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Business Associations Outline


I. Agency A. Agency: ability or authority to legally bind another B. Need agency for the concept of a corporation b/c it is a fictitious legal person C. Agency NOT dependent on the intent of the parties D. Different types of agency power 1. Actual Authority a. If manifestations from the principal to the agent would make a reasonable person in the agents position believe that principal would have authorized her so to act b. Undisclosed intent of principal doesnt matter c. Can be express or implied (dont use terms express and implied on exam) i. A common form of implied actual authority is incidental authority: authority to do things reasonably necessary to attain express goal of agent; authority to do what is usual, typical, and customary in a situation a. Subset of incidental authority is positional authority: unless principal says otherwise, agent has authority that typically goes with such a position b. E.g., simply by virtue of the position that the client has placed the lawyer in, the client confers upon the lawyer actual authority to conduct discovery and to do things which are usual, typical, and customary for a lawyer representing a client in that situation d. If agent has actual authority and is acting within scope of that authority, principal is bound even if third party didnt know he was acting as an agent 2. Apparent Authority a. manifestations from the principal to the third party that would lead a reasonable person in the third partys position to believe that the agent has authority b. The agent can never create its own authority no matter how clever he is in fooling the third party c. What counts as a manifestation is broad; based on whats reasonable; could be an omission d. Can be express, but is usually implied e. E.g., owner of car dealership told salesman earlier not to offer any discounts on a particular car; later, salesman offers you a discount on the car; you didnt know about earlier conversation, and it is usual, typical, and customary for salesman to give discounts off sticker price, so salesman has apparent authority to make deal f. Positional authority is also a type of apparent authority i. A person appointed to a position has apparent authority to do whats typical, customary, and usual to perform duties of position ii. Reasonable for third parties to believe a person in that position has that authority iii. Just by virtue of title, company confers actual and apparent authority to do certain things to complete job iv. E.g., if a manager takes away a plant managers ability to order light bulbs, he still has apparent authority to order light bulbs since its usual, typical, and customary for a plant manager to order light bulbs 3. Agency by Estoppel a. Requires a detrimental change in position b. For practical purposes, same as apparent authority c. E.g., if plant manager has changed his position in reliance of the original order, principal is bound and cancellation isnt okay i. In contrast, with apparent authority, as soon as the order is placed, the principal is bound 1

2 d. Principal still liable to those who have changed positions b/c of their belief of his involvement in the trans, or b/c he knew other might change their position and dint take reasonable steps to notify them of the lack of authority. 4. Inherent Authority a. Cases in which court felt someone should be bound as a matter of justice, but it didnt fit any of the other authority categories b. Third Restatement drops the term; rather, it defines scope of actual authority in an expansive way (p. 14) c. E.g., illustration 9 on p. 15 i. Circumstances have changed since principal conferred authority on agent such that agent reasonably believes principal would want to change his original instruction, but its impossible for agent to go back and ask ii. Reasonable for agent to think that principal would want him to make choice; acting in scope of authority iii. Principal would be bound by agents actions; agent had actual authority under Third Restatement E. Ratification: occurs when an agent that lacks authority purports to bind principal, who afterwards, with knowledge of the material facts, either 1) manifests intention to treat conduct as authorizedexpress or 2) engages in conduct only justifiable if he has such an intention-implied. 1. A principal cant ratify unless she knows the material facts 2. If an agent has no authority (actual or apparent) to bind the principal, then before ratification, theres no contract, and the third party can pull out of the deal 3. But, once the principal ratifies, the contract is binding, and the third party cant withdrawal a. Ratification must be before 3rd party withdraws, agreement has terminated, or sitch has so materially changed that it would be inequitable to bind third person 4. If the principal ratifies and the third party withdrawals, whether contract is binding depends on who acts first a. If principal sees the third party first and says he ratifies, then theres a binding contract b. If third party repudiates first, then theres no binding contract 5. Retaining the benefits constitutes ratification if the benefits can be returned a. If they cant be returned, what can third party do? i. Sue for unjust enrichment, quasi contract, quantum meruit, restitution, etc. ii. Principal should have to pay for value of benefit from ratification 6. Examples: a. Agent for Getty exceeds authorization of 3 Mil and buys a painting for 4 mil; he tells auction house that he exceeds his actual authority; they receive a 5 mil offer, they can take it BUT if Getty calls first and says that he ratifies the 4 mil price, then Getty has to take it b. Neighbors have your house painted while you are gone-painter says you are retaining benefit-you could sue your neighbor and make him pay, or painter could argue quasi-K, quantum meruit or unjust enrichment. F. Acquiescence: if the agent performs a series of acts of a similar nature, failure of principal to object to them is an indication that he consents to the performance of similar acts in the future G. CASE STUDY: Morris Oil Co. v. Rainbow Oilfield Trucking, Inc. 1. Agreement provided that Dawn would have complete control over Rainbows operations; Rainbow wasnt to become agent of Dawn and wasnt empowered to incur liability of Dawn other than in ordinary course of business; when Rainbow ceased operations, it owed P $25,000 2. No apparent authority b/c Morris believed it was contracted with Rainbow in its own capacity 3. HOLDING: Rainbow had actual authority to bind Dawn in ordinary course of business; doesnt matter that third party didnt know about authority; also, Dawn ratified Rainbows actions by saying that Morris payment would come out of escrow account it had set up for Rainbows debts and accepting and retaining money from deal (assumes $ could be returned) 2

3 4. Restatement Second of Agency 195: an undisclosed principal is subject to liability to third parties with whom the agent contracts where such transactions are usual in the business conducted by the agent, even if the contract is contrary to the express directions of the principal 5. RULE: secret instructions or limitations on agents authority must be known to third party or principal is bound Termination of an Agents Actual Authority 1. A principal can normally terminate an agent authority even if breaches a contract 2. No formalities are required for termination 3. Termination isnt effective until agent notified Termination of an Agents Apparent Authority 1. Apparent authority continues until third party has good reason to know it has ended 2. E.g., employees actual authority ends when employer tells him hes fired, but his apparent authority to customers continues until customers know hes been fired 3. Authority only continues if it already existed a. E.g., after hes been fired, if employee calls on customers that have never heard of him, the customers cant reasonably believe he has authority to take a down payment UNLESS the employee is generally known in the industry even to people who havent met him and they havent received notice of him being fired 4. REASONING: easier for employer to inform clients that employee was fired than for clients to find out on their own 5. Apparent authority is based on reasonable beliefs, and passage of time may make the beliefs no longer reasonable 6. HYPO: sign a contract with S, who claims to be an agent for principal, but isnt; X is honestly mistaken; no apparent authority (p. 17) a. A person who wrongly claims agency authority is personally liable to third parties even if she honestly thought she had authority to make sale b. Agents cannot create their own authority b/c principal must give manifestations to third party CASE STUDY: Tarnowski v. Resop 1. P relied on Ds advise to buy a business; found out Ds representations were false and rescinded deal; D collected a secret commission from sellers 2. RULE (from Restatement of Agency, Sec. 407(1) and (2): all profits made by an agent in the course of agency belong to the principal, whether they are the fruits of performance or the violation of an agents duty; doesnt matter that principal suffered no damage or even that transaction was profitable to him 3. REASONING: although P might be left better off, we dont want to let D keep benefit of bribe; discouraging breaches of fiduciary duty Vicarious Liability 1. Under respondeat superior, principle is liable for all torts committed by its agents w/in scope of employment 2. Principal is liable to a 3rd party as a result of an act or trans if agent had actual, apparent or inherent authority, or agent by estoppels or principal ratified the act/trans a. 3rd person liable to principal too! b. If the principal is bound i. Undisclosed: agent is bound even if principal is bound too ii. Partially disclosed: agent and principal are bound iii. Disclosed: agent is not bound c. If not bound b/c agent didnt have any kind of authority, agent liable to 3rd party d. If agent has no actual authority but binds principal anyway, agent liable to principal e. If agent acted w/in actual authority, principal liable to agent to indemnify 3. Mere absence of a contract isnt dispositive; doesnt mean youre an independent contractor or employee 3

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4 4. Criteria for Becoming an Agent a. Assent between the two parties that the agent will work for the b. Benefit of and subject to the c. Control of the principal 5. Types of Agents a. General Agent- authorized to conduct a series of transactions/continuity of service b. Special Agent- authorized to conduct only a single trans, or a series w/o continuity of service c. Servant i. A master is a principal who controls, or has the right to control, the physical conduct of an agent in the performance of the agents services (p. 7) ii. Restatement Third uses the terms principal and employee iii. Restatement Third defines an employee has an agent whose principal controls or has the right to control the manner and means of the agents performance of work (p. 8) iv. Employee: control of the physical details a. How much control of the physical details does there need to be? b. Benefit of making someone an employee is that you can tell them to drop everything theyre doing and work on something else c. It isnt the actual exercise of control over the physical conduct of the agent that establishes the employee relationship; it is the right to control the details v. If you are an employee or servant, then the principal/master/employer is liable for SOME of the torts you commit, but NOT ALL a. For principal to be liable, employee must be acting within scope of employment b. Frolic and detour i. Detour: minor departure still within instruction of employer ii. Frolic: employee has abandoned the employers instructions complete and gone outside scope of employment c. Restatement Second of Agency, Sec. 228 (supp. p. 7): whether conduct is within scope of employment depends on whether employee is motivated at least in part by a purpose to serve the master d. Under the coming and going rule, during your usual commute to and from work, you are NOT within the scope of your employment i. But, if you get up and drive to Akron for a special trip, it isnt your usual route, so its probably within scope of employment vi. Borrowed servant doctrine a. E.g., youre a lawyer from a corporate firm and your boss tells you to go straight to Zilchcos office and do what they tell you; firm has surrendered control over you even though you may be on their payroll; youd be an employee of Zilchco for purpose of respondeat superior vii. Shared/dual/joint control: original employer hasnt rendered control, but he has agreed to share control (e.g, ordered to take instructions from two firms) d. Independent Contractor/Operative i. Under the Restatement, an independent contractor may or may not be an agent ii. But, there are some courts that say an independent contractor isnt an agent iii. Dent prefers term independent operative iv. Dont need a contractual relationship between parties to be considered an independent contractor v. An agent is an independent contractor, not an employee, if the principal has general but not specific control over the conduct of the agents work vi. Question whether principal has control so independent contractor is an agent or no control, so independent contractor isnt an agent at all 4

5 a. Has to be control to be an agent at all b. HYPO: if you send a package with UPS, UPS hopes to reach a certain result, but theyre not subject to your control; you cant tell them how to send the package; UPS is an independent contractor, but not your agent c. HYPO: contrast with lawyer; lawyer must make the changes as you suggest them, but you cant control the physical details of the lawyers work d. HYPO: compare with an employee, who you can physically control by telling him to drop whatever hes working on and start something else e. Contractor and agent: control of the ends, but not the physical details f. Contractor and not agent: no control over physical details and no control of ends vii. Principal isnt responsible for the torts of an independent contractor, whether or not the independent contractor is an agent a. REASONING: principal doesnt have control over the physical detains b. So, its not an important to look at whether independent contractor is an agent viii. Benefits of treating someone as an independent operative rather than an employee a. Employer wont be subject to liability if the person screws up b. Employer doesnt have to worry about income tax withholding c. Avoids health benefits, workers compensation, FMLA, etc. d. Sometimes employees are harder to fire e. More employees means business is subject to more laws f. Person can avoid income tax withholding and doesnt have to become part of social security system ix. 3.7 million people who are wrongly being treated as independent contractors rather than employees 6. How much control does a franchisor have over a franchisee? a. E.g., pyramid schemes; franchisor has control over details b/c they give the franchisee the plan b. E.g., Goodrich puts up an add on TV saying go to our franchise; take your car to Mr. Goodrich; advertising makes customer think that franchisor stands behind franchisees product; courts disagree on this issue c. Courts also disagree about effect of disclaimers; put independently owner and operated Goodrich might be good enough for some courts but not for others 7. CASE STUDY: Murrell v. Goertz a. P claims Goertz was servant of newspaper; Goertz had no contract with newspaper; only responsible to Westbrook; Goertz was an independent contractor by terms of contract b. HOLDING: Ds polices and standards dont rise to level of supervision, dominion, and control over Goertzs day to day activities to make him Ds servant 8. CASE STUDY: Ira S. Bushey & Sons, Inc. v. U.S. a. seaman returning late at night turned wheels on drydock wall, opening valves controlling flooding of tanks on one side drydock; parts of drydock and ship sank; government argues Lanes actions werent within scope of employment b. HOLDING: while sailor wasnt serving purpose of master, his conduct wasnt so unforeseeable as to make it unfair to charge the employer with responsibility i. Even if the employee violates a clearly stated policy, this isnt necessarily dispositive ii. Foreseeable that sometimes drivers are going to go over the speed limit; principal isnt necessarily immune just b/c driver ignored instructions not to speed iii. Restatement Second of Agency, Sec. 229(2): even a specific prohibition wont necessarily preclude liability c. What is reasonably foreseeable in context of respondeat superior is different from foreseeably unreasonable risk of harm in negligent 5

6 d. REASONING: business cant disclaim responsibility for accidents which are characteristic of its activities 9. When an employee commits a tort, whom can the victim sue? a. Employee and employer are joint and severally liable; P can get all of her money from either one or other b. If employee werent liable, then employer couldnt be liable c. generally P will sue employer b/c its easier to collect from them; deeper pockets 10. If employees tort subjects employer to vicarious liability, employer can get indemnification from employee (rule from Firemans Fund v. Turner) a. Employee is the indemnitor who will pay indemnification to the employer, who is the indemnitee b. Exception i. If an agent in good faith performs an authorized act which isnt obviously illegal, then the employee isnt liable to the employer for indemnification ii. HYPO: employer tells employee to cut down trees at 32 Elm Street; turns out employer had wrong house number a. Employee would be liable to owner of property, but she couldnt be liable to employer for indemnification b/c she performed act in good faith and it wasnt obviously illegal b. If employee were forced to pay, then employer would have to indemnify employee because employers mistake caused tort c. If employer is bankrupt, though, employee will have to pay even though hes not at fault c. But, even when employers can seek indemnification from their employees, they usually dont because i. Employees dont have a lot of money ii. Harmful to employee morale iii. Dont want employees to be too careful b/c itll make them be less productive iv. Employer has to prove employee was culpable d. If in the principal action, the employee was found liable, the employer can use that finding through collateral estoppel i. But, possible victim wont sue employee because a. He doesnt have as much money b. He could testify for victim at victims trial i. If you serve the employee and the case goes to the jury, their sympathies are going to be with the employee; might say UPS driver isnt negligent but UPS is liable ii. If they do that, the judge will have to throw out the verdict as logically inconsistent e. If the agent takes an action that he doesnt have actual authority to perform, but the principal is bound b/c the agent had apparent authority, the agent is liable to principal for resulting damages f. If agent acts within actual authority, the principal is under a duty to indemnify the agent for payments the agent made which were authorized or made necessary in executing principals affairs g. CASE STUDY: Firemans Fund Am. Insurance Co. v. Turner i. While D was operating his car in the course of employment, he rear-ended another car; P recovered against both Oregon Sign (employer) and D ii. HOLDING: the right of an employer held vicariously liable to a third person injured by the wrongful act of an employee to seek indemnity against the employee is well established 6

7 iii. REASONING: fault concept that all persons should be held responsible for consequences of their wrongful acts, including inadvertent negligence 11. CASE STUDY: A. Gay Jenson Farm Co. v. Cargill, Inc. a. Ps (farmers) brought actions against Cargill (creditor) and Warren (debtor) to recover losses sustained when Warren defaulted on their contracts for sale of grain; Cargill extended more credit to Warren, called them daily, and sent regional manager to oversee operations b. Factors indicating Cargills control over Warren i. Cargills constant recommendations to Warren via telephone ii. Cargills right of first refusal on grain iii. Cargills right of entry onto premises iv. Cargills determination that Warren needed strong parental guidance v. Financing of all Warrens purchases of grain and operating expenses vi. Cargills power to discontinue financing of Warrens operations c. RULE: security holder who merely exercise a veto power doesnt become a principal; creditor who assumes control of his debtors business may become liable as a principal for the acts of the debtor when it assumes de facto control over the conduct of the debtor d. Case not based on actual or apparent authority: Cargill didnt say they were going to pay for everything Warren bought; none of the farmers really thought Cargill was going to pay for everything; so, it must be inherent authorityconstructed agency e. CAVEAT: as a policy matter, the decision in this case is problematic b/c it pushes creditors to cut off debtors earlier than may be profitable for them i. Ordinarily, creditors want to wait awhile and hope the debtors turn around and pay their bills; dont want to cut them off right away or sue them b/c they might file bankruptcy ii. There might be cases becomes so intrusive they should be held liable (i.e., when creditor initiates transactions), but with the facts here, most courts probably wouldve gone the other way iii. Although the creditor is pursuing its own interest, usually its interest overlap with interests of other creditors anyway iv. Can be dangerous for the creditor to pull the plug too early a. E.g., revolving credit agreement with bank, and they refuse to renew loan; variety of grounds on which debtor can sue creditor i. Implied promise to continue financing ii. Bad faith: debtor will argue creditor is really trying to force them out of business iii. Coercion b. Bank wants to preserve its reputation b/c if it gets to aggressive in collecting bills, no one will want to borrow from them f. But, going in and helping out a company is a dangerous strategy because i. You may not get your money back ii. You may be held liable for the companys debt Partnerships and Limited Liability Companies A. Definition of a Partnership 1. UPA 6(1): partnership is an association of two or more persons to carry on as co-owner a business for profit; identical definition in RUPA 101(6) but RUPA 201 states partnership = an entitysimplifies things a. No formalities required to create a general partnership other than meeting defs in UPA 6(1), RUPA 202(a) b. Dont need a specific intent to create the legal entity known as a partnership i. Only necessary intent is an intent to do those things which constitute a partnership ii. An express statement to the contrary (i.e., you didnt intend to create a partnership) is basically ineffective iii. Objective manifestations enough to create partnership 7

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8 c. Must be a single pool of profits being shared; co-ownership of A (as in single) business for profit d. Hilco Property v. US: factors in determining partnership includes intent to proceed as partners, whether they have shared profits/losses, right to participate in control, or commonly held real property. 2. Sometimes hard to tell at what point you become co-owner of a business for profit a. CASE STUDY: Martin v. Peyton i. Ds loaned P $2,500,000 worth of liquid securities; in compensation for loan, Ds were to receive 40% of profits until return was made; Ds were also given option to join firm; D had veto ii. HOLDING: the money given to Ds is just to pay off the loan; doesnt mean Ds are partners; option alone isnt enough to show that a partnership was created; lenders didnt have any control over business (no right to initiate transactions, etc.) iii. RULE: it is for the court to say whether a partnership exists; statements that no partnership is intended arent conclusive b. UPA Sec. 7(4)(d): receipt by a person of a share of the profits of the business is prima facie evidence that hes a partner in the business, but no such inference will be drawn when the money is in payment of interest on a loan (even though the amount of payment may vary with profit of business); wages of an employee or rent to LL; an annuity to a widow or rep of deceased partner; interest on a loan (even though the amt varies w/ profits of the business); consideration for sale of a good will of a business or other property 3. RUPA issued in 1993 and 2/3 of states have adopted it, but UPA is still important 4. Corporations can also be in partnerships; joint venture is just another word for partnership 5. CASE STUDY: Lupien v. Malsbenden a. D told P he had to sign over ownership of truck; gave him rental car, then purchased it for Ps use; P never received car he contracted for; D argues that his only interest in York Motor Mart was that of a banker b. HOLDING: D was a partner because there was no fixed payment schedule for his loan to Cragin, the amount of the loan wasnt fixed, and D participated in day-to-day business c. RULE: the realities of the relationship and not just the labels used by the parties are dispositive even if the parties dont believe theyve created a legal partnership; substance, not form, determines whether a relationships is a partnership 6. CASE STUDY: Davis v. Loftus a. P claimed that two lawyers at firm had committed malpractice; some partners were income partners and some were equity partners b. HOLDING: income partners arent partners under partnership law b/c they didnt have any voting power, had a fixed income and fixed bonuses, etc. B. Liability in Partnerships 1. UPA Sec. 15: all partners are liable a. Jointly and severally for everything chargeable to the partnership under Sec. 13 and 14, and b. Jointly for all other debts and obligations of the partnership (contract claims) c. Not just liable for your pro rata share in the partnership d. RUPA 306 provides partners jointly and severally liable for all obs in a partnership. 2. UPA Sec. 18: If you pay more than your share, you can sue partners for contribution 3. A partner can also go for indemnification under agency laws to get money from the negligent agent 4. Generally, partners are personally liable for the debts of the partnership a. Partner cant be held liable with a creditor who enters into a non-recourse agreement, i.e., agrees not to go after partners personally b. Partners can agree that one of them among themselves wont be liable, but it doesnt affect third parties 5. Partnership law often treated as a category of an agency law (though it isnt exactly) 8

9 6. UPA Sec. 16(1) and RUPA 308(a): partner by estoppel; when a person, by words or by conduct, represents himself as a partner in an existing partnership, he is liable to any such person to whom such representations are made 7. UPA Sec. 9(1) and RUPA 301: every partner is an agent of the partnership for purposes of its business and the act of a partner apparently carrying on in the usual way (applies for contracts entered into as well), binds the partnership unless the partner has no authority and the third party knows he has no authority a. For apparent authority, third partys belief that partner has authority must be reasonable b. RUPA 308: Liability of purported partner: liable to 3rd party for trans and if partners acquiescence to an apparent agency relationship, they are liable. c. Also, for there to be apparent authority, there must be manifestations from the principal to the third party d. What is meant by in the usual way of the business of the partnership is a question left up to the courts 8. UPA 13, RUPA 305: when a partner commits a wrongful act acting in the ordinary course of business and causes loss or injury to any person, the partnership is liable to the same extent as the partner a. RUPA 404: if partner commits a tort, partner has to indemnify the firm from vicarious liability unless its a matter of business judgment (ONLY gross negligence) b. BUT under the UPA partnership is not an entity in itself, so cant sue the partnership under the UPA, but can sue the partners. c. RUPA 307(a) partnership may sue and be sued in its own name. i. RUPA 307(d) a judgment against a partner based on a claim against the partnership normally cant be satisfied against the partners individual assets, unless and until a judgment on the same claim has been rendered against the partnership and a writ of execution on the judgment has been returned unsatisfied. 9. UPA 14: partnership is liable when one partner acting within the scope of his authority receives money from a third person and misapplies it. Bound by partners breach of trust. 10. Common thought is that all of the different phrases in UPA 9(1), 13, and 14 mean the same thing 11. UPA 9(2): partnership isnt bound by act of partner which isnt authorized or carried on in normal course of business or under apparent authority a. Seems to negate concept of inherent authority b. But, concept of inherent authority came from Restatements, which were drafted after UPA 12. UPA 11: partnership is bound by a representation made by any partner within the scope of his actual or apparent authority a. RUPA doesnt have a similar provision, but since its part of agency law, it presumably applies 13. Sometimes partners get non-recourse agreements, where a third party agrees not to go after the law firm personally in contract with partner; must have an agreement with third parties 14. CASE STUDY: Cook v. Brundidge, Fountain, Elliott Churchill a. Lyon was a partner of Brundidge; told P he was silent partner in a real estate firm, and told her to invest in Yummers; check made payable to Warren Lyon as Attorney for and mailed to law firm; conferred with P in law firm office; Yummers went bankrupt; P seeks recovery of damages against partnership law firm based on vicarious liability b. HOLDING: existence of factual issues about whether Lyon was acting in the ordinary course of business of the partnership when he breached his fiduciary duty to P; law firm is accountable to P for acts of Lyon b/c acted with apparent authority of the partnership. had knowledge of material facts, ie cashing check. c. IMPORTANT QUESTION: What did Cook reasonably believe when she handed Lyon the check? 9

10 d. Side note: one who lacks authority, actual or apparent, is responsible for his own actions, so P couldve sued Lyon as an individual 15. CASE STUDY: Scheinkopf v. Stone (1st Cir. 1991) a. P put money in a real estate venture suggested by law partner; venture flopped; P sued firm b. HOLDING: appellate court affirmed summary judgment for D; law firm wasnt liable b/c client was a businessman, so his belief wasnt as reasonable 16. How can firms avoid being liable in cases like Cook in the future? a. Could try to monitor the partners behavior, but thats going to be difficult, and would make for unpleasant working environment b. Could put a provision in the contract with the client, but this isnt good for client relations c. Useful to have an internal memo reminding people of these things every once and awhile, but how far that gets you is another matter d. Client audits: see if people are happy with the work theyre getting, etc. e. Malpractice insurance: usually covers breach of fiduciary duty unless theres fraudulent intent, but what does that mean? 17. What if Cook won her claim against the firm, but they were bankrupt/ a. In general partnership law, partners are liable for the debts of the partnership, so she could collect against all partners personally b. What if the firm was an LLP? i. Couldnt go after the partners as partners ii. Could go after Lyons personally since he committed the wrong (not purely breach of contract) iii. Rare exception of the act that is done at the instruction of the principal in good faith and not apparently illegal C. Partner Liable to Partnership 1. When an employee causes partnership to incur loss, he must indemnify firm 2. A partner doesnt need to indemnify the firm for losses caused by mere negligence; only for gross negligence or recklessness 3. RUPA 404(c): gross negligence standard 4. RUPA 103(b)(4): this standard of care cannot be reduced D. Limited Partnerships 1. Statutes concerning limited partnership: old ULPA, then RULPA, then re-RULPA (2001) a. RULPA 101(7) definition: partnership formed by two or more perons, having as members one or more general partners AND one or more limited partners. 2. Formalities required to create a limited partnership (RULPA Sec. 201) a. FILE a certificate of limited partnership with appropriate state official, usually Secretary of State 3. Corp General Partners: RULPA 402(9): a. A corp can be a general partner b. RULPA 303(b)(1): and director or officer of a corp general partner is not liable for debts of ltd liability partnership merely b/c he participates in control of partnership business i. may become liable if fails to maintain corp officer liability ID in conducting partnership affairs, or if corp assets intermingled w/ partnership assets, or if corp not sufficiently capitalized. 4. Diffs b/w Limited Partnership and General Partnership a. RULPA 303: In a limited partnership, general partners are liable for debts of the enterprise but limited partners are not i. Limited partner only liable if he participates in control, and person reasonably believes ltd partner is a general partner (Gateway Potato Sales v. GB Investment) b. Benefit of being in a general partnership is control over the operation, but this is only beginning of answer i. Under ULPA prior to 1976, a limited partner couldnt participate in control 10

11 ii. RULPA of 1976 softened this rule iii. Revision of RULPA in 1985 said limited partner isnt liable even if he does participate in control iv. Ways to avoid problem of being held liable in limited partnership a. HYPO: X and Y want to create a partnership in which they will control show, but neither wants to be personally liable i. Set up Z corporations with themselves as sole shareholders and officers ii. Then, set up limited partnership with themselves individually as limited partners and Z corporation as general partner iii. Corporation as general partner is liable, but neither of them is individually liable iv. Also, shareholder in Z have limited liability b. Used to be some disagreement about whether or not this was permissible, but it is now okay with a few caveats i. An agent that acts without disclosing the agency relationship is personally liable according to old agency law a. Have to say that youre here as President of Z corporation which is the general partner of the so-and-so limited partnership ii. Corporate veil may be pierced to make corporate officers liable in some circumstances (see above) 5. Benefits of forming a limited partnership rather than incorporating a. Usually, people form a limited partnerships rather than corporations b/c of tax reasons i. This only refers to federal income tax ii. Corporation is subject to firm taxation, a. taxes its income b. profits or losses directed to firm not the owners c. if distribution, the shareholders get taxed again iii. Non-corporate entities are taxed directly to the firms owners via flow-through taxation a. Firm not subject to taxation b. Firms income/expenses and gains/losses taxable directly to firms owners c. Distributions not taxed iv. E.g., income of $900; relevant tax rate is 1/3 a. Corporations would pay $300, leaving $600 b. If the shareholders of a corporation were also in a 1/3 tax bracket, they would pay $200, leaving $400 c. A partnership would pay nothing, leaving $900 d. If the owners of the partnership are also in 1/3 tax bracket, they would then pay a tax of $300, leaving $600 e. In a non-corporate form, you have 50% more money left after taxes v. But, this is really unrealistic a. A corporation is taxed when the income is realized, but owners are taxed only when the profits are distributed, so if the profits are left in the business, the second level of taxation may not occur for a long time b. Even if the profits are distributed, we now have special treatment for dividends, so this second level of taxation may be taxed at a lower rate or not at all c. Most corporations dont pay dividends b/c it would be taxed twice; instead, thy use the money to pay salaries i. Salaries are ordinary and necessary business expenses deducted from a corporations earnings before income tax is calculated ii. Limits on distributing profits as compensation a. Compensation must be reasonable 11

12 b. Must be agreed to on basis of work to be done; cant be decided on after the fact E. Rule for taxation of non-corporate entities a. Partners are taxed for their share of the profits from the partnership when they are entitled to them whether or not the profits are in fact distributed b. Could be a problem if the partners dont have enough money to cover taxes without full distribution c. So, there are some drawbacks to forming a partnership for tax reasons d. There are many factors that effect the decision of which type of entity to form for tax purposes i. How much income will the entity generate? ii. If its reasonable enough to eat up with salaries, then maybe the corporate form does fine iii. Money that you spend for things that are going to be used pretty quickly are expenses, and they can be written off right away iv. But, things that have a great life expectancy, like buildings, are capitalized and only take part of the total cost each year according to IRS scales F. Limited Liability Companies (LLC) 1. Designed to avoid the biggest problems of the other three business forms a. Problem with corporation: double taxation b. Problem with general partnership: partners are personally liable for debts of enterprise c. Problem with limited partnership: (traditionally) limited partners could participate in control 2. Liability: members of the LLC arent liable for its debts even if they do participate in control, like a shareholder of a corporation 3. LLCs didnt become popular until 10 years ago when the IRS through in the towel on tax treatment of LLCs 4. LLC is an entity (ULLCA 201) 5. Unlike the UPA, the ULLCA isnt the general law of the land 6. Creation: filing a document called the articles of organization with the Secretary of State (ULLCA 202) 7. Operating Agreement: All state statutes provide a set of default rules, which can be altered by a contract, which is usually referred to as the operating agreement (ULLCA 103) 8. Member-managed unless the articles says it is manager-managed(ULLCA 203(a)(6)) a. In a member-managed LLC, members have the same authority as general partners in a general partnership (ULLCA 301(a) i. Members can bind the LLC for acts carrying on ordinary business a. But member may have to indemnify LLC for loss resulting from the contravention of other members decision ii. ULLCA 404 Each member has an equal vote, and all matters are decided by majority vote, except those listed in (c) which require unanimous vote a. Amend operating agreement; Authorization or ratification of acts which would otherwise violate duty of loyalty; Amendment of articles of organization; Compromise of an obligation to make a contribution; Comprise of an obligation of a member to make a contribution or return money, etc. distributed in violation of the Act; Making of interim distributions; Admission of a new member; Use of companys proper to redeem an interest subject to a charging order; Consent to dissolve company; Waiver of right to have companys business wound up and company terminated; Consent of members to merge with another entity; Disposal of all or substantially all of companys property with or without good will b. ULLCA 409(c) imposes gross negligence standard for members of member-managed LLC 9. Manager-managed LLC, only managers have the authority, and to bind LLC 12

13 a. ULLCA 409h)(2) imposes gross negligence standard for members/managers in LLC 10. Member perks: can vote, participate in management, nad be supplied with info-ULLCA 408; can receive distributions can freely transfer financial rights (not governance rights); ULLCA 303-not liable for debts, obs or other LLC liabilities; dissociation of at-will member dissolves unless specified % of remaining members agree to continue; in manager managed LLC, only dissociation of manager results in dissolution. 11. Why would you not use an LLC? a. If you will soon be a publicly traded entity b/c of IRS rules, even if you are an LLC, youre taxed like a corporation; might be better to be a corporation if youre going to be publicly traded soon b/c corporations are better understood entities b. Partnership tax treatment may be unimportant i. In most closely held business, where most if not all of the profits are paid out in the form of compensation, dont need to worry about double taxation c. Some businesses dont care much about limited liability because i. Theres not much risk of liability (e.g., someone who make doilies) ii. Liability is covered by insurance iii. Creditors insist that you waive limited liability anyway iv. Personal liability is imposed by law v. Little or no assets that youre worried about protecting (e.g., dont have enough money to pay a judgment, so youll just declare bankruptcy) vi. One participant in LLC a. Can have a one participate LLC under ULLCA 202(a), but not in some states) vii. Uncertainty a. Biggest problem with LLCs b. Only in 1988 that IRS agreed to treat LLCs as partnerships c. Became easier with check box legislation; file a form with government and check box on how you want to be taxed (as a corporation or partnership) d. Not as much case law on fiduciary duties in LLCs, etc. as there is on corporations; might be easier to go with a form everyone is familiar with e. E.g., with an LLC, you dont know what the fiduciary duties are, so youre going to have to list them all in the operating agreement; probably going to cost a lot f. Uncertainties for LLCs are greatest for third parties i. authority of a member depends on which type of LLC it is, member-managed or manager-managed ii. Should you believe someone who tells you their LLC is member-managed and theyre a member, or should you make ht effort to go get the articles? G. Limited Liability Partnership (LLP) 1. An LLP is a general partnership with limited liability; its not a limited partnership 2. Partner in LLP not personally liable for all partnership obs, only for those obs arising from his own activities 3. Degree of limited liability is specified in statute a. Broad shield statutes say that a partner in an LLP is the same as a corporate shareholder and a limited partner in a limited partnership and as a partner in an LLS b. Partial shield statutes say partners arent liable for torts incurred by the entity but still remain liable for debts by contracts, etc. 4. If you have a general partnership, you dont have to convert to another form to create an LLP a. You must submit an election b. But, you were and still are a general partnership c. Not really changing to an LLP; instead, youre electing to become an LLP d. If a general partnership decides to submit an election to become an LLP, it must notify third parties within whom its dealt 13

14 i. Question of what constitutes notice to a third party of change of the legal status of the entity e. E.g., your law firm has a lease, but it doesnt say the lease is assignable to any successor firm; if you file an election to become an LLP (rather than convert to an LLC), the same general partnership exists H. Power to Act in a Partnership 1. UPA 9(1) and RUPA 301- partners are agents of the partnership for the purpose of its business and the act of every partner, unless partner has no authority to act. 2. UPA 18(e) and RUPA 401(f): subject to contrary agreement, partners have an equal vote 3. UPA Sec. 18(h) and RUPA 401(j): differences on ordinary matter subject to majority vote, and any act in contravention of the partnership agreement requires unanimity a. Under the UPA and RUPA, extraordinary matters require a unanimous vote even if they are contravened by the partnership agreement b. In contrast, ULLCA 404(a)(2) says that all matters can be decided by a majority vote, except for matters listed in 404(c) [listed above] 4. UPA 18g and RUPA 401(i): all partners must consent to the addition of a new partner 5. UPA 18(b): partnership must indemnify partner for costs reasonably incurred in ordinary and proper conduct of business a. Words reasonably incurred and proper conduct dont appear in RUPA Sec. 401(c) but otherwise same or ULLCA 403(a) b. Maybe deleting words reasonably incurred doesnt mean that you have to reimburse no matter how outrageous the act was, but that you must reimburse if the act was not negligently, but not if it was gross negligence c. Hypo: 1 of 2 equal partners buys paper clips for the firm and seeks reimbursement. Can the other partner bar it? i. No! under UPA 18b, RUPA 401c and ULLCA 403a partner must be indemnified for all payments reasonably made in the ordinary course of business. d. HYPO: you give a friend money to buy Coke which you will both sell at an outdoor concert and split the profits. While driving to get the Coke, she negligently hits a pedestrian. Are you liable? i. Both have control over the business and sharing the profits so partnership ii. Friend is acting as the agent of the partnership and when she went to buy Coke she was acting w/in her authority in the scope of employment. As partner, liable under UPA 13 and RUPA 305a b/c every partner is liable for the wrongful act of other partner in ordinary course of business iii. Could be liable for all damages/debts jointly/severally under UPA 15 iv. Would be liable under UPA 18b, the partnership will indemnify you or you can seek indemnification from friend. 6. CASE STUDY: Summers v. Dooley a. P and D entered into partnership; when either person was unable to work, non-working partner provided a replacement at his own expense; D became unable to work and hired an employee to take his place; P approached D about hiring an additional employee, but D refused; P hired him anyway; D refused to pay for new employee out of partnership funds; P argued that D retained profits earned from value of new employees labor and ratified by behavior b. HOLDING: majority of partners didnt consent to hiring of third man; manifestly unjust to permit recovery of an expense which was incurred individually and not for benefit of partnership but for benefit of one partner (Dent disagreed) c. REASONING: if you already know there is a dispute and one of the partners goes ahead and acts anyway, then the debt isnt reasonably incurred b/c youre violating the rule of equal power 7. Usually, hiring an employee is part of the ordinary course of business 14

15 a. So (in Summers below), Dooley couldnt have refused to pay the employee if Summers had hired him without asking Dooley b. Dooley could then come after Summers for indemnification, arguing that the expense wasnt reasonably incurred c. Question of ratification by acquiescence; if Dooley knew about employee, but failed to fire him d. Maybe summer shouldve just sued for unjust enrichment instead of indemnification 8. What other options did Summers have when Dooley said he didnt want to hire another employee? a. Dissolve the partnership; under RUPA, you can always get out immediately 9. If the employee in Summers knew the two partners disagreed, he no longer had a reasonable belief that Summers had authority, so he cant enforce the contract a. Cases are somewhat divided on this issue 10. What happens if there is a deadlock in the partnership over some issue? a. Dents view i. Cant do anything unless there is the requisite vote ii. No requisite vote to keep employee on, so she would be fired b. Some cases seem to hold that the status quo continues, so the employee will stay 11. In order to take away a partners ability to bind the partnership, the partnership must send notice to third parties a. Some call a vote to strip a partner of all authority an extraordinary act that requires a unanimous vote b. But, if you can deny him one part of his authority at a time by majority vote, why cant you take it all away by majority vote c. RUPA 303: a partnership can file a statement of authority which may extent or rescind authority of some or all partners i. Third parties arent bound to know of this statement if it restricts authority except with respect to real estate transactions ii. RUPA 304-statement can be filed which denies the partnership. d. UPA 9(1): third party has knowledge of the facts that a partner doesnt have authority when actual knowledge or knowledge of other facts and circs that show bad faith in th circs. RUPA 301(1)-third party has no duty of inquiry, or deemed to have notice from the circs. Only actual knowledge of lack of authority ok. 12. How can a partnership agree in advance to avoid deadlocks or to resolve them? a. Put provision for managing committee or managing partner in partnership agreement b. Agree to arbitration i. Removes some of the pressure to resolve the dispute on your own ii. Can be expensive and time-consuming (though not as much as litigation) iii. Airing your dirty laundry in public iv. May not want a stranger deciding cruel aspects of your business, especially one who doesnt know the business well c. Provisions for dissolution in case of disagreement i. UPA in a sense already resolves this since any partner can dissolve at any time ii. But, might want to limit dissolution (e.g., if certain partners want to, they can dissolve) 13. What states law applies to partnership disputes? a. Under old UPA, didnt make much difference b/c every state followed UPA, but now some states have adopted RUPA and some havent b. UPA didnt address the issue c. RUPA 106 says that the applicable law is the law where the partnership has its chief office 14. HYPO: a business is profitable but short of cash; X and Y are equal partners a. Y says to X he doesnt have any money, but he wants X to lend $1,000 to the firm i. X refuses even though the lack of money will mean the business will fail 15

