASSOCIATIONSA) Types of entities and the relationships within (see infra passim)

i) Sole proprietorshipii) Agency (not an entity, but a relationship)iii) Partnershipiv) Limited Partnershipv) LLPvi) LLCvii)S corporationviii) C corporationix) Not-for-profit (often a 501(c)(3) corporation)x) For each of the above entities, we should know five things

(a) Who owns the entity?(b) Relationship between owners and the entity(c) Liability exposure of owners to third parties(d) Who manages the entity, and how do the owners control them?(e) Relation between the entity and the state (esp. regarding formation and taxation)

B) Context – the legal environment of the business entities studiedi) State statutes concerning creation of corporations

(a) Court interpretation of those statutesii) Law internal to the corporation

(a) Certificate, charter, articles of incorporation(b) Bylaws(c) Resolutions of board of directors and shareholder votes

iii) Law made between corporation and third parties (contract)iv) Law that regulates the circumstances in which the corporation operates

(a) Property(b) Tax(c) Regulation

(1) Federal statutes, federal administrative regulations v) Strategies

(a) There are lots of ways to think about corporations (not mutually exclusive; use each perspective)

(1) Compare corporations to the zoo of business entities – e.g., compare to partnerships, not-for-profits, sole proprietorships

(2) Interaction of corporations and politics – commercial speech, as manifested in issues like acquisition of media outlets, and limits on that speech; comparison to speech rights of natural people

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(3) Creatures of state law (state declares the corporation’s existence); what are the corporation’s legal sources or foundations?(i) State statutes and common law; federal statutes; most rules come from the

corporation’s own charter / articles, and by-laws; ongoing decisions of the board of directors; administrative regulations (e.g., environmental, labor, financial (corporations impacted by their need for capital))

(ii) The term “corporation law,” though, does not include all of these sources (all the other sources are “laws that regulate corporations”); it’s about structure of corporations and relations therein

(iii) Think of a sitcom with 3 characters: shareholders, MGT, directors (not employees – somewhat more contractual relationship, less about corporation control)

(iv)Each character is pretty formulaic and does variations of a limited number of things1. Shareholders: own the corporation (invest money, expect return)2. Managers: they manage (daily operations)3. Directors: they direct (i.e., approving strategy)

(4) Governance and control(i) How the 3 actors interact and (sometimes) fight(ii) Our cases: fights – the actors take standard positions in these fights (e.g.,

shareholders say that management took the money; management claims legitimate use of the money)

(5) Corporation as way of raising and distributing capital web of property rights

(6) Economics (i.e., the academic subject)C) Motivations of actors in a corporation

i) Maximize profitii) Fulfill trust (fiduciaries)iii) Retain or extend control (e.g., takeover cases)iv) Benefit others (charitable purpose of not-for-profits)v) Even when all four of the above motives are in play, the primary purpose of any

business entity (except the non-profit) is to make moneyD) Distinction between purposes and legal powersE) Big themes in corporation law: investment, oversight, control, responsibility, liability

i) Much of this class about who is liable for what, and who paysii) Key to this is who controls, or who is responsible (e.g., agency) – who made it happen

or who has operational controliii) E.g., investing in a business: element of risk vs. return sought

(a) Investors try to lower their risk try to help run the business liabilityiv) One view of corporation law: contracts are the primary authority – do whatever you

want, with statutes as backstop for things you don’t think of (why there’s so little policy in this course – let private people do their own thing)

v) Another view: corporation law is law, which constricts what you can and cannot enter contracts to do court in Waltuch took this view

II) AGENCYA) Terms to know

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i) Agentii) Detour

(a) An employee’s minor deviation from the employer’s business for personal reasons. * Because a detour falls within the scope of employment, the employer is still vicariously liable for the employee’s actions. Cf. FROLIC.

iii) Frolic(a) When an agent or employee performs acts outside the scope of his employment, he

is “on a frolic of his own.” E.g., a truck driver who drives off the delivery route for personal activities is on a frolic. (Gilbert dictionary)

iv) Independent contractor(a) Trick question: are all independent contractors acting as agents?(b) No: no agency unless IC acts on principal’s behalf

(1) Agency: you would have to pay 84 Lumber for things bought by IC, if you tell IC to build you a deck and buy stuff on your account at 84 Lumber

v) Mastervi) Principalvii)Respondeat superior

(a) Masters liable for actions of servant in tort(b) Not every principal is a master: master = principal who must pay when held liable(c) Not every agent = servant(d) Underlying tort policy

(1) Be a little concerned about cases that hold the deep pocket responsible automatically; under that policy, the deep pocket would look to take control and wipe out autonomy of small businesses

viii) Scope of authority(a) Ira S. Bushey & Sons v. United States

(1) Drunken sailor opens valves on one side of the drydock ship turns over!(2) Navy denies that sailor is an agent(3) Judge upholds respondeat superior, in part for practical reasons: Navy can

afford padlocks on the valves more than sailor can afford to replace the ship(i) Note that foreseeability is not the issue here: the issue here is who better

can bear the responsibility of preventing these incidents; the Navy can’t pretend that sailors don’t get drunk, and that it doesn’t need to account for that

(ii) Note that the Navy was NOT negligent because no foreseeability1. In this sense, this case resembles Kidd v. Edison: there’s a sentiment

here that letting the boss off is just wrong, when the incident is connected in some way to the scope of employment

(iii) If instead the drunken sailor had killed his wife’s lover, then the Navy wouldn’t be responsible

(4) Respondeat superior goes back to Roman law: you’re responsible for the members of your household general type of forseeability for respondeat superior different from the type used in assessment of negligence

ix) Servantx) Vicarious liability

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(a) Liability that a supervisory party (such as an employer) bears for the actionable conduct of a subordinate or associate (such as an employee) because of the relationship between the two parties. See RESPONDEAT SUPERIOR.

B) Authorityi) Express (form of actual authority)

(a) Specific document creates the agreement (1) E.g., realtor who agrees to help you sell a house; attorney who represents a

client; typical employment contract (2) Compensation not necessary for relationship to exist

ii) Implied (form of actual authority)iii) Apparent authority

(a) Principal tells a third party that X is his agent even if principal and X have not had a meeting of the minds, X can bind principal as long as third party has no reason to believe that X was not the principal’s agent

iv) Ratification(a) What if agent enters a contract not authorized to enter, principal learns of it later,

and then signs off on it? Ratification(b) Happens a lot on corporations: managers enter contracts that would raise conflict

of interest concerns, but board ratifies after review (Enron as example of ratification gone wrong)

v) Estoppel(a) A bar that prevents a person from denying or asserting anything that contradicts

what he has, as a matter of law, established to be true (Gilbert dictionary)vi) Inherent authority

(a) Watteau v. Fenwick (GBR case)(1) Humble secretly sells his business, but keeps running it; no one knows that

Humble is an agent and not the owner(2) Humble buys stuff that he supposedly isn’t authorized to buy for owner

supplier sues owner when owner won’t pay(3) Problem: Humble is specifically forbidden from buying what he bought no

actual or implied agency; no apparent agency because supplier doesn’t know that Humble is an agent, and doesn’t know who owner is

(4) BUT(5) Buying that stuff is within the usual scope of buying stuff for a tavern

inherent authority(6) Question: what’s the point of holding a principal liable when an agent

behaves badly, beyond the scope of any agency agreement? Why responsibility that spans time and space?(i) {The event is still an attempt to carry out principal’s wishes; the event

would not have happened but for a desire from the principal}(ii) In Watteau, court admits outright breach of agency agreement

1. Still . . .(b) Kidd v. Thomas Edison

(1) Edison employs Maxwell, and in turn Fuller, to get recordings of music stars to show quality of phonograph recordings

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(2) Maxwell tells Fuller to book Kidd (a singer) for the purposes of making some recordings, but Fuller books her for the season (which includes tours and such)

(3) Maxwell doesn’t want to pay for a whole season; Kidd sues(4) Edison loses: the whole point of holding a principal liable is status (patrae

patestus, father of household); boss is liable because he’s the boss(i) Judge Hand thinks that this is archaic (because it’s an argument based on

status, and centuries of civil rights have made arguments on status very un-PC; conduct and consent should matter more some have written that the whole of legal history is the story of moving from status to consent), but upholds it because agency connotes reliability, and agency connotes some leeway to negotiate without having to check back all the time

(5) More than one form of agency could be found hereC) Difference between two types of responsibility that a principal can have

i) Responsibility for physical conductii) Responsibility for words (transactions) uttered on principal’s behalf

D) Relationship between insurance and principal liability – why, in the world of insurance, is liability of the principal a question?

E) Franchise agreementsi) What are they?ii) How do they relate to vicarious liability?iii) Murphy v. Holiday Inn

(a) Control vs. outsourcing(b) General setup is franchise arrangement with local independent operator

(1) The things that Holiday Inn requires relate to standardization, not to daily control and inspection

(2) Operator won’t sue Holiday Inn in part because the relationship would end, and the operator would need a new hotel affiliation; you’re stuck if you can’t find one

iv) Billops v. Magness(a) Extortion at a banquet hall?!(b) Case again turns on control; this particular court finds enough control to deny

summary judgment for hotel; court also turns question of law into question of fact, and denies summary judgment to let jury sort it out

(c) Control doesn’t matter in apparent agency; here, we need only a representation to a third party, and reasonable reliance by third party in response

(d) How would you argue that Hilton was not Brandywine’s principal?(1) Using trademark of Hilton just a formality, for standardization(2) Control follows capital

(i) Brandywine built the building(e) These arguments are OK, but there’s a real world problem

(1) Hilton has no equity stake in Brandywine(2) This is the hospitality industry: the main asset here is the Hilton name;

visitors don’t perceive the building as Brandywine’s – they see it as “the Hilton”

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(3) In response, Hilton might take more control and inspect the franchises (rationale: hell, if we’re liable solely based on name, then why not control the franchisee more?), or take out more insurance

v) Question on apparent agency: could Holiday Inn case have been argued under apparent agency?

(a) Would require that Holiday Inn told customer that Betsy-Len was its agent(b) Does customer have any reason to believe that Betsy-Len owned the hotel, and not

Holiday Inn?(1) Because of this, many hotels have little plaques somewhere that say who

owns that location(2) This starts to resemble a R90 / estoppel argument(3) In contrast, Billops court discusses control and apparent agency, but blurs

apparent agency with appearances / reliance / estoppelF) Agent’s liability on a contract

i) Normally, agents and principals both are liable in contract and tort(a) Principals have more power than the agents

ii) Why do we care about principals in this class?(a) Corporations can be principals(b) Consider the Exxon Valdez: captain liable, but Exxon too because of its influence

on actions at a distance (actions at a distance as opposed to individual actions)(c) Without agency, the captain of the Valdez is just some guy acting on his own(d) Big theme: moving from contracts between individuals actions at a distance

where we’re not sure where the legal relationship isiii) That said, agents are still liable: not always, but sometimes

(a) To escape liability, the agent must make clear to the third party that agent is acting on behalf of the principal

(b) Atlantic Salmon case: agent did not make clear that he was someone’s agent he’s liable

G) Restatement 2d of Agency – §§ 1, 2, 7, 8, 8A, 8B, 219, 220, 228, 229i) Section 1 (agency; principal; agent)

(a) Agency is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act.

(b) The one for whom action is to be taken is the principal.(c) The one who is to act is the agent.

ii) Section 2 (master; servant; independent contractor)(a) A master is a principal who employs an agent to perform service in his affairs and

who controls or has the right to control the physical conduct of the other in the performance of the service.

(b) A servant is an agent employed by a master to perform service in his affairs whose physical conduct in the performance of the service is controlled or is subject to the right to control by the master.

(c) An independent contractor is a person who contracts with another to do something for him but who is not controlled by the other nor subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking. He may or may not be an agent.