16 ii. According to Sanchez v. Saylor (see blow) partner isnt required to lend money to partnership b. Y offers to lend money, but X doesnt agree i. Is this a breach of fiduciary duty? ii. Y isnt asking the partner to do anything except say yes; not putting Xs money at risk; hasnt asked for a particular guarantee iii. But, X is personally liable on any loan to the partnership; U.S. law doesnt want to burden people iv. ANSWER: unless X is looking for an opportunistic dissolution, she doesnt have to approve the loan, even from her partner Y; partner doesnt breach a fiduciary duty just by saying no v. REASONING: courts reluctant to overrule business decisions even if seem outrageous 15. CASE STUDY: Sanchez v. Saylor a. P and D were partners; third party was considering lending money to partnership but required D to provide personal financial statements; P argued Ds refusal to provide statements violated his fiduciary duty b. HOLDING: where partners in a two-partner partnership disagree, dissolution, not an action for breach of fiduciary duty, is the appropriate avenue for relief c. RULE: you cant do something that will injure the partnership, but youre not required to do things that will shield the partnership from damage from other sources I. Distributions in a Partnership 1. Despite unequal contributions, distribution are paid equally to each partner a. REASONING: sometimes partners contribute in other ways then money b. UPA Sec. 18(a), RUPA 401(b), and ULLCA 405(a): distributions are shared equally unless something is said 2. Usually, you want to distribute enough to at least pay taxes, which is about 40% a. Partners still have to report their full share of partnership distributions on their income tax report even if other partners havent agreed to distribution b. Still have to pay income tax even if you dont have money yet, so thats why you might distribute enough to at least pay taxes 3. Partners can always override any provision with a unanimous vote 4. IMPORTANT: Profit doesnt necessarily generate any spare cash a. Profitable partnerships will often have their money tied up in assets b. So, dont assume that a profitable firm can necessarily make distributions or even pay their bills on time c. Might be wise to create an agreement for when this happens if you have no money and your partner has a lot and then tries to refuse offering money for partnership 5. UPA 18(f): no partner is entitled to remuneration for acting in the partnership business a. Doesnt matter that youre doing more work and receipts are down; you and your partner get equal shares b. Of course, provision is subject to agreement; can amendment partnership agreement by unanimous vote c. Courts will stretch to find consent for an amendment to partnership agreement d. What can you do if you feel like youre not getting your fair share in the business? i. Get specific consent from partner for a better deal ii. If partner says no, threaten to dissolve (but this can have dire consequences) 6. Under UPA, once a partner dies, the old partnership ceases to exist; living partners form a NEW partnership

16

17 J. Assigning Your Partnership Interest 1. A partner cant sell his partnership status; can only sell right to receive distributions of profits (interest). UPA 26/27 and RUPA 502. 2. Partner may convey title to property in the partnership name, but partnership may recover the property unless the partners act binds the partnership. UPA 10 and RUPA 302. 3. UPA 26: your interest doesnt mean your right to participate in management; partners interest in partnership is his share of profits and surplus, same as personal property 4. UPA 27= RUPA 503: a partner can sell his interest, but it doesnt dissolve the partnership nor the partners ability to participate in management; just gives assignee right to receive profits to which assignor would otherwise be entitled. Not even right to look at books. 5. UPA 18(g) and RUPA 401(i): cannot admit new partners without unanimous approval unless otherwise agreed a. Note how different this is from the default rule in corporate law b. If you sell a share of stock, the buyer becomes the stockholder with the same rights you had; dont have to get anyone elses permission c. In a way, the rights can be multiplied in a corporation (e.g., you hold two shares; sell them to two different people; increased the quantity of rights in the corporation) d. REASONING: partner has agency authority to bind the partnership in a way a shareholder in a corporation doesnt 6. CASE STUDY: Rapoport v. 55 Perry Co. a. Two families entered into a partnership agreement to form 55 Perry Company equally; Simon and Genia Rapoport assigned a 10% interest to their children Daniel and Kalia; Ds argue that partnership agreement didnt permit admission of additional partners without consent of all existing partners; paragraph 12 provided for assignment of interests b. HOLDING: consent of Ds was required to admit Daniel and Kalia to partnership; Ps couldnt transfer full partnership interest to children without consent of all partners, and their children only have rights as assignees to receive a share of the partnership income and profits K. Loans vs. Contributions to the Partnership from a Partner 1. UPA 8(2) and RUPA 204(c): property acquired with partnership funds or in the name of the partnership it is presumed to be partnership property a. UCLLA has no provision for this, so presumably it follows general and contract law, which looks to intent of parties b. UPA 25: specific partnership property: partner is coowner with other partners; has equal right ot partnership property, right not assignable except in connection with assignment of rights of all the partners in same property, deceased partners rights vested in partners for partnership purposes only. c. UPA 24: partnership property rights also includes interest in the property, and right to participate in management. 2. UPA 25(1): partnership property is owned by partners as tenants in partnership 3. UPA 25(2): strips away from partners almost all rights of ownership in specific partnership property a. Some question if there are any rights left b. RUPA: all ambiguity is eliminated; partner isnt a co-owner in partnership property and has no interest partnership property i. RUPA 501 Partner not a cowoner and has no transferable interest in property ii. RUPA 401(g) Can only use partnership property on behalf of partnership c. Same result in corporations as a shareholder, you have no rights in corporate property d. Same in LLCs 4. HYPO: a partner transfer to the partnership a patent; at the time of transfer, it is worth $1,000; a year later, the partnership dissolves, and the patent is worth $1 million 17

18 a. When the partnership property is distributed, what is given to the partner who transferred the patent depends on whether the patent was a contribution or a loan b. Contribution i. If its a contribution, then it become a part of partnership property upon transfer ii. Contributing partner would only get fair market value of the contribution when he gives it to the firm iii. When the firm dissolves, he would just get his share of the profits c. Loan i. If the partner loans the patent, then it would go back to him plus interest ii. If the value of the patent has increased over time, the partner will get the benefit of the appreciation 5. Contribution vs Loan depends on Intent. 6. UPA 28 and RUPA 504: a court can give a creditor of a partner a charging order on the partners interest a. Similar to an assignment of interest except an assignment is voluntary b. A partner subject to a charging order still acts as a partner in exercising management rights, just without rights to distributions, etc. c. If creditor forecloses, only partners interest sold, not the partnership assets. d. Under RUPA creditor owns partners entire financial interest, including all amts due on dissolution. Can put transferor into bankruptcydissolution. 7. HYPO: Partnership owned by husband and wife equally; husbands interest is subject to charging order, so creditor is entitled to any distributions to husband; husband and wife decide to make a distribution of $20,000 to the wife and $0 to the husband a. Seems like bad faith, but you can get away with this (according to informal advice) b. The creditor doesnt have an interest in the partnership just a charging order on personal property, which happens to be an interest in the partnership c. Foreclosure might be the creditors best option i. Foreclosure would entail a sale of the partnership interest ii. Still, could run into problem (e.g., firm might not have very many assets to sell, etc.) L. Fiduciary Duties in a Partnership 1. UPA 21: Partner accountable as a fiduciary. Must acct to partnership for any benefit and hold as a trustee for it any profits derived by him w/o consent of the other partners from any transaction connected with the formation, conduct or liquidation of the partnership or from use by him of its property. 2. RUPA, on the other hand, deals extensively with fiduciary duties a. RUPA Sec. 404: forbids interested transactions unless approved by other partners; duties of loyalty and care i. RUPA 404(b) Duty of Loyalty: - refrain from self-dealing, refrain from competing with partnership; dealing w/ party w/ adverse interest to partnership, prohibits stealing an opportunity ii. RUPA 404(c) Duty of Care: refrain from grossly negligent or reckless conduct, intentional misconduct, and should act w/ good faith and fair dealing. b. RUPA 103(b)(3-5): partners may by agreement modify all fiduciary duties as long as the changes arent unreasonable; courts cant add fiduciary duties, but parties can by agreement; cant have a clause that says NO fiduciary duties 3. To determine if parties intended to modify fiduciary duties, look to (Singer) a. Exculpatory clause; if none, then b. Intent of parties c. Reasonable expectations of parties in the circumstances 4. CASE STUDY: Meinhard v. Salmon a. D leased property to change hotel into shops and offices; D entered into financing agreement with P; D got a new lease with new cost; didnt tell P anything about it; partnership was 18

19 scheduled to wind up; P (wool merchant) was silent partner and D (real estate manager) was public partner b. HOLDING: D liable to P; number of shares allotted to P should be reduced as necessary to preserve to D expected measure of dominion; Ps equitable interest should be measured by the value of of the entire estate, not by merely half of some undivided part c. RULE: joint adventurers, like co-partners, owe to one another the duty of the finest loyalty; the punctilio of an honor the most sensitive; undivided loyalty d. REASONING: the very fact that D was in control with exclusive powers of direction charged him with a greater duty of disclosure, since only through disclosure could opportunity be equalized 5. Some commentators have used hypothetical bargaining or hypothetical contracting to understand Meinhard v. Salmon a. If Salmon and Meinhard had negotiated in the original deal about future opportunity, Salmon probably wouldnt have let Meinhard ride on his efforts forever, and Meinhard probably wouldve understood that this was a one time deal; he wasnt looking to become a regular real estate investor b. Could use this argument in court; urge the court to infer what the parties wouldve agreed to had they addressed the situation c. Context is really important in the analysis 6. CASE STUDY: Singer v. Singer a. Singer family formed an oil production partnership; interests were passed down to other family members; under 8, each partner was free to enter into other transactions for own benefit; partners discussed buying a certain piece of land Joe suggested; after meeting Stanley and Andrea formed a general partnership and purchased land without consulting any other partners b. HOLDING: Ds had a contract right to do exactly what they didcompete with the partners as if there never had been a partnership; had Stanley and Andrea pirated an existing partnership asset or used partnership funds, the courts decision would be different c. REASONING about why partners had this clause: in oil business, want partners to be able to enter into multiple, potentially conflicting partnerships d. But, this probably isnt the type of behavior that the drafters wanted to allow b/c Andrea and Stanley were stealing an opportunity that Joe found first 7. How do you avoid the type of situation in Singer without an exculpatory clause? a. Dont have a lot of different ventures b. Specify some objective basis for distinguishing between opportunities that are acceptable (e.g., in real estate limited partnerships to buy one apartment building and nothing else) c. Allocate opportunities to equalize the returns in various partnerships 8. HYPO: one partner agrees to sell her interest in the partnership to another partner; is there a duty of full disclosure or does caveat emptor apply? a. Some courts say that with your partner, fiduciary duties apply, including the duty of candor b. Other courts say when youre in a partnership, the duty of candor and full disclosure applies, but once you start talking about getting out of the partnership, youre in an adversarial position; each partner has full access to information and can insist on honesty M. Joint Ventures 1. Kind of business assoc created by co-owners for a limited purpose and duration (usu once) 2. A joint venture will probably be treated as a partnership unless it doesnt meet the definition of a partnership 3. Generally, under old UPA, joint ventures were treated as partnerships 4. RUPA 202, comment 2: a joint venture is a partnership if it meets the definition of a partnership 5. Business Opportunities that CAN be taken. a. has nothing to do with present business b. business opportunity outside the partnership or joint ventureship agreement 19

20 c. Requirement is pursuing business opportunity i. Disclose info to other joint venturer, fiduciary duty says it cant compete w/ business unless approved, can modify partnership agreement though, or limit the prupose of the partnership N. Suits by a Partner Against the Partnership 1. UPA 22: a partner can seek an accounting for breach of fiduciary duty whenever circumstances make it just and reasonable a. An accounting is an extensive review of partnership affairs b. Courts have been extremely reluctant to grant this remedy when the partnership is still operating; thought of as something that should be done only when partnership is winding down 2. UPA 13 provides for suit by someone not a member of the partnership, and because it is so specific, usu not. a. RUPA 305 drops the not being a partner in the partnership so a partner can sue the partnership on a tort or other theory during the term of the partnership instead of just having remedies of dissolution and accounting. 3. RUPA 405 and UCLLA 410 expressly allow suits before dissolution a. for breach of partnership or violation of partnership duty b. UPA 22 c and d = right to an accounting i. Comprehensive review. Does involve specific facts but ct looks at partnership as a whole O. Default rules should be ones that will best fit the most people, so the fewest people have to go to a lawyer to have the rules changed to suit them 1. Slight alteration on theory that default rules should be created with weaker party in mind b/c the stronger party is in a better position to insist on alternations P. Dissolution at Will 1. Dissolution winding up termination 2. UPA 29: dissolution = the change in the relation of the partner caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business 3. UPA 30: Partnership not terminated by dissolution. Continues til wound up. 4. UPA 31(1)(b): a partner can dissolve a partnership at will at any time a. No formalities are needed b. But, must send some kind of notice to other partners c. Partner doesnt need to state or have a valid reason to dissolve 5. Even if the partnership is for a term, any partner can dissolve by express will at any time a. UPA Sec. 38(2)(b): if partnership is for a term and someone says they dissolve before term is up, thats wrongful dissolution; other partners can then agree to continue business for the rest of the term; can also buyout wrongdoers; same is true in case of judicial dissolution b. UPA Sec. 38(2)(c): if the business is continued, wrongfully dissolving partner will have to wait until end of term to get money (less damages); wont get value of good will of business c. May be liable for breach of the partnership agreement, but indemnified from future partnership debts d. Other partners may be able to sue you for damages and they may even be able to continue the business for the duration of the agreed term or until the particular undertaking is complete 6. Dissociation under RUPA is different from dissolution under UPA a. RUPA Sec. 601 Events causing dissociation i. Partnerhship has notice of partners express will to withdraw ii. Event agreed to in partnership agreement iii. Expulsion pursuant to partnership agreement 20

21 iv. Expulsion by unanimous vote for: unlawful to carry on w/ that partner; partners interest has been transferred; notification of intent to expel a partner, revoke a charter, or right to conduct business is suspended; partnership is dissolved. v. Judicial determination vi. Partner becomes a debtor in bankruptcy, assignment for benefit of his creditors, appt of receiver for partners property vii. Partners death, appt of guardian for partner, determination that partner is incapable viii. Distribution of trust holding the interest ix. Distribution of an estate holding the interests x. Termination of a partner who is not an individual, partnership, corp, trust or estate b. Partners Power to dissociate (RUPA 602) i. Partner can dissociate at any time by express will; a partners dissociation is wrongful if: breach of partnership agreement ii. Partner who wrongfully dissociates is liable to partnership for damages caused by dissociation iii. Wrongful Dissociation a. Breach of express provision of K b. Before expiration of term or completion of undertaking if partnership for term c. RUPA 603: dissociation may result in dissolution or winding up. Upon dissociation, partners right to participate and duty of loyalty terminate. d. RUPA 701: Purchase of dissociated partners interest i. if partner dissociated w/o dissolution, his interest will be purchased for a buyout price ii. buyout price = amt that would have been distributable to partner on the date of dissociation, if the assts were sold at a price equal to the greater of liquidation or value based on a sale of the whole business iii. damages for wrongful dissociation must be offset against the buyout price iv. partnership shall indemnify the dissociated partner except for the liabilities he incurred on his own. 7. Events causing dissolution/winding up (RUPA 801) a. Notification of express will if partnership at will b. If partnership for a definite term: w/in 90 days of partners death or wrongful dissociation or express will of at least half of partners c. Express will of all the partners d. Event agreed to or expiration of term in partnership agreement e. Event that makes partnership unlawful f. Judicial determination 8. Partners can avoid the automatic dissolution of the business upon the death of a partner by providing for its continuation in the partnership agreement or obtaining consent from the estate (Creel v. Lilly below) 9. UPA 38(1): on dissolution, a partnership is liquidated a. In liquidation, theres a loss of going concern value; things will bid for less than theyre worth, so partners wont get compensated for true value of assets b. Common to contract out of liquidation c. If parties are acting reasonably, there wont be a loss of going concern value 10. CASE STUDY: Girard Bank v. Haley (p. 78) a. Mrs. Reid, a partner in an at-will partnership, sent a letter to her other partners saying she was terminating the partnership; trial court held that letter didnt cause dissolution b/c neither in letter nor at trial did Reid offer evidence to justify dissolution b. RULE: dissolution of partnership is caused by express will of any partner; expression of will doesnt need to be supported by any justification; dissolution is effective even if its in contravention of an agreement 21

22 11. CASE STUDY: Page v. Page a. P and D were partners; partnerships major creditor was a corp. wholly owned by P; P wishes to terminate partnership now that business is profitable; D argues that there was an understanding that they were going to let the business run until it could pay for itself, so it was a partnership for term b. HOLDING: a common hope that partnership earnings would pay for all necessary expenses doesnt establish a definite term or a particular undertaking; partnership was at-will c. RULE: if (1) P acted in bad faith (motive) and violated his fiduciary duty by trying to appropriate the benefit of the partnership (2) without adequate compensation to his copartner, he would be liable for a violation of an implied agreement not wrongfully exclude D from partnership business opportunities d. Real story behind the case: OPPORTUNISTIC DISSOLUTION i. D is afraid that if partnership assets go on the auction block, then P is going to buy all of them; P is going to buy everything at a reduced price b/c he has all of the money ii. If D had plenty of money, there wouldnt be an issue here iii. Very common for joint ventures to end in a Russian roulette buyout: either side can end the venture at any time, and when you announce you want to end it, you must name the price either to buy the other persons share or sell your own iv. P is bidding in, which means hes bidding for something that already belongs to him, so he doesnt have to put up the cash for his interest v. If you have a venture among people with very different financial means, and you know the venture will need more financing down the road, you want to deal with the problem of future financing early on e. Ways to deal with this problem i. Make a partnership for a term a. No point in doing this if youre going to run out of money before the term ends b. A partner can get out at any time, but if he wrongfully dissolves, then hes liable for damages under UPA ii. Clause in partnership agreement that if company is dissolved then one of the partners cant buy assets of company iii. Appraisal by an objective person iv. Incorporate b/c a corporation is harder to dissolve v. Agreement not to dissolve, but if you run out of money, you cant run business f. CAVEAT: the facts of this strange are a bit odd; most courts probably wouldve come out the other way; facts have to be pretty extreme for court to interfere g. GENERAL RULE: if you want to dissolve, even if your reasons are sketchy, in order to force your partner into action, knowing he cant buy the assets, thats permitted; dont want to put burden on partner who wants to dissolve 12. CASE STUDY: Hunter v. Straube a. Ps filed suit to dissolve partnership; D counterclaimed, alleging he was entitled to continue partnership, recover damages for Ps breach, and to settle with Ps as withdrawing partners as provided in partnership agreement, under which they get less $ than in liquidation b. HOLDING: filing of suit by Ps was an election to withdraw from partnership in contravention of partnership agreement; withdrawal entitled D to continue partnership business and to settle affairs of partnership in accordance with terms of partnership agreement; D also has right to damages suffered as a result of breach; Ps had power to dissolve, but they didnt have right to dissolve without complying with terms of agreement c. RULE: if its not manifestly unreasonably (like getting no money on voluntary departure), a court will uphold a provision for a buyout formula, even if it is substantially less than intrinsic or inherent value d. Why would parties agree to a buyout plan that gives them much less than intrinsic value? 22

23 i. Want to discourage parties from withdrawing ii. If partnership doesnt have cash, they might not be able to pay a high buyout price a. In the case of death, you could get a life insurance policy to cover buyout 13. HYPO: scientist has an idea for a preservative; his brother, a venture capitalist, puts in money to develop the process; worth $10, but neither party can bid for as much as $1 million a. If the process goes up at auction, a pharmaceutical company will buy it for $1, and the partners will lose property worth $10 million b. One partner could always buyout the dissolving partners share c. Or, they could have an agreement over an alterative disposition of assets 14. CASE STUDY: Meehan v. Shaughnessy a. Ps left D partnership to form their own; continued to work full time as they were planning departure; Ds claim Meehan and Boyle engaged in improper conduct in withdrawing cases and clients from the firm and in inducing employees to join new firm; under partnership agreement, voluntarily retiring partner can take only cases they brought into partnership themselves, and then they have to pay a fair charge to partnership b. HOLDING: P dissolve the partnership without violation of the agreement b/c one of the partners waived notice provision; Ps could take cases with them as long as client had a clear choice; Ps obtained an unfair advantage in breach of their duty of loyalty in their preparing to obtain clients consent and secrecy about which clients they intended to take; Ps get reimbursed for out of pocket expenses, but must reimburse D fair charge, which is old firms out-of-pocket expenses and work of old firms attorney at their out-of-pocket rates; have right to retain all fees generated by the cases in excess of the fair charge c. RULE: a firm cant prevent a lawyer from taking clients with her when she leaves i. But, they might be able to stipulate in the agreement that if a lawyer takes clients, she has to pay the firm something ii. Under the old code of ethics, fee splitting was forbidden except on basis of work done; so a kickback of a certain % of a lawyers fees wouldve been invalided as fee splitting on work yet to be done iii. Under the new rules, there can be fee splitting, but the firm can be responsible for malpractice iv. Also depends on how big the kickback is and how long it will last d. RULE: while still at old firm, a partner can plan to compete with it within limits i. Cant start competing with old firm before you leave ii. Cant slack off from your work iii. Must be honest with old firm; can say no comment, just cant be dishonest e. Problems with case i. If attorney is working on contingency basis a. The day before dissolution, you think a case is worth $450,000 b. Out of pocket expenses and associate fees have been almost $100,000 c. Later, one of the partners dissolves, and you take this case with you; now you owe the old firm $100,000 d. You will be enticed to settle even at $300,000 b/c you dont want to risk going to trial and getting nothing when you have a debt to pay to the old firm ii. If Ds lawyer says youll be happy about the $1 million settlement offer hell make a. Youll go back to the office and say you dissolve b. Then, you take the settlement as a sole practitioner, knowing that it will be far greater than the expenses of the old firm c. Basically same thing going in Page v. Page; partner trying to leave and get profit to himself iii. If a lawyer leaves one firm, joins a new one, and then complete a case she began with the old one, how should the resulting fee be split? 23

24 a. Is the lawyer working on the case as part of the winding up of the business of the old firm or has the case simply become business of the new firm? 15. CASE STUDY: Jewel v. Boxer (cited in Meehan) a. Law firm dissolved; no agreement about winding up b. HOLDING: applying UPA, court said cases have to be completed as part of winding up; first, reimbursement of reasonable out-of-pocket expenses; then, fees would be split in accordance with old partnership division regardless of who did the work 16. CASE STUDY: Cohen v. Lord, Day, and Lord (N.Y. 1989) a. HOLDING: an agreement denying a partner fees from a client she took with her was an invalid restriction on competition; cant impose this type of burden on a departing partner 17. CASE STUDY: Howard v. Babcock (Cal. 1994) a. HOLDING: an agreement imposing a reasonable toll on departing law partners competing with the firm is enforceable; law is a business as well as a profession; in contrast with Cohen Q. Judicial Dissolution 1. Someone comes into court and asks court to rule that firm is dissolved 2. Circumstances under which a court can dissolve a partnership a. UPA Sec. 32(1): i. (a) Partner of unsound mind, (b) partner incapable of performing K; (c) guilty of conduct prejudicial to business; (d) breach of partnership agreement; (f) other circs render dissolution equitable. ii. (e) Business can only be carried on at a loss b. RUPA Sec. 801(5) i. (i) econ purpose of partnership is likely to be unreasonably frustrated; (ii) partner engaged in conduct making it not reasonably practical to carry on business w/ him (iii) not otherwise reasonably practicable to carry one in conformity w/ partnership agreement c. Misconduct doesnt need to render the partnership unprofitable (see Drasher below), but there is a strong presumption against ordering the dissolution of a profitable partnership d. Behavior doesnt have to amount to fraud, but courts wont grant dissolution for all minor infractions e. Misconduct doesnt need to bear directly on partnership business 3. RUPA 601(5) has similar grounds for a partners expulsion by judicial determination a. (i) Partners wrongful conduct adversely and materially affects partnership business b. (ii) Partner willfully and persistently committed a material breach, or c. (iii) Its not reasonably practicable to carryon on the business in partnership with the partner d. But, dissociation doesnt cause dissolution i. RUPA 601 describes events causing a partners disassociation or expulsion ii. RUPA 801 describes when dissociation will lead to dissolution a. In a partnership at will, when partner (not dissociated) gives notices of express will to withdraw as partner b. In a partnership for a term or undertaking i. Within 90 days after partners dissociation by death or otherwise, the express will of at least half of the remaining partner to wind up business, where a partners rightful dissociation constitutes an expression of will to wind up, ii. Express will of all partners to wind up, or iii. Expiration of term or completion of undertaking e. ULLCA is very similar to RUPA in distinguishing between dissociation and dissolution i. ULLCA 601(6) pretty much identical to RUPA 601(5) ii. ULLCA 801(3-5) allows for dissolution a. (3) When an event makes it unlawful for substantially all of business to be continued 24

25 b. (4) On application by a member or dissociated member, upon a judicial decree that c. (5) On application by a transferee of a members interest, a judicial determination that it is equitable to wind up companys business 4. Why would someone seek judicial dissolution? a. In a partnership for a term, if a partner dissolves, he is in violation of partnership agreement wrongful dissolution triggering UPA 38(2) i. Wrongfully dissolving partner may have to pay damages, other partners can continue business or windup without wrongfully dissolving partners participation, and wrongfully dissolving partner wont get his share until end of term and good will (difference between going concern value and value of tangible assets) is excluded from calculation of interest ii. With a judicial dissolution, UPA 38(2) never kicks in b/c its not a wrongful dissolution b. One partner, who wants to get out, makes it miserable for the other partner to force the other partner to dissolve i. The other party doesnt want to dissolve wrongfully, so he seeks judicial dissolution instead 5. CASE STUDY: Drashner v. Sorenson a. Both P and Ds sought dissolution in contravention of the partnership agreement resulting from ongoing controversy of Ps right to withdraw money from partnership to defray living expenses; evidence that P spent too much time at bar during business hours b. HOLDING: not a partnership at will b/c agreement contemplated an association which would continue at least until $7,500 of Ds money had been repaid (conflicts with Page); trial court could reasonably conclude that insistent demands of P and his conduct rendered it reasonably impracticable to carry on business with him; evidence supports finding that P caused dissolution wrongfully; P had no interest in property b/c of exclusion from good will and assessment of damages c. RULE: dont take good will into account in determining a partys interest in the partnership when she dissolves wrongfully 6. Crutcher v. Smith: not for every trivial departure from duty or violation of articles of partnership or trifling fault or misconduct that cts will decree dissolution. R. After Dissolution: Winding-Up 1. winding-up is a process of settling partnership affairs after dissolution (RUPA is very specific though); termination is point in time when the partnership affairs are wound-up. Comment to UPA 29 and RUPA 803(c) 2. Partners who havent wrongfully dissolved the partnership can wind-up partnership affairs a. Partners still have fiduciary duties during winding-up process; most fiduciary duties end when the agency relationship ends, but there are exceptions i. CASE STUDY: Leff v. Gunter (p. 91) a. Competition with ones old partnership after disassociation which is facilitated by access to information only available to partners violates ones fiduciary duty to his hold partnership b. RUPA 802/803 permits operation of business for a reasonable time to maximize value while winding up; also how courts read UPA c. UPA 35(1)(a) and RUPA 804: permits a partner to bind the partnership even after dissolution for purposes of winding up, or would have bound before dissolution if 3rd party didnt know about dissolution i. RUPA 702 dissociated partners can also bind if it would have bound before dissociation and 3rd party reasonably believed he was still a partner, didnt have notice, and didnt know. d. UPA 38(1) and RUPA 807(b): any partner who hasnt wrongfully dissolved has a right to be paid in cash 25

26 i. Generally construed to mean that assets will be sold at an auction, i.e., liquidation ii. But, says subject to contrary agreement a. Agreement can be made before of after dissolution b. So, if a partner dies, partners can agree that her interest will be bought out and remaining partners will form a new partnership c. If you fail to make an agreement and partner dies, can ask estate if it would be willing to take payment instead of auction 3. A partnership isnt terminated until the winding up process is complete, which includes partners apply the partnership property to discharge liability and distributing surplus in cash (Creel v. Lilly below) 4. UPA 40(b): after payment of debts, partnership repays capital, then distributes profits to partners a. Person who puts up capital gets distribution before partners get profits b. If the firm lost money, then all of the parties have to share the loss, even if one party didnt put up capital, but worked instead; he never gets up getting paid for his work, but actually has to pay his portion of the debt to the capital-fronting partner 5. Distribution of Assets UPA 40, RUPA 807 a. Assets defined b. Liability payoff order: non-partner creditors, creditor-partners, partners owed in respect of capital, partners owed profits 6. UPA 18(a): If parties dont say how losses will be shared, theyre shared in the same proportion as profits a. ULLCA 806(b): each member is entitled to return of all contributions and a distribution of remainder in equal shares 7. UPA 18(f)and RUPA 401(H) no partner is entitled to renumeration for acting in the partnership business a. General rule is that, in the absence of an agreement, a partner contributing only personal services isnt ordinarily entitled to any share of partnership capital pursuant to dissolution; nevertheless, personal services may qualify as capital contributions where an express or implied agreement to such effect exists (Schymanski v. Conventz on p. 85) b. In entering a partnership with such a capital structure, partner should foresee application of default rule and take advantage of their power to vary allocation of capital losses by agreement (p. 87) 8. When a partner died and partnership automatically dissolved b/c there was no consent by estate to continue business or written agreement allowing for continuation, under old UPA, estate had right to compel liquidation of partnership assets a. Under UPA aggregate theory, a partnerships is characterized as the collection of individual members, and when one partner dies or withdraws, the partnership ceases to exist b. Under the RUPA entity theory, partnerships can continue even with departure of a member if existing partners buy out dissociating partner b/c the partnership is distinct from partners c. Under RUPA, a deceased party no longer has to consent to continuing business nor does estate have right to compel liquidation 9. CASE STUDY: Creel v. Lilly a. Creel entered into a partnership with Lilly and Altizer, who each paid $6,666 in capital contributions; Creel contributed $15,000 in inventory and supplies; partnership automatically dissolved upon Creels death; Lilly and Altizer began doing business under a different name, using the assets of the partnership; P wants liquidation of partnership assets b. HOLDING: new partnership is a successor partnership, rather than a continuation of the old partnership; where surviving partners have wound up business and good faith and deceased partners estate is provided with an accurate accounting, a forced sale of partnership assets is unwarranted c. REASONING: liquidation can be harmful and destructive and often unnecessary to determine true value of partnership 26

27 d. CAVEAT: general rule is liquidation b/c how else are you going to turn chairs into cash to give partners S. Expulsion of Partners 1. RUPA 601(4) need a unanimous vote to expel (dissociate) someone from partnership 2. RUPA 601(4-5), and ULLCA 601(4-6): allows for expulsion of partner if authorized in partnership agreement, unanimous, on judicial determination 3. CASE STUDY: Lawlis v. Kightlinger (p. 99-100) a. RULE: power to involuntarily expel partners in partnership agreement must be exercised in good faith; expelling partners act in good faith regardless of their motivation if the expulsion doesnt cause a wrongful withholding of money or property legally due to the expelled partner 4. CASE STUDY: Crutcher v. Smith (p. 102-103) a. HOLDING: debtors alleged minor infractions (such as failing to replace a $500 bad check) were insufficient to trigger dissolution of partnership; D was wrongfully expelled from the partnership 5. CASE STUDY: Bohatch v. Butler & Binion (Tex. 1998) a. A partner was over-billing the firms biggest client; the firm expelled the partner making the accusation b/c her accusation created friction in the firm, so she sued b. HOLDING: expulsion is okay even if her charges were true 6. Levy v. Nassau Queens medical Group: expulsion in bad faith may be actionable, must be some showing htat partnership acted out of desire to gain business or property advantage. T. Partnership Break-Up 1. Under UPA, break-up of a partnership was seen as too easy a. Except in cases where a partner breached his fiduciary duty when the partnership was for a term, any partner could get out at any time for any reason, for an auction of the assets, which might result in partners not getting their fair share of the intrinsic value of the firm b. Also, death, disability, or bankruptcy automatically caused dissolution 2. To reduce these problems, RUPA changes the rule of partnership break-up a. Most of the same events that cause dissolution under UPA cause dissociation under RUPA (death, bankruptcy, declaration of express will) b. Dissolution under RUPA is just the beginning of the winding-up process c. The power of a partner to dissociate by will cant be denied in contract d. death of a partner RUPA 601(7): doesnt cause dissolution; dead partners share bought out e. dissociation RUPA 701: doesnt cause dissolution unless majority of other partners decide to dissolve f. Any partner may demand liquidation, but partnership agreement can provide that dissociation by express will doesnt cause dissolution g. RUPA 802(b): even without prior agreement, after dissolution, but before winding-up, if all partner decide (excluding wrongfully dissociating partner), they can continue business as if dissolution never occurred; doesnt say anything about notice to third parties h. ULLCA 602(a) and 603: member can withdraw at any time, but withdraw doesnt cause dissolution unless specified in operating agreement III. The Corporate Form A. DE 101(b): Corporation for a lawful business purpose (to make a profit) B. Corporation law is generally in state statutes (e.g., basic regulation of internal affairs); generally speaking, no such thing as common law corporations C. Characteristics of a Corp 1. Limited Liability: shareholders not personally liable 2. Free Transferability of ownership interests: repped by freely transferable shares of stock 3. Continuity of Existence: legal entity which can secure against early termination 4. Centralized Management: normally managed by a board of directors 5. Entity Status: can exercise power and have rights in its own name 27

28 D. Corporations vs. Partnerships 1. A corporation is a legal entity separate from its shareholders and owners; it can sue, be sued, own property, commit crimes, etc. 2. Still ambiguous whether a partnership is a separate entity or an aggregate of the partners (as it is for tax purposes) 3. Corporate shareholders enjoy limited liability in contrast to full liability of partners 4. Continuity of existence: legal existence of a corporation is perpetual 5. Centralized management: corporation managed by a board of directors 6. Free transferability of interest: stock is freely transferable 7. Tax differences-double taxation for corps. 8. Because of the differences between corporations and partnerships, some say the biggest legal decision in form a business is whether to incorporate a. But, dont exaggerate the differences too much i. Control: day to day management vs major management ii. Liability: unlimited v. limited iii. Tax issues b. Whichever form you use, you can usually get close to the features you want in either model by planning and contracting c. Corps governed by state laws and securities/fed tax law E. Sole Proprietorship vs. Corporation 1. In a sole proprietorship, the owner has full personal liability if the company goes bankrupt -owned by single individual, no separate legal ID from owner. All personal assets tied to co 2. Drawbacks of incorporation for a single business owner a. Tax reasons: corporations are generally subject to double taxation; first, corporation has to pay taxes on profits, then after profits are distributed to shareholder, she pays taxes again b. Business is expected to lose money at outset: if youre acting as a sole proprietorship, you can deduct losses as business losses on your personal income tax return; cant do this as a corporation; can do this if youre a one-person LLC c. Formalities required: no formalities required to establish a sole proprietorship; with a corporation, have to file a certificate of incorporation, pay franchise fee, issue stock certificates, etc. d. Operation in other states: a sole proprietorship can operate in other states without registration; a corporation must file a document with Secretary of States in states you want to do business in, or it wont be considered a corporation in those states e. Limited liability: if the corporation doesnt have any assets, then the bank will probably force the sole owner to guarantee the loan, which destroys the benefits of limited liability with a corporation; if the sole proprietor makes his products himself, he will still be personally liable if he did something to injure someone else under agency law; also, he might not have to worry about liability at all if hes making something that isnt likely to injure; to preserve limited liability, must adhere to corporate formalities i. Incorporating to avoid personal liability might be illusory: corporate veil can be pierced and tortfeasors liable for torts they commit. Banks may ask for personal guarantees F. PROBLEM #1: can you represent all four parties in forming their business? 1. No b/c attorneys cant represent parties with conflicting interests; should tell them all to get 4 separate lawyers 2. Parties might want a different entity based on their different interests a. Limited liability: wealthy investor wants to protect assets, so wants limited liability; other partners might not care as much since they dont have much money to begin with b. Taxes: an investor who has a lot of losses might want this venture to be taxable to her b/c she has no gains off which to offset her losses c. Management: if the parties have different opinions of where they want to start, they might not be able to agree on the rules of the partnership or corporation 28

29 G. Where should you incorporate? 1. If a corporation will operate solely in that state, you should incorporate in that state b/c there will be less taxes 2. If you do business in OH after incorporating in DE, you must qualify to do business in OH and will end up paying 2 sets of fees 3. Foreign corporations have to pay a fee and file something with Secretary of State if they do any business under DE 371(b) and transact any business under OH 1703.03 in a state a. Generally, things like shipping goods to a state by an independent trucker doesnt constitution doing business in the states the truck passes through, but if you hire truckers in one state, that would constitute doing business in that state 4. If you dont qualify to do business in another state and still do business there, you might not get benefits of limited liability if youre sued, and if you want to sue someone else in that state, you might not be able to get jurisdiction to do them H. Special Rules for Lawyers Forming Corporations 1. Lawyers cant incorporate in many states 2. Many of the biggest law firms have become LLPs, but some states make partners personally liable for malpractice, so the point of becoming an LLP is defeated 3. Most important consideration in becoming an LLP is deferred compensation and pensions, etc. I. Pre-incorporation Transactions 1. Place of Incorporation a. Under traditional choice of law rules, a corporations internal affairs are governed by the laws of the state of incorporation regardless of whether it has any other contacts with that state (p. 107) i. Close Corporations a. Incorporate locally: tax reasons. State will impose doing business taxes as well as franchise taxes for being incorporated in a state even if they dont do business in that state ii. Publically Held a. Usually do business in a number of states and will pick the state w/ the most favorable corp law iii. If corp operates primarily in one state, incorporate there b/c it is cheaper a. Qualification by a foreign corp required i. For doing business in another state ii. DE 371b iii. If you dont, state official could stop business, may corp pay a fee, corp may be barred from bringing action in state ct b. A few states, notably CA, reject this rule and apply their laws to pseudo-corporations, which are incorporated in another state but do most of their business in their state c. DE is the favorite of most big companies i. Professor Kerry (predecessor to editor of our book): DE leads race to bottom by watering down shareholder rights to a thin gruel ii. Studies show that stock prices dont go down when a company incorporates in DE; if anything, they go up iii. DE is favored b/c its law is better developed and better known to lawyers a. Critics say DE allows managers to run the show w/o intervention of shareholders d. Generally, corporate laws of states coincide but differ in some significant ways 2. Filing Required for Corporations i. Filing a certificate of incorporation, articles of incorporation, or charter (DE 102 and OH 1701.04) b. Minimum Contents of Charter i. Name ii. Address 29

30 iii. Incorporators iv. Initial stated capital: number of authorized shares of stock and their initial values v. Purpose of corporation: can be as vague as to engage in any lawful business under DE 102(a)(3) and OH 1701.04(B)(2) a. DE law reqs a purpose clause, OH doesnt b. Purposes clause can be limited c. Charter can be amended to change the purposes clause: DE 241(b)(1)-board and majority shareholder vote-OH 1701.70, OH 1701.71-2/3 shareholder vote but no board resolution is required. d. Doctrine of implied powers can provide for a broad purpose i. Doctrine states auxiliary or incidental purposes related to the main business are acceptable as a part of the regular activities of the corp in maintaining copr purpose ii. DE 121(a): any powers so far as necessary or convenient to accomplish its purposes. c. Cant put anything in the charter thats inconsistent with law, but you can put everything else d. In public companies, the charter is usually brief, but in many private, closely-held corporations, the charter has special arrangements among the parties that would be unnecessary in public companies e. Not required in statute that corporation have bylaws but most do have them; also, statutes often say that an issue would be settled as specified in bylaws f. Side note: Ohio statute uses term regulations where other states use term bylaws; in Ohio, bylaws are housekeeping rules for the board ONLY g. Consequences of Defective Incorporation: de facto corp doctrine creates the corp even w/ a mistake in the filing if: i. There is a statute organizing and authorizing corps (one like this in every state) ii. Incorporator made a good faith attempt to comply w/ statute iii. Must show actual use or corp powersfunctions like a corp 3. After you file the charter you organize meetings and meetings, hold the initial meeting of directors, etc.; all very technical and scripted 4. If you fail to file something correctly, you can still have de facto corporation rule, where an entity is a corporation against everyone but the state if two conditions are satisfied (p. 118) a. Colorable attempt to incorporate b. Some actual use or exercise of corporate privileges 5. Promoters and Pre-Incorporation a. Promoter: transforms idea into a business by bringing together needed persons and assets and taking care of the various steps required to bring the new business into existence i. GENERAL RULE: when a promoter makes a contract for the benefit of a contemplated corporation, the promoter is personally liable on the contract and remains liable even after the corporation is formed ii. unless, if the third party knew the corp didnt exist when she was signing he contract. (Pottery Warehousesee below) iii. If Corp ratifies, adopts, or novates then corp can be liable. iv. Promoter and corp can both be liable jointly and severally b. CASE STUDY: Goodman v. Darden, Doman & Stafford Associates (p. 115) i. Goodman proposed to renovate an apartment building owned by Darden; said he would be forming a corporation to limit his personal liability ii. HOLDING: Goodman was liable on contract; the fact that a contracting party know that the corporation is nonexistent doesnt indicate any agreement to release the promoter; not enough evidence to show that DDS intended to contract with the corporation only 30