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iii) Section 7 (authority)(a) Authority is the power of the agent to affect the legal relations of the principal by

acts done in accordance with the principal’s manifestations of consent to him.iv) Section 8 (apparent authority)

(a) Apparent authority is the power to affect the legal relations of another person by transactions with third persons, professedly as agent for the other, arising from and in accordance with the other's manifestations to such third persons.

v) Section 8A (inherent agency)(a) Inherent agency power is a term used in the restatement of this subject to indicate

the power of an agent which is derived not from authority, apparent authority or estoppel, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent.

vi) Section 8B (estoppel; change of position)(a) A person who is not otherwise liable as a party to a transaction purported to be

done on his account, is nevertheless subject to liability to persons who have changed their positions because of their belief that the transaction was entered into by or for him, if

(1) he intentionally or carelessly caused such belief, or (2) knowing of such belief and that others might change their positions because

of it, he did not take reasonable steps to notify them of the facts.(b) An owner of property who represents to third persons that another is the owner of

the property or who permits the other so to represent, or who realizes that third persons believe that another is the owner of the property, and that he could easily inform the third persons of the facts, is subject to the loss of the property if the other disposes of it to third persons who, in ignorance of the facts, purchase the property or otherwise change their position with reference to it.

(c) Change of position, as the phrase is used in the restatement of this subject, indicates payment of money, expenditure of labor, suffering a loss or subjection to legal liability.

vii)Section 219 (when master is liable for the torts of his servants)(a) A master is subject to liability for the torts of his servants committed while acting

in the scope of their employment.(b) A master is not subject to liability for the torts of his servants acting outside the

scope of their employment, unless: (1) the master intended the conduct or the consequences, or (2) the master was negligent or reckless, or (3) the conduct violated a non-delegable duty of the master, or (4) the servant purported to act or to speak on behalf of the principal and there

was reliance upon apparent authority, or he was aided in accomplishing the tort by the existence of the agency relation.

viii) Section 220 (definition of servant)(a) A servant is a person employed to perform services in the affairs of another and

who with respect to the physical conduct in the performance of the services is subject to the other's control or right to control.

(b) In determining whether one acting for another is a servant or an independent contractor, the following matters of fact, among others, are considered:

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(1) the extent of control which, by the agreement, the master may exercise over the details of the work;

(2) whether or not the one employed is engaged in a distinct occupation or business;

(3) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision;

(4) the skill required in the particular occupation; (5) whether the employer or the workman supplies the instrumentalities, tools,

and the place of work for the person doing the work; (6) the length of time for which the person is employed; (7) the method of payment, whether by the time or by the job; (8) whether or not the work is a part of the regular business of the employer; (9) whether or not the parties believe they are creating the relation of master and

servant; and (10) whether the principal is or is not in business.

ix) Section 228 (general statement [of scope of employment doctrine])(a) Conduct of a servant is within the scope of employment if, but only if:

(1) it is of the kind he is employed to perform; (2) it occurs substantially within the authorized time and space limits; (3) it is actuated, at least in part, by a purpose to serve the master, and (4) if force is intentionally used by the servant against another, the use of force is

not unexpectable by the master.(b) Conduct of a servant is not within the scope of employment if it is different in kind

from that authorized, far beyond the authorized time or space limits, or too little actuated by a purpose to serve the master.

x) Section 229 (kind of conduct within scope of employment)(a) To be within the scope of the employment, conduct must be of the same general

nature as that authorized, or incidental to the conduct authorized.(b) In determining whether or not the conduct, although not authorized, is nevertheless

so similar to or incidental to the conduct authorized as to be (c) within the scope of employment, the following matters of fact are to be

considered: (1) whether or not the act is one commonly done by such servants; (2) the time, place and purpose of the act; (3) the previous relations between the master and the servant; (4) the extent to which the business of the master is apportioned between

different servants; (5) whether or not the act is outside the enterprise of the master or, if within the

enterprise, has not been entrusted to any servant; (6) whether or not the master has reason to expect that such an act will be done; (7) the similarity in quality of the act done to the act authorized; (8) whether or not the instrumentality by which the harm is done has been

furnished by the master to the servant; (9) the extent of departure from the normal method of accomplishing an

authorized result; and

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(10) whether or not the act is seriously criminal.III) FINANCE AND ACCOUNTING

A) Terms to knowi) Assetsii) Call optioniii) Collateraliv) Covenants (in loan documents)v) Debtvi) Defaultvii)Equity (aka “shareholders’ equity”; know in contrast to debt)viii) Financeix) Guarantees

(a) Something given or existing as security, such as to fulfill a future engagement or a condition subsequent

x) Investor (and related terms: lender, shareholder, etc.)xi) Preemptive rightsxii)Put option

B) Core conceptsi) Finance is an entity’s effort to do something with a third party’s (i.e., the investor’s)

money, in exchange for which the third party receives rights against the entity (this was illustrated by a triangle)

ii) Debt:owes::equity:owns (and variations on the theme)IV) PARTNERSHIP

A) Formation and governancei) Formed by agreement; the agreement may be express or impliedii) Sometimes a partnership not formed, despite a document purporting to form oneiii) Governed by

(a) State statutory law (statute often based on model acts, UPA, RUPA)(b) Case law(c) Partnership agreements (whether express as an actual document, or implied)

iv) Governed by simple majority, unless partnership agreement provides otherwise(a) Voting is per capita (not per shares) unless otherwise specified

(1) Nabisco v. Stroud(i) Freeman buys bread for partnership that Stroud didn’t want(ii) Stroud’s vote wasn’t a majority bound by Freeman’s conduct as

partnership agentB) Other general characteristics (most can be modified by agreement)

i) Partners own, but the partnership itself can own property too(a) A partnership, like a corporation, can be a legal person(b) Putnam v. Shoaf {not required by study guide}

(1) Putnam widow wants out; Shoafs want in, but the company needs investment from existing partners Shoafs will buy if that happens

(2) It happens, but in the interim, news breaks that company accountant had been defrauding company, with several banks complicit banks wind up paying restitution

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(3) Putnam widow argues that she deserves her share of that restitution, because she was a partner during the fraud

(4) Court says no: the restitution belonged to the partnership, not her; when she sold her partnership share, she sold right to future claims and benefits that the partnership would gain(i) Like selling shares in a corporation: you don’t have a right to future

profits because you were a shareholder once; and even when you are a shareholder, you have no right to dictate what happens to the company facilities

ii) Partners owe fiduciary duty to one another(a) Partners are both agents and principals to each other

iii) Partners can obligate(a) Within limits, partners’ actions bind the partnership, and the other partners

individually(1) E.g., opinion letter from a law firm (opinion on whether a valid contract

exists in some corporate transaction) opinion comes from the firm, not an individual in isolation two-partner rule for opinion letters, because of liability implications (i.e., clients now will rely on firm’s assessment)

iv) Partners share in control(a) Denial of share in control violates the partnership agreement

v) Partners share in profits and losses(a) Sharing occurs per capita unless otherwise specified(b) Raising additional capital

(1) Read on your own(2) Basic problem: imagine a joint venture with a specific project in mind(3) Venture may not be operational until completed, but current funding

inadequatevi) Limited transferability of shares

(a) Corporations: free transferability (you buy GM shares on the secondary market, not through a daily IPO; other shareholders have no say over whether you buy GM shares)

(b) Partnerships: no free transferability: no change of ownership without consent of other partners

vii)Partners have unlimited joint and several personal liabilityviii) Pass-through taxation

(a) Partnerships per se do not pay taxes; partners individually pay taxes on profits of the partnership

(1) Contrast with corporation, which pays its own taxes; shareholders also pay tax on dividends double taxation

ix) Limited lifetime(a) Default term is at will, but a term may be provided by contract, or even implied

(e.g., to repay a loan)(b) Dissolution leads to “winding up” – partnership continues to exist to wind itself up

(1) If a partnership cannot manage a winding up, then a court may order a sale and appoint a receiver to run the sale

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(c) Partners can bid for the assets of a partnership, including goodwill (i.e., the business entity itself)

(1) Buyout agreements (i) When the owners can’t get along, how do you get that ownership interest

out of the entity? Who decides?(ii) Trigger events: death, disability, partner desires to leave BUT who

decides when the trigger event has happened?(iii) Partnership may need insurance to cover payouts related to trigger

events (or, think about from where the money would come)(iv)In a buy-sell agreement, one partner has the option to force a change in

the partnership structure(d) Partners cannot dissolve in bad faith (i.e., cannot use dissolution to get control

over the partnership) partners who bid must pay a fair price(e) Classically, the departure of any partner = dissolution (UPA 1914)

(1) Now, most departures of partners = disassociations per UPA 1997C) Buy-sell agreements

i) Know what they areD) Cases to know

i) Meinhard v. Salmon(a) Managing partner (Salmon) and silent partner (Meinhard) enter a lease to build a

hotel(b) Sometime during lease, city of NY plans to build Grand Central Station nearby –

value of property shoots up third party approaches managing partner about a joint venture between them to build a new hotel on the premises

(c) Four months before the 20-yr lease runs out (why not wait just a few months?), managing partner entered lease with third party, without telling silent partner

(1) BUT managing partner had fiduciary duty to disclose dealings to silent partner, especially since the property in question was the same property that the two partners had leased in the joint venture silent partner wins one-half stake in the new lease

(d) When in doubt, disclose! you still may have screwed up, but at least no one will accuse you of bad faith

(1) Note that Salmon breached his duty even though he has not defrauded Meinhard in their lease, or hurt him in any other way, but as a fiduciary you have to put your own interests aside in a way that you don’t when you’re handling arm’s length transactions in the open market

(e) Difference between joint venture and partnership(1) Joint venture limited by finite duration, and focus on a specific project(2) At the time when third party approaches Salmon, Salmon has to consider

himself Meinhard’s agent(f) Dissent by Andrews: this was a joint venture for one project, not a partnership;

Salmon owed Meinhard nothing once the joint venture expired despite the property being the same as the one as the one in the joint venture, the new lease was a whole new project

(1) A possible response: the building doesn’t vanish after the 20 years expire Meinhard should have had some input into what happens after the lease

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expires; Cardozo says that the contract isn’t an issue – this is about holding fiduciaries to very high standards

ii) Fenwick v. Unemployment Commission(a) Case arises because beauty shop had avoided unemployment compensation law;

law kicks in when you have 8 or more employees was the ♀ who left the shop an employee, meaning that the law kicks and the shop owes back payments to the unemployment fund, or was she a partner?

(b) Employer’s plan to pay employee more based on future increases in profits: sounds like a partnership

(c) BUT(d) Employee didn’t have to share losses sharing profits sounds more like a

commission(e) Employer retained exclusive control of the shop’s management (f) Thus, she wasn’t a partner

iii) Martin v. Peyton (a) Friends loan a banking and finance firm lots of money to keep it afloat(b) The friends want to help, but don’t want to expose themselves to too much risk

(1) The plan: pledge a bunch of securities as collateral for a loan for the firm; obtain an agreement providing for dividends on their own securities; option to buy 50% interest in firm; option to veto unwise investments; inspection rights; pre-signed resignation letters from all current partners; make sure that a certain guy was the manager of the firm, and insure his life for lots of money (the agent of the financiers?)

(c) Firm takes the money, and invests it in the foreign currency market in the 1920s (bad!)

(d) Creditors swoop in, sue the friends claiming that they’re partners creditors want them personally liable for the firm’s debts

(e) Court decides that the friends are creditors, not partners, though it’s a close call(1) Friends had not exercised enough control of firm to qualify as partners(2) The manager could be seen as agent and friends could enforce the resignation

of all partners, but not much control actually used from day to day {Westbrook makes this sound as if either side could be argued if this were an exam question}

(f) Note that this isn’t a contracts issue – the contracts are valid; the question is what relationship the contracts created, creditor or partner reliance is not an issue here

(g) Can you reconcile this case to Cargill? Cargill sent an actual representative to control the other company, whereas the control here seems to be more passive

E) Other cases discussed in classi) Bane v. Ferguson

(a) Attorney retires from a firm, receives pension (pensions from firms typically unfunded; pay as you go)

(b) Firm enters merger disaster no successor firm, no more pension(1) (“Wooten tells me ERISA doesn’t apply”)

(c) Attorney sues, claiming that firm had no right to end pensions without his approval (d) BUT

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(e) That rule refers to the rights and powers of partners – attorney has not been a partner since he retired

(f) Attorney also fails to establish a fiduciary duty to former partner(g) Posner notes that the pension fund was not a trust analogy to shareholders when

a company folds: you lose your investment and your expectations in the company(h) Ultimately, court decides that there’s no remedy here

ii) Meehan v. Shaughnessy(a) Attorneys unfairly take clients with them when they leave their firm(b) Case really about right of clients to know that they have to choose between the

attorneys, and the firm(c) Attorney must inform clients of this choice, and that clients don’t have to come

alongiii) Lawlis v. Kightlinger & Gray

(a) Attorney develops alcohol problem; firm eventually kicks him out as a partner(b) Attorney alleges predatory purpose: kicking him out to increase profits that go to

each partner(c) Court finds no intent to be predatory or to hurt Lawlis; there’s just an expulsion

vote, and it followed the partnership agreement that Lawlis himself signed(1) Court treats partnership more like a contract and less like a fiduciary

obligation, compared to earlier casesiv) Day v. Sidley & Austin

(a) Day runs DC office of Chicago firm; merger with another firm merger of DC offices under a different attorney

(b) Day sues, claiming that he had an agreement to be the only attorney to run the firm’s DC office

(c) BUT(d) No written agreement exists about Day running DC office firm has not taken

any legal right from Day(e) This case is a more contractual emphasis on contract law, as opposed to Meinhard

v. Salmon case would the Meinhard court have decided otherwise?(1) Maybe not, post-Enron: more hands-on approach to fiduciary duty and

making partners level with each other, whereas pre-Enron a modern court might have told Day that he was a big boy and had to look after his own affairs

(f) Also, partnership dissolves when a partner comes in or leaves new partnership can arise

(g) There is a difference between dissociation and dissolution (more later)v) Owen v. Cohen

(a) Partnership to run bowling alley; Cohen treats Owen like crap Owen seeks and wins dissolution of partnership

(b) Debts of partnership paid first to third parties; then pay off loans of partners to partnership; then pay ½ of remainder to Owen, minus partnership costs incurred because of Owen

(c) Note that Owen goes to court for dissolution and receiver appointment, but partnership is a consensual agreement why doesn’t Owen just leave?

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(1) Cohen is such a jerk that he won’t sell the business, or voluntarily pay Owen’s debts

(2) This is a partnership for term; as a result, Owen would have breached contract if he had left unilaterally; had Owen breached contract, Cohen would have had right to carry on the business (did Cohen try to drive Owen out?), and collect some damages from Owen for breaching contract Owen must go to court to keep from being a breacher of the contract

vi) Exit strategies for partnersvii)Page v. Page

(a) 2 brothers become partners in a Laundromat(b) Business eventually makes money, but just as it starts to take off one partner wants

to force the other out(c) First question: is this a partnership for term? Must they do business with each

other long enough to pay off demand note?(d) Court says no: this partnership is terminable at will(e) BUT(f) Court raises good faith issue: partners must deal with each other in good faith

no dissolution would be allowed if the one partner were shown to have attempted to squeeze out the other in bad faith

viii) Consequences of dissolutionix) Prentiss v Sheffel

(a) Partners don’t get along D doesn’t pay his share partnership dissolved per court order P then bids for other partner’s share at judicial sale

(b) Some tension exists between ability to exclude a partner and requirement to include partners in management decisions

(c) At some level, we can’t make you two treat each other like partners(d) This touches on an important theme that we’ll discuss later: majority partners who

act in a prejudicial manner against minority shareholders (e.g., give themselves extra dividends, perks)

(e) Also, partners are allowed to bid on the outstanding assets of a dissolved partnership; that majority partners have less to spend to buy out the partnership (because they already own more) is not unfair to minority partner, especially where the majority partners’ bid raises the value of the minority partner’s interest

x) Kovacik v. Reed(a) One partner invests monetary capital, one partner contributes labor (sweat equity)(b) Court finds that under those circumstances, labor partner doesn’t owe the other

partner monetary losses each loses his own contribution(c) To strengthen his argument, Kovacik should have priced Reed’s labor, to make the

capital contributions equally monetary and rope in Reed to the financial losses(d) Note p. 179: Priority of repayment under UPA: first pay outside creditors, then pay

loans to partners, then pay original capital contribution, and then pay profits pro rata, if anything remains

(e) Revised UPA rejects Kovacik case: “labor partners” deemed to have contributed no capital, and ARE liable for monetary losses of other partners

F) Also know the chart comparing partnership and corporationV) FIDUCIARIES IN GENERAL

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A) Definition and rationalei) Fiduciary: In the nature of a trust, or a person holding the character of a trustee, which

requires confidence, scrupulous good faith, and candorii) In fiduciary relationships, we expect the fiduciary to put trust above self-interestiii) “A trustee is held to something stricter than the morals of the marketplace. Not honesty

alone, but the punctilio of an honor most sensitive, is then the standard of behavior.” – Cardozo, in Meinhard v. Salmon

(a) Cardozo’s point is that “the morals of the marketplace” are openly self-interested, albeit bounded by respect for the law and honesty

(b) But we expect something more from trustees (and other fiduciaries), namely, care for the interests of others

B) General duties: A fiduciary should . . .i) Put the interests of those for whom they act in trust above their (no self-dealing)ii) When in doubt, disclose (“A fiduciary’s silence is equivalent to a stranger’s lie.”)

C) Examples of fiduciary relationshipsi) Trustee to beneficiaryii) Agent to principal (e.g., attorney to client)iii) Partner to fellow partneriv) Joint venturer to samev) Senior management to shareholdersvi) Dominant shareholders to minority shareholders (difficult problems)

VI) BUSINESS CORPORATIONSA) Berle & Means on the corporation

i) Distinctive characteristic of the corporation is the separation of ownership (held by shareholders) from control (held by managers and directors)

ii) Central goal of corporation law, then, is restraining managers and directors from taking advantage of shareholders (self-dealing)

iii) This central goal has been attempted in two ways(a) Fiduciary duties, and other legal restraints imposed on managers by law and

regulation(b) Payment of managers with equity, in an effort to align managers’ interests with

shareholders’ interestsB) Form and formation

i) How do we form a corporation?(a) State statutes (e.g. NY Bus Corporation Law) set forth procedures that corporate

articles may, or must, include(b) Get the forms for your state; file the appropriate info, pay a fee certificate /

articles of incorporation(c) Meanwhile, directors draft by-laws for corporation; corporate equivalent of

statutes(d) Amending the articles of incorporation requires shareholder vote (analogous to a

government constitution)ii) Incorporator (generally same person as the “promoter”) files papers with the state to

form the corporation(a) Promoter has a fiduciary to the corporation itself, even before the corporation is

formed

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(b) Promoter draws up formal documents, gains acceptance by state, state mails back certificate, promoter holds first meeting of corporation, which establishes board of directors which then passes by-laws

(c) Directors then hire managers to run company and conduct business (i.e. enter contracts) for corporation

(1) At this point, promoter stops being promoter and usually becomes CEO(d) **Point: partnership exists if you act like one; corporation requires deliberate

effortiii) Certificate of incorporation (sometimes called Articles of Charter)iv) Bylawsv) Resolutions of first meeting of board of directors: know basic contentvi) Share certificatevii)Model Business Corporation Act (MBCA) (1984)

(a) See Supp at 160-62(b) One or more people may be incorporators(c) Articles must set forth corporation name, street address; name and street address of

each incorporator(d) Articles may set forth names and addresses of the initial directors; corporation’s

purpose; par value for authorized shares; powers of corporation, shareholders, directors, and management

(e) Corporate existence begins when articles of incorporation filed(f) Anyone acting on behalf of corporation is jointly and severally liable even before

incorporation becomes official(g) After incorporation, directors will hold the first meeting and finish organizing the

corporation, adopting the initial set of bylawsviii) DE Gen. Corp. Law §§ 101-110

(a) See text at 91-96(b) See MBCA above; same thing, but a lot more detail

C) Corporate purposesi) Actors and their roles: shareholders, directors, managersii) Other stakeholders

(a) What are their relationships? How do they figure in corporate governance?iii) Purpose of the corporation

(a) Mostly, to make money, but see aboveiv) Powers of the corporation

(a) Sue and be sued(b) Commit crimes

(1) How do you hold a corporation criminally liable? Prosecute the responsible officers, though the concept of corporation criminal liability is weird – we think of crimes as committed by people who can account for their actions

(2) Incidentally, piercing the corporate veil kicks in only when a corporation is bankrupt, and more money sought to settle a liability (no point in doing it otherwise)

(c) Own property(d) Contract (e) Own securities

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(f) It is taxed(g) Can make charitable contributions

(1) An issue to ponder: altruism is economically irrational how you justify it?(2) Best way to do it under economic theory is to say that donations pursue self-

interest in a broader way(h) Can speak (free speech rights)(i) Cannot vote or marry (“artificial person” concept doesn’t go that far)

(1) Although lobbying can be seen as indirect votingv) Ultra vires

(a) Unauthorized; beyond the scope of power allowed or granted by a corporate charter or by law <the officer was liable for the firm's ultra vires actions>.

vi) Intra vires(a) Of or referring to an action taken within a corporation's or person's scope of

authority <calling a shareholders' meeting is an intra vires function of the board of directors>.

vii)Corporate gifts(a) Permissible(b) Some benefit to corporation

(1) No gifts to pet charities(2) Must be reasonable in amount

D) Social purposes of the corporationi) Limited liability

(a) Liability of a shareholder is limited to the amount of the initial investmentii) Policy: why is limited liability important?

(a) Encourage people to invest fundamental mechanism of capitalism(1) Caps uncertainty, and risk of loss (not risk that you will lose – risk in itself)(2) Allows investment at a distance capping uncertainty avoids need to

research every aspect of the company before investing, and monitoring operations in detail thereafter

(b) Contrast with partnership: you’d better know what your partners are doing all the time, because the partners could be playing for your house

(c) Entrepreneur also benefits: he can solicit capital from people all over the world large pools of capital can be gathered

(d) In short, limited liability allows corporations to be much larger than they would be otherwise

(e) Thus, shareholders in a corporation are ignorant, distant, and won’t lose their houses

iii) In this context, what’s wrong with corporate law?(a) Problem: protecting shareholders in a system in which they’re at a structural

disadvantage tension between shareholders and management is a topic that we’ll discuss for the rest of the semester

(1) Shareholders don’t manage, they’re residual claimants who vote occasionally; management makes the daily decisions the owners are not in control

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(2) In contrast, partnership ownership and management are not separated, by law partners have right to manage partnership and can bind the partnership in contracts; shareholders can’t bind the corporation

(3) Some exceptions: in a large law firm, not every partner manages executive committee handles that

(b) What do directors do? They oversee and fire management; set corporation strategy and oversee its implementation

(c) Separation of ownership and management is the basic problem of corporate law(d) Has a director fulfilled his duties (duty of care, duty of loyalty)?

(1) If director has paid some attention to corporate decisions being made (i.e. fulfilled duty of care, and no conflict of interest that would violate duty of loyalty), then courts will not hear shareholder claims that director breached duty to corporation and shareholders

(2) This will happen by saying that decisions of director protected by business judgment rule

(e) Corporation law and securities law are not about eliminating risk to investors, or to keep them from losing money, and free market will never stop this

(f) Large corporations need vast structure, but some people are uncomfortable with the distance inherent in such vast structure (Rousseau, UNAbomber, globalization protestors) much of corporate law is about building size

E) Stocki) What is a share?