31 iii. Presumption that the parties intended that the individual promoter be liable unless the contrary is made clear c. CASE STUDY: Company Stores Development Corp. v. Pottery Warehouse, Inc. (p. 115116) i. Company Stores leased a store to Pottery Warehouse for 5 years; Pottery Warehouse wasnt incorporated at the time ii. HOLDING: promoter not liable; P intended to look solely to Pottery Warehouse, Inc. for satisfaction of obligation under the lease at time of execution; at time lease was signed, P was aware of nonexistence of corporate entity and didnt require promoter to sign agreement in individual capacity iii. Presumption that since the third party knows the company doesnt exist, the agent for the nonexistent principal wouldnt be bound d. PROBLEM #3: Harman made employment offer to Carton; she would set up and operate packaging division for 3 years in consideration of a salary of $70,000/year plus a bonus of $1,000 per 100,000 units produced; after first year, she wasnt given $5,000 bonus; now corporation is insolvent and has no assets Carton can reach i. Cartons arguments a. Cite Goodman, which says that promoter is personally liable b. Person who purports to act on behalf of a non-existent principal is basically deceiving the other party c. Doesnt matter that other party knows the principal corporation doesnt exist d. Harman was hiring her to work for him, not the corporation ii. Harmans arguments a. Cite Pottery Warehouse, where promoter wasnt liable to third party b/c he wasnt required to sign the agreement in his individual capacity b. Look to intent of parties c. Carton knew she was contracting with corporation, not Harman personally d. She was hired to operate a packing division, which seems like something youd do for a corporation, not an individual iii. If Harman isnt bound here, theres a problem with contract law; corporation wont be bound either since it didnt exist a. If Harman isnt personally liable, then theres no contract b. That cant be what the parties intended; intended for document to have some kind of legal effect c. Can see why traditional rule is that promoter is personally liable even if third party knows principal doesnt exist and why some courts have rejected this rule e. HYPO: suppose court finds that Harman was liable ab initio; can the court find he isnt liable any more? i. Substitution of a party: corporation would take place of Harman once it comes into existence; technically called adoption a. No magic words have to be used b. Can be implied by conduct which is consistent with a desire to adopt or ratify the contract ii. Evidence of adoption here: company paid Carton as soon as it was created iii. But, this doesnt get Harman off the hook for the bonus which the company cant pay a. Just b/c a new corporation adopts a contract doesnt mean the promoter is released from liability b. The new corporation and promoter are jointly and severally liable c. RULE: acceptance of partial performance by a third party doesnt excuse the obligor from the rest of the contract d. To find that the promoter is not liable at all, you have to find not just an adoption, but a novation 31

32 i. For a novation, you must have consent of both sides ii. Here, its hard to find that Carton consented to a novation just b/v she accepted the salary payments iv. Even if Harman isnt liable on the written contract, could argue that he implicitly promised to use his best efforts to bring the corporation into existence f. Planning Lessons i. Incorporate first ii. Make an agreement that youre personally bound, but when the corporation comes into existence, then youll be released from your obligations iii. If you want to make sure that the person signing the contract isnt personally liable, put by Joe and indicate the corporate status by adding Inc., etc. 6. Pre-incorporation Liabilities a. If you go from an unincorporated entity (like a partnership) especially when the sole proprietors are liable into some limited liability form, what happens to the old debts? b. Youd have to run through this novation/adoption analysis c. In your earlier loans, you never said you were a corporation, but if you start paying your bills as a corporation, do your lenders consent to novation for the original debts? 7. CASE STUDY: First Safety Fund National Bank v. Friel (Ma. 1987) a. Friel, with no business experience, became president of company her husband founded in name only; brother-in-law operated business; told to sign something; company defaulted and bank sued her personally; said she didnt intend to sign loan personally b. HOLDING: court still held her liable; ignorance of the law is no excuse; she could only prevail if she could show that the bank didnt intend that she be personally liable; bank guarantees are common, so bank didnt have any reason to assume she was nave 8. Limited Purpose Clauses a. Doctrine of ultra vires (outside the powers) i. Used to avoid corporation liability when an individual acts outside the stated powers of the corporation or beyond its purposes a. Classic doctrine applied to 2 sitchs: whether corp had acted beyond its purposes not permitted in a certificate; whether corp had exercised the power not specified in certificate. b. Common probs include: power of corp to guarantee a 3rd party debt, pwr of corp to be a general pwr, 3rd persons caught by surprise b/c they didnt check the limits on charter purposes. ii. Corp regarded as a fictitious person, w/ life and capacity insofar as provided in its charter. b. If theres something you want to do that isnt allowed under corporations purpose clause, then you could seek an amendment to charter i. DE 242(b)(1): board of directors will adopt a resolution setting forth amendment, AND then majority of stockholders must vote for it ii. OH Sec. 1701.71(A)(1): just need 2/3 of shareholders to vote for amendment c. Solution to the ultra vires doctrine i. DE 124 and OH 1701.13(h): no act of a corporation shall be invalid because the corporation was without power to do such act, but such lack of capacity can be asserted a. In a suit by a stockholder against the corporation to enjoin the doing of an act b. In a proceeding by the corporation against an incumbent or former officer or director for damages due to his unauthorized act c. In a proceeding by the Attorney General to dissolve the corporation or to enjoin it from the transaction

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33 9. Doctrine of Implied or Incidental Powers a. DE 121(a): every corp, its officers shall possess powers incidental to the corp so far as they are necessary or convenient to the conduct promotion or attainment of the business or purposes set forth in the charter b. OH Sec. 1701.04(B)2: corp may do all things permitted by law and exercise all authority w/in the purposes stated w/in its articles or incidental to its articles c. CASE STUDY: Jacksonville, Mayport, Pablo Ry. & Navigation Co. v. Hooper (p. 123) i. HOLDING: A Florida company whose purpose, under its charter, was to run a railroad, could also engage in leasing and running a resort hotel ii. RULE: business can also enter into and engage in transactions which are auxiliary or incidental to its main business IV. Powers of Management and Shareholders A. Removal of Directors 1. Removal W/o Cause: OH allows too. DE 141(K): any director or the entire board of directors may be removed w/ or w/o cause, by holders of a majority of the shares then entitled to vote at an election of directors. Except where the certificate provides otherwise; certificate provides that in the case of staggered board SH may affect such removal for cause; or where there is cumulative voting if less than the entire board is to be removed, no director may be removed w/o cause if the votes cast against such directors removal would be sufficient to elect such director. a. OH 1701.58(C): If SH can vote cumulatively, then unless articles say otherwise SH can remove all directors w/o cause by a majority vote unless all directors or all directors in a particular class are removed. No individual director shall be removed if votes are of sufficient number of shares are cast against his removal, that if cumulatively voted, would have been enough to elect at least 1 director. 2. Removal by Shareholders: SH can remove a director w/ cause, even in the absence of a statute that so provides. However SH cant remove director w/o cause in the absence of specific authority to do so under statute, the cert of incorp, or bylaws. 3. Removal by the Board: in the absence of statute, board cant remove director w/ or w/o cause a. OH 1701.58(B): directors may remove director if he is of unsound mind, bankrupt, or does not accept his election w/in 60 days, or ceases to hold required qualifications 4. Removal by Court: split decisions usu require a certain percentage or SH to petition the removal, some cts have pwrs in cases of fraud or dishonesty. B. Creating or Filling New Directorships 1. SH approval required to create new directorships b/c requires an amendment of charter or by laws. 2. If director steps down, board can fill it 3. DE 223(a) vacancies and newly created directorships may be filled by a majority of directors in office at that time. Vacancy exists if SH create new directorship and dont fill it. 4. OH 1701.58(F) when a vacancy exists, remaining directors may fill vacancy in board for unexpired term. Also if SH create new and fail to fill. 5. Directors fill vacancies and SH create new directorships C. Power to Act 1. DE Sec. 141(a) and OH Sec. 1701.59(a): generally, the board of directors has the power to act for the corporation 2. Usually, shareholder approval isnt need for the corporation to take action 3. CASE STUDY: People ex rel. Manice v. Power (p. 164) a. The powers of the board of directors are original and undelegated; they have a duty tot act for the corporation according to their own best judgment and cannot be controlled in the exercise of such duty b. GENERAL RULE: stockholders cannot act in relation to the ordinary business of the corporation nor can they control the directors in the exercise of their judgment 33

34 4. Formalities required for action of the board (p. 207-208) a. Directors must act at a duly convened meeting at which a quorum is present b. Formal notice isnt required for a regular board meeting, but it is required for a special meeting (date, time, place must be given to every director) c. Quorum is a majority of the full board, but can be as low as 1/3 in DE d. Affirmative vote of majority of those present required for action 5. Informal Board Approval a. Old rule was that informal board approval was ineffective, even if explicit and unanimous b. Absent a statute on point, as a matter of common law, the trend is to uphold informal board approval at least where it is unanimous and explicit, especially where a third party has relied c. OH 1701.54 and DE 141(f)-action w/o members being present if all members consent in writing d. DE 141(i)-telephone participation is OK e. DE 229-Waiver of notice will be deemed = to notice. 6. Matters on which statutes usually require shareholder vote (p. 216-217) a. Amendment of charter or bylaws b. Certain organic changes (mergers, etc.) c. Authorization of stock 7. Matters that dont require shareholder approval a. Changing nature of business b. Tearing down facilities c. Firing all of your American employees and moving everything overseas d. Changing the companys structure to one heavily leveraged on debt e. IMPORTANT: DOES NOT say anywhere that extraordinary or important acts cant be taken without shareholder approval 8. Situations in which shareholders can act on their own a. In many states, shareholders can amend the bylaws without a board vote b. But, even then, their power is irrelevant unless they can convene a shareholders meeting or some other forum to act, and in many states, they cant convene a special shareholders meeting, so theyll have to wait until the next annual meeting, which may be too late 9. Most states require corporation to convene an annual shareholders meeting; anything else is a special shareholders meeting a. DE 211(d): absent a charter or bylaw provisions, only the board can call a special meeting b. COMPARE: Ohio 1701.40(a)(3): chairman, officers and also holders of 25% of the shares (doesnt have to be one shareholders; just enough holders to amount to 25%) to call the special meeting 10. Vacancies: incumbent board members can fill a vacancy on board DE Sec. 223(a) and Ohio 1701.58(f) 11. PROBLEM #6(a)(1): Harman Corporation has become public, with over 1,000 shareholders; Jones has just purchased a 5% interest, making her the largest stockholder in company; Jones wants a place on the board, could the directors comply? a. If theres a vacant office, yes b. If theres no vacant office, the general rule is no; the board cant increase the number of directorships c. Of course, an incumbent director could always give up his seat, creating a vacancy that can be filled by the other directors d. Dont have automatic right as a holder of the majority of the stock to get a seat on the board e. All Jones can do is wait until the next annual meeting and wage a proxy fight D. Committees of Board and Delegation 1. In practice, boards of large public companies do much of their business by committee 2. In general, the board cant delegate its authority to someone else 34

35 3. All modern statutes, including DE 141 and OH 1701.54, permit the board of directors to create committees and to delegate to committees any power of the full board except a few which are specifically required by statute to be handled by full board a. In DE, committees cannot have the power to amend the certificate of incorporation, adopt an agreement of merger or consolidation, etc. 4. Pretty clear that the full board has an inherent, non-waivable power at all times to overrule the committee E. Authority of the Corporate Officers 1. Every employee of the corporation is an agent; scope of authority is determined by agency law 2. Generally, state statues dont mention the authority of corporate officers, except for corporate secretaries a. State statutes typically provide that every corporation will have as secretary with the authority to certify corporate documents for third parties b. DE 142(a) and OH 1701.64: corporation shall have such officers, etc., but neither say what the authority the officers have i. DE 142 does say one shall have the duty to record the proceedings of the meetings of SH and directors ii. OH 1701.64 says it will have a president, secretary, treasuer, and if desired a chairman of the board, vice presidents, and whatever else they want. iii. President: modern rule says prez has apparent authority to bind the company to K in the usual and regular course of business but not in K of extraordinary nature. Actual authority would be found in certificate, bylaws or board resolutions, board acquiescences or board ratification c. DE 142(a): each officer will have such duties as stated in the bylaws or in a resolution of the board 3. Resolutions of the board are contained in the minutes of their meetings a. If you want to know if these are authentic, go to secretary of corporation i. CASE STUDY: In re Drive-In Development Corp. (p. 213-314) a. HOLDING: Drive-In was estopped from denying Maranz express authority to sign the guaranty b/c a certified copy of a resolution of Drive-Ins board purporting to grant such authority was furnished to the bank by the secretary, whether or not such a resolution was in fact formally adopted b. Resolutions of the board may or may not say anything about the authority of officers; most often, youre going to have to look elsewhere for authority 4. Other places to look for actual authority of officers a. Look to prior dealings for implied actual authority: authority implied from manifestations from principal to agent inferred from words, customs, and relations of parties b. If theres no actual authority, there might be apparent authority: manifestations of principal to third party c. Ratification: where corporation would know of material facts and later approves of officers act; there is ratification if corporation engages in conduct that is justifiable only if he has such an intention (p. 15) d. Acquiescence of the board too e. Statutes, charter, bylaws and board resolutions also a source for authority 5. PROBLEM 10: Gilberte has been offered a position as delivery department manager of Guermantes, a large department store; the VP has agreed to give her a 3-year contract; does he have the authority to bind Guermantes to a 3-year contract? a. Positional authority: by putting VP in his position corporation implies that she has the authority (actual and apparent) thats customary, typical and usual for VP to have b. Case law on apparent authority of VPs is sparse (p. 213, note 4) c. Board may have ratified VPs act by paying Gilberte for a full year, but it could only ratify the behavior if it knew of the long term contract 35

36 d. If the client cant show ratification, she could go after the VP personally b/c a person who purports to be acting on behalf of a principal, but doesnt have actual authority, is personally bound; good faith wouldnt be enough to get him off the hook e. Finally, Gilberte could try to make an unjust enrichment argument if, for example, she worked for three months and hadnt been paid 6. Side note: directors probably arent very independent from CEO F. Cumulative Voting 1. Generally, candidates to become a director dont run for particular seats; voting is at-large a. So, for three open seats, the three highest vote totals win b. Occasionally, where the board is classified, one seat will be selected by class A, one seat by class B, etc. 2. Cert of Incorp states type of voting and must affirmatively state Cumulative Voting to have it 3. Mandatory cumulative voting: board can have classified board where each class serves for a term of years. Minority then must hold more stock to elect a single director than I fa board the same size was unclassified. 4. Comparison a. In non-cumulative voting, when electing directors, each shareholder casts a number of votes equal to the number of share he owns for EACH open seat on the board b. In cumulative voting, each person can cumulate their votes and cast them for a single candidate or otherwise pool them however she wants, and minority can influence voting c. NONCUMULATIVE You Me
A B C 51 49 51 49 51 49 153 147 Under cumulative, you have 153 votes and you can spread them how you like and the minority with 147 can elect at least one director. CUMULATIVE You Me A 77 0 B 76 0 C 0 147 153 147

5. DE 214: default is straight, non-cumulative voting 6. OH 1701.55: default rule is cumulative voting. OH 1701.69(b)(10) says that can be changed by amendment but 1701.04(C) says cant in the original articles of incorp. 7. Purpose of Cumulative Voting a. Protects minority shareholders by increasing the possibility that a minority of shareholders will get representation on the board b. In non-cumulative voting, the majority can elect all of the directors c. In cumulative voting, the minority will pool all of his votes for the candidate he really wants G. Straight Voting 1. SH can cast a number of shares equal to their ownership for each candidate. 2. Minority can never elect a director to the board over majority opposition. H. Classified or Staggered Board 1. Different classes of stock a. DE 141(d): board can be divided into 1, 2 or 3 classes if in the charter b. OH 1701.57(B)(1): if in the charter, board can be 2 or 3 classes but of not less than 3 directors each 2. Usu entire board elected annually (not staggered) 3. CAVEAT: possible to have different classes of stock each voting for separate director seats, but thats not whats meant by the classified board 36

37 4. Staggered Board: In a staggered board, not all of the directors are up for election at the same time. if the charter says nothing, the corporation doesnt have a staggered board. a staggered board can be permitted in the charter or regulations (bylaws) 5. Purpose of the Staggered Board a. Maintains stability of leadership i. Dont have to have a newly elected body each time ii. Seems silly b/c most boards are reelected every year; Dent thinks this argument is crap b. To slow down or prevent a hostile take over i. If someone comes along and gets the majority of the stock, now they have to not only wait until the next shareholder meeting, but even then they can only elect 1/3 of the directors c. A classified board dilutes cumulative voting i. With a staggered board, youll need a larger number of votes to go toward one individual candidate to assure theyre get voted on 6. Downside of staggering voting is that its less democratic I. Formalities Required for Shareholder Meetings 1. SH approval required for corp action: 1) ordinary matters at SH meeting (majority), 2) fundamental changes which include amendments, merger, sale of substantially all assets, dissolution (2/3 vote), and 3) election of directors (plurality) a. SH approval not required unless statute reqs it. Usu election/removal of directors and an amendment of charter/by laws do req SH approval 2. action can be taken w/o meeting if consent provided. DE 228 3. Who can call a Meeting of SH a. OH 1701.40(A)(3): Chairman of board, Prez, board of directors, owner of 25% of shares unless articles/regs specify a larger/smaller proportion but not above 50%, others specified in articles/regs b. DE 211: Board of directors, others authorized by certificate of incorp or by laws. c. Annual Meetings i. DE 211: place, date and time of SH meeting can be designated by by laws. If not held, ct may order on request of SH director. Can also be done solely by means of remote communication ii. OH 1701.39: annual meeting of SH for election of directors must be held on date designated in articles/regs. Or if none designated, on the 1st Monday of the 4th month following the fiscal year of the corp. d. Sometimes SH can act on their own. DE 109(a)-(b) and OH 1701.11(A) by amending by laws (but board has to approve SH convening) 4. Notice: DE 222 a. When SH are permitted/ required to vote, written notice shall be provided, and shall not be less than 10 and no more than 60 days in advance unless otherwise provided. When meeting adjourned, notice need not be given at the meeting unless it takes place more than 30 days later. 5. Record date: date at which it is determined whether you are eligible to vote at a shareholders meeting a. Date set by board within boundaries established by statute i. DE 213-board fixes date for determining who is entitled to notice, who may consent and who is entitled to receive dividends/distributions b. Usually, statute will say that record date should be fixed by board and be not less than 30 and no more than 60 days before date of meeting c. Someone who buys shares between record date and meeting still has some rights i. Some courts say that record holder holds voting rights as trustee for new owner and she may be compelled to vote as instructed by new owner 37

38 ii. Of course, this assumes that you know the person from whom you purchased your stock, which wouldnt be the case if you bought it on a national exchange 6. Quorum: number of shares, NOT shareholders, necessary for the transaction of any business a. If someone has a majority of the shares and they show up, it might be a quorum b. DE 216: general rule is a majority of shares serves as a quorum, though charter can fix number as low as 1/3 i. in all matters other than the election of directors, affirmative vote of majority of shares present and entitled to vote = act of SH ii. Directors shall be elected by a plurality (ie greatest proportion of votes) c. Inability to muster a quorum doesnt prevent all shareholder action forever i. DE 211(c): allows court to order special meeting without quorum ii. Some courts have held meeting valid where a shareholder consistently refused to show up to constitute a quorum; though, shareholder will claim unclean hands of other shareholders for causing the problem in the first place d. OH 1701.51: no quorum requirement unless required under articles or regulations e. Once you have a quorum, if the number of shares present later declines, then you still have a valid meeting J. PROBLEM #5: Harman owns 25% of stock in Harman Corporation and has controlled board for years; shareholders approved a bylaw (in Ohio, regulation) fixing number of directors at 9, divided into 3 classes whose terms expire in successive years; shareholders then elected 9 directors, all of whom were loyal to Harman; a month later, Jones purchases 51% of corporations stock; how can she assume control of board? 1. Answer in Ohio a. OH 1701.58(c): any individual director can be removed without assigning a cause i. Majority is enough to remove all of the directors ii. Cannot use selected removal of directors to defeat minoritys inability to elect a director under cumulative voting, but if you want to remove the whole board, thats okay b. OH 1701.55C-D and .69 B 10: OH companies have cumulative voting unless charter says otherwise. In .58C there is a provision barring a removal if the votes against removal would suffice to elect him. But Jones can still remove b/c provision only applies to removal of less than whole board. c. OH 1701.40(a)(3): holders of more than 25% of the shares can call a special meeting i. At the special meeting, she can remove the entire board ii. Then, all of the seats would be vacant, so she would hold an election for the new board iii. With a majority of the shares, she can elect all of the directors; with cumulative voting, only a majority, not all of them d. OH 1701.71(a)(1): to amend the charter, you need 2/3 vote of shareholders i. She couldnt amend the bylaws on her own at a special meeting b/c she doesnt have the 2/3 shares required e. OH 1701.11(a): just need a majority of the shares to amend the regulations i. So, she could amend the regulations (bylaws) f. But, even if Jones does call a special meeting, she has to call a record date 30-60 days before the meeting, and the board can act in that time g. TRICK QUESTION: danger for someone in Jones position is that board will get word of her plans for a special meeting and decide to sell more shares of stock; can the board do this without shareholder approval? i. Yes, the board can do it ii. The board can do whatever it wants unless the statute says it needs shareholder approval iii. The issuance of shares doesnt require shareholder approval unless they need to amend the charter to do so iv. So, youd have to look at how many shares are authorized in the charter and whether board is trying to exceed that limit 38

39 h. OH 1701.54: shareholders can only act without a meeting with unanimous consent 2. Answer in DE a. DE 141(d): staggered board is okay if its in charter or bylaws; not default b. DE 141(k)(ii): if its a staggered board, shareholders can only remove a director for cause i. REASONING: cant use removal without cause to defeat cumulative voting ii. If the minority has enough votes to elect someone, they should also have enough votes to prevent that persons removal iii. But, if you want to remove the entire board, you can do that b/c that just leads to a new election and the minority will have the same ability to elect the same number of seas as it would otherwise c. DE 231(b)(1): to amend the charter, first you need a resolution of the board, then a majority of the shareholder vote i. If theres hostility between Jones and incumbent board, its obviously not going to take the steps to remove itself from power d. Shareholders can amend the bylaws by a majority vote e. DE 211(b): special meetings can only be called by the board i. The board isnt going to call a meeting to permit Jones to oust them f. DE 228(a): shareholders can act without meeting by consent of vote sufficient to act i. So, Jones doesnt have to wait for the board to convene a special meeting g. If Jones creates more seats on the board, can she fill those seats? i. DE 223(a): directors get to fill newly created directorships unless bylaws say otherwise ii. So, Jones will also have to amend the bylaws to provide that newly created directorships will be filled by shareholders, not by incumbent directors iii. Then, Jones can fill the newly created seats with her nominees and take control of the board; she can hold a directors meeting right away and assert control of the company h. What did Harmans lawyers do wrong? i. He shouldve staggered the board a. Purpose of staggering the board is to prevent a hostile take over, but nothing in the statute says Jones still cant come in with a special meeting and remove all of the directors without cause b. But, theres a sense with a staggered board that directors are on there for a term, which cant be shortened, but its not clear c. Need a 2/3 vote to amend the charter to get rid of the staggered board provision d. Assume 3 directors are up for election each year on staggered board i. In OH, the default rule is cumulative voting, so Jones wouldnt be able to elect all 3 directors ii. The first year, Jones gets 2 and Harman will get 1 iii. By the second election, shell have 4/9 directors, but thats not a majority iv. Jones cant get control until the third annual meeting with a majority of the directors e. In DE, if you have a staggered board, Jones will have a majority of the board by the second election b/c the default rule is straight voting ii. Maybe Harman couldve put provision in charter to prohibit removal of directors without cause a. Need a 2/3 vote to amend charter; maybe Harman wouldve been able to get 2/3 iii. OH 1701.52: charter can have a supermajority clause a. Maybe Harman couldve stuck into the charter that 1) no removal without cause, 2) this provision cant be removed except by an 80% vote b. Since Harman has 25% of stock, this would give him a veto against change, but hed still have to get the original 2/3 to make the change at all 39

40 iv. In DE, Harman could fix the number of directorships in the charter; Jones couldnt change that number since she cant amend the charter, only the bylaws; charter controls over bylaws K. Disregard of the Corporate Entity / Piercing the Corporate Veil 1. General rule is limited liability a. But, limited liability is a misnomer b/c shareholders generally have no liability b. If the company goes bankrupt, the shareholders just lose their investment, but they arent liable for the debts of the company 2. EXCEPTION: disregard of the corporate fiction or piercing eh corporate veil; Ps trying to hold shareholder liable a. certificate may contain provision for imposing SH liability for corp debt DE 102(b)(6) 3. Piercing the Corporate Veil Doctrine (P has burden of showing this 2 part test is met) a. Unity of interest and ownership so that personalities of individual and corp not separate i. Failure to maintain adequate corp. records or to comply with corp formalities ii. Commingling of funds or assets iii. Undercapitalization iv. One corp treating the assets of another corp as its own b. Accepting corps separate existence would sanction fraud or injustice c. 3 Kinds of Piercing i. Alter Ego: P sues corp, and can pierce to get to SH. Can also be sues subsidiary gets at parent ii. Reverse Piercing: SH has many corps of diff kinds but operates out of one office. P sued one corp and SH, still could get to other corps. Sealand. iii. Enterprise: SH owns many same corps. P sues 1 and SH, can get at all the corps. Taxicab D. SEALAND SERVICES INC V. PEPPER SOURCE i. Facts: P an ocean carrier carries freight for Pepper Source. Pepper Source never paid freight bill b/c it had no funds at the time the bill was due. PS owned by Marchese, who owned 5 other entities. P sues Marchese and the 5 other entities. ii. Holding: Corp entity will be disregarded and veil pierced when 2 reqs met: a. Unity of ownership so no separate personalities (see above for factors) b. AND circs must be such adherence to fiction of separate corp existence would sanction a fraud or promote injustice (Van Dorn test) iii. Reasoning: Corps all pretty much run by Marchese. Same office, phone, expense accts and monies passed b/w all the corps pretty freely. 4. Question of whether to pierce corporate veil is a mixed issue of law and fact, so appellate courts will often give deference to trial courts findings 5. When do issues of piercing the corporate veil come up? a. First, you have to have a business fail, which happens all of the time b. Usually, when business fails, its because they dont have enough money c. When the creditor cant get their money from the corporation, they will try to get it from the shareholders d. Litigation is expensive, so not all of the creditors will end up suing, especially if amount sought is too small 6. Double Piercing a. Hollowell v. Orleans Regional Hospital i. Facts: Hospital an LLC under LA law and was operated by a partnership. P sued for violation of the Warn Act, requiring notice of layoffs. Looked to hold SH liable. ii. Holding: individual may not be held directly liable for Warn Act violation iii. Reasoning: double piercing involved. Veil pierced once to get SH, which here is a corp. but if corp bankrupt, must pierce the veil again to get corps individual SH. 40

41 a. Alter Ego critera: 1) failure to maintain adequate corp records, 2) failure to comply w/ corp formalities 3) commingling of funds or assets 4) under capitalization 5) failure o hold regular SH or director meetings. 7. Issues to consider in deciding to pierce the corporate veil a. Tort claim vs. contract claim i. Some argue that courts should be more willing to pierce corporate veil with tort claims b/c contract liability are entered into voluntarily and parties can contract around potential piercing of corporate veil ii. But, courts are on a percentage basis more likely to pierce corporate veil in contract case (p. 248) iii. Breach of contract cases: certain types of contract creditors who are capable of protecting themselves by reasonable credit investigation will be deemed to have assumed the risk of gross undercapitalization so no piercing the veil (Kinney Shoe v. Polan) b. Disregard of corporate separateness? i. Dont want commingling of funds; in small corporations this happens b/c corporate separateness isnt observed ii. Should it matter if a little mom and pop didnt observe formalities? iii. If you fail to disclose that youre acting on behalf of a corporation when dealing with a third party, you will be held liable under agency principles (discussed above) c. Parent/subsidiary issues i. Corporations set up wholly-owned subsidiaries (rather than divisions) all of the time to shield themselves from liability ii. General principle of corp law that parent corp not liable for acts of its subsidiaries. Nothing in the statute bars a parent from direct liability for its own actions in operating a facility owned by its subsidiary. The fact that a corporate subsidiary happens to own a polluting facility operated by its parent does nothing, then, to displace the rule that the parent corporation is itself responsible for the wrongs committed by its agents in the course of business. iii. Should it matter if the shareholder is a corporation rather than an individual? a. Some say yes; point of limited liability is to protect individuals who are risk averse, not corporations who are theoretically risk neutral b. On the other hand, if an individual can set up a corporation an have limited liability, why cant a corporation do the same? iv. Parent is liable w/o piercing the subsidiarys veil on the ground that the parent directed the subsidiarys operation or some relevant portion of those operations and is therefore directly liable as a primary wrongdoer for wrongs hat were committed in the course of those operations (US v. Best Foods) a. It is entirely appropriate for directors of a parent corp to serve as directors of its subsidiary and that fact alone may not prove that the parent directed the subsidiarys operations and therefore liability for its acts. b. Critical Q is whether in a degree of detail action directed to the facility by and agents of the parent alone are eccentric under accepted norms of parental oversight of a subsidiarys facility? (US v. Best Foods) 8. Benefits of Limited Liability a. What is the purpose of limited liability? i. In public companies, stockholders dont have to worry about selling someone their stock b/c they have limited liability ii. In small corporations, people will worry about who theyll be able to sell their stock rule b. People wont invest in a corporation unless there limited liability c. Moral hazard problems 41

42 i. If youre in a partnership engaged in dangerous work, you want insurance ii. If youre in a corporation involved in dangerous work, you dont need insurance; if something goes wrong, you can just declare bankruptcy and then the P cant go after you personally 9. CASE STUDY: Walkovszky v. Carlton a. P was injured when he was run down by cab owned by D Seon Cab Corporation; Carlton is a stockholder in 10 corporations, including Seon, which only owned 2 cabs each (dividing up assets); P argues that he can hold stockholders personally liable b/c multiple corporate structures constitutes an unlawful attempt to defraud members of the general public who might be injured by cabs b. HOLDING: The plaintiff relied on fraud not agency and because there is no fraud in this case and defendant prevails. While the law permits the incorporation of a business for the purpose of minimizing personal liability, this privilege can be abused. The corporate form may not be disregarded simply because the assets of the corporation together with liability insurance are insufficient to ensure recovery. It is not fraudulent for the owner of a single cab company to take out no more than the minimum insurance. c. RULE (most broad): courts will disregard the corporate form, or pierce the corporate veil, whenever necessary to prevent fraud or to achieve equity d. RULE: In determining whether liability should be extended to reach assets beyond those belonging to the corporation, court is guided by general rules of agency i. Is the shareholder making the corporation his agent? ii. Whenever anyone uses control of the corporation to further his own rather than the corporations business, he will be liable for the corporations acts upon the principle of respondeat superior applicable even where the agent is a natural person iii. Such liability extends not only to the corporations commercial dealings, but to its negligent acts as well 10. CASE STUDY: Minton v. Cavaney a. Seminole Hot Springs Corp. ran a public swimming pool it leased; Ps daughter downed in the pool; trying to hold Cavaney, who was a director, secretary, treasurer, and attorney for Seminole, personally liable; Cavaneys office was used to keep records and receive mail; Seminole had no assets and never functioned as a corporation b. Issue: Where person participates in a corp affairs and evidence shows him to be an equitable owner in such a company may that person be held personally liable for the corps debt where he knows its undercapitalized? c. HOLDING: D cant be held personally liable for debts of Seminole without an opportunity to re-litigate issues since he wasnt a party to action against corporation d. RULE: Equitable owners of a corp. are personally liable i. When they treat the assets of the corporation as their own and add or withdraw capital from the corp. at will ii. When they hold themselves out as being personally liable for the debts of the corp., or iii. When they provide inadequate capitalization and actively participate in the conduct of corporate affairs e. REASONING: no attempt to provide adequate capitalization; inference that Cavaney was an equitable owner b/c he was to receive 1/3 of shares to be issued; evidence that he actively participated in conduct of business since; cant divorce responsibility of director from statutory duties and powers of that office f. Arnolde v. Browne: evidence of inadequate capitalization is only a factor though g. Radaszewski v. Telecom: creation of undercapitalized subsidiary justifies an inference that the parent is either deliberately or recklessly creating a business that will not be able to pay its bills or satisfy judgments against it. 42

43 i. P must show that Ds control of a subsidiary has been used by D to commit fraud, wrong, perpetuate the violation of statutory or other positive legal duty, or dishonest and unjust act in contravention of Ps rights. 11. PROBLEM #4: Harman Corporation organized PK Corporation to manufacture plastic containers; invested $10,000 in capital stock of PK; president of PK was a former employee of Harman; PKs board was made up of Harman officers; same accounting system and purchasing and sales methods in both companies; profits were distributed as dividends to Harman; PK obtained loans through Harman in exchange for mortgage on plant which equaled amount of dividends distributed; explosion at PK killed people, but PK doesnt have enough to cover liability; can victims hold Harman Corporation liable? a. Ps arguments i. Court should adopt Walkovszky standard (most broad): pierce corporate veil whenever necessary to achieve equity ii. Shareholder here is dominating and control to the point where it becomes the principal and PK the agent iii. Inadequate capitalization b/c PK only had $10,000 iv. D was unjustly enriched b/c it took profits as dividends v. Took money from PK and gave it to Harman, and then took money from Harman and gave it to PK; why were they doing this? a. Harman claimed PKs profits as dividends b/c it was a shareholder b. Then, it turned around and made a loan; became a creditor c. If PK goes belly up, creditors get paid firstcalled line jumping d. Harman shouldnt be allowed to do this b. Ds arguments i. Would argue for narrowest standards for piercing the corporate veil ii. Emphasize that piercing is the rare exception in only the most extreme cases; general rule is limited liability iii. Who would you expect to control a corporation but a majority or sole shareholder; isnt it ridiculous to say were going to pierce the corporate veil just b/c of control? iv. $10,000 isnt inadequate capitalization a. If you dont have more than $10,000, you shouldnt be prevented from incorporating b. Whole idea of liberal incorporation laws it that benefit of limited liability shouldnt be restricted to rich c. If the state legislature wanted minimum levels of capitalization, it wouldnt said so in statute v. Inadequate capitalization is just one factor a. Not enough to show that company couldnt pay its debts to prove inadequate capitalization b. Purpose of limited liability is to avoid liability when company cant pay its debts c. If you say every time the company cant pay their debts, theres inadequate capitalization, and were going to pierce the corporate veil, then theres really no limited liability at all vi. Mere fact of enrichment isnt determinative b/c purpose of buying stock in a corporation is to make a profit vii. D didnt know there was going to be an explosion; just a freak accident viii. PK is paying dividends and borrowing money roughly at the same time a. Corporations do that all of the time b. Harman was just a nice guy and loaned money to his own subsidiary rather than going to a third party lender 43

44 12. Inadequate Capitalization a. CASE STUDY: Slottow Fidelity Federal Bank v. American Casualty Co. (p. 241) i. HOLDING: initial capitalization of $500,000 was woefully inadequate for a corporation that handled trust agreements (banking) of magnitude involved here; investors claimed damages in range of $10,000,000 and case settled for nearly half that ii. RULE: under CA law, inadequate capitalization of a subsidiary may alone be basis for holding that parent corporation is liable for acts of subsidiary b. CASE STUDY: OHazza v. Executive Credit (Va. 1993) i. Company had $100,000 in loans from creditor and $10,000 in equity ii. HOLDING: $10,000 in equity was adequate capitalization as a matter of law c. But Truckweld Equipment Co v. Olson says corp stockholders dont have to commit additional funds to already faltering corp. 13. Piercing the Corporate Veil of LLCs a. CASE STUDY: Kaycee Land and Livestock v. Flahive i. P entered into a contract with Flahive Oil & Gas LLC allowing it to use the surface of its real property; P alleges that company caused environmental contamination of property; P seeking to pierce LLC veil and hold Roger Flahive individually liable ii. HOLDING: no reasons for treating an LLC differently than a corporation when considering whether to disregard legal entity; equitable remedy of piercing veil is available under WY LLC Act; district court must complete a fact intensive iii. RULE: Circumstances under which corporate veil would be pierced pursuant to WY law a. There is such a unity of interest and ownership that the individuality, or separateness, of such person and corporation has ceased, and b. Facts are such that adherence to the fiction of the separate existence of the corporation would, under the particular circumstances, sanction of fraud or promote injustice iv. Factors to be considered in determining whether to pierce the veil a. Commingling of funds, failure to segregate funds, treatment by an individual of the assets of the corporation as his own, etc. b. Failure to observe legal formalities c. Failure to adequately capitalize corporation, absence of corporation assets, etc. d. But, factors which would justify piercing an LLC veil wont be identical to corporate situation b/c many of the organizational formalities in a corporation dont apply to an LLC (e.g., might have to distinguish between manager-managed LLC and member-managed LLC) 14. Equitable Subordination a. Alternative to piercing the corporate veil i. Much less drastic, simply takes an investment already made, and denies it the status of a creditors claim on a parity with outside creditors, whereas imposing liability for corp debts undermines the essential premise of limited liability: that SH risk limited to investment b. Arises in a different context than piercing the corporate veil i. In a piercing action, you decide to sue the shareholders in state court, claiming they owe you money and theyre not a different person than the corporation ii. Subordination arises in the context of bankruptcy or receivership a. The claim of controlling SH may be subordinated to the claims of others, including the claims of preferred SH, on various equitable grounds i. Subordinated creditors claim not invalidated, they are still a creditor, but they must step to the back fo the line b. Only occurs when company is insolvent or bankrupt and cant pay its debts 44

45 c. Common law doctrine now codified in bankruptcy code d. Benjamin v. Diamond: i. Claimant must have engaged in some type of inequitable conduct ii. Misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant iii. Equitable subordination of the claim must not be inconsistent w/ the provisions of the bankruptcy act iv. Three principles must be kept in mind: a. (1) inequitable conduct directed against the bankrupt or its creditors may be sufficient to warrant subordination of a claim irrespective of whether it was related to the acquisition or assertion of that claim b. (2) claims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct. c. (3) regarding the allocation of the burden of proof: an objection resting on equitable grounds cannot be merely formal but rather must contain some substantial factual basis to support its allegation of impropriety. e. HYPO: PK has a plant worth $4 million; $3 million is due on Harmans loan; victims have a $6 million tort judgment against PK i. If nothing is done, as a creditor, Harman will get $3 million from PK and the victims would get the remaining $1 million ii. If the court orders equitable subordination, then the victims would get the $4 million from PK, and nothing would be left for Harman f. What is the standard or test for equitable subordination? i. Achieving equity ii. Unjust enrichment iii. Similar to phrases court uses when talking about piercing the corporate veil iv. Much easier to get equitable subordination than to pierce the corporate veil b/c its a much milder remedy; shareholder isnt liable, just has to stand at end of line 15. How would you plan the capitalization of a corporate client considering the doctrines of equitable subordination and piercing the corporate veil if all or some of the shareholders hold debt in the corporation? a. Company has to be adequately capitalized b. E.g., company is capitalized with $300,000; three shareholders each put $100,000 into corporation$1 for stock and $99,999 in form of loan i. Equitable Subordination a. Phony capital structure; put themselves in the front of the line b. Worse than the Harman example b/c Harman at least put some equity and never reduced it below that amount; here, theyre only starting with $3 in equity c. Still not too big of a deal b/c equitable subordination just puts them in the back of the line where they belong ii. Piercing the Corporate Veil a. If the court finds that theres inadequate capitalization all around, it might pierce the corporate veil, which is more serious b/c shareholders could be held liable b. But, inadequate capitalization is just one factor; have to look at other factors c. N.B. A court will look more askance at a capital structure that includes shareholders holding debts if each has debt and equity in same proportions (?) 16. Caveats a. Dont start talking about piercing the corporate veil when you dont need to i. If a corporation can pay its debts, theres no reason to talk about piercing the corporate veil ii. The purpose of the doctrine isnt to punish someone 45

46 b. Dont start talking about equitable subordination unless you need to i. Equitable subordination only applies if a shareholder is also a creditor of the corporation ii. In other words, there needs to be a claim to subordinate 17. Uniform Fraudulent Transfer Act (supp. p. 1234) a. UFTA, Sec. 4: a transfer is fraudulent if it was made i. With actual intent to hinder, delay, or defraud creditor, OR ii. Without receiving a reasonably equivalent value in exchange, and the debtor a. Was engaged in a business for which the remaining assets of the debtor were unreasonably small (i.e., undercapitalization), OR b. Incurred debts which she shouldve known were beyond her ability to pay b. E.g., transfer to Katrina victims would be a transfer without reasonably equivalent value, so transfer could be set aside under UFTA if at the time you were engaged in business for which your remaining assets were unreasonably small i. Very vague standards ii. There are lots of small corporations whose assets are unreasonably small for the business theyre engaged in iii. You might think your company can make $100,000 gift to Katrina victims and still be able to pay your debts, but if you cant, people are going to claim that you shouldve known this could happen c. CAVEAT: as long as you can pay your debts, the UFTA doesnt come up Close Corporations A. Side note: OH 1701.591 and DE subchapter 14 (Sec. 341-350) apply only to close corporations, but most of the devices well talk about can also be used, and are often used, in public corporations as well B. DE 342 is much more specific on requirements to be considered a close corporation 1. No public offering 2. No more than 30 shareholders 3. One or more restrictions on transfer of stock in Sec. 202 (unclear why this is necessary) 4. DE 343: certificate of incorporation must have a heading stating that its a close corporation a. IMPORTANT: even if you meet the criteria of Sec. 342, you must still elect to become a close corporation b. Without this heading in your charter, you havent formed a close corporation c. But, what difference does it make since under Sec. 141(a) and (b) you can do anything under the general provisions; just about anything youd want to do under subchapter 14, you can do without subchapter 14 C. Typical Characteristics of a Close Corporation 1. Small number of shareholders (most significant factor) 2. No market for stock 3. Owner-management 4. Restrictions on transferability of ownership interest 5. Earnings paid out as compensation rather than dividends D. No precise boundary between the close corporation and the public corporation; its a continuum E. As a company grows, it might be hard to classify it as close or public F. Basic Corps v. Partnership Law 1. Internal Governance: corp statutes are mandatory. Partnerships use UPA to facilitate rather than being mandatory 2. Authority: SH have no right to participate ni management and have no apparent authority. In partnerships, partners have right to bind partnership 3. Distributive Shares: distributions are shared in proportion ot ownership of stock. In partnership, profits shared per capita and no salaries. 4. Transferability: share of stock are freely transferable. Partnership: no members can join w/o consent of all partners. 46

V.

47 5. Term: perpetual vs at will or for a term 6. Fiduciary Duties: SH dont have fiduciary duties, partners have a duty 7. Liability: SH not individually liable, partners are. Why should we treat close corporations differently than public corporations? 1. No market for the stock 2. Much harder to get information about a close corporation because people are acting out of the public light and may not care what the other shareholders think; compare with a public information with information filed with SEC 3. Shareholders have different expectations in a close corporation than in a public corporation a. People in a close corporation think of themselves as partners and have the expectations of partners b. Interest in a close corporation often reflects a substantial part of the shareholders wealth CASE STUDY: Weston v. Weston Paper Co. (Ohio 1996) 1. HOLDING: a company with 100 shareholders, even though it wasnt publicly traded, wasnt a close corporation as a matter of law CASE STUDY: Donahue v. Rodd Electrotype Co. 1. CAVEAT: DO NOT cite Donahue as the rule in DE; Nixon (below) is the rule in DE 2. Charles Rodd, acting on corporations behalf, negotiated purchase price at book value; when Donahues learned of the purchase, they offered their shares to corporation on terms given to Harry, but the offer was rejected; P claims majority breached fiduciary duty to minority by not giving her an equal opportunity to sell her shares to corporation 3. HOLDING: purchase of Harry Rodds shares by corporation is a breach of duty which controlling shareholders, Rodds, owed to minority shareholders, P and her son 4. Relief to which P is entitled a. Judgment may require Harry Rodd to remit $36,000 with interest to corporation in exchange for his 45 shares of stock, OR b. Judgment may requirement corporation to purchase all of Ps shares for $36,000 without interest 5. RULE: stockholders in the close corporation owe one another substantially the same fiduciary that partners owe one anotherutmost good faith and loyalty 6. RULE: if the stockholder whose shares were purchased was a member of the controlling group, the controlling stockholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of his shares to the corporation at an identical price 7. REASONING: controlling group cannot utilize its control of the corporation to establish an exclusive market in previously unmarketable shares from which minority stockholders are excluded; that would be a preferential distribution of assets 8. FOOTNOTE (omitted by editors): rule of equal opportunity doesnt bar a buy/sell agreement which is approved by all of the shareholders, so if you want a buy-sell agreement, you should do it at the very beginning CASE STUDY: Nixon v. Blackwell (p. 334)--DE 1. Two groups of shareholders, employee shareholders and non-employee shareholders; employee shareholders have liquidity b/c when they retire, they have a cash option and key man life insurance policies, which werent afforded to non-employees; lower court ordered board to treat non-employee shareholders same as employee shareholders 2. HOLDING: DE Supreme Court reverses: this is what the founder intended and it was important because the P had inherited the stock so he paid nothing for it; there was a market for the stock b/c P had an opportunity to self tender or sell their shares; ESOP makes sense from the corps viewpoint as an incentive to stay at the company and work hard. D met their burden of establishing the entire fairness of their dealings w/ non employee stock. 3. IMPORTANT: DE doesnt follow Donahue; in DE, stockholders need not always be treated equally for all purposes 47

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H. I.

J.

48 K. Comparing Donahue and Nixon 1. Policy in Nixon was corporate-wide while one in Donahue favored certain individual shareholders 2. Behavior in Donahue was more reprehensible than behavior in Nixon L. Problems with Donahue Rule 1. At first, it just seems like a rule of equal treatment 2. Companies have good reasons for wanting buy/sell agreements with majority stockholders, officers, etc. a. Might cause trouble if someone retries and still owns a big block of stock b/c they no longer have the interests of the company at heart; might start working with a dissident group if you dont buy back their stock b. Dont want to have an officer in an important position say he wont retire b/c he wont get anything for his unmarketable stock, and the company probably doesnt pay dividends (this is what is at issue in Donahue with Harry Rodds) c. Buy/sell agreements serve as an incentive while youre working; know that when you leave, the company will buy back their stock; also encourages people to leave when they need to 3. In MI (where Donahue was decided), if a member of the control group dies or retires, you have to offer to buy back EVERYONES shares a. May not have the money to buy back everyones stock 4. Can sympathize with widow in Donahue b/c she was the widow of a stockholder and now cant do anything with her stock either M. CASE STUDY: Estate of Schroer v. Stamco (Ohio App. 1984) 1. Ohio Supreme Court adopted general principles and specific requirement of Donahue; follow rule of equal opportunity, which seems to indicate that it would rule in opposite direction of DE Supreme Court in Nixon N. What do you do with companies that dont opt in to become statutory close corporations? 1. CASE STUDY: Ramos v. Estrada (p. 339) a. Estradas, who were members of one group, wanted to vote in a different way from the majority of their group; issue was whether voting agreement was enforceable; statute said close corporation could provide that in exercising any voting rights, the shares held had to be voted as provided for in the agreement b. HOLDING: although Broadcast Corp. wasnt a statutory close corporation, the court held that the voting agreement was enforceable and binding on Estradas; CA case 2. CASE STUDY: Nixon v. Blackwell (p. 340)See Above a. RULE: unless a corporation elects to become a close corporation under this subchapter In the manner prescribed in the subchapter, it shall be subject in all respects to this chapter, except this subchapter b. HOLDING: corporation before the court isnt a close corporation; therefore, it isnt governed by provisions of subchapter 14; in appropriate for court to fashion a special judicially-created rule for minority investors when the entity doesnt fall within those statutes, or where there are no negotiated special provisions in the certificate of incorporation, by-laws, or stockholder agreements O. Statutory Treatment of Close Corporations 1. States have taken three different approaches to statutory treatment of close corporations (p. 336-339) a. Unified strategies: make no special provision for close corporation as such, but to modify traditional statutory norms so that they will meet needs of close corporations though applicable to public corporations as well b. NY and Model Act Strategies: follow unified approach to a point, but add one or two important provisions that are applicable only to those corporations with defined shareholding characteristics 48

49 c. Statutory close corporations: follow unified approach to a point, but adds an integrated set of provisions that are explicitly made applicable only to corporations that both quality for AND formally elect statutory close corporation status 2. DE has a special chapter (subchapter 14) dealing with close corporations, but OH doesnt 3. CASE STUDY: Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling a. Parties entered into an agreement providing that they would vote together for all matters affecting their ownership of stock and interest in D corporation; disagreement will be submitted for arbitration to Loos; didnt agree about 5th director; Loos directed Mrs. Ringling to cast her votes in favor of Mr. Dunn; D Aubrey voted her shares against arbitrators orders and Edith sues b. Under cumulative voting, if Edith and Aubrey work together, they can elect 5 directors and John can only get two (otherwise it would be 4/3) c. HOLDING: arrangement itself isnt invalid, but also not an irrevocable proxy which would allow the arbitrator to cast votes of a noncomplying shareholder; didnt violate the statute; so no specific performance; John can elect 4 directors and Edith will only be able to elect 3 d. SOLUTION: if youre a lawyer after this case, stick in a provision in agreement to force recalcitrant party to comply e. RULE: 1) SH may exercise wide liberality of judgment in the matter of voting, and it is not objectionable that his motives may be for personal profit or determined by whims or caprice, so long as he violates no duty owned to his fellow shareholders (pooling OK) 2) Remedy: if voting agreement is enforceable the remedy usu sought is specific performance. Some cts have refused to grant specific performance where fewer than all SH were parties. 4. CASE STUDY: Abercrombie v. Davies (p. 355) a. Ps put a provision in agreement to force recalcitrant party to comply b. HOLDING: an agents agreement that was in the form of a voting agreement was in substance a voting trust; therefore, it had to comply with the statutory voting trust provisions; one essential feature of a voting trust is the separation of the voting rights of the stock from their other attributes of ownerships; because the statutory provisions governing voting trusts hadnt been complied with (because it was secret), the agreement was unenforceable P. Voting Trusts and Pooling Agreements 1. If its a vote to be performed by the trustee, then its a voting trust. If its a vote to be performed by shareholders, then its a pooling agreement. a. in specifying a pooling agreement, must specify terms and contents, cant just say its a pooling agreement. 2. A trust, by definition, involves the definition of the legal and beneficial ownership of some property; here, the property is shares of stock 3. Stockholders transfer legal ownership of stock to trustee 4. Two types of Voting agreements a. Parties agree in advance on the exact way in which they will vote their shares during the term of the contract; ie they agree to vote each other as directors b. Parties do not agree in advance on the exact way in which they will vote their shares, but instead agree that during the term of the K they will vote their shares as a unit, in a way to be decided by agreement, ballot, or other means. 5. People were upset about the Abercrombie decision, so the DE legislature revised the statute a. Allows a voting trust, but imposes restrictions on it i. DE 218(c): an agreement between two or more stockholders may provide that, in exercising any voting rights, the shares held by them shall be voted as provided in the agreement ii. DE 218(d): this section shall not be deemed to invalidate any voting or other agreement among stockholders or any irrevocable proxy which is not otherwise illegal b. Under this section, the arrangement in Abercrombie would be valid 49

50 c. Issue of specific performance isnt directly addressed by statute, but DE courts have routinely given specific performance when pooling agreements are violates d. In DE, if a voting trust isnt open for inspection, a shareholder could argue that he doesnt have to abide by it i. Seems like voting agreements could be challenged by third persons as well as parties to the agreement b/c this provision is protecting third parties e. DE 218(c): a pooling agreement must be in writing 6. How do you know in DE if something is a voting trust covered by 218(a) or some other kind of voting agreement covered by 218(c)? a. CASE STUDY: Oceanic Exploration Co. v. Grynberg (p. 356) i. HOLDING: agreement called a voting trust wasnt a voting trust for purposes of the voting-trust statute, and was therefore enforceable despite a failure to comply with the statute ii. REASONING: court was disgruntled b/c a party was trying to weasel out of an agreement b/c of a technicality 7. How does Ohio handle voting trusts? a. OH 1701.49: voting trusts i. Doesnt say anything expressly about pooling agreements ii. Sec. H: the rights conferred by this section are in addition to rights at common law, and no limitations established by this season shall limit rights at common law iii. So, youd have to look at the common law b. Universal assumption among practitioners that pooling agreements are okay in OH, but there isnt any case law in the subject c. One reason to incorporate in DE is that the law is more fully fleshed out and specified than OHs, even though OH is a large industrial state 8. HYPO: A is putting in money; B is going to run the company; C corporation is going to provide some facilities without rent; each will get 1/3 of stock, and they all want equal power 9. What is the purpose of a pooling agreement? a. To make sure that parties to the agreement vote together to elect directors to maximize their influence in election of directors b. Pooling agreements can cover other things shareholders vote on, such as amendment to certification of incorporation, amendment of bylaws, mergers, dissolution, etc. 10. Why didnt parties in Ringling, Abercrombie, and Lehrman create a statutory voting trust? a. May not have wanted to file it b. In many states, including DE, voting trusts are open to inspection, and they probably want to keep these matters private c. In a voting trust, it is in the trustees discretion when to distribute dividends to the beneficial owners i. UNLESS you specify in the trust agreements that dividends have to be distributed in a certain way, but that adds an extra drafting test ii. With a pooling agreement, your dividends dont change; only bound to vote in a certain way d. In some states, voting trusts are limited in time, but pooling agreements arent e. If the trustee dies, you might wind up in court for the designation of a successor trustee, but with a pooling agreement, you dont have to worry about a trustee dying f. The trustee owns the stock, so they vote for everything, not just the election of the directors i. Could provide in agreement that in matters other than for election of board, the trustee has to vote according to the individuals, but that adds another drafting step ii. A pooling agreement can be specific to the election of the board of directors g. GENERAL RULE: in organizing a close corporation, every effort should be made to reach agreement without resorting to a voting trust 50

51 11. So, when would you use a voting trust? a. Voting Trust= device by which SH separate voting rights in, and legal title to, their shares from beneficial ownership, by conferring the voting rights and legal title on one or more voting trustees, while retaining the ultimate right to distributions and appreciation. i. Requires: written trust agreement, transfer to trustee for specific period of stock certificate and legal title to stock (LESS than 10 yrs) b. When someone doesnt know what theyre doing, sometimes theyll create an awkward voting trust c. Find voting trusts when its not exactly voluntary, but shoved down someones throat d. Its only when someone else has imposed it that you would use it e. Much rarer to see a pooling agreement in a public corporation i. A company like DuPont that still involves a large family or close knit group might want to use a voting trust to maintain unity in voting ii. If a corporation sells someone a big block of stock, they might want to have a voting agreement with the other person that they wont try to seize control (e.g., agreement that you wont seek any more than your 2 seats on the board) 12. Problems w/ Voting Trusts a. Last for a statutory pd of time and parties may want to extend beyond this pd or act before its over b. Pooling agreements often dont have definite pds, but then money goes to trustee c. Voting agreements may specify one kind of voting, ie directors, and trustee might vote bad on other things d. Filing reqs for voting trusts e. If trustee dies, needs a successor f. Usu voting trusts not entered into voluntarily, ct or creditors order them into it. Q. Classes of Stock 1. One of simplest and most effective ways of assuring that all participant or that a particular minority will have rep on the board is the set up two or more classes of stock, provided that each class is to vote for an elect a specified number or stated percentage of the directors, and then issue each class or a majority of shares in each class to a diff SH or faction of SH. a. DE151(a). b. OH 1701.57 (B)(1) 2. CASE STUDY: Lehrman v. Cohen (p. 357) a. Lehrmans and Cohens both owned equal quantities of voting stock in Giant Food, Inc. in two different classes; each could elect 2 of the 4 directors; created a third class of stock and 5th directorship to prevent deadlocks owned by Danzansky who voted for himself; P claimed that in substance this was a voting trust b/c Danzansky and Cohens would vote together, but it didnt comply with the voting trust statute b. HOLDING: AD arrangement didnt separate voting rights of AC or AL stock from the other attributes of ownership of those classes of stock; it wasnt illegal to create a class of stock having voting rights but no proprietary rights c. RULE: criteria of a voting trust from Abercrombie v. Davies i. Voting rights of the stock are separated from the other attributes of ownership ii. Voting rights granted are intended to be irrevocable for a definite period of time, and iii. The principal purpose of the grant of voting rights is to acquire voting control of the corporation d. Other ways of dealing with deadlocks i. On the one hand, you want equality in voting, but on the other hand, you dont want to be stuck with deadlocks ii. Under the default rule, the deadlock can go on for awhile; eventually someone can sue for equitable relief iii. Could go to an arbitrator who doesnt have a financial interest 51

52 a. Problem in this case was that it was easy for the Cohens to strike a deal with Danzansky in exchange for his cooperation in electing their directors b. How would you select an arbitrator? i. Mutually agreeable arbitrator, but the parties probably couldnt agree on one ii. Arbitrator chosen by the American Arbitration Society c. Drawbacks of arbitration i. Can be expensive, though less expensive than litigation; have to pay arbitrator, costs of proceedings, lawyers involved ii. Might get an arbitrator who doesnt understand the business a. Can encourage parties to resolve deadlock themselves or encourage them to appoint a mutually agreeable arbitrator b. Might prefer to have arbitrator who doesnt understand whats going on if you have a weak case d. If you dont resolve some issues in arbitration, then youre stuck with the remedy that the law generally provides on those issues iv. Problem with any deadlock-breaking mechanism is that the deadlock may not be broken in a way you like 3. IMPORTANT: one of the simplest and most effective ways of assuring that all shareholders, and particularly minority shareholders, will have representation on board is to set up two or more classes of stock, provide that each class is to vote for and elect a specified number of directors, then issue each class or a majority of the shares in each class to a different shareholder or faction of shareholders (p. 357) 4. Uses for Classes of Stock a. Shareholders with equal financial interests, but you want to have one with more control b. Shareholders with unequal interests, but you want to give them equal share of control c. Good way to handle unexpected vacancies on the board i. Without different classes of stock, if one parties has a 2:1 majority of the board and one of the directors dies, the vacancy is filled by the other directors, so now the current majority will have 3:1 majority ii. If you have different classes of stock, then you can put in a provision that the same class will vote to replace that director iii. PROVISION TO ADD IN CHARTER: in case of a vacancy on the board, the board cannot take any action until the vacancy is filled, and the vacancy will be filled by the class of stock which originally voted on the past director 5. CASE STUDY: McQuade v. Stoneham a. Agreement said that parties would use their best efforts to continue as directors and officers in certain positions; at election of officers, McQuade voted for himself as treasurer and other 4 voted for Bondy while Stoneham and McGraw refrained from voting; at the next meeting, he was dropped as director b. HOLDING: a contract is illegal and void so far as it precludes board of directors from changing officers, salaries, or policies, or retaining individuals in office, except by consent of contracting parties c. RULE: stockholders cannot, by agreement among themselves, control the directors in the exercise of the judgment vested in them by virtue of their office to elect directors and fix salaries; Directors are fiduciaries, and must have unfettered discretion in voting on corp affairs; ultimate decision has to be with board acting in good faith d. Contrast with Abercrombie and Ringling, in which the voting agreements dealt with shareholders voting powers, such as electing directors, amending the charter, amending the bylaws, etc.; this case is talking about things in the discretion of the board e. Would agreement in McQuade be valid under current Ohio Law? 52

53 i. except where the law, articles, or regulations require action to be authorized or taken by shareholders, all of the authority of a corporation shall be exercised by or under the direction of its directors OH 1701.59(a): ii. To the extent that the agreement here was just a contract between the shareholders, it was invalid under OH law, but they couldve made this agreement if they put it in the articles of incorporation iii. OH 1701.591(c): basically says you can make any agreements you want for a close corporation a. Only applies close corporations, but statute doesnt defined the term close corporation except in paragraph (I) on i. Close corporation cant be listed on a national securities exchange or regularly quoted in an over-the-counter-market ii. Would only exclude companies that are clearly public iii. Seems theres a broad scope for what constitutes a close corporation b. To qualify as a close corporation agreement, it has to meet certain requirements under OH 1701.591(a); not a competing provision to Sec. 1701.59, but an alternative f. What is the DE law on these types of shareholder agreements? i. DE 142(b): permits officers to be chosen as determined in the bylaws or by board ii. DE 141(a): corporation will be managed by and under direction of board except as otherwise provided in certificate iii. Special subchapter 14 for close corporations a. DE 351: permits management by shareholders, getting rid of board completely; provision must be in charter, adopted by unanimous vote, and share certificates must indicate the special provision to give notice to new shareholders that company doesnt operate by normal rules b. DE 350: permits agreements restricting board if theyre approved by a majority of shareholders; doesnt need to be in charter; agreement is valid only as between parties iv. Seems to be permissible to say in certificate that officers will be elected by shareholders v. But, are there limits? Can you get rid of the board entirely? g. CAVEAT: the rule in McQuade is the old one; now, courts tend to be much more lenient in allowing parties to change the default rules 6. Case Study: Galler v. Galler: leading NON NY case. a. Two principal corp owners. Signed a SH agreement in which they agreed to pay certain dividends each year and in case of death to pay pension to widow. One died and ther refused to carry out agreement b. HOLDING: agreement valid even though it limited boards discretion. Cts tend to get nervous when nonparty members/creditors involved b/c harm may be greater than just harm to business. Also must follow the statutory formalities. c. RULE: Ct required an agreement must satisfy 3 tests before enforcement i. Must be no minority interest who is injured by it ii. Must be no injury to public or creditors iii. Agreement must not violate a clear statutory provision 7. How can you tell which agreement deals with shareholder voting and which deals with powers given to board of directors? a. Need to know which powers belong to shareholders and which powers belong to board b. If youre dealing with the voting of shareholders as shareholder, you look to cases like Ringling, Abercrombie, etc. c. If youre dealing with matters of discretion of the board, then you look to McQuade 53

54 R. Supermajority Voting and Quorum 1. Purpose of a unanimity provision is to give the minority veto power 2. Problem is that a unanimity gives other parties a veto, too, not just you 3. Its a matter of circumstances, the degree of trust, preferences of parties, etc. as to whether parties should create a unanimity provision a. E.g., if two of the shareholders are sisters, it is likely that theyll cooperate, so you might want a unanimity provision 4. OH 1701.52: permits supermajority (but less than all) shareholder requirement if in the charter 5. OH 1701.62: permits supermajority requirements for board of directors if in charter or regs 6. DE 216: permits supermajority requirement for shareholder action if in charter or bylaws 7. DE Sec. 141(b): supermajority requirement for board would be okay if its in charters or bylaws 8. Two Competing Theories of the Corporation a. Concession Theory i. Corporate charter is a concession from the estate ii. If you want to play the game, youve got to play by the states rules iii. So, if the states rule is that the corporation is run by a majority vote, cant change it b. Contract Theory i. Corporate charter and other arrangements are a contract among participants ii. State lays down a set of default rule just to make things easier, but you dont have to play by the states rules iii. Court would allow a unanimity rule under this theory if parties agree to it 9. IMPORTANT: on the exam, dont stop by saying that to help the minority, the corporation should have a supermajority requirement a. E.g., a 2/3 voting requirement would be the same thing as a simple majority if you have 3 single shareholders b. If you have 4 equal shareholder, and you want a supermajority requirement, you could mean 75% or 100% vote c. Ask, what is the goal youre trying to achieve by adding a supermajority requirement? i. If youre talking about shareholder votes, shareholders only vote on a few things a. Directors are usually elected by a plurality b. It would be a bad idea to elect directors by a supermajority i. Danger that no directors will end up being elected ii. If youre concerned about the majority electing everyone, just create different classes of stock, each entitled to elect one director and have a board of 5 directors to avoid deadlock c. Might want to be specific about over what matters a minority has a veto and over what matters it wouldnt ii. In other words, just to say that there should be a supermajority requirement here isnt enough; you need to be much more specific 10. Supermajority quorum a. Majority of shareholders = holders of a majority of the shares i. E.g., if one stockholder owns 51% of the stock, obviously he has a majority, so if he shows up at the shareholders meeting, theres enough to constitute a quorum b. At a shareholders meeting, shareholders can attend by proxy even if they arent physically there themselves c. Directors cannot show up by proxy (in contrast to shareholders) i. Director is a fiduciary, and normally a fiduciary cant delegate her authority ii. Might be okay under DE Sec. 141(a), which allows the company to be managed by the board of directors except otherwise provided in certificate d. Traditional rule is that once you have a quorum, the meeting is valid even if people leave later 54

55 e. A minority that repeatedly defeats the validity of a quorum by failing to show up lacks clean hands and cant attack action taken in a meeting b/c of lack of a quorum f. Purpose of a supermajority quorum requirement is to prevent action if you refuse to show up g. Usually better to have a supermajority voting requirements 11. CASE STUDY: Sutton v. Sutton a. Provision in certificate of incorporation provided that unanimous consent of shareholders was needed for transaction of any business; Ps tried to amend charter with only 70% of the shares; NY Business Code provided that supermajority provisions in the certificate could be amended by a 2/3 vote unless the certificate specifically provides otherwise b. Legislature was overruling Benintendi v. Kenton Hotel (p. 372), where the court invalidated a unanimity provision c. HOLDING: certificate need only clearly state what vote, if greater than 2/3, is required to amend a unanimity provision, and the certificate of Bag Bazaar, Ltd. does so; nothing inherently unfair or improper about a voluntary decision to assure protection of minority shareholders; shareholders arent without remedies where deadlocks occur d. NY 616(b) states: an amendment of the certificate of incorporation which changes or strikes out a supermajority provisions shall be authorized at a meeting of shareholders by vote of the holders of 2/3 of all outstanding shares entitled to vote thereon, or of such greater proportion of shares. 12. PROBLEM 7(a): Harman wants a free hand to run the day-to-day affairs; his father, Lindsay, and Smith are willing to give it to him, provided Lindsay and Smith can prevent major changes to which both of them object a. Could give him control of the board of directors, OR b. Give him an office with specific powers c. How do we allocate Harmans control powers? i. Classifying the stock to let Harman elect majority of board a. E.g., Class A stock entitled to elect 4 directors and other classes entitled to elect 1 b. But, there are circumstances under which you couldnt classify stock b/c it would mess up your S corporation status c. Minority shareholder might start saying that classifying stock is unfair b/c it dilutes his rights; breach of fiduciary duty ii. Pooling agreement entitling Harman to elect a majority of directors a. If youre starting from scratch, the different classes of stock approach is preferable, but if youre not, then a pooling agreement is the best alternative b. Maybe it would say: parties to this agreement all agree that they will vote for 4 candidates nominated by Robert Harman, one by William Harman, one by Lindsay, and one by Smith iii. Pooling agreement to allows shareholders to elect Harman president a. Would have to rig it so that the shareholders would have power to elect president, rather than the board b. So, well need an additional step c. Also, need to specify powers of president in charter d. If we made it a supermajority provision, his powers couldnt be taken away without his consent iv. Even if Harman doesnt have a majority of board, he may still be able to control day to day affairs with something less than a majority if there is a board of directors agreement giving Harman a majority vote on the board v. Agreement under OH 1701.58, which seems to allow you to get rid of board altogether d. Lindsays and Smiths collective veto power to major changes i. Eventually going to have to define major changes ii. Supermajority clause a. But, dont want a supermajority close for election of directors 55

56 b. Want a supermajority clause for actions of board; major changes must be approved by a certain number of directors iii. A voting trust would be the worst option for this situations, unless it was the only legal option; more awkward and cumbersome b/c youre surrendering your rights to a trustee e. Could we do all of this under OH law? i. OH Sec. 1701.49: talks about voting trusts ii. OH Sec. 1701.49(h) and (i): this section is in addition to common law voting agreements, and everyone assumes pooling agreements are valid in OH iii. Different classes of stock are permitted in OH iv. Supermajority provision okay under OH Sec. 1701.52 v. Supermajority requirement for vote on board is valid under OH Sec. 1701.62 vi. A polling agreement to allow Harman to vote majority on the board seems to be permissible under OH Sec. 1701.59A vii. OH Sec. 1701.591 seems to permit everything, so Harman could probably get extra votes on the board under it a. Must be adopted unanimously b. Must be in writing c. Refer expressly to Sec. 1701.591 d. Shares certificates must be legended viii. In Ohio, general rule is cumulative voting, so if you have 4 directors provided for in charter and 4 equal shareholders, then each will be able to elect a director; Lindsay and Smith will have two of those seats, and board wont be able to do anything without their approval f. Could we do all of this under DE law? i. DE Sec. 218(c) and (d): pooling agreement is permissible ii. Charter provision or bylaw giving president broad powers seems to be okay under DE Sec. 141(a) iii. Supermajority voting provision for shareholders is okay under DE Sec. 316 iv. Directors voting agreement also seems to be okay under DE Sec. 141(a), which says corporation is managed by or under the board of directors EXCEPT as specified in charter a. On its face, it seems to say you can do anything you want b. But, there is some concern about how far you can go; could you get rid of the board altogether? v. Special close corporation subchapter in DE a. DE Sec. 350: permits directors agreements, which would allow us to elect Harman as president and specify his powers b. DE Sec. 351: permits management by shareholders, so we can get rid of the board altogether S. Fiduciary Obligations to Shareholders 1. Majority has certain rights to selfish ownership; these arent charitable enterprises; theyre profit-making companies 2. In close corporations, the question is what are the reasonable expectations of the parties and have those reasonable expectations been denied? 3. Side note: Dent prefers restricted use of term freeze out to refer to the involuntary deprivation of a minority of its equity interest 4. CASE STUDY: Wilkes v. Springside Nursing Home a. Four men created corporation, agreeing each would be a director, participate actively in management, and each would receive money from corporation in equal amounts; Wilkes gave notice of intention to sell his shares; at a directors meeting, Wilkes was left off the list for the schedule of monthly payments; at the stockholders meeting, he wasnt reelected as director or an officer 56

57 b. HOLDING: majority hasnt shown legitimate business purpose for severing Wilkes from the payroll or for refusing to reelect him as an officer and director (no evidence of misconduct or neglect of duties); Ds breached their fiduciary to Wilkes as a minority stockholder and he should be awarded salary he wouldve received if he had remained an officer and director c. RULE: 1) controlling group must demonstrate a legitimate business purpose for its actions, 2) then the minority must prove that the objective couldve been achieved through an alternative course of action less harmful to the minoritys interests; d. LESSON: if youre advising a corporation who wanted to fire a member of the board, it should accuse her of being guilty of misconduct or neglect of duties e. PROBLEM: what constitutes a legitimate business purpose? How bad do things have to be? 5. SOLUTION: to avoid the problem Wilkes had, you could add a provision which says that officers cant be removed without some sort of supermajority vote; then, you would buy out his stock at a price agreed by the party, and if they dont agree in 30 days, then at a price to be set by an arbitrator chosen by the American Arbitration Society a. Now, it will cost something to fire him b. Gives the other officers/stockholders an incentive to keep him for longer c. PROBLEM: if you offer to buy out Wilkes, youll have to offer to buy all the stocks of all of the other minority stockholders at the same price according to Donahue d. LESSON: be very careful when brining in more minority shareholders in a close corporation e. But Donahue does say that if you have an agreement thats adopted unanimously, thats okay, so you should put the buy-out provision in the agreement first, then issue more shares to minority shareholders f. Could also have different classes of stock, and make it clear that the buy-sell agreement is in place to begin with and only applies to certain classes of stock i. If you want to be an S corporation, you can only have one class of stock ii. If youre an LLC, what are you going to do? 6. CASE STUDY: Gigax v. Repka (Ohio App. 1992) a. Ohio court said it would follow Wilkes and Donahue 7. CASE STUDY: Smith v. Atlantic Properties, Inc. a. Supermajority provision requiring an 80% vote for business decisions, like purchases, and had effect of giving any one of four original shareholders a veto on corporation decisions; Wolfson disagreed with other shareholders about whether to distribute dividends to avoid tax liability; Wolfsons refusal to vote on dividends acted as a veto b. ISSUE: Can minority SH in close corp use his veto power unreasonably as by refusing to vote for dividends when the accumulation of undistributed earnings will lead to a foreseeable tax penalty? c. HOLDING: P violated his duty (as a minority shareholder) of utmost good faith and loyalty by taking unjustified risks of penalty taxes that were eventually assessed; trial judge was justified in charging Wolfson with out-of-pocket expenditure incurred by Atlantic for penalty taxes and related counsel fees of tax cases; if the parties cant reach an agreement about dividends, the court will consider declaring dividends itself d. General rule is that the court doesnt order declaration of dividends i. Usu ct does not declare dividends, it a matter of business judgment ii. If your refusal to approve dividends is simply a ploy to buy the other partys stock at an inadequate price, the court might step in and require the declaration of dividends e. Question of what was determinative here: the fact that a majority of shareholders wanted a declaration of dividends or that Wolfson was acting unreasonably? f. Ways to solve the problem in this case 57

58 i. Can have an arrangement in which there are mandatory dividends, which can either be paid in cash or additional stock a. E.g., couldve had an arrangement in which 3 other shareholders would get cash and Wolfson wouldve gotten additional stock b. Probably wouldnt want this arrangement in most cases b/c it could still create a cash drain that the company might not be able to afford ii. Couldve said that dividends must be paid if necessary to avoid this tax penalty a. In some companies with a positive cash flow, its common to require cash dividends for 40% of profit b/c thats the top tax bracket; want to get at least enough cash to cover your tax liability iii. Couldve provided for arbitration, but the breach of fiduciary duty allegation mightve been a little awkward for an arbitrator to handle 8. CASE STUDY: Sletteland v. Roberts (p. 387-388) a. P was removed as an officer of BGI by a vote of 60% of shareholders; brought an action requesting return of excessive legal fees Ds had charged BDI and removal of Orndorff and Roberts as directors; Ds alleged that P brought suit in bad faith b/c lawsuit hampered refinancing of corporation; when asked to withdraw suit, he refused b. HOLDING: P shouldve known that his filing of a suit alleging director fraud would delay or derail the financing; there was no particular reason for filing suit when he did; violated his fiduciary duty as a shareholder (since he was no longer an officer) 9. CASE STUDY: Merola v. Exergen Corp. a. P, former VP of Exergen and former minority shareholder, brought suit against Exergen, president, and majority stockholder Pompei b/c of his termination as an officer without cause; company bought Ps stock at a fair price b. HOLDING: P was fired without legitimate business purpose; majority shareholder didnt breach his fiduciary duty to minority shareholder; not every discharge of an at-will employee of a close corporation who happens to own stock gives rise to a successful breach of fiduciary duty claim; P was terminated in accordance with employment contract and fairly compensated for his stock c. REASONING: P shouldnt have expected employment to go hand in hand with stock ownership; P was hired after the business was established; no evidence that other stockholders had expectations of continued employment b/c they purchased stock; corporation seemed to be intending to grow. Controlling group in close corporation must have some room to maneuver in establishing business policy of thecorp. d. CAVEAT: dont automatically assume that every time you have a close corporation, Wilkes applies; even if there is no legitimate purpose, the P still might be out of luck as in Merola i. Disposition of this case turns on reasonable expectations of parties or the policies (ie none that employment would continue) of the company, which means you can to some extent modify the rule of Wilkes by agreement in so far as an agreement would take away expectations that anyone is entitled to employment T. Restrictions on Transfer of Stock 1. General rule is that stock in a corporation is freely transferable; contrast with property rights in a partnership, where you can assign your interest in the partnership but cannot sell away your partner rights 2. Why would corporations want to make restrictions on trading stock? a. Keep a certain control group in power; keep out strangers b. This might be true of a majority block of stock, but is there any reason to restrict transfer of a minority block? i. Minority shareholders have rights to access corporate information ii. In a close corporation, this information isnt publicly available 58

59 iii. If theres cumulative voting or some kind of pooling agreement or classification of stock, minority shareholders might be able to elect a director or might be a member of the board herself and have more access to information iv. E.g., Sletteland v. Roberts (p. 387): minority shareholder files a derivative suit that mucks up companys efforts to refinance v. E.g., Wilkes and Donahue: suppose ownership has been tied to employment; paying out profits is a form of compensation, which could preach fiduciary duty to shareholder and also might be problem with IRS c. Tax issues might encourage shareholders to restrict transferability of stock; can only have a certain number of shareholders to qualify as an S corporation 3. Restrictions on transfer of stock can be burdensome on individual and costly to society 4. Restrictions on transfer tend to be disfavored by courts and narrowly construed 5. Restrictions on transfer are often read as inapplicable to transfers between existing shareholders (p. 423) a. Reasoning for rule is that if the general rule is to keep out bad people from the corporation then it doesnt need to protect against people who are already there b. But this is bad reasoning b/c sales to current shareholders could affect the balance of power c. So, this might be something you have to spell out in the agreement 6. OH doesnt directly address restrictions on transfer a. OH Sec. 25(b) talks about notice of restrictions, which presumes that some restrictions on transfer are permitted b. would have to resort to common law to figure out what restrictions are allowed 7. PROBLEM 9: recent law school graduate prepared a restriction on shares of Harman Corporation: prior to sale or disposition of his stock, any stockholder of Harman Corporation contemplating such a transaction shall offer his shares to his fellow stockholders at a reasonable price a. Reasonable price is so vague that it invites litigation and may be so vague as to be unenforceable b. To be enforceable, meaning of contract has to be reasonably ascertainable c. Not clear how long the person has to leave the offer open to his fellow shareholders d. Not clear how many shares the person will have to offer each of the other shareholders; are they offered equally or in proportion to their existing holdings? e. Not clear what happen if one of the shareholders says yes to buying the stock but the other says no i. Is this one offer with two parts or is it two different offers? ii. What about the mirror image rule of contracts, where if an offer isnt fully accepted, its rejected? f. The phrase sale or disposition is also vague i. If C dies, hes no longer a shareholder, and ownership of his shares have to move to someone else; is that a sale or disposition ii. Not clear whether the restriction applies to sales between current shareholders 8. Alternatives to this provision for a reasonable price (p. 423) a. Book value i. Easy to determine ii. Reflects historical cost of assets rather than present value, and use ignores goodwill or going concern value iii. Unreliable guide to real worth, cts held that must be a large disparity b/w book and real value b. Capitalized earnings: applying some multiplier to companys earnings i. Publicly traded companys price-earnings ratio ii. Historically, publicly traded companies tend to trade on average at 15-16 times earnings 59

60 iii. Less likely than book value to produce unfair price, but involves a number of drafting/interpretation probs such as defining earnings, over what pd, with or w/o salaries paid to officers, and the impact of the transfers withdrawal on value of business c. Periodic revisions: agree on a price when the provision is adopted, subject to periodic revisions. Can lead to probs if the parties dont do it or are in disagreement. d. Appraisal: price to be determined by an appraiser 9. CASE STUDY: Avrett and Ledbetter Roofing and Heating Co. v. Phillips (p. 423) a. HOLDING: unless explicitly provided otherwise, restrictions on transfer are inapplicable to testamentary transfers (after death) and to transfers by the operation of law, such as divorce decrees 10. CASE STUDY: Rafe v. Hindin (p. 422) a. A legend on each stock certificate made the stock nontransferable except to other shareholder, and written permission from other shareholder was required to record a transfer of the stock on Bil Cys books b. HOLDING: since the individual D is given the arbitrary power to forbid the transfer of the shares of stock by the P, the restrictions amounts to annihilation of property; the restriction is not only unreasonable, but it is against public policy and, therefore, illegal c. RULE: a consent restraint provision is invalid if it doesnt require that the consent or lack thereof be reasonably given 11. Types of Restraints on Transfer of Stock: reasonable restrictions valid and enforceable a. Consent restraint provision i. Most restrictive restraint on trade (p. 422) ii. Prohibits sale of stock without permission of the corporations board or shareholders iii. Permissible under DE Sec. 101(c)(3) iv. But, in absence of a statute, the validity of consent restraint provisions is a little unclear v. Even if a consent restraint isnt per se invalid, must the other shareholders act reasonably in deciding to give or withhold consent? a. DE Sec. 202(c)(4): talks about consent not being unreasonably withheld b. Could imply that when the DE legislature wanted to insist that a provision be reasonable, it said so, and in DE Sec. 202(c)(3), it didnt say so c. On the other hand, an expert on DE believes that consent cant be unreasonably withheld under DE Sec. 202(c)(3) d. One solution: just have a consent provision b/c it doesnt require you to come up with cash; just allows you to tell shareholder that she cant sell her stock b. First option i. Prohibits transfer of stock unless the shares have first been offered to corporation, other shareholders, or both, at a price fixed under the terms of the option ii. Restrictiveness of a first option depends largely on the relationship between the option price and a fair price at the time the option is triggered iii. Have to exercise it within a specified amount of time (similar to right of first refusal); time either specified by statute or agreement iv. Problems with the right of first option a. Would have to look to see if price in agreement is unreasonable b. What if the company doesnt have the money to buy the stock? c. On the other hand, if youre the one who wants to sell and the other shareholder can pay and has a right to buy, then youve got to sell at less than the true value of the stock c. Right of first refusal i. Prohibits the sale of stock unless the shares have been first offered to the corporation, the other shareholders, or both, on the terms offered by the third party 60