(a) Token of partial ownership in company(b) A bundle of sticks, where sticks = rights a bundle of rights and responsibilities

that you can separate (i.e., they’re up for grabs; we can add to or subtract from your bundle)

(c) Common stock: ordinary citizen of corporation, no right to contract for corporation or to manage corporation

(d) Right to vote on major corporate decisions (merge, dissolve, directors, amend charter)

ii) Basic terms to know(a) Authorized shares

(1) Articles of incorporation usually include a number of authorized shares; why?(i) Suppose a small corporation with 10,000 shares each of your buddies

and you start with 1000 shares(ii) Company starts up, does some things, but needs more money(iii) Corporation can offer more shares, but then your %ownership drops –

do you care? Probably yeah! That’s why shareholders must vote to dilute their own shares by offering more

(2) Economically, have you lost money? No – your ownership % drops, but each share retains its value, and the corporation’s larger size might bring in more profit later you now hold a small % of a bigger pie(i) Board of directors can issue shares at any time, as long as they stay under

the limit set in the articles(b) Common stock

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(c) Cumulative(d) Debt

(1) Corporate Debt(2) Debentures – long-term unsecured obligations sold as securities(3) Bonds – secured debt obligations (in practice, “bonds” used for secured and

unsecured); also sold as securities(4) We have a bond market, just as we have an equity market(5) For a corporation considering debt, the obvious alternative is a loan but bonds

better(6) Loans come from a bank – you have to deal with a bank in a formal contract;

limited number of people at the table; sometimes takes form of line of credit (which is good when you have fluctuating cash flow – you don’t need to reapply for more money, esp at a time when cash flows are down)

(7) In contrast, in a bond market the lenders can be numerous(8) A third option, if you don’t have a lot of collateral, then raise equity – you

sell ownership for cash(i) One factor to keep in mind: sometimes people say (though maybe a little

confusing) that when a corporation becomes insolvent and is at risk of bankruptcy, directors and management owe fiduciary duty to debtholders (to disclose)

(e) Dilution(f) Dividends(g) Earned surplus (a.k.a. retained earnings)

(1) A corporation's accumulated income after dividends have been distributed.(h) Equity(i) Issuing stock

(1) Securities issued when a company is first incorporated.(j) Liquidation rights

(1) Liquidate = To sell all of a company's assets, pay outstanding debts, and distribute the remainder to shareholders, and then go out of business.

(k) Market capitalization(l) Outstanding shares(m)Par value(n) Participating stock(o) Preferred shares (know the different sorts of preferences)

(1) Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preferred shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred share pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preferred share is that the investor has a greater claim on the company’s assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt,

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preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible. (i) Also called preferred stock.

(p) Preemptive rights(1) When new shares issued, shareholders have first crack at buying shares, to

preserve % ownership in corporation(2) Shares issued and owned outside company are outstanding shares(3) How does preemption right arise? Can be negotiated by contract, plus

management has obligation through partnership law not to use capital structure to demote fellow managers (managers have the right to exercise control in proportion to their offices, but this is NOT a fiduciary duty managers just have a “square deal” obligation through partnership law)

(4) Existing shareholder has to have money to buy, though presumes that shareholder has cash on hand, or preemption rights are worthless

(5) But are you necessarily unhappy? From control perspective maybe, but not economically if corporation takes off: owning 10% of a lame startup 1% of Cisco ($167.9B market cap) not a bad transition

(q) Redemption rightsiii) Typical basic rights of a share of common stock

(a) Vote (for directors, major corporate changes)(b) Residual claim to assets(c) Right to bring certain claims (shareholder derivative suit)(d) Right to a dividend if declared

iv) Preferred shares – know how these rights differ from those for common stock(a) Dividends(b) Liquidation rights(c) Redemption rights

v) Corporations may have more than one class of shares(a) Shares within a class must be treated the same (b) But see Unocal case

(1) Board allowed, per business judgment rule, to make a discriminatory self-tender offer to fend off a hostile takeover bid; the offer was discriminatory in that the raider was not allowed to participate

(2) Court ruled that the board did not try to entrench itself, and instead acted in proportion to the threat that the corporation faced (raider made a two-tiered offer in which shareholders would receive more money for shares sold sooner than later)

F) Ignoring the corporate form (piercing the corporate veil)i) Vaguely worded state doctrines under which, in certain extraordinary circumstances,

courts will hold shareholders liableii) In most states, courts do this only when the corporation has not been treated as a

corporation as a lawyer, respect the corporate form(a) Alter ego(b) Corporate form not respected(c) Funds commingled

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(d) Meetings not held(e) Purpose appears to be for use as mere shield against liability

iii) In most states, failure to pierce must be seen to work some injustice(a) Fraud would suffice, but fraud not necessary

iv) Word of warning: despite the attention that it receives in this class, piercing corporate veil is not an interesting part of the law and comes up seldom in practice

(a) It’s here to teach us about corporate relationships G) Cases to know

i) Sinclair Oil Corp. v. Levien(a) Sinclair owns 97% of a subsidiary(b) Other shareholder sues, making 3 claims

(1) Sinclair took corporate opportunities from subsidiary, Sinclair allowed another related company to breach contracts, and Sinclair issued too much in dividends

(c) Dividends issue – why sue because you as shareholder are paid too much?(1) Because Sinclair is squeezing a perfectly good subsidiary for every last drop

of money, at the subsidiary’s expense(2) Court, though, says that this isn’t self-dealing because corporations can issue

dividends to shareholders (who make money from the transaction)(3) There would be a problem if it wrote dividend checks to only itself as

shareholder, and not every shareholder proportionately(d) Lesson: shareholders in the same class take equally; also, the use to which a

company puts a dividend (pay out, reinvest) is not a legal issue, but rather a business issue

(e) Only sometimes does a bad management decision implicate the fiduciary duties of managers and directors

ii) Dodge v. Ford(a) Dodge brothers objected to Ford’s decision to reinvest excess cash in a new

factory – they preferred a dividend payout(1) The new factory was the River Rouge smelting plant vertical integration(2) Dodge brothers want the cash to go start their own car company, and want to

stop Ford from getting a stranglehold on the whole auto industry (by controlling all the raw materials)

(b) What else could a company do with excess cash?(1) Buy shares back increase the value of the remaining shares (supply and

demand)(c) Henry Ford had a messiah complex he said on the stand that he wanted to help

all of humanity angered the court this may be the only case ever in which a company lost a lawsuit because it did NOT issue a dividend

(1) What could Ford have said about the price of a Model T? He could have said that he was lowering prices to gain market share, not to advance philanthropy

(2) The philanthropic testimony angered the court because of the suggestion that shareholders aren’t supposed to make money you can be philanthropic, but not with other people’s money

(d) Post-script: vertical integration did not work too well in the auto industry(1) Ford overtaken by GM, which had a less centralized management structure

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(2) Vertical integration raises questions about how big you want the corporation to be, and what your core competencies are, and the tradeoffs associated with outsourcing(i) Outsourcing: some step in your manufacturing process done cheaper, and

your company can focus on what it does best VS. control of the process and control of proprietary info

(ii) Hewlett-Packard and AOL-Time Warner are looking at these issues right now – these are age-old issues

(e) Ronald Kose (sp?) – Nobel economist and taught at this law school for 10 years – developed theory of the firm from economic perspective (also created Torts theory of social costs)

(1) Theory of social costs: in a transaction cost-free environment (i.e., you could trade freely with anyone at no cost related to holding out or hard bargains or finding buyers), resources will find their way to who will use them best, and this will happen by contract alone; in the real world, though, there are transaction costs that affect resource distribution

(2) From this perspective, corporations are means of assessing transaction costs and distributing resources; in fact, Posner has written that courts should assess what corporations would do in a cost-free world

(3) Related to this is outsourcing: given the transaction costs associated with outsourcing, what should you keep in house and what should you farm out? You begin worrying whether you can monitor or trust the people with who you contract – if you can’t, and if contracts become too difficult, then you hire those people and make them agents of your corporation (i) E.g., if you want to buy gas for your delivery vehicles, then filling the

tanks is the point of contract – the cost of contracting is very low(f) BUT(g) What if you have a secretary and you need photocopies for a presentation, and you

need to negotiate each service (copies, bringing them to meeting, etc.) hard to contract for each of the range of services that the secretary provides, so just hire her and give her a status within the corporation

(1) The market for these individual secretarial services is thus altered – that market exists for the whole group of services

(2) One of the biggest outsourcing questions of all time: why did GM let Fischer Body exist independently for so many years, instead of buying it? Why would Fischer exist separately when GM held monopsony power?

(h) Back to Ford: the idea that the shareholders own the company sometimes conflicts with the practice that the corporation is the founder’s baby – Ford was Ford’s creation, and he wielded great influence over the corporation’s strategy as its top manager

(1) Remember that shareholders exert little influence over daily management(i) Now put the Ford case in the context of the charity cases – why are these cases

here?(1) Shareholders invest in a corporation for their own profit, not for the

betterment of mankind – we use market self-interest to improve the lot of

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others (Adam Smith: the baker makes bread to make money, not because he loves you)

(j) Corporations can give money to charity, though, and in the fiduciary context, we expect fiduciaries to look after interests not their own conflict between fiduciary duties and self-interest that drives markets

(1) “What does this have to do with happiness?” Henry Ford has good motives, but greed in the corporate world is not entirely bad and people have a right to pursue it

(2) If you’re sensitive to this balance, then you may worry about it in daily corporate practice you may seek that balance in daily transactions

H) Other cases discussed in classi) Southern Gulf Marine case

(a) Founder of corporation contracts to buy a boat; incorporates later D tries to escape its obligations by claiming that P didn’t exist as an entity at the time

(b) D held liable to corporation anyway(1) D dealt with same people throughout transaction substance over form(2) Estoppel: you can’t complain now if you knew then that corporation doesn’t

exist; also, you would sue the corporation if you weren’t paid(3) Finally, promoter speaks for corporation in the early phases of incorporation

fiduciary duty to corporationii) Walkovszky v. Carltoniii) (BIG case – know the facts!)

(a) Capitalization = placing investments into company; giving corporation capital(b) In a world without insurance, if you did business with a corporation and worried

about corporation hurting you, then you would want to be able to sue corporation(1) Suing the shareholders would be tough you’d want to sue the assets of the

corporation(2) Limited liability thus creates a massive deadbeat risk

(c) The classic approach to undercapitalization (liability) fear: seek personal guarantees, perhaps from third parties

(1) E.g.: when capitalizing, corporation issues par stock (stock assigned a particular minimum value; stock may be sold for more in an IPO, but par value is guaranteed equity in the corporation) that much capital is known, but perhaps that’s too little

(d) Three basic theories at play here(1) Piercing corporate veil

(i) Corporations have limited liability, BUT if shareholder uses corporation for personal benefit or personal purposes, then shareholder faces unlimited liability

(2) Agency(i) Under agency, Carlton sued via respondeat superior; Carlton’s the sole

shareholder and he dominates the corporation Carlton is the principal(ii) Court not sympathetic: no allegation of fraud

(3) Enterprise liability

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(i) Several smaller corporations can work together on business objectives as a larger enterprise entity all members of the enterprise entity can be liable when someone sues

(ii) COA dismissed because none of the theories works here(iii) Policy: let the legislature change minimum insurance requirements if

necessary; we won’t require it through judicial edictiv) Sea-Land v. Pepper Source

(a) Request for “reverse piercing”: finding sister corporations responsible once the common owner / controller found personally liable

(b) Sidenote: how would you avoid piercing?(1) Respect all corporate formalities, including meetings and minutes, board of

directors, by-laws; do NOT commingle funds(c) Court decides to pierce, because of unity of interest: ownership and control of the

separate entities so blended together that separate corporate identities do not existv) These cases, in a sense, are about vicarious liability: hold liable a shareholder who

wasn’t there when the alleged tort occurred analogous to our agency cases {sort of}VII) GOVERNING THE BUSINESS CORPORATION

A) Overview of fiduciary obligations to shareholdersi) Directors, officers, promoters, and sometimes shareholders with a controlling position

owe fiduciary duties to the corporationii) Business judgment rule

(a) Generally protects directors from shareholder suits based on their decisions, if the directors have upheld their duties

(b) Courts don’t like to run businesses will oversee a conflict, but managers generally immune to shareholder suits about bad decisions (“losing money happens”)

(c) BUT(d) Even so, managers have a duty of care to avoid gross negligence in running the

companyiii) Duties of directors

(a) Duty of care(1) Imposes a standard similar to gross negligence(2) Sometimes, though, directors have a duty to investigate – “we didn’t know”

will not suffice where director should have known or should have tried to find out

(b) Duty of loyalty(1) Owed to shareholders(2) Put fiduciary obligation above self-interest(3) When in doubt, disclose

B) Directorsi) Set strategy for the corporationii) Periodic meetings and special meetingsiii) Hire, fire senior management

C) Shareholder votingi) Shareholders vote for directors

(a) Cumulative voting (as opposed to straight voting)

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(b) Number of shares necessary to elect a director under cumulative scheme (1) S / (D + 1) + 1(2) Where S = number of shares voting and D = number of directors to be elected