61 ii. Have to exercise it within a certain amount of time either specified by statute or agreement iii. Book says right of refusal is least restrictive restraint, but Dent thinks this is misleading iv. Problems with right of first refusal a. Whos going to make an offer knowing that the corporation has the right of first refusal b. Other shareholders will get to look at the price youve offered c. If they think its a good deal, theyre going to take it away from you, but if they think youve offered more than the stock is worth, theyll waive their rights and let you have the stock 12. CASE STUDY: FBI Farms, Inc. v. Moore (p. 415) a. Restriction on transfer said that no stock of FBI could be transferred with director approval, corporation had first opportunity to purchase stock at book value, and a stockholder would have next opportunity to purchase stock at book value, and stock could be sold to any blood member of family at not more than book value b. Linda and Moore were divorced; Linda was awarded all of the FBI shares and Moore was awarded a monetary judgment and secured a lien on Lindas shares; Moores obtained Lindas shares at a sheriffs sale; seeks a judgment that shares are freely transferable c. Court calls this a right of first refusal, but thats misleading at best; agreement is more accurately labeled as a first option since price isnt to exceed book value and isnt fixed by a third party d. HOLDING: having failed to demand their right to buy at the time of the sale, the corporation gave up their rights of first refusal (or more accurately, first option) and cannot upset the sale later; transfer was valid b/c sheriffs sale was an involuntary transfer; transfer restrictions remain applicable to shares in Moores hands; director-approval and bloodmember restrictions are reasonable and enforceable e. RULE: a restriction is reasonable if it is designed to serve a legitimate purpose of the party imposing the restraint, and the restraint isnt an absolute restriction on the recipients rights of alienability i. In determining reasonableness of a transfer restriction, relevant factors include a. Size of the corporation b. Degree of restraint upon alienation c. Time restriction was to continue in effect f. RULE: transfer restrictions cannot preclude transfer in a foreclosure sale and thereby leave creditors without recourse; also dont apply in intestacy proceedings 13. PROBLEM 7(b): Smith has proposed an agreement among shareholders to sell their shares only to persons approved by the other three shareholders a. This is called a consent restraint provision; most restrictive restraint on trade (p. 422) i. Permissible in DE, but impermissible under some of the case law ii. Also, consent must not be unreasonably withheld b. What does it mean that consent should not be unreasonably withheld? i. Definitely inviting litigation if you word the provision this way ii. But, if you leave the idea out, court might strike provision down iii. So, you need some objective criteria, but what kind? c. What kind of approval is required? i. Unanimous approval? ii. Majority of number of shareholders or majority by shareholdings? d. How long do the shareholders have to reply? e. What information has to be provided by the proposed seller? f. If we decide not to go with the consent provision b/c we think its too harsh, what other options are there? i. Right of first refusal 61

62 ii. First option U. Retiring Shareholder 1. When a shareholder in a close corporation dies or becomes disabled, she or her heirs may want to sell her stock, but, by definition, theres no market for stock in a close corporation 2. Even if there is a buyer, there might be restrictions on transfer 3. If no buy-out agreement, and there is a death, the IRS may impose an estate tax. IRS can value the stock at whatever they want, so can be a lot of $. And if you cant liquidate the stock, estate cant pay the tax. 4. What provisions are you going to put in articles to avoid a shareholder seeking dissolution when she retires? a. Buy-sell agreements: usually says that shareholder has a duty to sell and company has a duty to buy at a specified price i. This gives the shareholders liquidity, which is a very important issue in close corporations b. Potential problem with buy-sell agreements: if the company doesnt have a lot of available cash (which is common with close corporations), they may not be able to buy out shareholder i. Can solve this problem by getting life insurance on the shareholders; then when the shareholder dies, the cash comes in as you need it. Problem there with appraisal of the stock, so insurance may be too low. ii. In case of retirement, you could form a pension or something equivalent iii. Could also provide for installment payments. c. Also, with buy-sell agreements, you have to watch out for the Donahue rule of equal opportunity i. If you buy back the stock of a member of the control group, you have to make the same offer to the minority shareholders ii. This could double the cost 5. What if you think the price in a buy-sell agreement is unreasonable? a. E.g., if you inherit stock from your grandmother and you think its worth $10 million, but the company is going to buy to back at book value at $4 million, can you go into court and sue to get the book value provision deleted as unfair? b. Courts have tended to hold that a large disparity between book value and real value isnt itself sufficient to avoid the operation of a book-value provision (p. 423); difference must be so grossly out of line that no reasonable party wouldve agreed to it c. CASE STUDY: In re Mathers Estate (p. 421) i. Buy-out agreement set price per share at $1; actual value was $1,060 per share ii. HOLDING: court upheld the agreement, but not clear that every court would reach the same result V. Dissolution for Deadlock 1. As in partnership law, in corporation law, there are procedures by which shareholders can voluntarily dissolve the entity a. But, just because you have the votes for voluntary dissolution doesnt mean that you may not be breaking a fiduciary duty if you do in fact dissolve b. DE 275: Voluntary dissolution: needs a resolution from the board then a majority SH approval of resolution c. DE 355: Stockholders option dissolution- certificate may include a provision granting any SH an option to have the corp dissolved at will or upon the occurrence of any specified event or contingency d. OH. 1701.86(e): voluntary dissolutiondo not need to go through court, but do need 2/3 vote of shareholders (or less if in charter) 2. But, judicial dissolution is when one shareholder asks a court to declare dissolution; involuntary dissolution 62

63 a. DE 273: dissolution of joint venture corp w/ 2 stockholders- unless otherwise provided in the certificate, can file a petition w/ ct to discontinue business and dispose of assets. b. OH 1701.91(a)(4): judicial dissolutionaction brought by one-half of the directors when there is an even number of directors i. The court may order means that courts authority to order dissolution is discretionary c. But, judicial dissolution cant be denied on the ground that the corporation is solvent or on the ground that the business has been or could be conducted at a profit d. OH Sec. 91(a)(3): judicial dissolutionafter a petition by holders of the majority of the shares, the court must determine whether it is beneficial to the shareholders that the corporation be dissolved i. Brought by directors or SH voting power; when directors are deadlocked and SH are unable to break the deadlock (1791.(a)(4)) ii. Almost always going to have different shareholder interests at stake, and court will have to decide which one to favor (see Littman below) 3. Traditionally, courts were loath to dissolve a profitable company, but that tradition is fading a bit, and courts more regularly grant dissolution a. Deadlock alone does not warrant a dissolution b. Dissolution must be equitable 4. One of the reasons for the traditional reluctance to dissolution was that it seemed as if a profitable business would be destroyed, but thats not really true a. If a business is worth running, one of the shareholders will just buy out the shareholder who wants to dissolve b. It is unlikely that a shareholder will chop up a company if they think its profitable 5. Nonetheless, dissolution is problematic: what do you do when the parties are squabbling but dissolution might not be a satisfactory remedy b/c it would allow one party to grab the assets at a bargain price? 6. Alternatives to Dissolution a. Court could appoint a receiver, but traditionally, the function to wind up the business and distribute the surplus i. So, if you want to keep the business going, that probably isnt the way youll want to go b. courts can appoint a provisional director or custodian who can take over and run the business until shes no longer needed or only step in when the parties are deadlocked on a particular issue i. DE 226: appt or custodian or receiver on deadlock or other causes. ii. DE 352: Appt of provisional director. NOT a receiver and must be impartial. iii. OH 1701.911: court can appoint provisional directors, but must be in charter and P must establish that, because of irreconcilable differences among existing directors, the continued operation of the corporation has been substantially impeded or made impossible a. directors or 1/5 SH voting power. b. Hearing before the ct required before appt c. Provisional director must be generally conversant w/ corp affairs, have no legal or equitable interest in shares or obs of corp and not indebted to corp. iv. CASE STUDY: Giuricich v. Emtrol Corp. (p .435) a. P petition for appointment of custodian based on a shareholder deadlock between Ps and Continental Boilerworks, Inc.; trial court refused to appoint a custodian b/c there had been no injury to any of the vital interests of Ps as stockholder or to Emtrol b. HOLDING: reversed by appellate court; custodian appointed and will be empowered to act only in situations in which board of Emtrol has failed to reach a unanimous decision, resolving issue in a manner which he shall deem appropriate; 63

64 will serve for as much time as court will deem necessary or until shareholder unanimously request his removal v. Problems with provisional directors or custodians a. Courts are typically reluctant to have a court appointed officer take over and run the business indefinitely b. So, it only works if parties can quickly resolve their differences 7. Issues if Court Must Order a Buyout a. If minority shares are worth less than control shares in arms length transactions, should courts discount minority shares in a judicial buyout? i. CASE STUDY: English v. Atromick Intl, Inc. (Ohio App. 2000) a. HOLDING: in an appraisal proceeding, there should be a discount for minority shares b. Other courts have said this is unfair b. Should the price in a buy-sell agreement be followed in a judicial buyout? i. Cts sposed to determine or get someone determine a fair a fair buyout price ii. Courts are divided on this issue c. Dissolution for Oppression and Mandatory Buy Outs i. Tendency to grant relief more freely to minority SH who petition for it, bu to give relief in the form of a mandatory buy out of petitioners shares at fair value. Petition by minority SH for dissolution commonly a trigger for mandatory buy out of minoritys stock. ii. Benefits: a. Liquidation not required, so liquidation of profitable business not reqqed. b. Gets rid of concern that granting dissolution a lot will allow minority to use it to put pressure on majority/extort a high settlement c. Less drastic remedy d. And minority can get the value of his stock and exit pretty much on demand. iii. Valuation a. In mandatory buy out: ct must value corps business; in dissolution public sale so market decides. Dissolution may be the better way to value stock though. 8. Dangers in bringing/resisting suit for dissolution a. If you dont win: run the risk of obtaining a result you dont like out of the alternative remedies the ct can order (ie buyout provision against you) b. May create more disputes than it solves (ie bad blood then you have to go back and negotiate with those you sued) c. Run the risk of majority SH creating a provision bad for you if you bring suit against corp. 9. Legitimate Business Purpose a. In Wilkes, court says you cant fire someone without a legitimate business purpose b. In Merola, court said it was okay to fire someone without a legitimate business purpose c. What if you cant show a lack of legitimate business purpose? i. Denial of shareholders reasonable expectations in Hinkley: if action defeated Ps reasonable expectations, then P is entitled to relief ii. Reasonable expectations are to be ascertained by examining the entire history of the participants relationship (p. 445) d. Legitimate business purpose: ct focuses on reasonable expectations that are fulfilled. Original understanding of the parties and course of subsequent dealings. i. Includes expectations at the inception of relationship, those altered over time, those which develop as parties engage in course of dealing in conduct affairs fo corp. ii. Dent says legit business purposes req has not been abandoned, but not always applied 10. So, does the court have implied powers to order dissolution aside from its statutory power? a. As to Ohio, Dent isnt aware of any case law 64

65 b. In some other states, courts have held that they do have an inherent power to grant dissolution and other remedies that go beyond the statutes, but it is unclear when and if courts will find the need to exercise this power 11. CASE STUDY: Wollman v. Littman a. P claims that two shareholding groups were at odds, so management was impossible; seeking dissolution b. HOLDING: disagreement among shareholders doesnt mandate dissolution here b/c their disagreement hasnt destroyed the function of the company; dissolution would accomplish the wrongful purpose that Ps in this are charged with as Ds in the other case c. REASONING: functions of the two disputing interests are distinct, one selling and the other procuring, and each can pursue its own business without the need for collaboration; Ps are the only interested purchasers financially strong enough to take advantage of buying the inventory of the business upon liquidation at a bargain price (similar to Page v. Page partnership) d. RULE: deadlock alone doesnt necessarily warrant dissolution; dissolution must also be equitable 12. CASE STUDY: Matter of Kemp & Beatley, Inc. a. Once Ps were fired, company changed policy and decided to pay bonuses on work done rather than pay dividends, so Ps get nothing for stock; Ps claim they were frozen out b/c assets are worthless; involuntary dissolution statute permits dissolution when a corporations controlling group is guilty of oppressive action toward complaining shareholders b. HOLDING: trial court didnt err in finding that this conduct constituted oppressive action within meaning of statute; Ds suggested no feasible alternative remedy to forced dissolution; in light of apparent deterioration between Ps and governing shareholders, it wasnt unreasonable for court to find that forced buyout of Ps shares or liquidation of the corporate assets was the only means by which Ps could be guaranteed a fair return on their investments c. RULE: oppression only arises when majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the Ps decision to join the venture d. RULE: assuming P has set forth a prima facie case of oppressive conduct, D must demonstrate the existence of an adequate, alternative remedy to dissolution i. Ct has broad latitude in fashioning alternative relief, but if it wont fulfill oppressed SHs expectations, ct shouldnt hesitate to order dissolution. e. RULE: every judicial order of dissolution must be conditioned upon permitting any shareholder to elect to purchase the complaining shareholders stock at fair value 13. CASE STUDY: Muellenberg v. Bikon Corp. (p. 451) a. Burg was a minority shareholder and general manager of Bikon; willing and able to purchase shares of Mullenberg b. HOLDING: went against SH reasonable expectation, and gave Burg right to buy out the majority shareholders c. REASONING: Burg was primarily responsible for developing companys contacts with U.S. and Canada and is best situated to maintain existing operation; it was Burg who sought to preserve the corporation at a time when Muellenberg and Passerini attempted to dissolve it d. RULE: courts arent limited to statutory remedies, but have a wide variety of equitable remedies available to them

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66 W. Arbitration 1. Can be a way to deal w/ deadlocks or oppression. Best to have a unanimous board approval reqs for certain issues and decisions. 2. CASE STUDY: Application of Vogel (p. 463) a. Vogel and Lewis agreed to arbitration to deal with disputes; disagreed about whether or not to exercise an option over the warehouse; when Lewis invoked arbitration clause, Vogel argued that statute provided that business of a corporation be managed by its board b. HOLDING: ct wont always enforce arbitration agreements, such as where the matter is one of everyday management and does not req assumption of any burden of continuing management 3. Courts are now much more willing to enforce arbitration agreements 4. Drawbacks to Arbitration a. Expensive and time consume, though still cheaper and faster than litigation b. Brining a stranger in to settle affairs c. Assumes that parties want to continue business together (on the other hand, if someone wants to enforce an arbitration agreement, they havent agreed to break up) d. Not always enforceable (Vogel) X. Preemptive Rights 1. Power to issue authorized but unissued stock and the unissued stock at the price at which the will be issued is in the hands of the board subj to exception: each existing SH has the right to subscribe to her proportionate part of a new issue of stock-modern statutes req this ot be in certificate 2. Basically a close corporation issue; rare that issue of preemptive rights would arise in large, publicly-held corporation 3. Courts and legislatures designed preemptive rights so that clients can continue to own the same proportion of stock 4. In both OH 1701.15 and DE Sec. 102(b)(3), the default rule is no preemptive rights unless the charter states otherwise. Also lots of exceptions 5. But, even where statutes dont protect minority shareholders, there is still the idea of fiduciary duties or equity a. Ct intervenes if stock issuance is inequitable b. IE where stock is issued knowing that minority has no money to buy proportionate share under preemptive rights c. Now under breach of fiduciary duty reqs nad reasonable expectations 6. CASE STUDY: Schwartz v. Merien (p. 109) a. RULE: quasi-preemptive rightclient may be entitled to relief if there is i. No good reason for the sale, OR ii. The stock is being offered at an inadequate price 7. HYPO: shareholder owns 1/3 of a corporations stock and has protected herself from the majority with cumulative voting; unanimous shareholder approval needed to amend charter; majority of board votes to have corporation sell them, but not our client, 10 authorized, but not initially offered, shares of stock a. Now, our client has 10 total shares, where A and B now have 20 b. So, even with cumulative voting, she cannot elect a director; she has been ousted from the board of directors c. This is the type of problem that preemptive rights were designed to solve d. Now, this probably would probably be addressed through the concept of fiduciary duty since this would be a violation, but in the past fiduciary duty was enforced more narrowly e. So SH would be entitled to demand 1/3 share in new stock issue 8. LESSON: if youve got someone whos being a pain and owns 40% of the stock blocking amendment, you could issue more stock so he owns less than 1/3 of the stock, but he may sue a. Or plan ahead and make an exception for certain cases 66

67 VI. Corporate Governance A. Under the corporation model, shareholders have the ultimate power b/c the elect the board of directors, who then select of the officers (this is only in theory though) B. Directors arent technically agents of the shareholders b/c theyre not subject to the control of the shareholders and can exercise their own discretion in managing the corporation, but they are fiduciaries C. Officers are elected by the board of directors, and they really run the show 1. Officers are agents of the corporation, which is embodied by the board; theyre employees 2. Theyre subject to the control of the board 3. Shareholders dont control the corporation b/c they are so many of them and they each own such a small amount of stock (rational apathy); leads to Wall Street Rule: vote with management or sell b/c not worth it to fight w/ managment 4. There is a theory called the director primacy model, which posits that the directors run the show, but this doesnt really seem to be the case; media reports always mention CEO, etc. 5. We know board doesnt really control company b/c they only meet 10 days/year D. Board of directors consists of inside directors and outside directors 1. Inside directors: officers who are also directors; in exerting control, tend to act as managers 2. Outside directors: on board, but not officer. Generally the majority of board. Probs: a. Lack of information or lack of control over information: dont have an independent source of information. b. Constraints of time: only there sometimes, whereas managers/officer have daily contact c. Composition: typically CEOs of other companies, so when in position of director, they usually shut up and take on a docile role; CEO will dominate the selection and pick people who arent going to rock the boat d. Movement to get more outside directors on the theory that this will produce a more independent board i. Dent doesnt think this is likely to work ii. Studies have shown no correlation between the number of outside directors and the performance of the company 3. Mushroom theory of directors: directors kept in the dark aobut corp affairs and fed BS and if they dissent, removed. 4. Separation of ownership/control: those that own dont control and people who control dont own E. Theory of the corporation is that it is run for the benefit of the shareholders 1. Improve shareholders position by maximizing share value 2. Does that mean current share value or future share value? 3. An efficient market hypothesis would say theres no difference b/c current value reflects all future expected payouts 4. Corporations can make some exceptions from the rule of maximizing share value for things like charitable contributions (p. 142, note 1) 5. But, this is just a model of how things are supposed to work (e.g., in reality, CEOs have exorbitant salaries) 6. CASE STUDY: Dodge v. Ford Motor Co. (p. 134-136) a. Ford declared a policy not to pay in the future any special dividends but to put future earnings back into the business other than regularly dividends; Dodge brothers brought suit; Ford said he thinks the company has made too much money and wants to reduce prices for public b. HOLDING: business corp organized and carried on primarily for profit of SH. it is not within the lawful powers of the board of directors to shape and conduct the affairs of a corporation merely for the incidental benefit of shareholders and primary purpose of benefiting others; corporations must be operated for benefit of shareholders 67

68 7. CASE STUDY: Katz v. Oak Industry, Inc. (p. 145) a. HOLDING: board doesnt have to consider creditors when making decisions about money; if the boards playing with the creditors money, it hasnt breached any fiduciary duty; creditors have protected themselves by contract F. Constraints on managers self-serving behavior 1. Fiduciary Duties (legal constraint) a. Unless the behavior is outlandish, courts are going to uphold it, so not much of a constraint b. But, the executives cant steal money; cant take $1 out of the corporate till without authorization, but as long as the compensation is authorized, basically, the skys the limit c. In the last 15 years, executive compensation has grown much faster than corporate profits b/c CEOs pick their own pay 2. Threat of Takeovers a. If an officer isnt doing a good job, the stock prices will go down, and then someone might come in, buy up the company, and take it over b. This isnt a realistic fear b/c there are a lot of obstacles to takeovers i. People dont make takeover bids for a premium of 20%, so the officers can let the stock prices fall quite a bit before they have to worry about a take over ii. Lots of states have adopted anti-takeover laws iii. Might be provisions in charter to prevent takeovers iv. Ohio has every kind of anti-takeover law every conceived, and they make it much more difficult and expensive for a public company incorporated in OH to be seized in a hostile takeover 3. Align interests of fiduciary with interests of beneficiary (i.e., stockholder) a. Make payment contingent on good performance b. Give executives stock or stock options c. Limitations of this type of constraint i. Even if the company goes up in value, youre only going to get some small percentage of that as dividends if you own stock ii. If an officer owns a small percent of the companys stock, he might not care about a silly company project, like building a retreat b/c hell still get to use it and the other shareholders wont iii. Also, its not likely that there will be a 1:1 ratio between your performance and the price of stock d. If youre the CEO, youre likely to get a package which benefits you whether or not you perform well e. Under the current model, we dont care directly about employees b/c corporation should be run for benefit of shareholders f. But may want money in your pocket rather than in the corp 4. Apart from money, executives also want company to grow a. If the company grows, you can justify more compensation for yourself b. Want to motivate all of the executives who work under you by having incentives, i.e., promotions c. Side note: dont see as many poor executive motivations in close corporations b/c its different when youre playing with your own money G. Theories Competing with Maximized Share Value Model 1. Resurgence lately in the corporate responsibility theory a. In other industrialized societies, employees are given a director voice in governance, and there is a greater concept of social responsibly of corporation b. Problems with corporation responsibility theory i. Theoretical: doesnt the concern for stakeholders or social responsibility undermine productivity or efficiency? ii. Practical: how would you restructure corporate governance to effectuate your goals? 68

69 2. Stakeholder theory: corporate governance should greater account of concerns of other stakeholders 3. Dent dislikes shareholder primacy model and thinks director should be nominated by largest 1020 shareholders, which would be institutional shareholders in most cases 4. European model of a two-tiered board, in which half of the directors are picked by the employees a. A lot of people say this is just window dressing b. Most American unions show very little interest in the two-tier model b/c they dont want to put people on the board where they will be expected to behave in something other than a selfish way H. Publically Held Corporations 1. Rational apathy still applies 2. Are institutional SH though a. They can play a role in corp business policy VII. Duty of Care A. Two Fiduciary Duties: Duty of Care and Duty of Loyalty 1. If director is interested in some way, think in terms of duty of loyalty If not, think in terms of duty of care 2. Duty of care a. Duty of care under OH Sec. 1701.59(B): director must perform his duties in good faith, in a manner he reasonably believes to be in or not opposed to the best interests of the corporation, and with the care that an ordinarily prudent person in a like position would use under the circumstances i. Standard for negligence in torts ii. Very few directors are actually held liable for a breach of their duty of care under this standard b. Ohio has several provisions weakening the standard for duty of care i. OH Sec. 1701.59(C)(1): clear and convincing evidence as opposed to preponderance of the evidence; higher burden to prove a breach of duty of care ii. OH Sec. 1701.59(D): director liable for damages if deliberate intent to cause injury or reckless disregard of best interests of organization a. Still leaves negligence as standard for liability in equitable cases, but how often do people sue for an injunction? b. So, we start with an ordinary negligence standard, but when it comes to an action for damages, which includes most actions, we have an exception that dominates the general rule iii. OH Sec. 1701.59(E): director may consider constituencies other than the shareholders a. This section is of fairly recent vintage in OH b. This is really an anti-takeover provisions; if someone comes along and makes a bid for your position and all of the shareholders are clamoring to the let the bid go through, you cant say the bid isnt attractive for the shareholders, so the managers to this provision to allow them to say theyre considering the employees c. DE courts apply a gross negligence standard i. Point is to raise the bar to require something more than regular negligence ii. Only actions that violate duty of care = intentional misconduct or knowing violation of law (Van Gorkom and see DE 102(b)(7)) 3. Duty of loyalty a. Stronger duty, If an act is self-dealing, then the duty of loyalty applies but Sometimes hard to know what self-dealing is b. P must prove by clear and convincing evidence deliberate intent to cause injury or reckless disregard of the interest of the corp. 69

70 B. CASE STUDY: Kamin v. American Express Co. 1. Derivative suit by two minority stockholders seeking declaration that dividend in kind was a waste of corporate assets; Ps think company shouldve offset losses and gains from selling stocks, but company distributed stock as dividends instead; didnt get to realize the loss under tax lows, so they threw away the possibility of tax savings just so profits didnt go down 2. HOLDING: that the board was mistaken, that other courses of action wouldve been better, or that the boards action might benefit some shareholders more than others provides no basis for judicial judgment, so long as it appears that directors have been acting in good faith; Ds motion for summary judgment granted 3. RULE: imprudence or mere errors of judgment arent sufficient grounds for court inference b/c the powers entrusted with corporate management are largely discretionary; the court wont interfere unless a clear case of fraud, oppression, arbitrary action, or breach of trust, or neglect of duties is made out 4. Inconsistency in ruling: NY Sec. 717 says ordinarily product person, the court says more than imprudence must be shown C. Business Judgment Rule 1. The business judgment rule is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith, and with the honest belief that the action taken was in the best interests of the company. OH 1701.59B 2. 4 conditions: if satisfied, special standard of review of rationality or having a rational basis. If not satisfied, standard is based on entire fairness or reasonability. a. Director must have made a decision i. Failure to make an inquiry or action does not qualify b. Director must have informed himself w/ respect to business judgment rule to extent he reasonably believes appropriate under circs c. Decision must be in good faith d. Director may not have a financial interest in subj matter of decision 3. CASE STUDY: Aronson v. Lewis (p. 527) a. RULE: directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them; under the business judgment rule, director liability is predicated upon concepts of gross negligence b. But, recognize that theres no one accepted definition/meaning of the rule 4. Test for Duty of Care in DE a. Board mustve been fully informed, i.e., had substantial information, and b. Board mustve acted in good faith c. Burden of proof on P 5. Presumption that directors didnt act improperly protects them from liability a. Similar to the presumption that D isnt liable in civil cases; P has burden of proof b. Sometimes see it said that business judgment rule means that directors arent liable for mere errors of judgment, but isnt this true in other areas, like malpractice? 6. After Van Gorkom, corporation executives were upset and went to DE legislature, which enacted DE Sec. 102(b)(7) a. DE Sec. 102(b)(7): permits provision in charter (which must be approved by shareholders) to eliminate duty of care except for i. Intentional misconduct ii. Bad faith, or iii. An act motivated by desire to increase directors own profit b. This provision does away with duty of care, but Disney tells us that a board can still be held liable under Sec. 102(b)(7) 7. Standard of review under business judgment rule: the decision must be rational or must have a rational basis (p. 541) a. Sometimes debated whether reasonable is a higher standard than rational 70

71 b. ALI caved in and changed it to rational after corporate directors complained c. Doesnt seem to be much of a requirement of rationality in the Kamin case since court didnt care that P claims Ds behavior was irrational; didnt need trial to see if Ds decision was rational d. Courts sometimes say that theres a requirement that behavior must be rational or reasonable, but its hard to find cases in which court says that directors acted in good faith, but their behavior was irrational 8. Court looks to process used to reach the decision, not just what decision was made (see Van Gorkom below) a. But, no matter how closely some adheres to the process, they might not come to the right result b/c they lack prudent wisdom or experience b. When youre planning, you have to take this rule into account i. Discuss the issue for awhile, roll in documents from experts, etc., then vote on it (even if youve really already made up your mind) ii. Then, if the project doesnt turn out well, the directors wont be held liable for making a hasty decision c. Make sure you make a record of your discussions in the minutes; correct the minutes before you approve them, etc. 9. In a given case, the standard for the business judgment rule might be different for different directors a. OH Sec. 1701.59(B): directors in a like position b. Directors might be in different positions when one director has specialized knowledge c. CASE STUDY: In re Emerging Communications, Inc. Shareholders Litigation (p. 528) i. HOLDING: Muoio, a director, was culpable b/c he voted to approve the transaction even though he knew or had strong reasons to believe that the $10.25 per share merger price was unfair; he was in a unique position to know that b/c he possessed specialized financial expertise; as a fiduciary, he was required to advocate that board reject the $10.25 price; other directors could plausibly arguing that they voted for transaction in reliance on Houlihans opinion, but Muoio shouldve known better 10. Duty of care can vary from time to time and in different circumstances a. OH Sec. 1701.59(B): mentions similar circumstances b. what issues you should spend more time on depends on what kind of business youre involve in and size of company 11. Van Gorkom holds that a director must be informed, but no director can get all of the information she needs herself, so she can sometimes rely on information from others a. Reliance must be AT LEAST in good faith i. If you know the expert is wrong or doesnt know what hes talking about, then your reliance isnt justified (e.g., In re Emerging Communications, Inc.) b. OH Sec. 1701.59(B): rely reasonably in good faith (subjective good faith + objective reasonableness) c. DE statute doesnt say reasonable, but its clear that its included under the Van Gorkom rule 12. Arguments for a Stringent vs. Lenient Duty of Care a. Stringent duty (reasonableness) i. Will compensate losses of shareholders b. Lenient duty (business judgment rule) i. CEOs need discretion ii. If there was a stringent duty of care, no reasonable person would want to be a director, and if I they did, they would be unduly cautious iii. Courts are ill-equipped to second-guess the judgment of directors; due to hindsight bias, court might treat things that turned out badly as bad decisions 71

72 iv. Generally, directors arent supposed to run the day-to-day business; theyre just supposed to monitor the company 13. CASE STUDY: Parnes v. Bally Entertainment (Del.) a. RULE: directors are liable for an act so far beyond the bounds of rational judgment that it seems essential inexplicably on any ground other than good faith; in the corporate area, no special competence or intelligence is required; very low standard 14. CASE STUDY: Smith v. Van Gorkom a. Ps, shareholders of Trans Union, seeking rescission of a cash-out merger of Trans Union into D New T Company, a wholly-owned subsidiary of Marmon Group, Inc.; Romans report didnt come up with price for company, but said $50-$60/share for a leveraged buy out would be good; CEO Van Gorkom told board that $55/share was a good price; Pritzker offered $55/share; no one supported it; lawyer said they might get sued if they rejected the offer; stockholders approved proposal b. HOLDING: directors had a duty to make a reasonable inquiry of Van Gorkom and Romans; board didnt reach an informed business judgment to accept Pritzkers merger offer; they were grossly negligent in approving the sale of the company; court rejected shareholder-approval defense b/c shareholders werent fully enforced or facts material to approving merger c. RULE from Aronson: under business judgment rule, director liability is predicated upon concepts of gross negligence. Thus the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one. d. What should the board have done? i. If they werent sure they shouldve rejected offer (but, attorney says, you might get sued if you reject the offer) ii. Offer premium was 50% over market pricewell beyond norm for mergers; not prima facie inadequate e. Side note: directors here probably didnt argue like they were differently situated (like directors in In re Emerging Communications, Inc.) b/c they all had the same lawyer; less is to get your own lawyer if youre part of a group thats being used 15. CASE STUDY: Cede & Co. v. Technicolor (p. 540) a. RULE: if board is uninformed, P doesnt even have to show injury; burden shits to D to prove decision wasnt unfair 16. CASE STUDY: In re The Walt Disney Company Derivative Litigation a. P alleged that D directors breached their fiduciary duties when they blindly approved agreement with D Ovitz, and then, against without any review or deliberation, ignored Eisners dealing with Ovitz regarding his non-default termination b. HOLDING: Ps complaint sufficiently alleges a breach of the directors obligation to act honestly and in good faith in the corporations best interests to conclude that, if the facts were true, Ds conduct fell outside the protection of the business judgment rule; Ds motion for summary judgment denied c. RULE: A DE 102(b)(7) provision in a corporations charter doesnt eliminate or limit the liability of a director for i. Any breach of the directors duty of loyalty to the corporation or its stockholders ii. Acts or omission not in good faith or which involve intentional misconduct or a knowing violation under the law iii. Under DE 174 of this title, or iv. For any transaction from which the director derived an improper personal benefit d. RULE: where a director consciously ignores his or her duties to the corporation thereby causing economic injury to its stockholders, the directors actions are either not in good faith or involve intentional misconduct e. AFTERMATH: case went to trial, and court ruled in favor of Ds, finding they werent grossly negligent; therefore, DE Sec. 102(b)(7) didnt apply 72

73 17. CASE STUDY: In re Caremark International, Inc. Derivative Litigation (p. 562) a. HOLDING: directors liable for a sustained or systematic failure to exercise oversight D. Causation 1. Notion of proximate cause, forseeability, and Palsgraf 2. E.g., suppose on a particular matter board votes 15 to 0 to go ahead with a certain project; directors defense is that even if he voted against it, it wouldnt have made a difference; therefore, he didnt cause the loss 3. If that were the law, no director would be held liable 4. CASE STUDY: Barnes v. Andrews (p. 529) a. Andrews only attention to Liberty affairs consisted of talks with Maynard as they met from time to time; Liberty went into receivership b/c of mismanagement; Andres was sued for violating his duty of care by not paying sufficient attention to the corporations affairs b. HOLDING: Andrews violated his duty of care b/c he had a duty to inform himself of what was going on with some particularity, but P also had to prove Libertys losses wouldnt have occurred if Andres had properly performed his duties, and no such showing was made c. RULE: P has burden of showing that the performance of Ds duties wouldve avoided the lass, and what loss it wouldnt avoided d. But, in the case of an illegal transact, theres a fair inference that a protest wouldve stopped the illegal transaction E. Criminal Liability 1. Criminal liability not effective against corp misconduct: cant put a corp in jail! 2. If you impose fines on a corporation, it will treat the fines as a cost of doing business and pass it on to the consumers and shareholders a. Troubling to punish shareholders b/c they dont have no control over how the corporation acts 3. 4 elements: a. Offense level of the crime b. Base fine c. Culpability score d. Fine range 4. Federal Sentencing Guidelines focus on: monitoring whether corp has established compliance programs-standards that the board should ensure exist. 5. Criminal penalties for directors who knowingly commit or order someone else to commit illegal acts 6. Problems only arise with things like negligence 7. Types of Statues imposing liability a. First type make corp managers crim liable for unlawful corp acts if managers themselves performed or caused the performance of the act b. Second type makes managers crim liable for unlawful acts of employees over whom they have the power of control, even if not exercised c. Requirements of foresight and vigilance imposed on responsible corp agents are beyond Q demanding and perhaps onerous, but no more stringent than public has the right to expect. 8. CASE STUDY: United States v. Park (p. 600-601) a. Park was Acmes CEO; FDS advised Park by letter of unsanitary conditions, including rodent infestation, in Acmes Philadelphia warehouse; Park told that VP of Baltimore division was investigating matter; government brought criminal proceedings against Acme and Bark on grounds that food held for sale in Acmes Baltimore warehouse was exposed to contamination by rodents b. HOLDING: Park was convicted, although he hadnt authorized the violations and the statute didnt explicitly impose criminal liability on managers based on the acts of others; strict liability; very high amount of diligence isnt a defense 73

74 c. RULE: not enough to tell subordinates to clean up the business; Park shouldve gone to Baltimore himself to clean it up; ridiculous standard to hold CEO 9. CASE STUDY: Bowes v. Cincinnati Riverfront Coliseum, Inc. a. Patrons died while entering coliseum; P seeks damages for wrongful deaths and personal injuries; Ds include 9 directors of the Coliseum and Heekin, a shareholder, director, President, and CEO of the Coliseum, who took an active party in its day-to-day operations b. HOLDING: directors shouldnt have been dismissed from litigation; trial court also erred in rendering summary judgment in favor of Heekin c. REASONING: directors were fully aware of public nature of Coliseums business; knew of festival seating and crowd control problems; Heekin was manifestly the Coliseums headman with untrammeled sanction from board d. RULE: a corporate officer is individually liable for injuries to a third party when the corporation owes a duty of care to the third person, the corporation delegates that duty to the officer, the officer breaches that duty through personal fault, and the third person is injured as a proximate result of the officers breach of that duty i. Recall from agency law: one who participates in a tort is liable to the victim even if hes acting as an agent; narrow exception of agent followed principals directions in good faith e. LESSON: this case shows that the kinds of issues that arise in shareholder suits like Van Gorkom can also arise in suits by third parties who have been injured by the corporation, and in addition to going after the corporation, they may go after individual directors F. Civil Liability of Directors and Officers 1. Director/officer may be civilly liable to 3rd persons for acts he commits in a corp capacity. 2. But individual who signs a K on behalf of corp is cloaked in mantle of the enterprise and is not personally liable for action taken in corp name 3. But same individual who acts for same corp in same capacity taking an action that is tortious loses the corp cloak and held individually liable w/ enterprise VIII. Duty of Loyalty and Self-Interested Transactions A. The old common law rule was that a self-interested transaction was voidable at the instance of the corporation or its shareholders, without regard to the fairness or unfairness of the transaction (p. 606) B. The current common law rule is that a self-interested transaction is permissible if it is fair to the corporation (p. 608) C. Corporate directors and officers may under proper circumstances transact business with the corporation, but it must be done in the strictest good faith (strict scrutiny); much stronger than with duty of care and business judgment rule D. Analysis with Duty of Loyalty Cases 1. Interested transaction 2. Burden usually on D to prove intrinsic fairness of deal 3. But, if transaction was approved by disinterested board after full disclosure, then 4. Burden shifts to P to prove transaction was unfair E. DE Sec. 144(a): no contract or transaction by a corporation in which one of its directors or officers have a financial interest shall be void or voidable solely for this reasons IF 1. Material facts are disclosed to board, and board in good faith authorized contract by affirmative votes of a majority of disinterested directors, OR 2. Material facts are disclosed to shareholders and contract is approved in good faith by them, OR 3. Contract or transaction is fair to corporation at the time it is authorized by board or shareholders 4. N.B.! Courts have interpreted an additional element which requires directors who engage in self-dealing to establish that they have acted in good faith, honesty, and fairness a. Requires showing of fair price b. Some courts hold that statutes shift burden of proof: burden of proof in an interest transaction is usually on D to prove fairness, but if transaction is approved by disinterred directors, then burden shifts to P to prove transaction was unfair 74

75 F. CAVEAT: DE 144(a) only says that contrast isnt voidable solely for this reason; which means that DE legislature wasnt saying that a transaction is okay if clause 1, 2, or 3 is satisfied 1. Rather, they are simply doing away with the common law rule under which such actions were automatically voidable 2. Rule just says, self-interested transactions arent automatically avoidable if one of these clauses is satisfied 3. Even if D falls under clause 1, 2, or 3, there is still the remaining issue of whether the transaction is fair G. General approach is that there must be some personal financial interest either in the transaction or somehow the director must be financial beholden to the D in order for the director not to be considered disinterested H. If youre worried that one of the directors isnt disinterested, you seek shareholder approval for the interested transaction 1. Shareholder ratification will be ineffectual if a. A majority of those affirming has a conflict of interest b. The transaction ratified constituted a corporate waste (p. 641) I. N.B.! Look at whether or not the transaction was fair at the time it was made; not at the time the suit is brought; e.g., look at the prospects of the enterprise J. One consequence of the difficulty of determining fairness is that the burden of proof can be crucial 1. Burden of proof only makes a difference when the weight of the evidence on both sides is exactly equal 2. The burden of proof can be a way of courts getting out of deciding a hard case K. Types of Interested Transactions 1. Most obvious type of interested transaction is a contract between a director and the corporation 2. Also includes transactions between two corporations, in which one person is a director of one corporation and an executive of another or where the individual is a director of A corporation and a majority shareholder of B corporation (perhaps even a minority shareholder) L. Remedies for Breach of Loyalty 1. Damages or restitution 2. Disgorgement of unjust enrichment/profit (often through the imposition of a constructed trust) a. Just take out whatever part of Ds returns was unjust profit and take that out b. Similar to what we saw in agency and breach of fiduciary duties c. Requiring P to disgorge all profits to deter such transactions and squeeze any possible of gain out of such transactions 3. Damages are hard to determine M. Principle of Waste 1. Waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade; basically a gift 2. If there is any substantial consideration received by the corporation and if there is a good faith judgment that the transaction is worthwhile, there should be no finding of waste, even if the fact finder would conclude ex post that the transaction was unreasonably risky 3. Shareholders cannot ratify waste except by unanimous vote 4. If a transaction cant be set aside as interest, it can only be set aside as waste 5. Donations a. De 122(9): donations allowed for public welfare/charitable/scientific/educational purposes/time of war/natl emergency. Dont have to justify w/ share price or maximizing profit b. DE 122(12): can transact lawful business to aid govt authority. c. Implied limit of reasonableness.