(c) More on cumulative voting(d) It’s essentially a race – for, say, 5 positions, the top 5 vote getters win the positions

(1) Now suppose that A has 100 cumulative votes and B 80(2) If B casts all 80 votes for a candidate, then there’s no way that A could keep

that candidate out of the top 5 B basically concedes the other 4 spots to A in exchange for the certainty of having one director

(3) In this way, cumulative voting protects minority rights: the minority can elect at least one director (or a few) who will look out for their interests

(4) Applies only to shareholder election or removal of directors – does not apply to any other shareholder proposals

(5) Would apply to dissolution of corporation, and to amendment to articles of incorporation, but not to adoption of bylaws (the directors pick that) incidentally, articles typically don’t say much so that shareholders don’t have a lot that they can control

(6) What are the drawbacks to cumulative voting?(7) Breeds contentiousness – may slow down board(8) Founder may want a team that helps him carry out his agenda

ii) Shareholders also vote for(a) Amendments to the articles(b) Dissolution(c) Merger(d) Sale of all or substantially all of the assets(e) Note that these votes are responses to actions by the board of directors – only

election of directors is a shareholder action in itself(f) Supermajority requirements may exist for these votes as a matter of state law, or in

the articles(g) Also, cumulative voting occurs only for election of directors – these votes are

straight votesiii) Proxy fight vocabulary

(a) SEC no-action letter(b) Proxy

(1) Proxy = agency agreement where someone can vote someone else’s shares(c) Proxy fight(d) Proxy statement(e) Record date

(1) When directors give notice of a shareholder meeting, they give notice to those holding shares as of a record date (because shares change hands all the time declare a record date and find out the shareholders of record for that date)

(f) Record owner(g) Shareholder meetings

(1) Annual meetings

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(i) At annual shareholder meetings, shareholders vote on directors; they can also have special meetings for major corporate events, including but not limited to: mergers, dissolution, sale of all corporate assets, sometimes on acquisitions (if big), changes to corporate charter – in short, anything that changes the corporate existence

(ii) At meetings, you must have quorum as defined in charter or statutes(iii) Directors, management, major shareholders can call a special

meeting, but must give notice to other shareholders(iv)Shareholders tend to be spread out and passive, though many of them

do not go to meetings quorum of shareholders tough sometimes proxy

(2) Special meetings(h) Shareholder inspection rights(i) Shareholder proposal

(1) Statement of 500 words or fewer; the proposal must concern at least 5% of the corporation’s economic interest, or have a general relationship to the corporation’s business

(2) Two types of proposals: management and public policy(3) Shareholder, e.g., proposes that CEO and Chairman never be the same person

(a management proposal)(4) In this case, you’re not proposing a change in management – you’re

proposing a change in policy or strategy(5) Problem: you don’t know who your fellow shareholders are you have a

right to have your proposal distributed along with management’s proxy solicitations (e.g., proxy card will mention your proposal)

(6) Suppose, though, that shareholder wants to replace management (which won’t make management too thrilled about distributing this with its proxy solicitation) – then what?

(7) Shareholder has right to have proposal distributed in separate mailing, OR shareholder has right to see the shareholder list

(8) Cost of mailing must be borne by the insurgents(9) Which do you do, if you’re management?(10) Agree to the separate mailing – don’t let the insurgents know who the

shareholders are, especially the ones who own, say, 5% each(11) Public policy proposals(12) E.g., proposal to have nothing to do with making pate de foie gras;

there’s a famous case about Dow Chemical and napalm during Vietnam War(13) “Poison pills” – a tool for entrenching management (device designed

to protect corporation from takeovers by hurting capital structure if takeover happens)

(14) Other proposals that are popular right now, in an attempt to improve corporate goverance

(15) Secret ballot(16) Require different CEO and chairman(17) Require majority of key committee members to be outside directors

(j) Street name

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iv) SEC Rules(a) Rule 14a-9: Proxy statements cannot be materially misleading

(1) Have misleading fact OR(2) Omit any material fact that makes a statement misleading

(b) Rule 14a-8: Proxy statements must include shareholder proposals(c) Understand the general purpose of these rules

v) Proxy fight rules(a) Corporation may reimburse any party only if the dispute were over corporate

policy(1) The fight can’t be merely over who gets to be boss, but this restriction is easy

to get around because labeling most things as a policy dispute is fairly easy(b) Firm may reimburse only reasonable and proper expenses(c) Firm may reimburse incumbents whether they win or lose (business judgment rule)(d) Firm may reimburse insurgents if they win

D) Shareholder derivative suitsi) Westbrook hates teaching it, because it’s out of the rhythm of the rest of the class

(a) This is all about rules of procedure; very technical; and the cases don’t agree with each other

(b) Why is this here, then?(c) SDS are the mechanism of enforcement for the idea of fiduciary duties by directors

(1) Corporation can’t sue directors directly – conflict of interest in corporation suing itself

(2) Judicial remedy, then, is to let shareholder bring suit on behalf of corporation (d) Note that shareholders don’t own any corporate property or chattels, but rather a

claim (claim can be a type of property)(e) SDS is an equity suit brought by third party; typical example is SDS who sues

corporation for an injunction forcing it to sue a corporate officer for fraud(1) Corporation would receive the recovery, not the shareholder

(f) Sometimes, whether a suit were SDS is not clear(1) Did shareholder suffer individually, or did the corporation suffer the loss?

ii) Black’s Law Dictionary (7th ed. 1999), derivative action(a) DERIVATIVE ACTION(b) derivative action. 1. A suit by a beneficiary of a fiduciary to enforce a right

belonging to the fiduciary; esp., a suit asserted by a shareholder on the corporation's behalf against a third party (usu. a corporate officer) because of the corporation's failure to take some action against the third party. -- Also termed derivative suit; shareholder derivative suit; stockholder derivative suit; representative action. Cf. DIRECT ACTION (3). 2. A lawsuit arising from an injury to another person, such as a husband’s action for loss of consortium arising from an injury to his wife caused by a third person.

iii) Derivative suits distinct from direct suits (know the distinction)iv) Classically, shareholder sues both the corporation for failing to enforce its rights (giving

a court the possibility of issuing an injunction), and some third party (directors, managers, or other third party) on behalf of the corporation

v) Recovery(a) Shareholder’s pro rata interest may be small

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(b) Shareholder’s litigation expenses may be covered either by terms of settlement or an order of the court

vi) Process could be abused by plaintiffs (strike suit)(a) The fundamental problem here:(b) There is a belief that directors may not act in corporation and shareholder’s

interests(c) Equity courts thus allow shareholders to sue(d) Two problems:

(1) You decide to sue on behalf of corporation, but you’re one shareholder court decision will be binding in that case you are foreclosing other suits by representing all shareholders

(2) If you settle the case, then you forclose other suits(3) This is tailor-made for litigation abuse: company will settle a case to close off

all future suits; corporations sometimes even try themselves to start suits against themselves, to insulate themselves against future litigation (this was a problem in the Caremark case “Strike Suits” this is why legislatures discourage SDS and require shareholding suing to post bond, and this why we have an elaborate procedural test for judging whether suit should proceed

vii)Process could be abused by defendants (see Caremark for a hint)viii) Understand that we have enacted a host of procedural devices designed to screen out

nuisance suits but allow meritorious suits to go forward(a) Corporation can indemnify

(1) Indemnification (page 525)(2) What does this mean?(3) Corporation pays for acts of corporate officers, and shields the officers(4) Can be direct (indemnity) or indirect (insurance) payment; officers can be

shielded against shareholder or outside suits(5) Question here: in some suit against an officer, does the indemnity policy

cover the officer?(6) Start with extreme case: CEO kills secretary – indemnity? Probably not –

corporation won’t stand behind CEO here(b) D & O insurance – the method of indemnification

ix) Demand requirement – why not let any shareholder sue?(a) When 1 shareholder sues, you’re essentially making all the other shareholders

litigate, too you drag the whole company into litigation(b) To prevent this problem, shareholder first must take complaints to board and make

formal demand of board derivative suit can exist only after board denies demands

(1) Demand can be excused in some states, though, if making a demand on the board would be futile prove futility and then you can fight the business judgment rule

(c) Problem: hard to tell whether a shareholder has a legitimate complaint until many facts have been gathered

x) The SDS conflict continues: we don’t want to shut down shareholder rights, but we don’t want single shareholders to dictate the course of litigation and settle at the

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expense of other shareholders (a “strike” suit paid off with shareholder equity as ransom)

(a) Shareholder legislation in 1995: tried to make suing a corporation for a settlement more difficult

(b) Shareholders can bring SDS even if they own just one share – that’s enough for standing to sue

(1) No proportionality with regard to settlement, because the company is the one that receives awards, not the shareholders

(c) Institutional investors DO matter, though, with regard to voting for directors, or for impact on stock price

(1) If you Microsoft stock, then you wouldn’t care if Bob the next door neighbor sells his shares; you would care if TIAA-CREF did

E) Duty of carei) Smith v. Van Gorkom

(a) Van Gorkom is CEO of a company with some cash flow problems ripe for acquisition

(b) Van Gorkom quietly offers to sell corporation to Pritzker at $55 per share (trading at the time for $38 per share)

(1) Point of offering shares at higher than market prices: sometimes a corporation undervalued; sometimes you have to do this to ensure that enough shareholders will sell to transfer majority control to the buyer

(c) Van Gorkom proposes sale in an oral presentation; board approves after 2 hours of discussion

(1) At this point, board has not seen the details of the proposed sale, especially any of the associated documents

(2) Also, most shareholders tendered shares to Pritzker because shareholders tend to go along with directors’ recommendations

(d) Court decides that board did not make an informed decision; you have to look at documents and you have to examine the numbers after this case, corporate boards more likely to review documents before making decisions

(e) McNeilly’s dissent: business people are very experienced and know what they’re doing can’t assume uninformed decision

(f) Smith v. Van Gorkom was shocking – directors RARELY held liable in the real world (the cases in our book are not representative of common situations)

ii) In re Caremark(a) Shareholder sues director saying that he should have prevented massive legal

violations that corporation has incurred ($250 million!)(b) Civ pro issue: since shareholder sues in company’s name, if shareholder wins, then

offensive collateral estoppel may kick in if other shareholders sue(c) Directors had reached a favorable settlement with corporation; shareholder

challenges settlement as inadequate, but court upholds(1) Settlement upheld because court thought that directors probably would have

won at trial even a modest settlement that forecloses future claims is the better option for shareholders

(2) Directors would have won because of business judgment rule, but also because corporation had taken some steps to correct internal problems

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judicial review inappropriate because directors had a process and made decisions in a reasonable fashion

(d) Lesson from social policy perspective: bureaucracy is safe set up lots of process to CYA

iii) Proving that directors caused harm in a general business failure is difficult, where a shareholder does not challenge a specific decision of the board (Barnes)

F) Duty of Loyaltyi) Absent a conflict of interest, plaintiff has burden of proof, and must overcome the

business judgment rule (which would say that plaintiff loses)ii) Given an ungratified conflict of interest, defendant directors have the burden of proving

that the transaction was fair and reasonable – “intrinsic fairness”(a) Under these circumstances, plaintiff has a chance(b) Conflict of interest includes corporate opportunity

iii) If, however, the interested directors sought and obtained ratification from disinterested shareholders and directors (as provided in most corporate statutes) then the burden shifts back to the plaintiff, and directors can take advantage of the business judgment rule

iv) Duty of loyalty problems arise in three basic ways(a) Competing with the corporation(b) Taking a “corporate opportunity”(c) Director has a personal interest in the corporation’s decision

G) Close corporation problemsi) Understand how shareholding and employment and lack of transferability of shares

create problemsii) Buy-sell agreements

(a) What triggers one?(b) What sets the purchase price?(c) What funds one?

iii) In many jurisdictions, if the transferability of shares is restricted by a buy-sell agreement or otherwise, that should be made clear in the articles and on the face of the stock

VIII) SECURITIES MARKETSA) There is some overlap here with the finance section discussed aboveB) Securities laws try to balance two poles

i) One pole: stop people from lyingii) Other pole (concerns SEC’s jurisprudence under 10b5): level playing field – public

markets are public markets, and as a member of the public you should have access to the info

iii) Securities are more than private market, which would have no duty to discloseiv) Under this scheme, members of the public get access to info equallyv) One pole: face to face fraud, you buy from me when I lievi) Other pole: level playing field in which each member of public judges the same infovii)Neither pole is the law; law lies somewhere in between

C) When we sell shares, we give up control of the corporation to at least some extenti) Selling to public = giving up control to someone you don’t even knowii) Why, then, would management ever sell shares?

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(a) Shareholder bears more risk than lender (return can vary, or be zero; loan must be repaid at stated terms)

(b) No restrictive covenant – lender may force borrower to agree to restrictions on operations

(c) Too much debt service could make income statement look bad – bite out of income

iii) The whole point of equity financing is to sell the corporation some founders want to start a corporation, and then move on (deal only with early stages of corporate growth)

(a) E.g., Smith v. Van Gorkom – older manager wants to ease out, does so by offering shares

iv) Big reason: if the investor wants regular repayments, then you may not be able to get the loan if you can’t promise this

(a) You may not get the loan if your income stream isn’t big enough, and you may not want to agree to put up collateral (or you may not even have the collateral) management will have to sell some of the corporation

(b) Debt is generally better for management control, but sometimes your hand is forced

(c) Flip side of what investor is buying = what corporation is in position to sell; new corporation will have no income, the rights to which you could turn to collateral growth exceeds capacity for self-funding, and debt financing not possible yet

v) Much of the discussion here deals with issuance of stock, and the associated control issue

vi) Market capitalization = number of shares x current market pricevii) “This is a 100 million corporation” usually refers to market capitalizationviii) Owning 10% of corporation = 10% of dividends, 10% of votes, 10% of assets upon

dissolutionD) SEC in general

i) Regulates the disclosure of information, rather than the likelihood of success of the business in question

ii) The 33 and 34 Acts have helped create a national market for capitalE) The 33 Act

i) The 33 Act deals with initial offering of securities to the public (primary market), and the associated transactions; sets regulations for those institutions that set up the IPOs (investment banks, etc.)

ii) It is possible to specialize as a “33 act” attorney (or to specialize in other particular acts)iii) Section 5 – requires registration

(a) Security may not be offered for sale through the mails / interstate commerce unless registration statement has been filed with the SEC

(b) Securities may not be sold until registration statement has become effective(c) Prospectus must be delivered to the purchaser before a sale and must disclose all

material info(1) Material info = info that a reasonable investor would want to know before

making an investment decision ever-widening category because it’s hard to say that an investor would not want to know something; also, as corporations get bigger they have more info to disclose, and more complex

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info at that (e.g., “The report from our Chilean subsidiary is wrong – I was just in Chile ....”)

(2) What are the disclosures at the board level? The investor level? The prospectus is supposed to provide all the material info for investors – that’s the goal, at least

(3) Remember, we don’t regulate the corporation – we regulate the quality of available info

(4) Prospectus: who actually reads it, though?(5) The idea here is that we want the typical educated investor to get through it,

and that various intermediaries (“gatekeepers”) will guide the market by issuing advice(i) Enron, other scandals: the gatekeeping institutions failed

iv) Section 11(a) Establishes standards for fraud

(1) The federal laws here expand concept of fraud to failure to disclose any info that a reasonably prudent investor would want to know (older concept at state level: fraud = knowing misrepresentation)

(2) Requires that registration not be materially misleading(b) Deals with problems with registration statement

(1) Applies to lots of people in registration process(2) Applies to their participation in formation of registration statement – once we

decide that statement is materially misleading, these various actors are liable(3) Defense to this claim: due diligence (hard to claim after finding of materially

misleading)(4) Due diligence = digging beneath the surface to determine whether

corporation could be sued based on some document not yet releasedF) The 34 Act

i) 34 Act – deals with secondary market (member of public who owns shares sells to another member of public)

(a) So when Enron fails to report business activities, or Adelphia screws up with its records, that’s a 34 act violation (disclosure required to inform secondary market better)

ii) Note that just about all of securities law deals with disclosure – government doesn’t say what is or isn’t a good investment, it just wants public to be informed disclose all material info to public, affirmative duty to disclose

iii) Section 10(b)(a) Makes illegal any use of mail or other interstate commerce vehicle to distribute

deceptive devices in violation of rules that the Commissioner adopts as needed(b) Note that this provision does not in itself make anything illegal – it leaves the

Commissioner to decide what is illegal Rule 10b5 does thativ) Section 14(a)

(a) Can’t make proxy offer out of line with the rules; one of the rules requires proxy statement

v) Rule 14e-3(a)(a) You can’t make a tender offer based on inside information the tender offer is

fraudulent if you do

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vi) Section 16(b)(a) Prohibits short-swing trading (corporation gains any profit from a sale of

corporation stock within 6 months of purchase)vii)Rule 10(b)(5) (esp. 10b5-1 and 10b5-2)

(a) Easily the most famous of all SEC rules(b) Makes any fraudulent scheme illegal (when distributed by “any means or

instrumentality of interstate commerce”)(c) Makes illegal any untrue statement of a material fact, or any omission of a material

fact needed to back up a statement made(d) 10b5 prevents fraud or deceptive practices in selling a security(e) For practical purposes, this is where insider trading happens

viii) Form 10: file at time of IPO; it’s a filing for public trading(a) Once IPO set up, corporation has obligation to update the market continuously,

through Form 10 any secondary buyers can turn to this info for guidance on market

ix) Corporation also files 10Q and 10K (the “financials”), for benefit of 2º market x) Rationale: adequate disclosure will make the market sound (sound = market price

reflects actual worth) allow people to plan retirement (micro); maintain confidence in market, and allow corporations to raise capital and compete with one another (macro)

xi) Purpose of market (macro) = helping good corporations and hurting bad ones sound info helps us figure out which are which; we compete not by building a better mouse trap, but by raising capital to build a factory to build the better mouse trap at lower prices, at which point the competition gives up and sells us the assets

xii)The system is what decides who and what will provide the stuff that makes up much of social life

G) Integrated disclosurei) 33 act has focused on initial transactionsii) 34 act has focused on corporations iii) if you have a corporation traded publicly on a going forward basis, then it updates info

on itself for the benefit of third partiesiv) If a corporation wants to issue debt (bonds), then, both the 33 and 34 acts applyv) 33 act because the issuing is newvi) 34 act because of the impact of the offering on the continuing state of the corporationvii)This is known as integrated disclosure – corporations prepare multiple statements from

same info; to prepare two totally separate statements would be burdensome(a) Integrated statement adequate also because the market already knows lots about

the corporation H) Terms to know

i) Blue sky laws(a) State-level securities law

(1) State laws often track the federal laws, but not always(2) In particular, some blue sky laws are substantive – they actually assess the

risk of an investment (e.g. MA blocking sale of Apple as risky!) states try to protect consumers from bad info, not bad investments

(b) No protection from bad investments, because businesses will fail and people will lose money (different from, say, food laws, where failure can’t be tolerated –

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“Look, this beef does look a little septic, but it’s only 25 cents a pound – you can go ahead and take your chances, if you want”; different also from FAA regulations (disclosure that some planes will crash not enough)

(c) Focus of securities law is on quality of the info – procedural and not substantive(1) What info does investor need, though? There’s so much out there, and not all

of it can be made available (“We hear that you’re interested in GE – welcome to our server”)

(d) How will corporation package its info, and what will be considered “material”?(1) Color of CEO’s car – not material(2) CEO salary – material(3) Lots of stuff in between

(e) Securities law covers offerings to PUBLIC – filing disclosure not required for private offerings, though of course that begs the question of what = public or private offering

(f) Section 4-2 of 33 act: if private, then no need to register(g) The basic idea here: this was the most important legal development since the Civil

War – directing huge parts of national capital will occur on basis of sound info(h) Coincides with debut of federal government as massive, regulating entity

ii) Bondsiii) Debenturesiv) Due diligencev) Filevi) Form 10-Q

(a) Unaudited document required by the SEC for all U.S. public companies, reporting the financial results for the quarter and noting any significant changes or events in the quarter. The Form 10-Q contains financial statements, a discussion from the management, and a list of "material events" that have occurred with the company (such as a stock split or acquisition).

(1) Also called quarterly report.vii)Form 10-K

(a) Audited document required by the SEC and sent to a public company's or mutual fund's shareholders at the end of each fiscal year, reporting the financial results for the year (including the balance sheet, income statement, cash flow statement and description of company operations) and commenting on the outlook for the future. The term sometimes refers to the glossy, colorful brochure and sometimes to Form 10-K, which is sent along with the brochure and contains more detailed financial information. All 10-Ks for public companies and mutual funds incorporated in the U.S. are available on the SEC's website for free.

(1) Also called annual report.viii) Form 8-K

(a) Document required by the SEC to announce certain significant changes in a public company, such as a merger or acquisition, a name or address change, bankruptcy, change of auditors, or any other information which a potential investor ought to know about.

ix) Indenture agreement (or simply “indenture”)

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(a) A document containing the terms and conditions governing a trustee's conduct and the trust beneficiaries' rights.

x) Indenture trustee(a) A trustee named in a trust indenture and charged with holding legal title to the trust

property; a trustee under an indenture.xi) Initial public offering (IPO)xii) Insider trading

(a) We spoke last time of two poles, fraud and level playing field, and that insider trading occurs between those poles

(b) Question: what is the source of the duty not to commit insider trading?(c) Duty not to defraud the market – don’t trade on nonpublic info(d) SEC has used this argument from time to time(e) At the same time, turn the problem around: the basic notion of participating in the

market presumes an info advantage(f) If you think that something’s worth 100, and it’s priced at 100, then why would I

buy it? I won’t make any money – I would have to believe that it’s mispriced, and that it’s worth 110 because I know something that the market does not

(g) You could argue, then, that all trading presumes private info(h) There’s a difference though between info and evaluation of info (SEC would say

this to refute the above argument about all trading involving private info)(i) Supreme Court has not adopted the fraud on the market theory (i.e., proving only

that D traded on info not publicly disclosed)xiii) Public offeringxiv) Private placement

(a) The sale of securities directly to institutional investors, such as banks, mutual funds, insurance companies, pension funds, and foundations. Does not require SEC registration, provided the securities are bought for investment purposes rather than resale, as specified in the investment letter.

xv) Offering prospectus (or just “prospectus”)xvi) Registrationxvii) Registration statementxviii) Regulation D

(a) An SEC regulation that governs private placement exemption.(b) Certain restricted offerings, limited partnerships, and angel investor networks are

open only to accredited investors.xix) Rule 10b-5xx) Securities Act of 1933 (“33 Act”)xxi) Securities Exchange Act of 1934 (“34 Act”)xxii) Short swing tradingxxiii) Trust Indenture Act of 1939

(a) A law that requires all corporate Bonds and other Debt securities to be issued Subject to Indenture agreements and comply with certain indenture provisions approved by the SEC.

xxiv) Venture capitalistI) Where are we, then?