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76 N. PROBLEM 11: Hazard proposed a transaction where he would create a new company, Newco, giving it his property, Blackacre, in exchange for stock; then, Alchemy Corp., of which he is a 10% shareholder, would lend Newco $4 million for $5 million interest and mortgage on Blackacre; Hazard abstained from voting, and board voted 4-3 in favor of proposal; one of directors voting in favor was Hazards cousin; board then voted 6:1 to exercise Alchemys options to convert Note into Newco common stock; Blister, dissenting director in both votes, wants to sue 1. Disinterested Director Approval a. Dent isnt sure if being a cousin would by itself be enough to make a director disinterested b. On the other hand, its hard to be disinterested when dealing with relatives 2. Fairness of Transaction a. Hazard put up 20% of the money, but hes getting 50% of the equity; doesnt sound too fair b. Alchemy put up 80% of the money ($4 million), and now has 50% of a company worth $10 million, so they now have $5 million, so D would argue this is fair c. But, we should look at whether the transaction was fair at the time it was made, so the fact that Alchemy made a profit isnt dispositive i. Whether the transaction was fair would also depend on the prospects of the enterprise; what were the odds that the company would return at least the $4 million of Alchemys loan? d. Alchemy gave the money as a loan, so their status wasnt the same as Hazards i. Equity investors take more risk than lenders b/c they get paid after lenders ii. Equity investors get profit from sale, not lenders iii. In effect, Hazard stood to lose first $1 million, so you could argue he was taking a much greater risk; therefore, the transaction is fair O. CASE STUDY: Cookies Food Products v. Lakes Warehouse 1. Shareholders derivative suit brought by minority shareholders in a closely-held corporation (Cookies); alleged that Herrig, by acquiring control of Cookies and executing self-dealing contracts, breached his fiduciary duty to the company and fraudulently misappropriated and converted corporate funds; claim Herrig is getting paid too much, substantially reducing corporate profits, and he negotiated for exclusive distributorship and taco sauce royalty without fully disclosing benefit he would gain 2. HOLDING: cannot agree with Ps that Herrigs services were either unfairly priced or inconsistent with Cookies corporate interest; he was the driving force in the corporations success; Herrig may in fact be underpaid for all he has accomplished; members of board were aware of Herrigs dual ownership of Lakes and Speeds; Herrig furnished sufficient information to Cookies board to enable it to make prudent decisions 3. RULE: strict scrutinypolicy of courts to put such fiduciary beyond the reach of temptation and the enticement of illicit profit; burden on D to prove his good faith, honesty, and fairness 4. RULE: self-dealing transactions must have the earmarks of arms-length transactions before a court can find them to be fair or reasonable P. HYPO: Board of Zilchko run by Zilchko family; board wants to make a donation to the Zilchko Family Charity 1. Easy to say this is a charitable donation permitted under DE Sec. 502 2. Donations are tax deductible 3. Some courts go by the IRS guideline that 10% of a companys profits in donations is reasonable 4. Maybe such a gift is waste

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77 IX. Executive Compensation A. In theory, shareholders could sue the executive claiming excessive compensation and try to get the money back 1. But, in the Disney case, Ovitz himself wasnt a member of the board of directors, so he could argue this was an arms length transaction as to him, not an interested transactions B. Now, corporations almost always have a compensation committee comprised exclusively of outside directors, so Ps have a hard argument to make that a compensation decision is an interested transaction 1. But, compensation committees staffed with outside directors dont usually work 2. They usually dont know anything about compensation, so they hire a compensation consultant 3. They usually compare themselves to better companies that probably have a higher compensation 4. Difficult to challenge executive compensation in public corp when approved by disinterested directors or disinterested SH, and usu a tiny share of earnings. 5. In close corps, cts often hold exec comp unreasonable b/c rare to have disinterested parties and compensation likely a large fraction of earnings. a. Also Taxation: exec compensation deductible, and dividends not, so execs would rather choose higher salary so IRS will challenge. C. Under DE Sec. 102(b)(7), a P can argue that the board wasnt informed or wasnt acting in good faith D. P can also allege waste, but it carries a high standard to meet 1. Unless you can show that someone was being paid $1 million/;year for a no-show job, its going to be tough to make this argument 2. Unless you can show that no reasonable person couldve possibly approved this transaction, then youre going to fail E. CEO salaries increased by a factor of 6 over the last two decades F. From 1970-1996, the ratio of CEO compensation to average factor worker increased from 30 to 210 times G. Justifications for Large CEO Compensation Plans 1. Incentive argument: pay people more money and theyll work harder 2. Tournament argument: this is the big prize; dont just want CEO to work hard, but all of the lower executives who are gunning for the CEO position 3. CEOs face more liability and the job is more difficult nowadays H. In theory, executive compensation plans are interested transactions which can be set aside by the court if the compensation is unreasonable; in practice, compensation decisions are almost never set aside when approved by outside directors (e.g., Walt Disney case above) Corporate Opportunities A. An extension of the duty of loyalty of an agent to a principle is that an agent cannot complete with her principal; i.e., an employee cannot complete with an employer when still employed by it B. Rules for corporate opportunities are generally the same in corporation law as they are in partnership law C. Recall Meehan v. Shaugnessy: could plan to compete before they left, but couldnt actually start competing until after they left D. What constitutes competition? 1. What if you open a restaurant on one side of the city and your employee opens a restaurant on the other side? 2. What if the restaurants are next door to each other but ones a hamburger stand and the other is an expensive French restaurant? E. Once you begin to compete, you may not use confidential information acquired during employment 1. Where do you draw the line between general acquisition of skills and use of confidential information? 2. E.g., if youre an associate for a law firm and learn all of the partners technique, you can use them in your own practice; thats not confidential information 77

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78 F. Courts will general uphold contracts not to compete if they are reasonable, unless, of course they violate the law G. Courts will sometimes frown on stealing employees from your former employer H. Different Tests for Corporate Opportunities (p. 661-673) 1. Line of Business Test: whether opportunity is so closely associated with existing business activities that it would throw it in competition with the company a. Does the line of business include things youre thinking about going into or only things youre already into? (see problem 11) b. Issue has become more pressing with companies like GE that make everything c. Guth v. Loft: factors used: fundamental knowledge, practical experience, ability to pursue, logically and materially adaptable to business, within financial position, reasonable needs, aspirations for expansion. 2. Fairness test: unfairness in particular circumstances of a director, as a fiduciary, taking advantage of an opportunity for his own profit; ethical standards of what is fair and equitable a. FAIRNESS TEST (from Durfee v. Durfee & Canning, Inc. on p. 662): overall unfairness in the particular circumstances of a director, taking advantage of an opportunity for his personal profit when the interest of the corporation justly calls for protection; application of ethical standards of what is fair and equitable in the particular set of facts b. Test lacks any useful, predictive value 3. Two-Step Test: 1) line of business, 2) equitable considerations a. Strict req of full disclosure prior to taking advantage of corp opportunity b. Policy: allows corp to decide at the time of the opportunity instead of leaving it to the unfettered judgment of individual directors/officers c. If there is doubt, must be resolved in favor of the corp so officer/director will have strong incentive to disclose business opportunities 4. Interest or Expectancy Test (a.k.a. Lagarde/DE test): corporate opportunity doctrine only applies when the director has acquired property in which the corporation already has an interest or expectancy growing out of a right or interference would balk the corporations purpose a. Interest means a legal interest, but what constitutes an expectancy is unclear 5. ALI test: Director first offers to Corp and discloses conflict of interest and corp rejects and rejection is fair to the corp (disinterested board members). 6. DE has traditionally followed the interest or expectancy test from Lagarde v. Anniston, but the court in Broz makes it seem like its following the line of business test (p. 670), so its no longer clear which standard applies in DE a. DE also offers a safe harbor provision to board or SH i. Director can pursue opportunity unless boards rejection of opportunity fails the business judgment test. Full disclosure not reqqed. I. Two Types of Corporate Opportunities (p. 674) 1. Corporate opportunity that an executive became aware of through the use of corporate property, corporate information, or his corporate positionthat is, through the use of corporate assets 2. Corporate opportunity that is closely related to the corporations business J. Issue whether executive received the opportunity in his individual or corporate capacity (p. 674) 1. ALI Corporate Governance Principles, Sec. 5.05 (p. 664): looks at how the information comes to the director 2. Some argue that this shouldnt be a consideration b/c once youre a director, youre a director 24 hours/day; fiduciary at all times K. Dispute about whether executive must first offer the opportunity to the corporation 1. According to Broz, it isnt the law in DE that presentation to the board is a necessary prerequisite to a finding that the corporation opportunity hasnt been usurped 2. A director can take opportunity and then argue later that company wouldnt have take the opportunity or they didnt have the money 78

79 3. But, some courts have held that a fiduciary is obligated to offer the opportunity to the corporation first and let it decide whether it wants to take the opportunity (p. 676) 4. Seems intuitive that a director should be able to take an opportunity if the corporation CANT take it (see p. 675, note 4) a. Question becomes what are the standards by which we determine whether a corporation has the ability to seize an opportunity b. E.g., corporations often go out and get financing for a project if they dont have the money L. If the board turns down an opportunity, then presumably the business judgment rule applies M. Ways to Mitigate Problems of Later Corporate Opportunities 1. Could put in charter that directors have no fiduciary duties with respect to seizure of corporate opportunities a. Court probably wouldnt like that, but recall Singer v. Singer 2. Limit the purpose of the corporation in its purpose clause a. E.g., purpose of this corporation shall be to own and operate building at 17 Elm St. and nothing else b. DE Sec. 122(17): a corporations charter can renounce a corporations interest in certain opportunities or classes of opportunities N. PROBLEM 12: Board of Waldorf Corp., which owns and operates hotels and restaurants throughout U.S. began considering buying a gambling casino; Castellano, a director of Waldorf and president of Alodium, Inc., purchased a casino in the Caribbean on behalf of Alodium 1. Castellanos (D) arguments a. A broad test would be too restrictive b/c it would prevent someone from taking economic opportunities, and then no one would want to be a director any more b. Wouldnt want the line of business test b/c its the most narrow, especially for corporations like GE that make everything c. Because the Lagarde test is the most narrow, it is the most favorable to the D; the company here doesnt have an interest or expectancy in this land d. Castellano got business opportunity in her individual capacity b/c she was just visiting and got a call from a personal friend e. Good directors are knowledgeable and have a lot of contacts. Have access to a lot of business opps, deterred from serving 2. Waldorf Corp.s (P) arguments a. Shouldnt have a narrow test for business opportunities b/c we want good people to serve on the board of directors, not just people who want to get an opportunity from the company b. Distinguish between opportunities that should belong to corporation and director c. Interest or expectancy test is too narrow: suggests the possibility of facts in Singer v. Singer, where partnership expressed interest in property, adjourned meeting to think about it, and two members went out and grabbed it for themselves d. Brass case 796 e. 798 lagarde f. 798 editorializing end of g. 796 brahs starts w/ tie to business h. Limitation on interest/expectancy. What do we mean by that? Language of Brahs almost sounds like line of business test. Rule/std incumbents dont like, want to change but dont want to say theyre chaging it. Brahs decided they dont like the test but dont want to be accused of judicial imperialism. i. Top of 796 reference to the fairness test. No test at all, just throw in everything at all. More an absence of a test. Could also say Waldorf had interest in expanding its activity j. Top 787, 790 k. ALI do not assume its influence is like restatement like torts/contracts l. Line of business is key line of ALI. m. One element not to compete is geographical scope. Here, they go there for vacation 79

80 i. 6 months cant open another one. If advantage would be gone by that point, ok ii. n. We dont know if Castellano got information from a personal friend; maybe person called her specifically b/c she knew she was a director of Waldorf and thought she might be interested in the opportunity as a director of Waldorf 3. Dent would say that Waldorf didnt have an interest or expectancy here; just had some vague interest in buying land, but not in the legal sense 4. If court follows line of business test a. Waldorf wanted to buy a casino in the U.S., not in the Caribbean i. On the other hand, if you have a casino in the Caribbean, youre probably expecting to get most of your customers from the U.S. b. Even if the casino had been in the U.S., though, that wasnt the type of business Waldorf was in; they were into restaurants and hotels i. But, in Vegas, you usually find casinos in hotels and they have restaurants; could argue that lines of business are at least related

O. CASE STUDY: Northeast Harbor Golf Club v. Harris 1. Nancy prez of club. Clubs only asset the golf course. Nancy wanted to have corp develop some of clubs real estate. Board said no. Nancy was told that property around the club open, and she bought it in her own name to develop. Told the board afterwards, and told them she woudlnt develop it. 2. HOLDING: full disclosure reqqed prior to taking a corporate opportunity. Disclosure req recognizes paramount importance of corp fiduciary duty of loyalty and protects fiduciary. 3. Corporate Opportunity Doctrine: trustee held to something stricter than morals of marketplace. Must disclose and noth withhold relevant info concerning any potential conflict of interest, or knowledge of the affairs of the corp and must refrain from using position/influence/knowledge of the affairs of the corp to gain personal advantage. P. CASE STUDY: Broz v. Cellular Information Systems, Inc. (p. 668-672) 1. Broz was president and sole stockholder of RFBC, a corporation engaged in business or providing cellar telephone service in Midwest; he was also an outside director of CIS, a competitor of RFBC; CIS was at all times fully aware of his relationship with RFBC; after PriCellular became owner of CIS, it caused CIS to sue Broz, claiming that the purchase of Michigan-2 license usurped a corporate opportunity of CIS, even though CIS wouldnt have been interested at time 2. HOLDING: facts dont support conclusion that Broz misappropriated a corporate opportunity; CIS wasnt financially capable of exploiting the opportunity; CIS didnt have a cognizable interest or expectancy; CIS was fully aware of Broz potentially conflicting duties; Broz wasnt under a duty to consider the interests of PriCellular when he purchased Michigan-2 license b/c the acquisition was speculative at the time 3. But should this case be the law given that it seems to reward people for having a conflict of interest? Q. CASE STUDY: In re eBay, Inc. Shareholders Litigation (p. 677-678) 1. eBay retained Goldman Sachs to underwrite its initial public offering; Goldman Sachs rewarded the individual Ds by giving them thousands of IPO shares at the initial offering prices; investors who were well connected flipped got an instant profit by selling the equities; P claims Goldman Sachs provided the IPO shares to show appreciation for eBays business and enhance its opportunity of obtaining future business 80

81 2. HOLDING: even if one doesnt consider Sachs IPO allocations to corporate insiders as a corporate opportunity, D directors were nevertheless not free to accept this consideration from a company that was doing significant business with eBay and intended the consideration as inducement for maintain a business relationship in the future 3. RULE: an agent is under a duty to account for profits obtained personally in connection with transactions related to his or her company XI. Duties of the Controlling Shareholders A. Controlling SH has same fiduciary duty as director when asserting control-if acting just as a SH, they can vote however they wish. B. Traditional rule is that directors dont owe fiduciary duties to creditors; creditors have to rely on their contractual rights alone 1. During insolvency, however, the controlling shareholders may owe some duty to shareholders 2. Also potentially when NEAR insolvency, Credit Lyonnaise. Mostly overrule though. 3. Unclear what fiduciary duties are owed. Generally you are not reqqed to take a very cautious approach and can take justified risks. C. Duty of Disclosure 1. Federal securities laws require disclosure 2. Many state courts have held that fiduciary duties also require full disclosure by majority shareholders D. Analysis for Fiduciary Duty Cases 1. First, ask if there is any self-dealing a. If there is self-dealing, then duty of loyalty, ct applies intrinsic fairness/strict scrutiny test i. Ie when parent company controls all transactions of the subsidiary, receiving a benefit at the expense fo the subsidiarys minority SH, the intrinsic fairness test applies, placing burden on parent company to prove transactions entirely fair. b. If there is no self-dealing, then there is a duty of care, ct applies business judgment test E. CASE STUDY: Zahn v. Transamerica Corp. 1. P asserts that D caused Axton-Fisher to redeem its Class A stock at $80.80/share ($60 + dividends) instead of permitting the Class A stockholders to participate in the assets on liquidation of the company where they wouldve gotten $240/share; Class A stock was entitled to receive twice as much per share as Class B stock upon liquidation; voting rights vested in Class B stock; D purchased outstanding Class B stock and dominated management; Axton-Fishers principal asset was leaf tobacco; P claims D was trying to appropriate value to himself by kicking out Class A shares a. Redeemable/Callable: meaning that subject to conditions in the contract, the company can pick up the phone and take the stock back from the shareholder b. Convertible: means that stock can be converted into a different class of stock at the option of the shareholders at any time. c. Liquidation preference: if the company dissolved, you would get twice as much of the surplus left over than the class B stock 2. HOLDING: act of board of directors in calling the Class A stock (which couldve been consummated by a disinterested board) was effected at the direction of the principal Class B stockholder in order to profit it; call is voidable in equity at instance of injured stockholder; Ps entitled to receive amount they wouldve received upon liquidation 3. RULE: majority stockholders have a fiduciary relationship with respect to corporation and its stockholders b/c it has right to control a. Their dealings with the corporation are subjected to rigorous scrutiny b. Burden is on the stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the view point of the corporation and those interested therein 81

82 4. REASONING: Radical difference when a stockholder is voting strictly as a stockholder and when voting as a director a. When voting as a stockholder, he may have the legal right to vote with a view of his own benefits and to represent himself only b. When he votes as a director, he represents all of the stockholders in the capacity if trustee for them and cannot use his office as a director for his personal benefit a the expense of the stockholders 5. AFTERMATH (Speed v. Transamerica): in a later phase, the court held the call was rightful; a disinterested board of directors wouldve called the Class A stock redemption if it appeared that the distribution in liquidation would exceed that figure on a 2:1 basis; Class A stockholders get price of Class B stock had they converted it; suggestion that if the board hadnt redeemed the Class A stock, they couldve been sued by Class B stockholders for not fulfilling their fiduciary duty to them 6. ULTIMATE RULE: Class A stockholders were entitled to notice of purposes of conversion (so they could decide whether or not they wanted to convert) and a chance to convert; werent allowed to keep stock, but didnt have to deal with redemption process 7. Side note: provision for redemption of Class A stock was there for the benefit of Class A stockholders, not Class B stockholders (???)

F. CASE STUDY: Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp. (p. 145-146) 1. HOLDING: when a company is the vicinity of insolvency, the directors have a fiduciary duty to the creditors, not just the shareholders; the shareholders would want the company to take greater risks with the companys money in the hopes that they could get some of their money back and at the risk of the creditors getting nothing G. CASE STUDY: Geyer v. Ingersoll (p. 917) 1. HOLDING: only if the corporation is actually insolvent do the directors owe fiduciary duties to the creditors, whether or not there has been a statutory filing under bankruptcy law H. CASE STUDY: Sinclair Oil Corp. v. Levien 1. Sinclair (parent holding company in oil business) owns 97% of Sinvens stock (subsidiary Venezuela oil company); Ps argue that Sinclair caused Sinven to give it dividends b/c it needed cash to expand its business, an improper motive; dividends resulted in virtual liquidation; Ps wanted Sinven to expand 2. HOLDING: Sinclair didnt receive anything from Sinven to the exclusion of its minority shareholders; they got paid dividends, too; because the court found that there was no selfdealing, it applied the business judgment test rather than the intrinsic fairness test; Sinclair didnt usurp any business opportunity that came to Sinven b/c Sinven only did business in Venezuela and Sinclair took oil from different subsidiaries in each country around the world 3. Basically, this is a business opportunity case; Sinclair was taking money from Sinven so it could expand its own business; meanwhile, Sinven was seeking to expand its business I. CASE STUDY: David A. Green and Co. v. Dunhill Intl, Inc. (p. 694) 1. Dunhill owned 80.3% of the stock in Spalding; Dunhill acquired Child Guidance Toys, and the minority shareholders in Spalding brought suit against Dunhill, claiming it had appropriated a corporate opportunity that belonged to Spalding 2. HOLDING: business opportunity was in the line of Spaldings business which wouldve been of practical advantage to it and which it was financially able to undertake; that opportunity was acquired by Spaldings controlling shareholder; found for P J. Freezeouts 1. General rule: board of directors can do anything without shareholder approval unless statute says otherwise 82

83 2. But, in the case of selling substantially all of the assets other than in the ordinary course of business, the statutes require shareholder approval a. Substantially all doesnt really mean all i. Cut off in DE seems to be 50-60% ii. Any time a company decides to sell a very large part of its assets, this might be construed as substantially all assets to which special rules apply 3. In many states, shareholders also get appraisal rights 4. A freezeout is a corporate transaction whose principal purpose is to reconstitute the corporations ownership by the involuntary elimination of the equity interest of minority shareholders a. Term is often used to described any oppressive provision which squeezes out the minority in favor of the majority interested, especially in close corporations b. So, watch out for different uses of the term c. Ways to Freeze Out: i. Dissolution: assume S owns 70% and wants to eliminate minority SH. S causes C to dissolve under a plan of dissolution which provides that Cs productive assets will be distributed to S (or entity controlled by S) while cash distributed to minority SH. a. illegal under most cases b/c violates corp norm of equal treatment ii. Sale of Assets: Cs controlling SH, S, organizes new corp T, all of whose stock S owns. S then causes C to sell its assets to T for cash. Result: S owns Cs business through T while equity interest of Cs minority SH is voluntarily terminated. iii. Debt or Redeemable Preferred Mergers: begins like sale of assets w/ org by S of new corp T. S causes C to merge w/ T but instead of issuing common stock, T issues either short term debentures or redeemable preferred stock. Cs minority SH interests in T either terminates automatically after pd of time or terminable at Ts election. iv. Cash Out Mergers: all the survivor in a regular merger to issue cash as well as stock or securities. 5. Can there ever be real negotiations between a company and its controlling shareholders? a. One approach is to form a committee of independent directors to negotiate on behalf of the subsidiary b. DE Supreme Court has been surprisingly strict on insisting on proof that a committee is truly independent and not a sham c. Once and awhile the committees do turn out to be independent, sometimes leaving the majority out in the rain (E.g., RJR and Nabisco; leveraged buyout; committee of independent director conducted an action, company went to someone else, and the CEO lost control of the company 6. Appraisal: court procedure in which court appoints master to decide what stock is worth; then, company has to pay minority shareholders appraised value of stock 7. Board isnt required to do anything if they think the tender offer or other merger deal stinks, but they can advise the shareholders not to take it 8. CASE STUDY: Weinberger v. UOP, Inc. a. P, a former shareholder of UOP, Inc., challenges the elimination of UOPs minority shareholders by a cash-out merger between UOP and its majority owner, Signal; one study found that $24/share wouldve been a fair offer, but Signal offered $21; $24 figure wasnt discussed before a majority of minority shareholders approved merger b. HOLDING: court applies intrinsic fairness test b/c there was self-dealing here; minority vote wasnt informed b/c material information was held, which amounted to a breach of fiduciary duty; merger doesnt meet test of fairness and no burden shifted to P; Ps get quasi-appraisal remedy, which leaves possibility of recissory damages, including an injunction i. But, recissory damages arent much different from an appraisal c. RULE: initially, the burden of proof in intrinsic fairness cases is on the D, the majority shareholders, but where corporate action has been approved by an informed vote of a 83

84 majority of minority shareholders, burden entirely shifts to P to show that transaction was unfair to minority d. RULE: in the context of a freeze out, fairness = fair dealing + fair price; aspects of issue must be examined as a whole b/c its not a bifurcated test; look at fairness of process in determining price i. On the other hand, could argue this focus on process makes no sense b/c a price that is unfair cannot suddenly become fair b/c of negotiations, etc. ii. But, because its hard to determine the fairness of the price, it might make sense to look to the procedures e. RULE: return to the established principles mandating a stockholders recourse to the basic remedy of appraisal, but appraisal may not be adequate when fraud, misrepresentation, selfdealing, deliberate waste of corporate assets, or gross and palpable overreaching are involved (p. 1096); but, freezeout cases necessarily involve self-dealing, so the exception swallows the rule f. N.B. DE has since decided to use whatever techniques are considered appropriate by financial experts and have gotten rid of the appraisal law

9. CASE STUDY: Pure Resources, Inc. Shareholders Litigation (p. 1104) a. Unocal, who owned 65% of Pure Resources, made a tender offer for remaining 35%; minority shareholders claimed that tender offer price was inadequate; Unocal claimed that it could offer at whatever price it chose b/c it made a tender offer rather than entering into a negotiated transaction b. HOLDING: offer in its present form is coercive b/c it includes within definite of minority those stockholders who are affiliated with Unocal as directors and officers; requiring minority to be defined exclusive of stockholders whose independent from the controlling stockholder is comprised is the better rule; as aside from this, the offer satisfies the other requirements of non-coerciveness c. RULE: an acquisition tender offer by a controlling shareholder is only non-coercive when i. It is subject to a non-waivable majority of the minority tender condition, ii. Give full disclosure, iii. The controlling stockholder promises to consummate a prompt Sec. 253 merger a the same price if it obtains more than 90% of the shares, and a. Short-form merger: in DE, if a person holder over 90% of the stock, it doesnt make sense to hold a shareholder meeting, so they can just do the merger on their own and send the shareholders notice b. If the majority shareholder says if they succeed in the tender offer, they will do a short form merger later at the same price, then the minority shareholders dont have to feel pressured to sell at the tender offer b/c they can sell later c. Minority shareholders still have appraisal rights in a short-form merger iv. The controlling stockholder has made no retributive threats d. Despite this decision, most freezeouts dont use this procedure XII. Sale of Control for a Premium A. GENERAL RULE: sale of control for a premium is permitted; however, there are exceptions to the rule, and the exceptions are hard to define 1. Exceptions: a. Looting Corporate assets 84

85 b. Conversion of corp opportunities c. Fraud or other acts of bad faith 2. If you have a merger, you must have a merger proxy statement where you state that the price is fair and why; people arent going to agree that he price is fair; may be sued for inadequate disclosure 3. If it is done in conjunction with the merger of a whole company, typically public shareholders would have a right to dissent and demand appraisal; when the Ps come in to make their case that $20/share was inadequate, theyll claim Dent sold his stock for $70/share 4. Controlling SH breach fiduciary duty to minority SH if they transfer controlling shares to person or group they know/have reason to know will deal unfairly w/ corp. a. Usu gross negligence standard b. Controlling SH accountable to minority SH for the premium received and any damage caused to corp Why is there a premium on a controlling block of stock? 1. Could give yourself a job on the board of directors and elect yourself as an officer 2. Compensation may be a factor, but it cant alone explain why a premium is paid for controlling stock 3. Might get some kind of monopoly; anti-trust laws prevent against this in theory, but they arent sufficient rigorous 4. Dont have to worry about anyone else exploiting you 5. Certain rights of selfish ownership beyond the obvious one; get to make important decisions, etc. In most circumstances, a controlling block of stock can be sold for a premium What constitutes a control block of stock depends on the circumstances 1. In a close corporation, you could own 49% and have no voice or control 2. In a public company, its not uncommon to assert control with substantially less than 50%; if you own 30% of the stock in most public companies, its virtually impossible to remove you from control How to acquire a Controlling Block 1. Try to acquire all of corp shares from the majority. 2. Induce holders of sufficient shares to make requisite majority needed to vote for merger w/ or sale of all assets to corp he controls Not suspicious for new directors to demand resignation of old directors; if youre buying control, its natural to want control right away; if you dont get it, then old directors might sell assets of company at an inadequate price 1. GENERAL RULE: when the resignation of incumbent directors in favor of the purchase comes in conjunction with the sale of a control block of stock, then its okay 2. HYPO: directors of IBM sell their stock at a premium, resign, and then fill their seats with nominees of the buyer a. This is different from the situation in Gerdes b/c the directors of IBM dont own a controlling interest in the stock b. In this case, the buyer is bribing the directors to hand over their control of the board without him buying a majority share of the stock c. No reason why the directors stock should command a premium in this case How can a client disguise a premium? 1. Other shareholders might give him a non-competition agreement and pay him $100,000/year for that 2. Or, they might say they want C to be a consultant for the company; once a year they call him and send a check for $250,000 3. In terms of t Donahue case, the other shareholders wouldve bought back Cs stock at the price theyd be willing to pay anyone, $5/share 4. Make sure the board is fully informed with documents from experts saying they should get a noncompetition agreement or a consultant agreement 85

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C. D.

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86 H. CASE STUDY: Gerdes v. Reynolds 1. Ds were officers and directors of Reynolds and owned a majority of its common stock; sold ownership of majority stock, resigned, and elected as their successors 4 people designated by purchaser; P claims that corporate assets were wasted and improperly applied 2. HOLDING: price was so grossly in excess of the value of the stock that it carried on its face a plain indication that it wasnt for the stock alone but party for immediate en masse resignations and immediate election for the purchasers nominees as successors; having violating their fiduciary duty, Ds must account to corporation for the premium they got for their shares and all damages naturally resulting form their official misconduct 3. RULE: officers and directors cannot terminate their agency or accept the resignation of others if the immediate consequence would be to leave the interests of the company without proper care; cant sell company to looters; board has some duty to inquire into people who are buying the controlling block of stock; lack of knowledge about the buyers intent to look the company isnt a defense 4. PROBLEM: not clear how much of a warning there has to be to trigger a duty to investigate a. Here, the guy who was buying didnt have any money or assets b. There mere fact that the buyer offered a premium wouldnt be suspicious b/c its common to pay a premium for a controlling block of stock c. Here, stock was selling for at least 8 times its value; grossly disproportionate to value of firm d. Nature of the assets: securities in other companies; buyer was interested in these assets b/c he could sell them for cash very easily and disappear I. CASE STUDY: Brecher v. Gregg (p. 736) 1. President and founder sold his stock at a premium and helped fill vacated seats 2. HOLDING: seller was liable for the premium even thought here was no damage to the company b/c the seller only owned 4% of the stock; premium was an illegal payment in exchange for the sellers cooperation 3. REASONING: even if the shareholders werent harmed, incumbent directors control the proxy mechanism, so its very hard to dislodge them J. CASE STUDY: Perlman v. Feldmann 1. D was the dominant stockholder, chairman of board, and president of Newport Steel; his sold his interest (37% of shares) to Wilport Co., which consisted of end-users of steel; Ps argue that the consideration for the stock include compensation for the sale of a corporate assetboards ability to control the allocation of the product in time of short supply 2. HOLDING: shareholders werent injured, but there doesnt have to be any damage for there to be a cause of action; Ds action in siphoning off for personal gains corporate advantages to be derived from a favorable market situation due to the war doesnt show undivided loyalty that a fiduciary owes his principal; D has to give up premium; Ps are entitled to recovery in their own right, instead of in the right of he corporation; court isnt holding Wilport liable, just Feldmann 3. RULE: only if Ds had been able to negate completely any possibility of gain by Newport could they have prevailed; impossible standard to meet 4. RULE: So, in a time of market shortage, where a call on a corporations product commands an unusually large premium, a fiduciary may not appropriate to himself the value of the premium 5. When the war ended, Newport wouldve been back where it was before unless it had purchased by a syndicate of users; then, when they war was over, they could purchase steel from Newport, renovate its facilities, etc.; stock prices rose after deal 6. REASONING: court is punishing Feldmann from profiteering from the war XIII. Proxy Voting A. DE Sec. 220: a shareholder is entitled to a shareholder list unless someone can show an improper purpose 1. E.g. of improper purpose: wanting the list to sell insurance, etc. 2. Proper purpose is the desire to contact other shareholders 86

87 3. DE said that desire to solicit proxies is a desire sufficiently related to constitute a proper purpose (from General Time Corp. v. Talley Industries, Inc. on p. 265) a. Soliciting proxies for social or political reasons generally improper. Pillsbury, 274. 4. Reasons to see SH list a. Communicate w/ other SH, but not idle curiousity b. Discover who controlling SH is. 5. Legit purpose if: communication for voting or to talk about management, investigation of waste or mismanagement. 6. Demand for list almost always proper, but company will delay by taking them to ct. Corp has the burden of proving SH list shouldnt be produced. SEC Rule 14a-2 1. Rule 14 of SEC Act of 1934: enabling. Does not forbid or require anything, only allows SEC to set the rules and applies only to 12 companies 2. SEC 14a-2: says proxy rules apply to proxy solicitations w/ respect to securities registered under 12 of the SEA a. Proxy Solicitation: anything that may influence SH including a press release b. Rule includes communications that do not solicit a proxy but are part of a plan to do so 3. SEC Rule 14-3 provides that no solicitation of proxies shall be made unless person being solicited is concurrently furnished or has previously been furnished with a written proxy statement containing info specified in Schedule 14(a) SEC Rule 14a-7: requires a company to surrender a shareholder list within 5 days of demand 1. But, most companies arent subject to the SEC proxy rules Standard is NOT the same for books and records 1. Proper purpose for books and records: reasonably related to the persons interests as a stockholder; general curiosity isnt enough a. E.g., suspicion of wrongdoing or incompetence b. E.g., concerned about excessive compensation c. Must offer credible evidence of suspicion management wrong doing and each category is essential to its purpose (270) i. Burden on SH to offer. SH does NOT need to prove wrongdoing. 275 d. DE 220 Proper purposes for books and records: investigation of mismanagement; determine financial condition of corp; ascertain value of petitioners shares 2. REASONING: providing access to books and records is much more burdensome and intrusive than just providing a list of shareholders 3. Also, a competition couldnt do much with your shareholder list, but he could do a lot with your books and records to damage you 4. Directors have a broader rights to inspect books and records under DE Sec. 220(d) than shareholders do under DE Sec. 220(b) DE Sec. 211(c) and OH Sec. 39 and 40: if you dont hold an annual meeting within about 13 months of your last one, any shareholder can come into court, and the court will require the company to convene a shareholders meeting At a shareholders meeting, the record owner can vote any shares owned by the record date 1. Record date: date set by the directors to determine who is eligible to vote at the shareholders meeting 2. The boundaries for when the record date can be set is laid out in the statute 3. In DE, the record date must be set no fewer than 30 and no more than 60 days before the shareholder meeting 4. If you buy shares between the record date and the date of the meeting, you arent the record owner, and you dont have the right to vote the shares a. You can ask the seller for a proxy i. In order to do this, you must know the seller, which assumes a face-to-face purchase 87

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88 ii. If you bought the stock on the NYSE, then its unlikely youre going to be able to get a hold of the seller; bocks of stocks are bundled, which makes them hard to trace b. Even if the seller doesnt give you a proxy, equity may require him to vote in the buyers favor i. Seller is the record owner, but he doesnt have beneficial interest in the stock any more ii. So, buyer could argue that seller is in theory acting as his trustee, so he should vote in the buyers favor iii. In reality, though, this almost never happens G. Proxy: a power given by one person (the shareholder) to another person (the proxy holder) to vote the shares 1. The proxy holder doesnt have to be a shareholder 2. Purposes for Giving Someone a Proxy a. A proxy can authorize the proxy holder to vote only as the shareholder instructs, or b. It could give the proxy-holder complete discretion c. Could give a proxy simply for purposes of creating a quorum 3. If SH doesnt indicate how shares to be voted, then generally understood to be complete discretion 4. Ordinarily, a proxy is revocable, a. automatically revoked by giving someone another proxy b. notifying proxy also revokes or personally attending meetings and voting the shares 5. A proxy can be made irrevocable under certain circumstances a. Common law rule: to be irrevocable, a proxy had to state that it was irrevocable and be coupled with an interest b. Under DE law, the person seeking an irrevocable proxy must have an interest in the stock (e.g., stock is pledged to secure a loan), or an interest in the company (e.g., made a loan to the company) H. PROBLEM 6: Harman is a public corporation with over 1,000 shareholders; Robert Harman is president and CEO; Jones has just purchased a 5% interest, making her the largest stockholder in the company 1. If your client wants to buy shares until the last possible date, what information do you need and what further steps would you take? a. Need to know the date of the meeting and the record date for the meeting b. If she buys shares after the record date, then she doesnt have the right to vote the shares herself, but she could ask the seller to vote them for her (see above) 2. Pilgrim, a record-holder, gives Harman an irrevocable proxy to vote its shares in return for Harmans agreement to purchase the shares within six months at a higher price a. Can only get an irrevocable proxy if he has a legal interest in the stock or the company (see above) I. Securities Exchange Act of 1934: Disclosure and Filing Requirements for Companies Under Sec. 12 and Rule 12g-1 1. Difference between Securities Act of 1933 and Securities Exchange Act of 1934 a. 1933 Act created to regulate distribution of securities b. 1934 Act adopted primarily to govern trading of securities, including regulation of brokerdealers and proxy solicitations; later provisions relating to tender offers 2. IMPORTANT: Sec. 12 requires certain companies to register with the SEC a. SEA Sec. 12(b) says $1 million, but this has been changed by SEC rule 12g-1 (see below) 3. SEC Rule 12g-1 has redefined what it means to be a Sec. 12 company: a. (1) Traded on a national securities exchange, OR b. (2) Over $10 million in assets (not total assets or net assets) AND at least 500 shareholders i. A company could be bankrupt as long as it still has $10 million in assets ii. E.g., one of the shareholders in a company was an order of nuns, who didnt like what the corporation was doing, so they took their 200 shares of stock and allocated them to 88

89 each individual nun, creating 200 new shareholders, which made the company subject to Sec. 12 c. CAVEAT: Sec. 12 companies are those who satisfy these rules; doesnt matter if its considered to be a close or public corporation as long as it meets the test d. Consequences of Filing: i. Must file periodic reports: annual reports on 10K, quarterly on 10Q due 45 days after the end of the quarter; trigger report on 8K ii. No general req to promptly disclose material corp developments. Except when only a periodic report is due or when the issuer acts in certain transactions. 4. Some sections of the SEA apply to any company participating in interstate commerce, and some apply only to Sec. 12 companies a. Sec. 12 companies have to file reports with the SEC, including quarter reports on Form 10Q and annual reports on Form 10-K; also Form 8-K describes important events which must be reported within 4 business days, but the list isnt comprehensive b. CAVEAT: there is no general obligation under the general securities laws to make a timely report of all material developments; there are separate, specific violations c. IMPORTANT: proxy rules only apply to Sec. 12 companies 5. What can you do if a companys filing is inadequate? a. SEC can come after company for injunctive relief b. Criminal charges are rare c. Opportunities for private suits are pretty limited; just b/c youre a shareholder and you think filing is inadequate doesnt mean you can sue, unless you were defrauded d. CASE STUDY: J.I. Case Co. v. Borak (p. 281) i. SEA authorizes SEC suits to enforce proxy rules but says nothing about private rights of action ii. HOLDING: Supreme Court found an implied private right of action for violation of the proxy rules for shareholders; since this case, the Supreme Court has been less generous about finding a private right of action 6. SEA Sec. 27: gives federal courts exclusive jurisdiction over cases coming under SEA a. Could also have actions for false disclosure and violation of fiduciary duty under state law b. Can bring state law claims in federal court under pendent jurisdiction 7. Sarbanes Oxley Act (SOX) added a requirement that officers certify to their best knowledge that filing with the SEC accurately state the financial condition of the company, and the companys internal controls must support accurate filing a. CEOs have reacted to this requirement by demanding sub-certifications from their subordinates 8. If you buy stock through a broker, you can have them put the stock in a street name or nominee name a. E.g., Cede and Co. hold the legal title for a lot of stock, but its for the benefit of all these investors b. Downside to this process it that it makes it hard for people to discover the real, beneficial holders of the stock are; proxy materials under SEC must be forwarded to beneficial holder 9. The proxy rules apply to every solicitation of a proxy a. SEA Sec. 14(a)(1): it shall be unlawful for any person, by use of mails or any means of interstate commerce, in contravention of rules of Commission, to solicit or permit the use of his name to solicit any proxy or consent or authorization in respect of any security b. CAVEAT: SEA Sec. 14(a), like many of the federal securities laws, doesnt by itself make anything illegal; just empowers SEC to make rules c. Usually, anything that will influence voters is considered a proxy statement i. E.g., if you send a letter to the shareholders, that would probably be considered a proxy solicitation 89

90 ii. E.g., if you put out a press release saying management of company is ruining the environment and the shareholders should do something about it, that could be considered a proxy solicitation 10. State law determines when shareholder approval is required for an action a. In a proxy solicitation, were assuming that its a matter where the company needs a shareholder vote to act b. Suppose Mary owns 51% of the stock; she wants to amend the charter; she doesnt have to solicit proxies since she already has a majority, but does she have to comply with the proxy rules? i. It used to be that she didnt have to comply with the proxy rules ii. But, the SEC said that shareholder should know whats going on in the company iii. SEA Sec. 14(c): even if a shareholder isnt soliciting proxies, the company still must issue a proxy statement a. State law determines when necessary to have a solicitation. b. Even if SH not asked to vote, SH still entitled to disclosure

J. Materiality 1. SEA Rule 14a-9: forbids any materially false or misleading statement or omission of a material fact necessary to make the facts state not materially misleading in any solicitation of a proxy; heart of proxy rules; basically an anti-fraud provision 2. CASE STUDY: TSC Industries v. Northway, Inc. (p. 288-289) a. Appellate court held that material meant a fact which a reasonable shareholder might consider important; court here is debating use of might vs. would b. RULE: an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote c. N.B. This same standard applies to Rule 10b-5, which applies to ALL companies, whether or not they are Sec. 12 companies 3. Analysis for Materiality on Exam a. Was it materially false? b. What were the odds that these events would come to pass? c. Would a reasonable shareholder think this is important? i. No req that a SH would have changed his mind or vote, just that they would have thought it important d. Is there a substantial likelihood? e. CAVEAT: question of whether something is material must be considered separately from the issue of whether theres any obligation to disclose at all f. Showing of Materiality satisfies the Causation Requirement 4. What is a substantial likelihood? a. Some practitioners say more than a 50% likelihood, but this doesnt seem right to Dent b. E.g., a 1/6 chance seems like a substantial risk if were talking about a bullet in a gun 5. The reasonable shareholder standard is something youd want to stress to a client; very factdependent; might want to err on the safe side rather than leave your fate up to the jury 6. What amount of money is material depends on the size of the company; some companies are so big that almost nothing is material 7. CASE STUDY: In re Burlington Coat Factory Securities Litigation (3rd Cir. 1997) 90

91 a. RULE: if the stock price doesnt change after disclosure, then, as a matter of law, the information wasnt material b. Problems with this rule i. How do you know in advance whether information will cause the companys stock price to change? ii. Assumes that if information doesnt cause the stock price to change, then the shareholders dont care about it 8. RULE: Supreme Court has said that for contingent information (such as a pending lawsuit), we multiply the odds that an event will occur times the magnitude of the impact of the event if it does occur 9. HYPO: paid an official $1 million to secure a government contract; is this material? a. Could treat it as a pure financial product; if the company is big enough, it might not be financially material b. Might be concerned about the fact of the payment being made itself; under the Foreign Corrupt Practices act, its illegal for U.S. companies to make such payments even if its common practice in the other country c. Could argue it affects the quality of earnings i. If it comes to light that youre bribing officials in other countries, other corporations may think its too hot to deal with your company at home d. Under the SEC rules, integrity of management is always a material factor, but in the last few years, the SEC hasnt bee particularly aggressive in pressing this in court e. What if studies show that 95% of the investors dont care? Do you conclude that reasonable shareholders dont care, or that 5% do care, and they are reasonable? 10. CASE STUDY: Kurzweil v. Philip Morris (SDNY) a. D failed to disclose in public documents that nicotine is addictive b. HOLDING: court found that everyone knew that anyway, so the fact that they didnt disclose it wasnt material 11. Think of the disclosure document as an insurance policy, and you can write the insurance policy to cover whatever you want it to cover a. Tell client, if you dont disclosure this, you might be sued by the SEC, and you might prevail, but that will be a few years of expensive litigation 12. Soft Information: Predictions and Projections a. Matters of opinion and not matters of historical fact b. There are matters of opinion which dont relate to the future but to future condition c. How should this type of information be treated under the federal securities laws for the purpose of avoiding any materially false or misleading statements? d. If the warning is forceful enough, then it shields the speaker from liability of prediction doesnt come true e. Standing: if P not fooled, ct says SH could still sue b/c ct would be protecting body of SH 13. CASE STUDY: Virginia Bankshares, Inc. v. Sandberg (p. 290) a. HOLDING: statements of opinion that relate to future conditions are statement of fact of the speakers opinion; e.g., the statement we think this deal is fair is a statement that the speaker honestly believes the transaction is fair; can also be considered materially misleading if it seems so outrageous that the jury doesnt honestly believe that you believe your own statement Statements about internal belief by directors may be material, if accompanied by misleading objective statements; but without, they are insufficient. b. RULE: merely couching a statement in terms of a motive or opinion doesnt necessarily get you off the hook for making materially false statements; P can prove that D didnt really believe what he said. Statements taken as a whole K. Standard of Fault or Culpability 1. Federal securities laws are meant to protect investors 2. CASE STUDY: Gerstle v. Gamble-Skogmo, Inc. (p. 302) 91

92 a. RULE: negligence sufficient to establish liability under Rule 14a-9; Ps arent required to establish any evil motive, bad faith, or reckless disregard of the facts 3. CASE STUDY: Adams v. Standard Knitting Mills, Inc. (p. 302) a. RULE: different standards should apply to different Ds and scienter may be required for certain defendants L. Shareholder Proposals 1. SEA Rule 14a-8: recommendation from SH; an issuer must include a shareholders proposal in its proxy statement unless you can find an exception for why it should be excluded under 14a-8 a. Issuer means a corporation subject to Sec. 12 b. When can a proposal be omitted? i. SEA Rule 14a-8(b)(1): in order to be eligible to submit a proposal, the shareholder must hold at least $2,000 in market value or 1% of the companys securities ii. SEA Rule 14a-8(i)(12): a proposal may be omitted if it was previously submitted within the last 3 years and got less than a specified amount of support iii. SEA Rule 14a-8(i)(5): a company can exclude a proposal when the issue accounts for less than 5% of net earnings and total assets and isnt otherwise significantly related to the companys business iv. One proposal per meeting and SH must hold stock for at least 1 year a. CASE STUDY: AT&T Co. (p. 303) [SEC] i. Shareholder proposal asked for company to evaluate environmental and human rights context in which company operates ii. HOLDING: sufficiently related to companys business to be included in proxy statement b. CASE STUDY: Aon Corp. (p. 304) [SEC] i. Proposal requested a policy mandating no further purchases of tobacco equities and that the company divest itself of current tobacco equities ii. HOLDING: sufficiently related to companys business to be included in proxy statement c. ExceptionsReasons corp doesnt have to comply i. Relevance: if proposal less than 5% of companys total assets at the end of the most recent fiscal year, and for less than 5% of net earnings and gross sales for most recent fiscal year, and is not otherwise signif related to companys business. ii. SEA Rule 14a-8(i)(6): a company can exclude a proposal if the company would lack the power or authority to implement the proposal iii. SEA Rule 14a-8(i)(7): company can exclude a proposal if it deals with a matter relating to the companys ordinary business operations a. According to SEC, presence of a widespread public debate regarding an issue is among the factors to be considered in determining whether proposals concerning that issue transcend day to day business matters (p. 305) b. But, the Commission has wavered on this, and changed its position on employment plans i. If it covers all employees, proposal could be excluded unless it would really affect earnings ii. But, if it covers just executives, then its extraordinary, and proposal must be included c. These issues come up often with social proposals (e.g., if a pharmaceutical company test products on animals, is that ordinary business or does the moral question take it out of the realm of ordinary business? iv. SEA Rule 14a-8(i)(1): a company can exclude a proposal that is, not a proper action for shareholders under the laws of the state of incorporation a. POSSIBLE EXAM QUESTION: proposal to amend charter i. Proper action for shareholders in OH 92

93 ii. In DE, you first need a board resolution, then a shareholder vote iii. If youre in DE, a proposal to resolve that the Charter be amended to delete the provision for a staggered board wouldnt be allowed b/c it isnt a proper action for shareholders b. Note to this subsection: the shareholders can include a hortatory proposal where a mandatory proposal would be barred b/c its not a proper subject for shareholder action i. E.g., shareholders recommend, request, or urge board to adopt a resolution deleting the staggered board from the charter and then submit that resolution for consideration to the shareholders 2. HYPO: a proposal says Resolved: That the antitrust law be revised?; are there any grounds on which the issuer could omit that resolution? a. Might not be considered significantly related to companys business (see cases above) b. Company has no authority to change antitrust laws c. If the provision were revised to say that the company use its best efforts to petition for a revision of the antitrust laws, that would be okay b/c the company can petition the government 3. Under state law, a shareholder can attend a shareholder meeting to submit a proposal a. As a practical matter thats usually a waste of time b/c very few shares are represented in person b. In effect, then, the proxy solicitation is the meeting; once the secretary alls the meeting ot order, its over, so if you want to get a matter considered, you have to get a proxy c. You can solicit proxies on your own, but thats expensive 4. Benefit of Rule 14a-8 is that you just send your proposal to the company and they include it in the companys statement 5. Problems with Rule 14a-8 a. Shareholders usually lose, but its the publicity their after b. Proposals receive very little support, so the argument that this is essential to shareholder democracy is unpersuasive c. Many managers when faced with a shareholder proposal will sit down with the proponent and agree to make changes in exchange for the shareholder agreeing to drop the proposal d. Now, shareholder proposals are geared more towards anti-takeover provisions, and they have been very popular; usually hortatory provisions, which arent binding M. Proxy Fights 1. Sometimes an insurgent brings a proxy fight to elect its own board members to the board and gain control of the company 2. Proxy fights exist as a possible way of dislodging corporate management 3. Shareholders dont use SEA Rule 14a-8 in a real proxy fight; that rule is for gad flies, not a serious takeover bid 4. Proxy fights are rare b/c incumbents have huge advantages a. Costs of the incumbent proxy solicitations are paid by the company while insurgents have to pay their own costs i. If the insurgent wins, they could make the company repay them for proxy solicitations on the theory that he provided a benefit to the company ii. CASE STUDY: Heineman v. Datapoint Corp. (p. 324) a. HOLDING: victors in a proxy context using their newly acquired position to cause the corporation to reimburse the costs of waging that contest creates a prima facie case of director self-dealing b. Most investors follow the Wall Street Rule, which says vote with management or sell c. Most institutional investors do business with the corporation and fear losing business if they vote for the insurgents 5. The success of insurgents in proxy fights is proven by how few proxy fights are actually waged 93

94 6. Because proxy fights are so expensive and difficult, you would only try one if you have a good reason to think there is a large number of disgruntled shareholders XIV. SEA Sec. 10(b) and SEC Rule 10b-5 A. SEA Sec. 10(b) was designed as a catch-all to cover all abuses not covered by other parts of the SEA B. SEA Sec. 10(b) doesnt by itself forbid anything; it just empowers the SEC to adopt rules to forbid any manipulative or deceptive device or contrivance from being used in connection with the purchase or sale of a security C. SEA Rule 10b-5 doesnt mention private damage actions, but federal courts implied a private right of actions D. CAVEAT: Rule 10b-5 is best known for forbidding insider trading, but it forbids ANY deceptive or manipulative contrivance in connection with the purchase or sale of a security 1. Its not limited to inside trading 2. Its NOT limited to Sec. 12 companies like SEA Sec. 14(a) is 3. FOR THE EXAM: its easy to start writing on self-dealing and strict scrutiny, etc. and neglect the possibility that Rule 10b-5 also applies E. Under 10b-5, it is unlawful in connection with purchase or sale of any security by use of mail or other means of interstate commerce to: 1. Employ any device, scheme, or artifice to defraud 2. Make any untrue statement of material fact or omit to state a material fact necessary in order to make the statement made, in light of the circs under which they are made, not misleading 3. Engage in nay act, practice or course of business that operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of security 4. Rule 10b-5 only applies when the D uses a means of interstate commerce, the mails, OR any facility of a national securities exchange a. Courts ALWAYS find interstate commerce if they want to (e.g., will find that even a telephone is a means of interstate commerce) 5. 10b-5 applies to: anyone who makes a misrepresentation in connection with purchase/sale of stock, any security, misrepresentations/nondisclosures by an insider, especially officers, directors or controlling SH a. So Corp insider must abstain from trading in the shares of his corp unless first disclosed all material inside info known to him. 6. NOT limited to Insider trading in public companies F. Federal courts have sole jurisdiction over SEA claims 1. Supreme Court and Congress repeatedly narrowed scope of Rule 10b-5, so Ps were taking class actions to state court 2. Congress responded with Uniforms Standards Act of 1998, which preempts state law by barring class actions under state law for fraud involving public companies; creating exclusive federal court jurisdiction for these issues G. CASE STUDY: Blue Chip Stamps v. Manor Drug Stores 1. RULE: only a person who had purchased or sold stock under the in connection with clause of SEA Sec. 10(b), had standing to bring a private action under Rule 10b-5 2. REASONING: litigation under Rule 10b-5 present a danger from general litigation; even a complaint which may have very little success at trial has settlement value to the P; potential for possible abuse of discovery; most importantly, this rule bars actions by people who claim they wouldve sold stock that they owned had they not been induced to retain the stock by the misrepresentations or omissions H. Of course, SEC can sue even when it is not the purchaser or seller I. Liability and Standing to Sue 1. Lower courts are split over whether a non-selling P can bring a claim for injunctive relief (p. 758, note 4) 94

95 a. On the one hand, the Supreme Court said that you need to be a buyer or seller to bring a claim under Rule 10b-5 period; didnt distinguish between monetary and injunctive relief b. On the other hand, all of the concerns the court expressed about private actions for a P who isnt a purchaser or seller seemed to only apply to private damage actions, not actions for injunctions c. General rule is probable that its okay for a non-buyer or non-seller to bring a private action for injunctive relief 2. Defendant does not have to be a buyer or seller a. An insider tipper, passing the info b. Issuer can be sued, someone speaking on behalf of the issuer c. Anyone who makes a false statement on behalf of someone who does buy or sell can be held liable (like sellers lawyer as agent) If a company sells stock to an insider, it can sue but usually wont do so; the shareholders can also sue derivatively, on behalf of the corporation The most common situation in which someone is excluded from suing under Rule 10b-5 is when insiders have been trading in stock on a national stock exchange Definition of Sale Under Rule 10b-5 1. If the bank insists that you pledge stock as the collateral for a loan, the courts have said that this constitutes a sale for purposes of Rule 10b-5 2. Delayed sales or purchase do not count as sales CAVEAT: the D doesnt have to be a purchaser or seller of securities; anyone makes a materially false statement in connection with he purchase or sale can be a D 1. E.g. #1, anyone who lies on behalf of a purchaser or seller, even if that person didnt purchase or sell himself 2. E.g. #2, a tipper; insider tells their cousin that tomorrow earnings will double, so he should buy stock 3. E.g. #3, issuer (company) makes a false or misleading statement not even intended to make people purchase or sell as such even if its not selling its own stock (see Basic below) What does in connection with purchase or sale mean? 1. Doesnt mean that deception or false statement must bear on value of security 2. CASE STUDY: SEC v. Zandford a. Relying on Ds promise to conservatively invest their money, Woods entrusted him with $419,255; before Mr. Woods death, all of the money was transfer from Woods account to accounts controlled by D; appellate court found without relationship to market integrity, there was no violation of Sec. 10(b); D claims his scheme wasnt different from simple theft b. HOLDING: in the aggregate, the sales are properly viewed as a course of business that operated a fraud or deceit on a stockholders customer; security transactions and breaches of fiduciary duty coincide; therefore, the breaches are in connection with securities sales within meaning of Sec. 10(b) c. Suggests that P must plead and prove intent to steal proceeds from the outset 3. CASE STUDY: Head v. Head (4th Cir. 1985) a. Wife says that husband lied during course of divorce proceedings about marital assets, including securities, which had to be divided; argued this was in connection with sale of securities b. HOLDING: court said that connection was too attenuated 4. CASE STUDY: In re Carter-Wallace, Inc. (2nd Cir. 1998) a. Put an add in a medical journal saying drug cures arthritis; product advertising was false, but you werent trying to induce people to buy stock, just the drug itself b. HOLDING: court said connection was close enough to be considered in connection with sale of securities; analysts read and relied on such journals 5. CASE STUDY: Semerenko v. Cendant Corp. (p. 780) 95

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96 a. RULE: its irrelevant that misrepresentations werent made for purpose or object of influencing investment decisions of market participants 6. CASE STUDY: SEC v. Texas Gulf Sulfur Co. (p. 784) a. RULE: the mere fact that an insider didnt engage in securities transactions doesnt negate the possibility of wrongful purpose; device employed must be the sort that would cause reasonable investors to rely on it and cause them to purchase or sell a corporations securities 7. Some courts have said that D must have a reasonable expectation that the information will be used in connection with a sale or purchase of stock O. Scienter Under Rule 10b-5 1. CASE STUDY: Ernst & Ernst v. Hochfelder (p. 758) a. RULE: Supreme Court held that you must prove scienter (intent or knowingly) in Rule 10b5 private actions; expressly rejected a negligence standard 2. Scienter: involves the intent that a rep shall be made, that it shall be directed to a particular person or class of persons, that it shall convey a certain meaning, that it shall be believed, and that it shall be acted upon in a certain way. a. Not required for 17(a) of 1933 Securties Act. 3. Lower courts have said recklessness satisfies Scienter, but they disagree about the definition of recklessness a. Some lower courts define recklessness as negligence, which conflicts with Hochfelder b. Most courts use a more rigorous definition of recklessness: reckless conduct may be defined as highly unreasonable conduct, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care where danger is either known to D or is so obvious that he mustve been aware with it (p. 759)\ 4. In practice, scienter is the greatest limit the Supreme Court has put on Rule 10b-5 a. Its usually very hard to prove what the D actually knew b. Problem is magnified by SEA Sec. 21D(b)(2), which provides that a P who alleges securities fraud must state with particularity facts giving rise to a strong inference that D acted with required state of mind, i.e., scienter (p. 806); must be in complaint before any discovery 5. Courts disagree about whether knowledge of materiality is an element of a Rule 10b-5 claim, but most courts say it isnt 6. Scienter is required for a suit for injunctive relief under Rule 10b-5 as well as a suit for money damages (p. 760, note 3) 7. The scienter for a corporation must be imputed to it from some agent P. Materiality and Reliance Under Rule 10b-5 1. A company has no general duty to disclose material information: if a company isnt filing a quarterly report, an annual report, AND the company isnt trading in its own stock, then it doesnt have a duty to disclose 2. Reliance and fraud on the market theory are two ways of proving causation a. HYPO: if you buy stock from a close corporation and learn that the company put out a press release false claiming it had a cure for cancer last week but you never saw the release, would you have a claim under Rule 10b-5? i. Theres no market and you didnt know about it, so wheres the reliance or the causation? b. On the other hand, if you bought stock from a public information, you could use the fraud on the market theory to show that the false information caused a loss i. Would have to show that 1) the false information inflated the stock price, and 2) you paid the inflated stock price c. Of course, the line between publicly-traded and close corporation is thin d. If the court doesnt accept the fraud on the market theory, then you have to prove reliance 96

97 i. If you have to prove reliance, a class action doesnt look to good b/c each P would have to show reliance 3. The fraud on the market theory is based on the efficient market hypothesis a. Fraud on the Market Theory i. Allows for imposing liability when misrepresentation no known by injured P ii. Nonpublic companies, cant use fraud on the market for a 10b-5 claim b/c no market! iii. Defense to theory that press release didnt affect stock price b. Weak form of efficiency i. Price reflects past prices, but past prices tell you nothing of future prices, so prices follow a random walk ii. You cant beat the market by discovering patterns and taking advantage of them iii. The best thing the average Joe can do is put his money in a diversified portfolio of stocks c. Semi-strong form of efficiency i. N.B. This is the form that underlies the fraud on the market theory ii. Prices quickly reflect all public information; after that, its a random walk iii. No one can consistently beat the market by taking public information and trading on it iv. Typically, when theres a big announcement, the company will tell the NYSE, which will stop trading for 2-5 minutes, so the market can digest the information, and then theyll start trading again v. Markets are informationally efficient, NOT rational d. Strong form of efficiency i. Prices reflect all information that can be gained by careful analysis, even if not public ii. Informational efficiency doesnt imply fundamental efficiency a. Informational efficiency: market reacts quickly to all new information b. Fundamental efficiency: current prices are the best possible predict or future earnings or cash flow c. If the market isnt fundamental value efficient, in theory, there should be corrective mechanisms i. Rational investors who have a lot of money will be willing to put it down on rational investments and wait until the market corrects itself ii. In theory, its hard for corrective mechanisms to work d. Not a question of coming up with a program that can beat he market; you might get a little edge for awhile, but the market will eventually adapt 4. Transaction Causation vs. Loss Causation a. SEA Sec. 21D(b)(4): requires proof that the misstated matter caused the loss, i.e., must show fraud on the market on reliance on the misstatement or omission b. HYPO: Zilchko says their patented new widget will revolutionize the market, and you go out and buys stock, relying on statement; market price falls; widget wasnt patented, but thats not why price fell; it fell b/c widgets have no useful purpose i. In this case, theres transaction causation but no loss causation ii. P loses if he cant show that it was the absence of a patent that caused the loss 5. CASE STUDY: Shivangi v. Dean Witter (1987) a. Broker-dealer failed to tell customers that it pays its brokers higher commissions for trading stock in which the broker-dealer is a market-maker b. HOLDING: court said this didnt pass the scienter test b/c there was no intent to deceive; the broker didnt mention it, but there are lots of things they dont mention; d didnt know it was material at the time, so they didnt act with scienter as t o its materiality 6. CASE STUDY: SEC v. Falstaff a. RULE: knowledge means awareness of the underlying facts not the labels that the law places on those facts; the fact that you didnt know it was material isnt a defense b/c that isnt an element of the claim 97

98 7. CASE STUDY: Basic, Inc. v. Levinson a. Combustion Engineering, Inc. was interested in acquiring Basic; stock prices went up b/c of rumors; Basic made 3 public statements denying that it was in merger negotiations, which caused stock prices to go down; when the merger was announced, stock prices went up; Ps sold their stock after Basics first public statement before the merger actually occurred and claim Ds issued false or misleading statements in violation of SEA Sec. 10(b) and Rule 10b-5; Ds argue that merger negotiations arent material until agreement-in-principle is reached b. HOLDING: practical solution for Basic was just not say anything at all or no comment; materiality can be reached before an agreement-in-principle is reached, especially with a big merger and a small company; policy of securities laws is full disclosure; reject 3rd Circuit test that says merger negotiations dont become material until an agreement-in-principle is reached c. RULE (adopted from TSC Industries, Inc. v. Norway, Inc.): to fulfill the materiality requirement, there must be a substantial likelihood that the disclosure of the omitted fact wouldve been viewed by the reasonable investor as significant d. RULE (from SEC v. Texas Gulf Sulfur Co.): when information is contingent or speculative (like in a proposed merger), materiality will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity e. RULE (fraud on the market theory): because most publicly available information is reflected in market price, an investors reliance on any public material misrepresentations may be presumed for purposes of a Rule 10b-5 action; D can overcome this presumption by showing that the misrepresentation didnt lead to a distortion in price or that a P wouldve traded despite knowing the statement was false; but here price depressed by statement. f. PROBLEM: corporate investors dont like this rule b/c no comment really means yes, were engaged in merger negotiations g. WHITES DISSENT: fraud on the market theory assumes that investors rely on the integrity of the market, but people usually trade b/c they think the market is wrong 8. CASE STUDY: In re Verifone Securities Litigation (p. 794) a. RULE: an investor who has never seen or heard of a fraudulent disclosure is no less a victim than one who pored over its details; if a misleading or fraudulent disclosure or omission couldve had no effect ton the securitys market price, the information could not have been material 9. CASE STUDY: Cammer v. Bloom (p. 800) a. RULE: five-factor test for when a market is efficient for purposes of the fraud-on-themarket-principle i. Whether the stock trades at a high weekly volume ii. Whether securities analysts follow and report on the stock iii. Whether the stock has market makers and arbitrageurs iv. Whether the company is eligible to file SEC registration Form S-3 v. Whether there are empirical facts showing a cause and effect relationship between unexpected corporate events or financial releases and an immediate response in the stock price 10. CASE STUDY: Binder v. Gillispie (9th cir. 1999) a. HOLDING: court said fraud on the market theory didnt apply to an initial public offering, so reliance had to be pledged and prove for the entire class; it couldnt be so, class action certification was denied 11. Reliance in Omission Cases a. RULE: in omissions cases, you only have to show that the omitted statement was material; you dont have to show reliance or fraud on the market b/c those concepts dont make any sense with omissions; you cant rely on something that wasnt said 98

99 12. CASE STUDY: AES Corp. v. Dow Chemical (9th Cir. 2003) a. The company signed a document saying it was relying only on certain documents; company sued and said this was a waiver, which wasnt permitted under 1934 Act b. HOLDING: court said it wasnt a waiver, but it wasnt conclusive; statement is only evidence that you didnt rely on those documents Q. Forward-Looking Statements 1. Also known as soft information 2. See SEA 21E(i) for definition 3. SA 27A and SEA 21E(c)(1): create a safe harbor for forward-looking information and other soft information, like evaluations if the forward looking statement is: a. IDed as such and is accompanied by a meaningful cautionary statement IDing important factors that could cause actual results to differ materially from those in the fwd looking statement b. Immaterial c. If the P fails to prove that the fwd looking statement was: i. Made w/ actual knowledge by that person that the statement was false or misleading ii. Made by a business entity by or w/ approval of executive officer of that entity; or made or approved by such officer w/ actual knowledge that the statement as false or misleading 4. SEC reqs disclosure of soft info for 12 companies. Civil liability for failure to disclose.

5. RULE: under these provisions, a D isnt liable under the federal securities laws because a forward-looking statement or other soft information is false if EITHER a. P cant prove Ds actual knowledge that the statement was false or misleading, OR i. Seems to exclude liability even for recklessness ii. P can prove this by inference b. Document contains meaningful cautionary statements which identify documents which might prove the statement wrong i. The way statute is phrased seem to preclude liability even if the D knows the meaningful cautionary statements are false ii. A general vague warning (e.g., this prediction may prove inaccurate) isnt going to suffice 6. An annual report to shareholders must include the corporations financial statements, selected financial data, and managements discussion and analysis of the corporations financial condition and results of operations (MD & A) (p. 279) a. MD & A (management discussion and analysis) is supposed to include known trends that management thinks will have an impact b. SEC has imposed administrative sanctions for unjustified failure to make a forecast c. This requirement could also require updating soft information thats no longer accurate (e.g., may have a duty to say that hurricane messed things up and earlier prediction is no longer valid) 7. CASE STUDY: Shaw v. Digital Equipment (1st Cir. 1996) a. HOLDING: could be liable for failure to disclose that quarter in process would be very different from other quarters when you clearly knew what was coming and didnt disclose it; civil liability for failure to make a prediction 8. CASE STUDY: Levitt v. Lyondell Petr. (9th Cir. 1993) a. HOLDING: must disclose underlying facts in a prediction, but not necessarily all conlusions; e.g., it is sufficient to say we expect our sales to drop 10% and let investors figure out for themselves how much that will effect profits 99

100 9. CASE OF BILL FRIST: he had health corporation stock in a blind trust; he said something, trust sold a bunch of stock, and 9 days later, the stock tanked; claims that he issued the instruction to sell b/c it wasnt good to have all of your money in one stock, and he was the majority leader of the Senate, so he shouldnt have had all this money in a health care company a. In 2000, SEC adopted Rule 10b-5-1, which imposes liability if one trades while are of material non-public information, but leave exceptions for trades executed pursuant to plans made before the D had the material nonpublic information (p. 808) 10. IMPORTANT: no liability for non-trading on material non-public information R. Aiding and Abetting a Rule 10b-5 Violation 1. CASE STUDY: Central Bank of Denver v. First Interstate Bank of Denver (p. 809) a. RULE: liability cannot be imposed on someone for merely aiding or abetting a violation of Rule 10b-5. 2. RULE: Supreme Court said that any person or entity who employs or makes a material misstatement on which a purchase or seller of securities relies may be held liable as a primary violator under Rule 10b-5 (p. 809) a. E.g., if a bank knew a scheme was fraudulent and provided financing, the P cant sue the bank; this is just aiding or abetting or participating in a conspiracy; bank never made any false statement or did anything to deceive buyers b. E.g., if a lawyer drafts or helps to draft documents used in a fraudulent security deal, then he has made a material misstatement and can be held liable under Rule 10b-5 c. Different courts have adopted different tests for whether it is sufficient that the lawyer merely drafted the document or whether he has to sign it, etc. (p. 810) i. Substantial participation test: lawyer knowingly drafts false or misleading statements ii. Bright line test: misrepresentation must be attributed to D iii. Of course, D must have scienter; at least, the lawyer would have to be reckless, but its unclear what this means 3. Some court shave held that one who controls another person held liable for a false statement may herself be held liable under respondeat superior 4. SEA Sec. 20(f): SEC can sue aiders and abettors, but private parties cant sue them for private damages S. Defenses to a Rule 10b-5 Action 1. In Pari Delicto (of equal fault) a. Supreme Court has laid down a pretty demanding standard for this defense; the mere fact that both parties are wrongdoers doesnt mean they are of equal fault b. E.g., broker trying to stir up commissions; calls people sand says he has a tip that Zilchko will be acquired in 2-4 days; turns out this is totally false; P was trading on what he knew to be materially non-public information, so D claims in pari delicto; court held that tipper was at greater fault than tippee 2. Due Diligence/Contributory Negligence a. If P was also negligent, then D wasnt responsible b. Court has said that contributory negligence isnt a defense; there has to at least be an equal degree of culpability; P at least has to be reckless c. It is uncommon that D can show that P is reckless T. Damages in a Rule 10b-5 Action 1. GENERAL RULE: P can recover larger of Ps actual losses or Ds unjust enrichment a. Factors: public or close corp, P a buyer or seller, whether wrong a misrepresentation or wrongful disclosure, and whether P dealt directly w/ D. b. Fraud: Damages and Restitution i. Out of Pocket Measure: P recovers price paid for property he was induced to buy as result of misrep less the market value of property 100

101 ii. Loss of Bargain Measure: attempts to put P in the economic position he would have been if the rep had been true. Also guarantees the P will have no loss and achieve any economic gains he would have had if the rep had been correct c. Restitutionary Relief i. May sue for rescission, in which case he would return the purchase price and get back the property he sold ii. Sue for money equivalent of restitution a. Purpose not to compensate Ps loss, but to restore what D received. 2. Exception to the General Rule a. E.g., P deceives P into selling stock at $20 when its true value is $25 b. If when P sues, D still holds stock and its value has risen to $25, P can either rescind, get back the stock, and give back the $20 he got for it, OR he can get rescissory damages (i.e., loss of bargain damages) and get $15 c. But, if D sold the stock for $28 before P sued, P would probably only get $8 (Ds unjust enrichment) rather than the $15 in rescissory damages b/c once the news came out, P knew as much as anyone and couldve bought the stock back if he wanted to 3. Damages in Insider Trading Cases (p. 817, note 4) a. E.g., D buys 1,000 shares at $20/share on insider information; new of miracle cure is disclosed and companys stock price jumps to $28; Ds illegal profit is $28,000 i. Between the time D purchased and the time when the news was disclosed, D is liable to anyone who contemporaneously sold their stock not knowing the news ii. Some of the lower courts have held that insider traders are liable only to those with which they actually traded; in this case, people who sold the 1,000 shares which D bought a. Very difficult in practice to trace where the shares came from b/c orders are often bundled b. To avoid a possible no penalty and alternatively a draconian penalty , Congress adopted SEA Sec. 20A, which provides that a insider trader is liable to anyone who traded the wrong way, but liability is limited to unjust profit in 20B i. Problems with this rule a. If D caused to loss to those people, he should be liable, but if D didnt cause loss to those people, he shouldnt be liable to them b. Makes it more likely youll get caught, but you just have to give up profits; not much of a disincentive c. SEC can also sue inside traders for an injunction and a civil penalty for 3 times the illegal profit and disgorgement of profit d. SEA Sec. 21D(f): when there are several people at fault replaces joint and several liability with proportionate liability as found by trier of fact unless D knowingly violated securities act U. Fiduciary Duty Requirement in Rule 10b-5 Actions 1. CASE STUDY: Chiarella v. U.S. a. D, printer, was able to figure out the names of target companies involved in corporate takeover bids, purchased stock of target companies, and sold immediately after takeover attempts became public b. HOLDING: D wasnt a corporate insider and receive no confidential information from the target company; trial court and appellate court failed to identify a relationship between D and sellers that could give rise to a duty to disclose; court doesnt hold that Chiarella hasnt violated Rule 10b-5, just that the trial courts instructions were wrong c. RULE: a duty to disclose under Sec. 10(b) doesnt arise from mere possession of nonpublic information; duty to disclose arises when one party has information that the other party is entitled to know b/c of a fiduciary relationship of trust and confidence; a purchaser 101

102 of stock who has no duty to a prospective seller b/c he is neither an insider nor a fiduciary has no obligation to reveal material facts i. E.g., an officer selling to an investor on the NYSE still owes a fiduciary duty to the investor who has no relationship with the company b/c he is seeking to become a stockholder ii. E.g., if a raider fails to disclose plans to make a tender offer while buying the targets stock, he hasnt violated Rule 10b-5 b/c hes not an officer of the company; just an outsider; also, its information he created himself iii. IMPORTANT RULE: if you dont keep silent, i.e., if you make a false or material misstatement, you can be held liable even if you owe no fiduciary duty to company (see Basic) 2. AFTERMATH: after Chiarella, the SEC adopted SEA Rule 14e-3, which forbids anyone except the bidder or raider from purchasing stock on the basis of non-public information about a tender offer even if the bidder allows it; if someone did what Chiarella did today, they would be violating Rule 14e-3 a. If any person has taken a substantial step to commence a tender offer, it shall constitute a fraudulent, deceptive or manipulative practice w/in meaning of 14e for any other person who is in possession of material info relation to such tender offer which info he knows or has reason to know is nonpublic, and which he knows or has reason to know has been acquired directly or indirectly. i. Means that raider does not have to disclose, but he cant lie and he can engage in trading but no one else can that knows of the tender offcer ii. This stops raiders from being tippers or tippees but purchasers who use raiders info liable! 3. CASE STUDY: Dirks v. SEC a. Secrist told Dirks that assets of Equity Funding were vastly overstated b/c of fraudulent corporation practices and urged Dirks to disclose it publicly; Dirks discussed information with clients and investors, some of whom sold their Equity Funding stock; Dirks led investigation which brought attention to Equity Fundings wrong doing b. HOLDING: no 10b-5 violation by Dirks b/c he was a stranger to Equity funding with no preexisting fiduciary duty to its shareholders; Secrist didnt violate his fiduciary duty by providing information to Dirks b/c the tips were motivated by a desire to expose fraud, so, there was no derivative breach by Dirks; Dirks had no duty to abstain from use of inside information he obtained c. BASIC RULE: outsiders may become fiduciaries of shareholders (i.e., temporary insiders) b/c of a special confidential relationship i. Problem with rule: when is a special confidential relationship formed? ii. Parties to a deal different b/c general market relationship not fiduciary, not expected to keep info confidential iii. E.g., a manufacturer of widgets gets a huge order from a regular customer whos never ordered that much before, so the manufacturer thinks business must be doing well; is this a confidential relationship? a. Seems like an arms length transaction b. On the other hand, there should e some expectation of a certain degree of confidence; suppliers cant just blab any information they get when they do an order iv. What if the customer stresses secrecy? Is that enough to turn an otherwise arms length transaction into a relationship of trust and confidence? d. RULE: a tippees duty to disclose or abstain from trading is derivative from the insiders duty; arises from his participating after the fact in the insiders breach of his fiduciary duty; tippee is only liable when an insider has breached his fiduciary duty to shareholders by 102

103 disclosing the information to the tippee AND when the tippee knows or shouldve known there has been a breach e. RULE: passing along material inside information constitutes a breach of fiduciary duty when there is an improper purpose of exploiting the information for personal gain i. Doesnt necessarily mean pecuniary gain; elements of exploitation also exist when an insider makes a gift of confidential information to a trading relative or friend ii. To find an improper purpose, court should focus on objective criteria f. CAVEAT: the rule from this case that there is a violation only if there is a breach of fiduciary duty only applies to cases of SILENCE; everyone has an obligation to refrain from making public lies, including non-fiduciaries g. Secrist intended Dirks to injure purchasers of Equity Funding securities; majority just refers to personal gain as an improper purpose, so this probably wouldnt constitute an improper purpose under Dirks rule 4. CASE STUDY: SEC v. Lund, 570 F. Supp. 1397 a. CEO invites a friend to joint venture; friend says no but goes out and buys stock b. HOLDING: business part of the conversation made it a proper purpose, but the recipient knew or shouldve known that the statement was made in confidence, so he was liable as a temporary insider and had a duty to keep the information confidential in 10b-5 V. Misappropriation 1. Misappropriation theory holds that person commits fraud in cnxn w/ securities transaction and so violates 10b and 10b-5 when he misappropriates confidential info for securities trading purposes in breach of a duty owed to the source of the info. a. Valid uses of the info req a fiduciary duty or a relationship of trust and confidence. b. If employer permits trade, then its OK c. If fiduciary had intent to trade despite prohibition, must be deception to = violation 2. Causation: a. To show nondisclosure caused a loss to the minority SH, P must establish that effective state remedy foregone as a result of the nondisclosure b. P usu attempts to satisfy this req by arguing that if disclosure had been made, minority could have sued for injunctive relief against the proposed transaction under state law. 3. CASE STUDY: U.S. v. OHagan a. D was partner in firm retained to represent Grant Met in a potential tender offer for Pillsbury; D began purchasing call options for Pillsbury stock; later, Grand Met publicly announced tender offer and price of Pillsbury stock rose; D sold options and stock and made a huge profit b. HOLDING: misappropriation at issue was properly made subject of Sec. 10(b) action b/c it meets statutory requirement that there be deceptive conduct in connection with securities transactions c. RULE: in lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the companys stock, the misappropriation theory premises liability on a fiduciary-turned-traders deception of those who entrusted him with access to confidential information i. Criminal liability can be predicated on misappropriation theory. d. Problems with this case i. Securities laws are meant to protect people trading on the market; this case is premised on idea that securities laws are meant to protect the employer or supplier of information ii. Who can sue under this theory? a. Investor cant sue under Chiarella b/c D owes no duty to him b. Source of information cant sue under Blue Chip b/c it didnt purchase or sell securities in the transaction 103

104 c. The only person who can bring an action against the D in this case is the SEC for an injunction, or they could refer case to justice department for criminal action, but no one could sue for damages d. Congress subsequently changed fact that no one could sue by legislation iii. HYPO: what if Grand Met, the source, traded on the same information; would it have violated Rule 10b-5? a. No b/c they owe no fiduciary duty to themselves b. Like if a raider buys stock without divulging information that theyre making a tender offer c. But, if an employee like a secretary trades and makes a few hundred dollars, thats a federal crime; seems to be something wrong with this iv. What if the source permits you to trade? a. Then, youre not violating a duty to the source b. But, the president cant tell the secretary that its okay to trade on information; cant tell an employee that its okay to steal from the till; would be an improper gift under Chiarella c. REMEMBER: SEA Rule 14(e)(3) forbids trading by anyone other than the raider even if the raider approves trading, so if someone trades on information form a raider, it wouldnt be a violation of Rule 10b-5, but it would be a violation of Rule 14(e)(3) 4. CASE STUDY: U.S. v. Chestman (p. 778-779) a. CEO tells his sister that the company will be acquired at a big premium; the sister tells her daughter, and her daughter tells her husband; the daughters husband then tips a broker (Chestman), who trades on the information b. HOLDING: not a 10b-5 violation; the husband wasnt a blood member of the family or the control group, so he wasnt a fiduciary; court didnt consider marriage a relationship of trust and confidence; the fact that the wife told the husband not to disclose wasnt enough; a fiduciary duty couldnt be imposed unilaterally by intrusting people with confidential information for purposes of Rule 10b-5; wife didnt intend any personal benefit to herself or as a gift to her husband 5. CASE STUDY: SEC v. Yun (p. 837) a. Tip was given between friends who sometimes did business together; SEC had evidence that two were friendly b. HOLDING: evidence was sufficient for jury to reasonably conclude that tipper expected the tippee to benefit form her tip 6. SEC was annoyed with cases like Chestman, so they adopted SEA Rule 10b-5-2, which gives a non-exclusive definition of a relationship of trust and confidence for the misappropriation doctrine ONLY a. Includes cases with a history of sharing confidences such that the donee should know that the donor expects confidentiality b. Applies to close family relationships c. Unless D can show that in her case, there is no duty of trust and confidence 7. Insider Trading Sanctions and Securities Fraud Enforcement Act of 1988 a. Increases fines and jail terms for insider trading; gives a bounty of up to 10% for squealers b. Also added SEA Sec. 20A(a), which makes anyone who violates the 1934 Act while trading on material nonpublic information liable to anyone who traded the wrong way at the same time (p. 817) i. Dont have to trace your securities to that particular offender ii. Covers a violation for Rule 10b-5, but Sec. 20A(a) provides the basis for the suit 8. CASE STUDY: Santa Fe Industries v. Green a. In DE, if you own more than 90% of the stock, you can put through a short form merger without a shareholder meeting; Santa Fe owned over 90% of Kirbys stock 104