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i) Remember that fiduciary not telling = anyone lying, because fiduciary has duty to disclose (from Goodwin v Agassiz case)

ii) This doesn’t work, though, if we’re talking about targets – fiduciaries of one corporation do not have a duty to the other corporation

(a) Hence Rule 14e3a – don’t do anything concerning a tender offer; but Supreme Court hasn’t wanted to go this far

iii) The question then becomes: what is the source of the duty not to trade? Simple corporate duty seems not to suffice

iv) Second problem, from contract theory: from perspective of shareholders of a corporation, they have to pay management; management sometimes will have good, nonpublic news; why shouldn’t management be allowed to trade on its info, since they’re taking over the target anyway and shareholders would have less to pay to management in the form of salary? (This is not the law, just a good academic argument)

(a) Put another way: why isn’t the nonpublic info considered IP and treated as property off which management can profit? (Again, this is not the law, but this argument has an audience in academic circles)

v) Third thought: who’s hurt here?(a) Recall Texas Gulf Sulfur: people at the corporation know that it will do well – why

not buy shares? You could say because the existing shareholders will not participate in the upside, but then again, you have no idea who the buyer is in an open market – how are you hurt? To understand how you might be hurt, you would need to have a concept (which the law has) of not taking advantage of passive shareholders, in exchange for their being passive you have to give them some opportunities from time to time

vi) On a practical level, though, criminal liability for a lost opportunity seems a bit muchvii)Finally, lots of insider trading goes on all the time, and we think it’s a good thing that

employees and managers own a part of their own corporation – seems progressive; finding the line between this and insider trading is hard to find

J) Review of duty to disclosei) Silence from a fiduciary = a stranger’s lieii) Seems plausible, then, that corporate insiders (officers, directors, significant

shareholders) would owe a duty to regular shareholders to disclose info relevant to trading

iii) Because this is a public market – disclosure can’t be to the individual shareholders; pursuant to 34 Act, and because shareholders are anonymous and dispersed, the disclosure must be to government / public at large (Westbrook here is trying to build a notion of insider trading from common law concept of fraud) shareholders should not profit just because they have inside info

K) Problems with this argumenti) Doesn’t account for targets – insider in corporation A has no duty to directors of

corporation B, which corporation A is planning to acquireii) Who’s hurt? Suppose that you have inside info and you buy your corporation’s stock in

anticipation of news. So what? iii) The market as a whole is hurt – in fact, Great Depression happened in part because

people thought that the market was corrupt and they lost faith in it

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iv) But why can’t you say that the market should be fair (SEC has come close, and Supreme Court has rejected the idea)? The whole point of a market is a belief in your own superiority – you buy stock when you think that you know something that others don’t, and you compete with other corporations when you think that you will win (info advantage)

v) The logic of the market itself is at odds with notion of a public market where traders are equally informed we must be talking about more than fraud here, because the notion of fraud not enough to justify the notion of a public market; fraud alone won’t get us there

vi) We care about corporations lying to the public not because that’s fraud (though perhaps a little), but because we need potential investors to be on equal footing with info for trust to exist this idea never will be perfectly aligned with idea that corporate officers always will know more about the corporation

vii)Policy argument: we want to encourage many people to direct capital to good corporations a sound, trustworthy market is one way to direct that capital hence, e.g., the transition from union pensions to 401(k) plans for retirement

(a) (Westbrook thinks that market integrity is “the right answer”)viii) One academic argument existing only in law reviews: insider info = IP, and

corporations have the right to act on their IP (this never has been adopted outside of academia)

L) Cases to knowi) Basic v. Levinson

(a) Investors are entitled to rely on price of security; if public statements of CEO (deny merger talks that were occurring) depress the price, then investors can certify as a class because they made decisions based on corrupted info

(b) Basic makes chemicals for the steel industry(c) Combustion (another corporation) wants to buy Basic for years, but can’t because

of antitrust worries(d) Then antitrust laws change merger talks restart

(1) This matters because Basic’s stock price will rise if news of merger talks reaches the market, but that in turn makes the merger harder because Combustion would have to pay more for the shares

(e) Basic CEO denies three times that merger talks were occurring merger then occurred

(f) Group of shareholders sued: they would have made more money without denials of merger, because the stock would have been higher

(1) This is a direct suit and not SDS, by the way: shareholders benefit personally, not corporation

(g) Case raises a couple of issues(1) Materiality: Basic argues that at time of statements, we had no deal

(i) Shareholders argue that death of corporation big enough that even talk would be relevant to a stock sale

(2) Confidentiality: Combustion does not want to pay highest possible price for Basic strong interest in keeping this secret as long as possible

(3) Also, if Basic wants the merger to happen, then it should keep quiet so as not to discourage Combustion

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(4) If Basic had not spoken, then court would have to decide whether Basic had to make any disclosure (maybe, though generally no because corporations are allowed to have secrets be careful, though, about insider trading); as it stands, Basic chose to talk court has to resolve whether what it chose to disclose misled investors

(h) Various investors are differently situated, though class certified only because everyone perceives the same price – the price was thought to have reflected all available info

(i) If we care about the capital markets, then we should care that the prices are sound / informationally efficient

ii) SEC v. Texas Gulf Sulfur(a) Another mining corporation – TX corporation wanders around Hudson Bay(b) Big mining strike – people start buying call options, as soon as corporation starts

buying land (sign that corporation will make lots of money)(c) Management issues press release saying that it hasn’t fond much – price fluctuates

still drifts up(d) Eventually price rises 300%(e) Disadvantaged shareholder sues, not under corporation law or fraud, but under

10b5(f) Shareholder wins – Goodwin case would come out differently if decided today

(1) Message: if you have info, then don’t disclose and don’t trade, or disclose and trade

(g) Lesson: 10b5, and 34 act by extension, is about making sure that participants have equal access to info (this is an overstatement – the other pole, but law reflects some of this)

(h) All of this raises an important question: insiders always have more info than market – are all of their transactions insider trading?

(1) No – under the right circumstances (to be cont’d)iii) Dirks v. SEC

(a) Dirks is a financial analyst with major institutional shareholder clients(1) Expectations that analysts come up with <> insider info because the analysts

make up their own projections based on public info(b) Dirks received inside info from corporate officers that he didn’t know, and flew

around the country investigating it interviews corporate officers, confirms the info goes to SEC, and Wall Street, which ignore him

(c) Passed it on to his investors then massive amounts of shares sold, other shareholders notice and sell too NYSE halts trading, WSJ belatedly publishes, and SEC investigates confirms that the corporation is tanking, but then prosecutes Dirks

(d) SEC ultimately censures Dirks instead of prosecuting he did the right thing, but still traded on private info even though he tried to make it public

(e) Supreme Court rejects this on appeal: Dirks as outside analyst had no duty to disclose to outside world; the corporate officer who tipped off Dirks should have blown the whistle publicly on the fraud; that officer didn’t breach his fiduciary duty, though, because he didn’t profit from his failure to disclose tippees are liable only if they inherit the duty to disclose

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(1) Note that insider trading charge must be connected to a trade, but it doesn’t have to be your trade – someone else trading on your info can put you on the hook (think Martha Stewart and Sam Waksal – Waksal himself didn’t trade any Imclone stock, but Stewart did based on Waksal’s inside info)

(f) If Secrist had been the corporate attorney, then he would have had a duty not to breach a client confidence

iv) O’Hagan(a) OH was an attorney – he was WRONG and don’t do anything that he did (selling

stock in a corporation whose tender offer you’re handling could get you disbarred)(b) GBR corporation makes tender offer to Pillsbury – OH buys tons of call options in

Pillsbury and winds up cashing them in for $4.3 million profit(c) Rule 14e-3(a) exists because someone making a tender offer has an incentive to

commit “warehousing”: you want shares to fall into the hands of people who support your efforts

(d) OH hasn’t misled the market, though, and caused a misappropriation of capital – his info is not false, and thus Court’s holding that he harmed the public seems questionable; the deal is still shady, though

(e) Second part of argument goes to acquisition of shares in a tender offer context – there are rules for this independent of 10b5

(f) Issue: whether SEC overstepped its bounds under the 34 act in passing a rule prohibiting exchange of shares in target corporation without fiduciary obligations

(g) In 14e3a, no duty exists as it does in 10b5 – does SEC have authority to impose one? (That is, can SEC legislate?)

(h) The idea here is to have a prophylactic rule regarding all shares on an exchange of corporation’s own stock – if officers sell their stock in their corporation, and repurchase within 6 months, and make money in the sale and repurchase, then they must disgorge profits to corporation (the rule is prophylactic in that it makes no economic sense, but it’s designed to discourage this conduct before it happens)

(1) E.g., Warren Buffett sells 50% of his shares stock drops Buffett then repurchases the stock, which causes the stock to rise again (profiteering through ability to manipulate stock price) Buffett would have to send that profit to the corporation (see p.522-23 notes)

v) Metropolitan Life Insurance Co. v. RJR Nabisco, Inc.(a) Big message: Who’s vulnerable to what? Put another way, which actors have

which responsibilities?(b) Bondholders find their position hurt by additional debt that helps shareholders

through the LBO; they have no legal right to stop this, and it throws off their risk/reward analysis that brought them into the picture in the first place

(c) KKR, through the LBO, takes the corporation private by buying out all the shareholders huge debt incurred because the shareholders had to be bought out at prices above market rate the losers here are the old debtholders

(d) P tries to raise implied covenant to maintain high credit rating, which would be done by avoiding incurrence of new debt alleged breach D must cash out P’s debt

(e) Page 876: where P’s contract right have not been violated, there can have been no breach of an implied covenant

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(f) As long as bondholders are paid regularly, they have dispute to raise(g) A “great” case

IX) ENDGAMESA) Generally

i) Shareholder-centric viewii) Shareholder sells, perhaps because he’s discontentiii) But what if corporation ceases to exist?iv) For example, corporation can vote to dissolve then what?v) For one thing, you have to pay off the debtholdersvi) Corporation also could be acquired or mergedvii)Types of mergers (assume A the larger corporation)viii) Consolidation: A + B = Cix) Merger: A + B = Ax) Reverse merger: A + B = B

B) Dissolutioni) Often a supermajority requirementii) Creditors have to be paid offiii) Notice of dissolution

C) Mergeri) Methods of merger

(a) Statutory merger: done pursuant to state corporation law – shareholders of both corporations vote

(b) If you were a shareholder who votes against merger, and you lose, then in most states you have statutory appraisal rights (corporation must buy you out at judicially determined price (taking into account market price and control premium))

(c) De facto merger: you just buy out all the shares you become THE shareholder and can vote to install new directors fire existing management and install new officers who will raise value of corporation to the level that convinced you to do the takeover in the first place (takeovers don’t make sense unless you believe that the corporation is not as valuable currently as it could be)

(1) Another de facto method: sell all the assets, and then dissolve the remaining husk of a corporation (creditors may or may not be able to stop the sale of assets)

(d) Why buy a corporation?(1) You want to grow, and buying an established infrastructure is easier than

building your own from scratchii) Shareholder who objects to a merger has three courses of action available

(a) Vote against the merger (if a statutory merger)(b) Sue for breach of fiduciary duty (if a de facto merger)(c) Sue for / assert dissenting shareholder’s right of appraisal (if you lose)

iii) Sale of all, or substantially all, of the corporate assets(a) Alternative to formal merger(b) Goal is to acquire value, without attendant liabilities

iv) Freeze-out merger(a) Coggins v. New England Patriots

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(1) Freeze-out merger: major shareholder tries to wipe out the others(2) Sullivan was owner, was bought out, borrows lots of $ to buy back in then

tries to have corporation assume the debt that he incurred to buy back in(3) Problem: MA corporation law required elimination of the non-voting shares,

and Coggins didn’t want to give up his shares(4) Court agrees with Coggins: this is essentially a closed corporation – major

shareholder exploiting his position; a dominant shareholder can go only so far Sullivan has to show that the merger has to be for a legitimate reason, but only point of merger was to assume Sullivan’s debt

(5) Problem: deal is 10 years old at time of suit – can’t undo, but remand for computation of damages

(6) Very lefty caseD) Hostile takeover

i) Tender offer – buy more shares from other shareholders for some offered price per share more control over selection of directors

ii) If tender offer occurs contrary to management’s wishes, then it’s a hostile takeoveriii) If you buy control of a corporation, then will you pay market rate for a share?

(a) NO – if someone buys control then they’re willing to pay above market price per share, and are more willing to do this for a group of minority shareholders than for a single minority shareholder

(b) The majority shareholder, though, can extract perks from the corporation the ability to do this carries a price, which puts shares about market value

(c) BUT(d) You can also realize a gain if you think that under your management, the company

will do so well that you afford to pay a little above market value – the shares are worth more to you than to market at large

(e) This is the logic behind hostile takeovers – there’s value in the corporation that you will find, that management does not see

(f) In this case, there’s a control premium for the corporation because of the high demand for steel for the war a fiduciary ought not to benefit from war profiteering at the expense of the corporation or his other fiduciaries the control premium belongs to all shareholders equally (court says this over a strong dissent)

(g) Control premium is not always shared equally, though – sometimes majority keeps the premium

iv) Cases to know(a) Unocal

(1) Corporation threatened by takeover(2) Why threatened?(3) Directors, management in jeopardy because they would be kicked out(4) Shareholders would be concerned because they voted for the directors, and

takeover would nullify the last shareholders’ election(5) But how would this harm the corporation?

(i) Possible violation of fiduciary duty to sell stock at best price – push for the best possible price

(6) In this case, Unocal rejected a takeover bid from a company called Mesa, and offered shareholders an alternative self-tender offer

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(i) Mesa challenged, arguing that Unocal bought back stock only to preserve control of the corporation and not to pursue any corporate purpose (entrenchment)

(7) Court ultimately decides that directors acted defensively in proportion to the threat raised (Mesa led by a corporate raider two-tier offer was coercive and too low)(i) That is, corporation can discriminate against a shareholder if that defends

the corporation from a proportionate threat(8) Proportionate defensive moves do not violate rule form Cheff case (in a

selective stock repurchase, directors may not act solely or primarily out of a desire to perpetuate themselves in office)

(9) The corporate raider eventually is paid for his takeover threat (greenmail) – corporation buys his shares at high price to make him go away, and corporation now is worth less than before Mesa came along

(10) How does the two-tier offer work?(i) Sell your shares to raider quickly and receive $x per share; take too long

and you receive $(x-n) per share, or just junk bonds in exchange for the shares

(ii) To reach this result, though, the court creates tension between the finding of coercion and the belief that market prices are efficient – court says essentially that market undervalued the corporation

(11) Coercive measures (aka poison pills, etc.)(i) Provisions that take economic value out of a corporation in the event of a

takeover makes the corporation harder to buy(ii) The idea: if you try to take over the corporation, then we’ll strip it and

leave nothing that you want(12) Can this hurt shareholders? Sometimes (see Revlon case)

(i) In Unocal case, corporation had a provision that triggered stock repurchase and massive debt load if anyone bought 50% of the shares BUT Unocal did not make this offer to the corporate raider shareholder this is where the discrimination comes in

(13) BUT what if the defensive maneuver creates too much debt? This is the Revlon case, coming up next(i) E.g.: If corporate raider offers $300 per share when stock trades at $30,

then corporation will not be allowed to incur massive amounts of debt to tender an even better offer to the shareholders

(b) Revlon case(1) Corporation called Pantry Pride tries to take over Revlon; Pantry Pride is a

younger corporation culture clash(2) Revlon adopts poison pill that lets shareholders exchanges shares for notes

under certain circumstances(3) BUT(4) The plan was so defensive that it turned away bidders who might have

offered a better deal to Revlon shareholders than the poison pill, to the detriment of shareholders breach of fiduciary duty of care to shareholders

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(i) A board must show reasonable grounds to believe in a danger to corporate policy and effectiveness

(ii) A board also must prove that the defensive measures used were reasonably related to the threat imposed

(5) Part of the poison pill contained a cancellation fee to Revlon: if takeover fails, then we’ll write you a check to compensate once board committed to this, it essentially committed to selling to highest bidder

(c) Paramount v. Time(1) Court tries to back away from its Revlon ruling(2) Time wants to merge with Warner tender offer to acquire Warner at $70

per share(3) Paramount comes in and makes an all-cash offer of $200 per share, but Time

rejects as incompatible with the “Time culture” adopt the Warner merger as a defensive maneuver

(4) Paramount and Time shareholders sue to enjoin the Warner merger, claiming a violation of the business judgment rule (violation = failure to consider all offers and pick the best one for the shareholders)

(5) Court upholds the Warner merger(i) Time board acted reasonably in perceiving threat to Time culture and

journalistic integrity(ii) Time board examined the Warner merger carefully before approving it

(d) Paramount v. QVC(1) Compromise: court tries to determine at what point board has to admit that it

is selling the corporation(2) DE ultimately allows a number of corporate takeovers to go through(3) Paramount talks about merging into Viacom

(i) Proposed merger agreement would make competing offers very difficult to succeed

(4) QVC comes along and makes a hostile takeover bid of $90 per share compared to Viacom’s $85 per share

(5) Paramount goes with the Viacom offer Paramount and QVC shareholders sue to block a merger into Viacom

(6) Court enjoins merger and holds Paramount board in violation of fiduciary duty to it shareholders(i) Board did not evaluate competing offers thoroughly because it couldn’t,

due to restriction provisions in the Viacom proposal that made competing offers difficult

(ii) Paramount shareholders would have a minority voting position in the expanded Viacom would lose control over any decision that required a majority vote, whereas they could shape policy in Paramount

v) Other cases discussed in class(a) Wilkes case

(1) Majorities can attempt a “freeze out” of the minority – refuse minority’s sale of shares at market prices, or refuse minority the corporate offices needed to arrange sale at market price minority can’t get out without paying a penalty of sale below market price

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(2) Here, majority keep Wilkes off payroll for no particular business purpose (e.g., misconduct by Wilkes) – a freeze out! court finds that majority breached its fiduciary duty

(3) Wilkes lucks out by being in MA, which is more liberal than DE – his facts are good but his law is weak a DE would have ruled that it didn’t have the job of refereeing relations between shareholders in a closely held corporation

(b) Some courts impose the extra fiduciary duties by saying that the close corporation in question functions more like partnership

(c) BUT(d) Another view: don’t do violence to corporate structure – majority shareholders

bear the brunt of risk on the investment in the corporation, and should be allowed to dominate

(e) As an attorney for a jilted minority shareholder, do not rely on equity alone – all of these cases easily could come out the other way, in favor of the corporation based on the structure that all the shareholders agreed to don’t mess with the corporate structure

X) Not-for-profit corporationsA) No owners

i) This means that non-profit is not barred from making a profit, but barred from distributing profits to “owners” (i.e., those people in positions that would make them equity owners in a for-profit venture)

B) Things that a non-profit can doi) Churches and other religious associationsii) Health careiii) Educationiv) Social servicesv) Arts and culture

C) Not taxed as entities have advantages in enterprises in which they compete with for-profit entities

D) Formsi) Unincorporated associationii) Business trustiii) Nonprofit corporation

E) The nonprofit sectori) GBR notion (statute of uses from Queen Elizabeth): we should have entities that do

good things – things that gov’t wants done but does not want to do itselfii) Nondistribution requirement: there are no owners of a nonprofit no distribution of

equity(a) The entity itself can profit (e.g., a development office in a college that grows an

endowment), but no one can take value from the entityiii) Since the 1930s and the New Deal, many of the purposes listed in the preamble to the

Statute of Uses have been seen as roles for the federal government; when not done there, we look to the nonprofit sector

iv) Why does a nonprofit handout appear in a class on corporations?(a) Our corporation law book is not objective reality; it’s essentially an argument that

the corporation as an idea should be organized around self-interest

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(b) The handout presents an alternative idea: that corporations should be organized around public interests or common interests, not self-interest

(c) Don’t abuse nonprofits, though: don’t set up nonprofit simply to evade taxes states have limits on the granting of nonprofit status, as does the federal government through the tax code

v) The NFL, and sports leagues generally, are a different issue: you want sports competition on the field, but you don’t want business competition – avoid making some teams inherently uncompetitive

(a) The goal of business competition, after all, is to put other people out of business(b) Another abuse of nonprofit: those running the nonprofit give themselves huge

salariesvi) In sum, then, we have fiduciary duty as an alternative to the profit motive, which is the

theme of the book(a) Another motivation in corporations and corporation law: control for the sake of

having control (“It’s good to be king”)vii)What happens when nonprofits compete with for-profits, as in health care (Kaleida vs.

nonprofit Catholic Health System)?(a) For profits can raise capital more easily, because they can promise a higher return

on investment(b) BUT(c) Nonprofit will not have to pay taxes HUGE advantage over for profits

(1) In fact, nonprofits receive contributions precisely because they’re not taxed donor receives tax deduction

viii) Churches(a) Automatically tax exempt

ix) Charitable trusts and foundations(a) States a trust’s purpose, names trustees, may state a duration

x) Non-profit corporation (World Wildlife Fund, Sierra Club, etc.)(a) Fully incorporated, act just like a corporation except no distribution of profits

xi) Why do we talk about nonprofits?(a) First-year courses talk about individuals and the state – individuals do stuff, with

the state intervening from time to time(b) Nonprofits cover a vast area in between the individual and the state

XI) OTHER FORMS OF BUSINESS ASSOCIATIONA) Limited partnerships (LLPs)

i) Entity established by state filingii) A corporation may be the general partneriii) Limited partnership interests may be security interestsiv) Partnership agreementv) Pass-through taxationvi) LLPs limit liability to the general partner who runs things; the limited partners benefitvii)Essentially runs like a corporation, but taxed like a partnership – GP receives profits

first and is taxed there; if money spread out then to LPs, then the profits are taxed again at the LP level

B) Limited liability companies (LLCs)i) Entity established by public filing

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ii) Owners called “members”iii) Members have limited liability; there is no general partner to bear residual liabilityiv) Pass-through taxationv) Business conducted through “operating agreement”vi) Distinguish “member-managed LLC” from “manager managed LLC”vii) It’s an entity established by public filing

(a) Owners called members(b) Members have limited liability(c) There is no GP who bears residual liability(d) Business conducted through operating agreement (kinda like partnership

agreement)(e) Members are free to decide whether they want more or less involvement in LLC –

member managed or manager managed)(f) LLC like an LLP – “same song, second verse” – started in WY in 1977(g) Has some features of corporation, but not all looks a little like a partnership too(h) In an LLC, individual members pay individual taxes – beyond a point, LLC can’t

retain earnings because the members deemed to have received profits and are taxed accordingly go for full C corporation if you want to build up a lot of retained earnings for acquisitions and R&D (the way Microsoft does)

(i) LLC can choose whether to be taxed as a corporation members taxed if LLC decides not to be taxed itself

(j) Law firms usually aren’t C corporations because they spend their clients’ fees no buildup of retained earnings

viii) Great Lake Chemical Co. v. Monsanto(a) Great case on 5 levels – read carefully(b) Sweetener company makes L-phenylalanine (for aspartame), but did not disclose

info about R&D risks and product development – did not want this info to reach competitors

(c) Nice review of LLCs and securities(d) Is an LLC interest a security?

(1) If Y, then Great Lakes can claim that Monsanto should have disclosed all material risks

(2) If N, then caveat emptor regarding the business that GL wants to enter(e) Court then looks at 33 act for definition of security

(1) Congress clearly wanted to regulate stocks and bonds, and some other stuff, but lots of instruments are less clear

(2) Howey definition of investment contract: contract of money in exchange for return without further work

(f) LPs generally are securities (unless an LP does a lot of work GP)(1) Court then goes through LLC cases where some LLCs were securities, and

some not (e.g., mgr-managed LLC feels more corporate; LLC run jointly by all mgrs feels more like an LP)

(2) Generally, LLC will be a security if LPs are passive and expect others to do the work for them

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(g) Ultimately, Monsanto didn’t lie about anything, and the LPs in questions had no authority to manage affairs directly, but could hire and fire profits did not come solely from the work of others, but no investment contract exists here

ix) A hypo (flowing from Great Lakes case)(a) You know that based on recent East Aurora elections, Wal-Mart will be built and

the resulting traffic will reduce value(b) You decide to sell before this happens – do you have an obligation to disclose this?(c) NO – info economically relevant, but buyer would not have relied on the info(d) BUT(e) What if instead you own the Roycroft holding company, which is publicly traded –

would you then have a duty to disclose these things to potential shareholders?(f) YES – a reasonable investor would want to know these things

C) Professional corporation (PC)i) But don’t you want your doctor personally liable for screwing up your surgery?ii) No, since the state requires a high level of insurance for PCs

D) S corporation i) S corporation – seen less often these daysii) No more than 75 shareholdersiii) Not taxed like C corporation – used sometimes for holding companiesiv) Limits on retained earningsv) Know the names for these hybrid entities, but we don’t need to know too much about

details {just what’s here}XII) CIVIL SOCIETY

A) The spectrum of individualism / government control (most government control at the bottom; also least personal liability at the bottom)i) Sole proprietorshipii) Partnershipiii) Hybridsiv) Corporation

(a) Bank would fall somewhere between here and Fannie Maev) Utility (still pays taxes)vi) Non-profitvii)Government corporation

(a) Peace Bridge Authority, Resolution Trust Corp., maybe Fannie Mae)

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