105 b. Santa Fe availed itself of DE short form merger statute; minority shareholders were only told of merger after fact but were offered $150/share; minority stockholders of Kirby objected to terms of merger, but didnt pursue their appraisal remedy in trial court; instead they seek to set aside merger or recover fair value of stock ($772/share); claim D was seeking to freezeout minority at an inadequate price c. HOLDING: transaction was neither deceptive nor manipulative; therefore, it didnt violate Sec. 10(b) or Rule 10b-5; breach of fiduciary duty isnt good enough; failure to give advance notice didnt count as deception b/c Ps didnt indicate how they mightve acted differently had prior notice of merger been given; in fact, any disclosure wasnt material to Ps b/c under DE, appraisal was their sole remedy; P must resort to whatever remedy is created by state law, which is supposed to deal with issues of internal corporate mismanagement d. REASONING: minority shareholders were furnished with all relevant information on which to base their decision; no evidence of manipulation or deception; this extension of federal securities laws would overlap and interfere with state corporate law e. Problems with case i. If you trick or deceive someone, you violate Rule 10b-5, but if you pull a gun out, put it to someones head, and say give me your money, thats not a violation of Rule 10b-5 ii. Since Santa Fe is in such a powerful position, it can push the merger through whether the minority shareholders like it or not, and its not liable under Rule 10b-5 iii. On the other hand, Santa Fe doesnt have to fool anyone; they can just shove it down their throats; so, the minority shareholders dont need the protection of Rule 10b-5; that kind of problem (breach of fiduciary duty) is handled under state law

9. CASE STUDY: Goldberg v. Meridor (p. 855) a. Parent Maritimecor sells all of its assets other than the stock of its subsidiary UGO to UGO in exchange for additional stock of UGO; Maritimecor is left with one assetstock of UGO (making it a holding company, which hold stock in companies which it dominates); minority shareholders suing derivatively argue that exchange was unfair, i.e., asset Maritimecore sold UGO wasnt worth stock; Ps votes werent needed to approve transaction, so they argue their state remedy was foregone; if full disclosure had been made, Ps couldvse sought injunctive relief under state law b. RULE: a derivative action can be brought under Rule 10b-5 on the basis of a unfair transaction between a corporation and a controlling shareholder if i. Transaction involved stock ii. Material facts concerning the transaction werent disclosed to all shareholders c. RULE: in this type of self-dealing transaction between a corporation and a controlling shareholder, the court seems to require full disclosure to the minority shareholder d. Side note: this case consistent with Bluechip b/c shareholders are bringing a derivative suit on behalf of UGO, which did sell stock to Martimecor; also, if UGO had purchased Maritimecors assets for cash, Rule 10b-5 wouldnt apply b/c then there wouldnt have been a purchase or sale of a security e. Problems with case i. Seems inconsistent with Santa Fe b/c state law doesnt require disclosure to minority shareholders; federal law is interfering with state law a. Judge Friendly argues that hes not interfering with substantiate state corporation law but just requiring disclosure, which federal laws are supposed to do; really supports state law 105

106 b. But, a shareholder vote wasnt required here, so why do the minority shareholders need disclosure? c. Purpose of disclosure here is to assist shareholders in litigation by giving them information so they can file a suit for an injunction; some litigators have called this the sue-fact doctrine ii. But, this case is distinguishable from Santa Fe b/c here, if the Ps had gotten full discovery, they couldve sought a remedy under state law, whereas the Ps in Santa Fe couldnt have done anything even if they had full disclosure iii. To tell you if you have a claim under Rule 10b-5, you have to look to state law; if you have a state law claim, then you win (Goldberg); if you dont, you lose (Santa Fe) iv. Goldberg is essentially giving the Ps a remedy the state court wouldnt give f. N.B. Goldberg v. Meridor has been widely followed, except by 7th Circuit; also, courts have disagreed about nature of showing that P must make that foregone remedy wouldve been successful (p. 856) 10. Santa Fe/Goldberg Combination a. Under Goldberg, a shareholder cannot sue under 10b-5 claiming a breach of fiduciary duty when i. If it was a sale of assets for cash, then there would be no Rule 10b-5 claim b/c to have a Rule 10b-5 claim, there must be a purchase or sale of a security ii. If the suit is derivative, Blue Chip requires that the P corporation be a purchaser or seller iii. There must be self-dealing by a controlling shareholder a. If the corporation just pays too much in an arms-length merger, than Rule 10b-5 doesnt apply iv. It must be alleged that public shareholders have been deceived by the misstatement or omission a. If they received full disclosure, but they still claim the deal was unfair, they would have no claim under Goldberg b. In reality, if Ps just claims breach of fiduciary duty under state law and alleges they didnt get full disclosure, it might be enough to get their Rule 10b-5 in the door of a federal court house even though it might later be dismissed, and the court will probably keep pendant jurisdiction for the state law claim 11. Analysis for Exam a. IMPORTANT: any time theres a breach of fiduciary duty, you should ask, can you bring a Rule 10b-5 claim, too? b. Purchase or sale of security? i. If no, forget about it c. Was the company a purchaser or seller? i. If its just inside trading, then forget about it; P must be purchaser or seller d. Transaction with a controlling shareholder? i. If no, forget about it W. Disclosure Requirements 1. GENERAL RULE: there is no legal obligation on a corporation to make general continuous disclosure 2. Specific Disclosure Obligations a. When a company engages in the purchase or sale of securities, Rule 10b-5 kicks in, and you must give disclosure to the extent required to satisfy Rule 10b-5 i. Cant say anything materially false or misleading or be silent when there is a fiduciary duty to speak b. When a periodic report is due under SEA Form 10-K or Form 10-Q, you must give full disclosure c. SEC requires disclosure of a list of matters described in Form 8-K 106

107 i. Must file it within 4 days of the event ii. Limited list; doesnt cover all material events 3. RULE: if you do say something, you cannot make a statement that is false or misleading (recall Basic v. Levinson) 4. ULTIMATE RULE: Otherwise, if youre not trading in your own securities, theres no periodic report due, and its not a matter listed on Form 8-K, you dont have to say anything at all or can say no comment 5. Duty to Correct vs. Duty to Update a. Duty to correct: once you learn that a past statement was false when made, you have the requisite scienter, and if you fail to correct the statement within reasonable time, you would be violating Rule 10b-5 b. Some courts have held that if a corporation makes a public statement that is correct when made, but that becomes materially misleading in light of subsequent events, the corporation may have a duty to update the statement (p. 859) c. Scope of duty to update has been brought into question by safe-harbor provision in SEA Sec. 21E(d), which says that nothing in this section shall impose a duty to update a forwardlooking statement d. Congress is pretty clear that it doesnt want a duty to update, but its unclear how the courts will interpret this e. One reason some courts have held that there is no duty to update is b/c if there is a duty do update, it will discourage companies from disclosing information at all f. If there is a duty to update i. When do you have a duty to disclose? a. Presumably within a reasonable time, but when is that? b. Could use Form 8-K as a yard stickdisclosure within 4 days ii. What is a material change? a. E.g., what if you received an offer to buy the company at $52/share, and it changes to $53/share; is that a material change? 6. CASE STUDY: Backman v. Polaroid (p. 859) a. RULE: a duty to correct can also apply to a certain narrow set of forward-looking statements; duty arises from an implicit factual representation that a company makes whenever it makes a forecast, i.e., that the forecast was reasonable at the time it was made (p. 859); if the underlying factual basis for your claim is no longer valid, you have a duty to update b. Dent thinks this probably isnt good law any more, but hes not sure 7. HYPO: suppose a CEO gives material information to a few, selected security analysts, who then trade on the information before it becomes public; is there a Rule 10b-5 violation? a. Theres a purchase of sale and securities, and trading on material non-public information, but the tippees dont owe a duty to the corporation b. Dirks test: tipping violates Rule 10b-5 when the tipper has an improper purpose; intent to realize personal gain constitutes an improper purpose c. CEO could say he didnt intend to receive any personal gain; only doing this for the analysis that give the company good reports d. Under Dirks, it was unclear whether this violated Rule 10b-5, and it still is e. SEC adopted Reg. FD to deal with this situation; you have to invite the public to attend at least over the internet to information session XV. SEC 16(b) A. Rule 10b-5 applies to EVERY company; in contrast, SEA Sec. 16(a) applies only to Sec. 12 companies B. SEA Sec. 16(a) requires every officer, director, OR owner of over 10% of the stock of a Sec. 12 company to report to the SEC within 10 days at the end of any month in which she buys and sells the companys stock 107

108 1. An officer is one who performs a policy-making function under the statute 2. Even if you otherwise own nothing and youre a director or officer, youre still subject to statute These reports are watched by analysis; sign of what insiders think of the company SEA Sec. 16(b): imposes strict liability for any profit realized by a director, officer, or 10% shareholder from the purchase or sale of a security within any period less than 6 months 1. Liability based on purchase/sell price 2. CAVEAT: neither actual use of inside information nor intent to use such information is required to establish Sec. 16(b) liability, and it is no defense for D to prove absence of inside information 3. Applies to purchases and sales of equity security: any security other than pure debt instrument, including option, warrants, preferred stock, common stock etc 4. Timing: purchases or sales made by persons before becoming an officer or director are generally excluded from scope of 16(b) b/c person generally doesnt have access to inside info before hand. Same for transactions that make you a 10% SH. Limits on Sec. 16(b) Liability for Insider Trading 1. A low-level employee who is an insider isnt covered by Sec. 16(b); it only applies to officers, directors, or 10% shareholders 2. If the purchase or sale isnt within 6 months of the last purchase or sale, then Sec. 16(b) doesnt apply 3. Sec. 16(b) only applies to trading in stock of the company of which the individual is an insider a. E.g., if youre an insider with the acquiring company and buy stock of the target company, you wont be liable under Sec. 16(b) if the acquisition doesnt go through 4. If you buy stock on inside information for $20 and sell at the same price to avoid an impending loss b/c the stock price is expected to crash, you wouldnt be liable under Sec. 16(b) b/c the profit is measured by the difference between the price at which you bought and the price at which you sold, which is $0 here 5. If you fall into any of these exceptions, then Sec. 16(b) doesnt apply, but REMEMBER Rule 10b-5 still might a. If you can show use of inside information, Rule 10b-5 might apply The exercise of options is counted as a purchase Congress wanted Sec. 16(b) to be a mechanical statute 1. Want to impose liability regardless of proof b/c its hard to prove insider trading 2. One problem is the definition of purchase and sale CASE STUDY: Kern County Land Co. v. Occidental Petroleum Corp. (p. 872) 1. Occidental owned 30% of Kern stock; Kern merged with Tenneco; shareholders of Kern got stock of Tenneco, including Occidental; all took place within 6 months; does this stock exchange constitute a sale for purposes of Sec. 16(b)? 2. HOLDING: mechanical application of the statute was considered undesirable if not impossible; this wasnt the kind of thing Congress had in mind, so Sec. 16(b) doesnt apply In the mid-60s, courts starting using a subjective or pragmatic approach in determining what constitutes a sale as opposed to the old mechanical approach (p. 869) 1. Under the pragmatic approach, in BORDERLINE casesparticularly cases involving an UNORTHODOX transaction, rather than a garden-variety purchase or salethe statute would be interpreted to impose liability only if the insider actually had access to inside information, or the transaction was a type that carried a potential for insider abuse (p. 869) 2. REMEMBER: in ordinary, garden-variety sales, access to insider information is irrelevant; doesnt matter that this wasnt the type of sale Congress was thinking about Sec. 16(b) imposes liability in many cases where there doesnt seem to be any wrongdoing 1. HYPO: client is a high-ranking officer in company; tuition bill for son has just arrived, and he wants to sell shares to get money to pay the bill a. Even if he doesnt have any material inside information, if this is a Sec. 12 company, youd have to ask when he sold or bough stock in the company last in light of Sec. 16(b) b. Have to report all purchases and sales under Sec. 16(a) 108

C. D.

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F. G. H.

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109 c. CAVEAT #1: even if the answer is yes, then you have to ask whether hell be making a profit with the sale d. CAVEAT #2: even if the price has gone up, this isnt a jail issue; just strict liability to take away the profit; no one can sue you for breach of fiduciary duty 2. Sec. 16(b) imposes punitive liability on the innocent, the nave, and the unaware (p. 862) a. If youre aware of Sec. 16(b), you can avoid it, even if youre doing terrible things; just have to wait 6 months and a day to buy or sell stock K. Sec. 16(a) requires covered persons to report all sales and purchases of a companys stock, so Sec. 16(a) would show a violation of 16(b) L. Restrictions for Suing Under Sec. 16(b) 1. A shareholder can sue if the corporation doesnt bring a suit within 60 days of demand, AND 2. Its a Sec. 12 company, AND 3. Its short-swing trading (i.e., D held stock for no more than 6 months), AND 4. D is director, officer, or 10% shareholder, AND 5. Its only for the profit realized under Sec. 16(b) 6. There are a lots of situations in which it is possible there has been some insider trading and neither the corporation nor the shareholders would be able to sue under Sec. 16(b) 7. SEC doesnt have enforcement authority. M. Deputization 1. CASE STUDY: Blau v. Lehman (p. 894) a. Thomas, a partner in Lehman Brothers, sat on the board of Tidewater, and Lehman profited from short-swing trading in Tide Water stock b. HOLDING: Lehman Brothers could be a director of Tide Water, if Lehman actually functioned as a director through Thomas, who had been deputized by Lehman to perform a directors duties not for himself but for Lehman; ultimately, Lehman Brothers werent liable b/c there was no evidence of deputization c. RULE: one enterprise, A, could be a director of the second enterprise, B, within the meaning of Sec. 16(b), if one of Bs directors had been deputized by A to act on its behalf d. DISSENT: this makes a joke of the statute b/c Lehman Brothers can evade liability under Sec. 16(b) by just winking whenever one of its partners becomes a director of another company N. CASE STUDY: Diamond v. Oreamuno (NY) 1. P, suing derivatively, claims that D officers used inside information to reap large personal profits from sale of MAI shares and profits rightfully belong to corporation; MAI was farming out maintenance of its computer repairs to IBM; IBM increased charges for services, and MAIs expenses rose and earnings declined; prior to release of information, Ds sold a bunch of shares of MAI stock; when information was made public, stock price dropped 2. HOLDING: Ds avoided Sec. 16(b) liability b/c they held the MAI shares for more than 6 months before selling; the present derivative action is the only effective remedy available against the abuse by Ds of their privileged position; common law claim for breach of fiduciary duty 3. RULE: public policy wont permit an employee occupying a position of trust and confidence toward his employer to abuse that relationship to his own profit, regardless of whether his employer suffers a loss; agency principles 4. Injury to corporation: company didnt trade, so its balance sheet didnt suffer; when officers or directors abuse their positions in order to gain personal profits, the effect may be to cast a cloud on the corporation name, injure stockholder relations, and undermine public regard for the corporations securities 5. CAVEAT: a number of states have held that insider trading doesnt violate common law fiduciary duties; OH hasnt ruled on issue XVI. Public Distributions of Securities A. Except for the federal income tax laws, the Securities Act of 1933 is the cause of more inadvertent violations of federal law than any other federal statute 109

110 B. Definition of a Security 1. LESSON: if your client is raising money for some venture, you should always ask, is this a security? 2. SA Sec. 2(1) defines securities; biggest problem is the definition of the term investment contract, which was intended to be a catch-all a. Investment contract, stocks, bonds, debentures 3. CASE STUDY: SEC v. W.J. Howey Co. (p. 1271) a. Still the leading case; Ds sold strip of orchards along with service contracts to harvest and sell fruit; purchasers tracts were jointly cultivated, and corporation sold fruit, distributing to purchasers a pro rata portion of the profits based on acreage they owned b. HOLDING: court found this was an investment contract; most sales of an orchard probably arent investment contracts, but here, the interest in the orchard was found to be a security c. RULE: Definition of an Investment Contract i. Investment of money ii. In a common enterprise iii. With the expectation of profits iv. primarily from the efforts of others a. This element isnt as important any more b. Supreme Court has never ruled on this, but subsequent cases have held that if the effort from the franchisee is purely ministerial, thats good enough; changed solely to primarily 4. CASE STUDY: SEC v. Glenn W. Turner Enterprises, Inc. (p. 1272) a. Pyramid selling scheme, i.e., franchise; salve of self-improvement contracts by Dare to Be Great, Inc., which offered buyers opportunity of earning commissions on sale of such contracts to others; D argued that buyers of contracts were required to exert some efforts of their own b. HOLDING: the success of the enterprise was dependent upon the essential managerial efforts of Dare, so the court found the Howey test for investment contract was satisfied c. RULE: realistic test focusing on whether efforts made by those other than the efforts are undeniably significant ones, those essential managerial efforts which affect the failure or success of the entire enterprise; if the effort of the franchisee is purely ministerial, then a franchise will be considered a security 5. HYPO: a broker with managed accounts; makes decisions separately for each of several customers; is that a common enterprise? a. Courts disagree about this b. Broker is getting a share of the profits, so some courts say theres a common enterprise between you and the brokervertical commonality c. Other courts say there must be a pool in which the broker combines the funds of several investors and makes the decisions collectivelyhorizontal commonality 6. HYPO: is a partnership interest a security? a. Probably not b/c a partner is an agent for the partnership with apparent authority to conduct ordinary business of venture; not benefiting primarily from efforts of others b. On the other hand, if the powers of the partner are whittled down virtually to nothing, then the court will find that the partnership interest ins a security c. Courts are extremely reluctant to find that a general partnership interest is a security d. A limited partnership interest is traditionally considered a security b/c limited partners usually cannot participate in control of the business; might change with RULP and reRULPA 7. CASE STUDY: United Housing Foundation, Inc. v. Forman (p. 1274) a. Tenants purchased shares of stock in Co-op City, a nonprofit cooperative housing corporation, in order to obtain the right to lease apartments; stock was tied inextricably to the apartment, and no profit could be realized on the re-sale of the stock 110

111 b. HOLDING: Supreme Court held shares lacked the most common feature of stockthe right to receive dividends contingent upon an apportionment of profits; shares of stock were therefore not securities within the meaning of the 1933 Act, but in effect only a recoverable deposit; not a business enterprise, but primarily a housing arrangement c. RULE: scope of the definition of security was that form should be disregarded for substance and the emphasis should be on economic reality 8. HYPO: you buy a condo in a resort, and the manager rents the condo when youre not using it; youre not allowed to occupy the condo for more than 2-3 weeks per year; is this a security? a. Condo might be a security b. Youre investing money, theres a common enterprise (high rise building with 100 units), youre primarily doing it for expectation of profits (only going to be there 2-3 weeks/year), and youre primarily depending on efforts of others 9. HYPO: company buying up life insurance policies at a discount for people dying of aids; puts them together and sells them for a profit; is this a security? a. In 1996, DC circuit held this wasnt a security b/c it didnt depend primarily on efforts of owners; depended primarily on whether people died or managed to hang out b. SEC v. Mutual Benefits (11th Cir. 2005): these contracts are securities b/c investors are just putting their money in and sitting back to see what happens 10. N.B. Whether or not the sale of an entire business is the sale of a security depends on how the transaction is structured a. HYPO: Suppose you Zilcho Corp. owns one asset, a piece of land called Blackacre, with a factory on it; a company wants to buy the piece of land, Blackacre from Zilchco; how can you sell Blackacre to the company? i. One option is to sell the stock of Zilchko, which is the sale of a security b/c its stock; no need to ask if its an investment contract ii. Another option is to buy Blackacre, the land and the building, which isnt the sale of a security 11. After investment contract, the most problematic part of the definition of security is the term notes a. A note is just another debt instrument like a bond or debenture b. Notes are clearly securities if you promise to pay someone later c. Many things are notes in common parlance that arent securities; e.g., if you sign a note to borrow money, thats just a consumer financing contract, not a security d. e. Dont use the definition of investment contract to analyze whether a note is a security; a note is different from an investment contract C. SA Section 5 1. Sec. 5 is the backbone of the 1933 Act in the sense that everything grows out of it 2. Under SA of 1933 Sec. 5(c), unless an exemption is available, you cant even offer to sell a security using interstate commerce unless a registration statement has been filed with the SEC, and you cant sell a security unless the registration statement is effective 3. Structure of the Act is that you must file, unless; begin with presumption that you have to file, and then look for an exemption 4. Statistically, the exemptions swallow the rule 5. Sec. 5 defines two events that divide time into three eras a. Filing of the registration statement i. SA Sec. 5(b) prohibits sales and any offers to sell during the pre-filing period a. Can negotiate but no actual offers allowed. b. Publicity prior to registration may be illegal too. ii. Once youve filed, then youre out of the pre-filing period and into the so-called waiting period a. Sales are still prohibited, but offers can be made orally 111

112 b. You can solicit expression of interest, but you cant close an offer c. SEC reviews registration statement; usually asks for substantial reviews only for IPOs (initial public offerings) iii. Any person proposing to sell a security by any means of communication in interstate commerce or by mail or sends a security throughthe mail for purposes of sale, or offers to buy/sell a security by such menas, the security must be registered unless exemption applies b. SEC determines registration statement is effective (effective date) i. Oral offerings can continue, and sales may be made/consummated. 6. Definition of offer isnt the same in Sec. 5 as the traditional contract definition of offer a. Contract definition of an offer is something that will enable the other person to say, I accept b. Sec. 5 definition of offer covers every attempt or offer to dispose of a security or any solicitation for offers to buy a security i. SEC and courts have extended this definition beyond what one would normally infer from it ii. E.g., at a rotary club meeting, a head of a local business says his company is doing great, and will be doing even better after it does its offering of stock next months; could be deemed an offer for purposes of federal securities laws iii. Publicity about an issuer may constitute an illegal offer to sell (p. 1328) iv. SEC refers to conditioning the market; anything that might arouse interest of a potential buyer; referred to as gun-jumping v. Courts tend to defer to SEC in its broad definition of offer (p. 1285) 7. Registration statement: comprises of prospectus + some other information, i.e., stuff that SEC wants to know for its own purposes a. Guts of registration statement is prospectus, which is the comprehensive disclosure document that will be given to potential buyers after it goes through SEC review, so they can make an intelligent decision about whether to purchase the security b. Purpose of registration is disclosure i. Some tried to argue that we should have a body like the FDA, which decides whether securities are safe and effective ii. Ultimately, the disclosure approach prevailed D. Exemptions to Sec. 5 Disclosure 1. Why not just always register? (see p. 1298) a. Registration is expensive; anything under $15 million probably wouldnt make sense to register b. SEC requires books to be edited to a standard which very few publicly traded companies can actually meet 2. Alternatives to Registration a. Structure the financing without the use of a security i. E.g., franchises, dealerships, general partnerships ii. E.g., go to the bank and have the bank lend money b. Bring it within an exemption, so you dont have to register 3. SA Sec. 4(1) exempts from Sec. 5 disclosure transactions by any person other than the issuer, underwriter, or dealer a. Core idea is that the ordinary investor selling anything but a huge number of shares has this exemption b. Dealer is just a dealer in securities c. An issuer is the individual or entity in which interests are being issued i. Term issuer isnt limited to corporations; a partnership, LLC, or even an individual which creates and sells securities is an issuer 112

113 4. SA Sec. 4(2) exempts from Sec. 5 disclosure transactions by an issuer not involving any public offering a. RULE: question about whether an offering is public or private under Sec. 4(2) i. Are the offerees sophisticated? ii. Do the offerees have access to the same type of information that would be in the registration statement? b. N.B. ALL of the offerees must meet the sophistication and access requirements c. The D has the burden of proof to satisfy the two criteria under Sec. 4(2); has to prove ALL offerees were sophisticated d. In transaction practice, if your client is doing financing in reliance of Sec. 4(2), you want to get information about the offerees in the beginning; make sure youre careful about who offers are made to; sometimes called the burden of proof file e. If an offer is made to JUST ONE ineligible offeree, then youve blown the Sec. 4(2) exemption for the entire offering f. Private Offering: i. Knowledgeable or sophisticated buyer ii. Buyer has access to kind of info that registration info would otherwise provide iii. No real minimum number so something as small as 2 buyers may req registration if they dont have the info that registration would provide. No max number either. g. CASE STUDY: SEC v. Ralston Purina Co. i. Leading case on what SA Sec. 4(2) means; D sold nearly $2 million of stock to key employees without registration and using mails; only sold stock to employees who, without solicitation, inquired as to how to purchase stock from company; D claims Sec. 4(2) exemption should apply ii. HOLDING: employees didnt have access to kind of information which registration would disclose; obvious opportunities for pressure make it advisable that they be entitled to compliance with Sec. 5; not a private offering. iii. RULE: the applicability of Sec. 4(2) should turn on whether the particular class of persons affected need the protection of the act; an offering to those who are shown to be able to fend for themselves is a transaction not involving any public offering; issuers motives are irrelevant; focus should be on need of offerees for protections afforded by registration iv. RULE: People who dont need the protections of the act are a. People who are sophisticated investors, AND b. People who already have access to the kind of information that a registration statement would provide v. There no minimum number of people who can constitute the public for a public offering; could be anywhere from 2 to infinity, perhaps even one; e.g., if it is intended to be the first of a series of offers, then its a public offering as soon as you make the first offer; theres no maximum number of people you can have for a private offering 5. Regulation D a. Reg. D is a safe harbor for Sec. 4(2) i. If you comply with Reg. D, then you qualify for the Sec. 4(2) private offering exemption ii. In theory, you dont have to comply with Reg. D; you could just comply with the statue, but the regulation is broader than the statute b. Regulation D gives THREE separate exemptions (p. 1294-1296) i. Rule 504 provides an exemption for offer and sale of up to $1,000,000 of securities in a 12-month period a. No limitation on number of persons purchasing securities b. Offering may be made w/ general solicitation or general advertising c. Securities received are not restricted securities 113

114 d. Form D notice must be filed w/in 15 days after 1st sale e. Does not req that specific disclosure be provided to purchasers ii. Rule 505 provides an exemption for offers and sales of securities totally up to $5 million in any 12-month period a. no specific info need be furnished for accredited investors b. if nonaccredited, then all material info must be provided and issuer must be available to answer Qs c. offering may not be made by means of general solicitation or general advertising. d. Sell to unlimited number of accredited investors but only 35 non accredited investors e. Securities are restricted: sale must be for investment not solely for the purpose of resale f. File form D w/in 15 days of the first sale. iii. Rule 506 is a safe harbor for the private offering exemption, Sec. 4(2) a. Unlike 4(2), you dnt lose your exemption by making an offer to ineligible offeree. b. Can have up to 35 non accredited investors if they are sophisticated or advised by sophisticated person (purchaser rep) c. No max amt of money d. No general solicitation or ads permitted e. Can sell to unlimited number of accredited investors f. No specific info need be furnished for accredited investors g. If non accredited, all material info must be provided and issuer must be available to answer Qs h. Securities restricted, sale must be for investment not solely for purpose of resale for at least 2 years. i. File a form D within 15 days. iv. Not exempt from 10b-5, just from registration reqa. v. 4(6) Accredited Investor Exception a. No more than 5 mil b. No ads or public solicitation c. Same definition of accredited investor d. Form D required. e. Not exempt from 10b-5 but no specific disclosure req. c. Offeree Qualification i. Sec. 4(2) is very tricky, but under Rules 504 and 505, there are no offeree qualification requirements; you can sell to anyone ii. Under Rule 506, the offeree requirement only need to be met by buyers, and the issuer need only reasonably believe the buyer is sophisticated iii. Accredited investor: if you have a certain amount of wealth, then you automatically meet the requirements to be an accredited investor for purpose of Rule 506 even if youre not sophisticated iv. Under Rule 506, up to 34 non-accredited investor can purchase if they are either sophisticated themselves or represented by someone who is sophisticated d. Under Rules 505 and 506, re-sales must be restricted; to be truly private, the offer cant just be the first step in a distribution, so you have to restrict sales e. Under Reg. D, you must file notice, called Form D i. The penalty for failing to file may be an injunction or future loss of exemption, but the failure to file doesnt destroy the emption for the transaction in question ii. If you forget to file a Form D, then you can just say you didnt rely on Reg. D, you relied on the statue 114

115 f. REMEMBER: meeting the requirements of Reg. D or Sec. 4(2) doesnt exempt you from SEA Rule 10b-5, and Rule 10b-5 applies to all companies; they only exempt you from registration and prospectus delivery requirements of SA Sec. 5 g. Under Reg. D, there is an integration safe harbor; if you make a Reg. D offering on June 30 of that year and then no other offerings in that year (nothing 6 months before or 6 months after), then its okay 6. Regulation A: technically an exemption from registration, but requires filing of disclosure document with SEC and delivery document to offerees, so its basically a disclosure requirement 7. SA Sec. 3(a)(11): The Intra-State Offering Exemption a. SA Sec. 3(a)(11) provides an exemption from the Sec. 5 registration requirement any stock offered and sole to residents of a single state, where the corporation is incorporated and doing business inside the state b. Requirements for the statutory in-state offering exemption i. Business must be incorporated in state ii. Business must carry out significant business in state iii. Business must make offer and sales only to residents of state c. HYPO: if a corporation is incorporated in DE and does all of its business in OH, it cant make an in-state offering in either DE or OH d. EVERY OFFEREE must reside in the state, NOT just every buyer i. A single, improper offer, even if accidental, destroys the exemption* ii. E.g., you make an offering just to your employees in reliance of interstate offering employee, and then you find out Suzie has been commuting from W. PA; your Sec. 3(a) (11) exemption is gone iii. But, other than residence in the state, there are no other offer qualification requirements including limits on number e. The securities must come to rest within the state, i.e., re-sales must be limited i. Buying stock back from people in state and turning around and selling them to people out of state isnt an intrastate offering f. SEC has said that doing business in the state requires substantial operational activities in the state of incorporation 8. Rule 147: The Intra-state Offering Safe Harbor Provision a. SA Rule 147 is only a safe harbor for the intrastate offering provision in the state i. You can rely on the statute if you want to ii. If you want to rely on the rule, and you meet its requirements, then youll be exempt from the statute iii. If you fall substantially short of the criteria set forth in the rule, you risk an SEC suit iv. If you meet most of the criteria under Rule 147, youre probably safe arguing that you dont quite meet the rule, but you meet the requirements of the statute b. SA Rule 147(c)(2) lists a series of 80% tests: 80% of revenues and assets in state, 80% of proceeds must be used in state, principal place of business must be in state, etc. (supp. p. 1602) c. Rule 147(e) lists objective standards about when an issue has come to rest: after 9 months, sales outside the state are permitted under the rule (p. 1306) d. There are lots of situations where you might n5t be sure if you satisfy the rule, so you claim both the rule and the statute e. If SEC finds you meet this, they assume you meet 3a-11. If not can still be exempt, but not automatic. 9. Integration a. Cant split an offering into different exemptions, like a local offering and private offering. b. HYPO: suppose an OH company wants to sell stock to many buyer in OH plus a few buyers out of state; can you use an intrastate offering for buyers in OH and a separate offering for people outside of OH? 115

116 i. Reg. D offering in PA and an intra-state offering in OH ii. SEC will treat two as one under doctrine of integration, which says that you dont split what is essentially a single offering into two parts and claim theyre separate (p. 1307) iii. RULE: factors of integration (p. 1307-1308): offerings are a. Part of a single plan of financing? b. Same class of securities? c. At or about the same time? d. Same type of consideration? e. Same general purpose? iv. Here, there would be issue integration c. HYPO: Suppose the company says theyll set up a subsidiary in PA; now the OH parent can do an intrastate offering in OH and the subsidiary can do an intrastate offering in PA i. Raises issue of issuer integration ii. Are the two issuers really independent of one another? d. At or about the same time factor for integration is unclear E. Remedies Under the Securities Act of 1933 1. SA Sec. 17(a) [general anti-fraud provision] is very similar to the language of SEA Rule 10b-5 a. Originally, no one cared whether there was a private damage action under Sec. 17(a) b/c if there was one, it was redundant with Rule 10b-5, so it didnt make any difference b. The issue got more attention when the Supreme Court added scienter requirement and manipulation or deception requirement in Santa Fe; pruning back scope of Rule 10b-5, so people thought they might be better of suing under Sec. 17(a) c. Clear now that there is NO private right of action under Sec. 17(a) (p. 1338) d. Regulates only sellers, and has a scienter req 2. SA Sec. 12(a)(2): any person who offers or sells a security by means of a prospectus or oral communication is liable to the purchaser for rescission or damages, if the prospectus or oral communication includes a material misstatement or has a material omission a. Only applies to securities sold in public offerings by issuer or controlling SH. b. Clearly, there is a private right of action under SA Sec. 12(a)(2), but no one paid attention to it b/c it didnt seem to provide any remedy you couldnt get under Rule 10b-5, at least before recent Supreme Court limitations on Rule 10b-5 actions c. Ways Sec. 12(a)(2) is preferable to Rule 10b-5 for Plaintiffs i. Lack of scienter requirement in Sec. 12(a)(2) a. Standard of culpability is negligence, not scienter b. D has to argue that he didnt know and with reasonable care couldnt have known that the statement was false ii. Burden of proof as to culpability is on the D in Sec. 12(a)(2) actions: P need only show material misstatement, then burden shifts to D a. Buyer must not have known the truth b. If involves fwd looking statement, safeharbor provision in 27A c. Seller not liable if he can prove that nay or all of the amts that buyer could otherwise have recovered arose from factors other than the misstatement/omission d. Must show false statement or material omission e. Does not need to demo reliance. d. Limitations on Sec. 12(a)(2) Actions i. Sec. 12(a)(2) only permits suits by defrauded purchasers, not sellers ii. Short statute of limitations: one year from the time you discover the untruth but in no case more than 3 years iii. Damages are limited to rescission 116

117 iv. Sec. 12(a)(2) only extends liability to one who offers or sells; in other words, you have to show privity; in other words, unless its a face to face transaction, Sec. 12(a)(2) is of little use v. Doesnt apply to anyone who aids and abets according to Pinter v. Dahl (although it did before 1988) (p. 1339) vi. Sec. 12(a)(2) extends only to false or misleading statement; doesnt seem to apply to cases of mere silence, like Rule 10b-5 does if there is a duty to speak vii. Sec. 12(a)(2) only applies to public sales of securities; e. The only thing Sec. 12(a) seems to be useful for is suing in LEGAL, UNREGISTERED PUBLIC OFFERINGS i. This could cover a. An intrastate offering b. A Reg. A offering ii. In most of those cases, you could also sue under Rule 10b-5 3. Sec. 12(a)(1) extends to someone who offers or sells a security in violation of Sec. 5 a. Any time a person makes an unregistered offering, that person is liable under Sec. 12(a)(1) unless exempt b. Liability is strict i. Buyer doesnt have to show fraud or a material misstatement ii. Not a defense that D didnt know the securities were unregistered c. Under Sec. 12(a)(1), the person selling securities is liable to the people to whom he SOLD d. Remedy is Rescission 4. HYPO: your client says he bought some stock 3 months ago in what was described as an exempt, intrastate offering in OH; he just found out they accidentally sold to people in PA, so the offering is no longer exempt; what do you do? a. Depends on the value of the stock; if the stock is worth more now then when you paid for it, dont do anything b. You can wait until the end of the statute of limitations to see if the price drops later c. If the issuer discovers that their records were wrong and they go to all the purchasers and tell them about the illegal offering and allow them to rescind, what do you do? i. Say you dont want to rescind or waive your rights ii. Theres an anti-waiver provision in the securities laws iii. Puts the seller in a tough position, but liability is only for rescission with people to whom hes sold, so the scope of liability isnt all that great F. Liability of Lawyers Under the Federal Securities Laws 1. Lawyer can be primarily liable under Sec. 10b-5 and Sec. 12(a)(2) if he makes a materially false or misleading statement 2. 102-b: lawyer can be liable for engaging in insider trading. 3. SEA Sec. 4(c): gives SEC power to suspend from practicing before it anyone who lacks character, integrity, or has engaged in unethical, or improper conduct or has aided and abetting a violation of the federal securities laws a. So, even if lawyers cant be held liable for aiding and abetting a Rule 10b-5 violation, they could get disbarred for it 4. Sarbanes Oxley Act (SOX) Sec. 307: give SEC rulemaking power to discipline lawyers, which SEC has utilized by adopting Rule 205 a. Rule 205: lawyers are required to report evidence of material violations of the federal securities laws up the corporate chain of command i. SEC says it has to be reasonably likely that a violation will occur ii. Rule applies when lawyer becomes aware of evidence of material violations, but does this mean he actually ahs to be aware? iii. What about willful ignorance or reckless indifference? 117

118 b. In conjunction, the SEC revised Model Rule 1.6: although SEC doesnt require you to squeal, they do talk about effective action; if you go up the chain of command with no result, then that would seem to require squealing XVII. Shareholder/Derivative Suits A. When a shareholder sues, the action can be derivative or direct B. A derivate suit is a suit brought by a shareholder on behalf of a corporation asserting a claim on behalf of the corporation 1. Valid claim the corp could have sued on 2. Corp must refuse to proceed after suitable demand, unless excused by extraordinary conditions or it would have been futile. 3. P must be a SH at time the action is begun and remain an SH during pendency of action a. Ownership at time of wrong too (contemporaneous ownership) or continuing wrong 4. Parent corp can bring derivative action on behalf of subsidiary 5. Creditors dont have right ot bring a derivative action unless the copr is in bankruptcy b/c the board of directors is not merely an agent of the SH 6. Direct Suit: Differing b/c P must suffer an actual direct harm. Claim for injury separate and distinct from that suffered by other SH, or a wrong involving contract rights existing independently of corp right. Brought on SHs own behalf C. Promoting accountability for officers and directors who wouldnt normally sue themselves D. Most derivative suits are brought against insiders, but they dont have to be E. Gives a shareholder, who almost always has a very tiny interest in the corporation, the possibility of typing up the company in expensive, debilitating litigation; for that reason, there have to be special protections for derivative suits F. CLASSIC E.G. OF A DERIVATIVE SUIT: a shareholder suit alleging looting of the company by a corporate officer is a derivative action b/c the corporation itself is harmed; any harm to the shareholders is only indirect as a result o their status as owners of stock, impairing the value of the stock, not any rights they have individually G. If a claim must be classified as a derivative suit, and you cant meet the requirement, then youre just out of luck H. Generally thought that derivative suits arent for recovery but are just prophylactics; individual shareholder wont recovery much; trying to deter insiders from becoming wrongdoers I. Usually, recovery in a derivative suit goes to the corporation 1. If the corporation is insolvent when the suit is finally resolved, the money would go immediately to creditors and not to shareholders 2. If it goes directly to shareholders, then the creditors get stiffed 3. In Crosby (below), the court didnt want money to go to corporation, so they let shareholders sue directly 4. Some states have made a compromise, and say that Ps have to sue derivative, but its a close corporation where wrongdoers would get the recovery that goes to the corporation, then the recovery can go to the individual P shareholders J. Usually, a direct suits is preferable b/c recovery goes directly to individual shareholders, and you can avoid requirements of a derivative suit, but if your suit is based on federal diversity jurisdiction, each P would have to have a claim worth $75,000 with a direct claim, but in a derivative claim, the whole class claim just needs to be worth $75,000 K. CASE STUDY: Tooley v. Donaldson, Lufkin, & Jenrette, Inc. 1. P allege that members of board breached their fiduciary duties by agreeing to a 22-day delay in closing a proposed merger; delay harmed minority shareholders due to lost time-value of cash paid for shares; Ps are getting money later rather than sooner 2. HOLDING: suit is properly classified as a direct suit, not a derivative suit; the contractual claim is non-existing until it is ripe, and the claim wont be ripe until the terms of the merger are fulfilled; also, merger agreement specifically disclaims any person as being third party beneficiaries to the contract 118

119 3. RULE: issue of whether a suit is direct or derivative should turn solely on a. Who suffered the alleged harm (corporation or stockholders individually), AND b. Who would receive the benefit of any recovery (corporation or stockholders individually) CASE STUDY: Crosby v. Beam (OH) 1. P claims that D, controlling shareholders in a close corporation, officers and directors of Seascape, violated their fiduciary duties by looting the company with exorbitant salaries, etc.; normally, this would be classified as a derivative suit 2. HOLDING: Ps properly brought this action as a direct action rather than a shareholders derivative action; Ps can recover directly; heavy reliance on Donahue v. Rodd Electrotype 3. RULE: claims of a breach of fiduciary duty alleged by minority shareholders against shareholders who control a majority of the shares in a close corporation, and use their control to deprive minority shareholders of the benefits of their investment, may be brought as direct actions 4. REASONING: if the suit were to succeed as a derivative suit, then the relief would go to the corporation, but the corporation is controlled by the wrongdoers here 5. Limitations of this Rule a. Limited to close corporations i. CASE STUDY: Weston v. Weston Paper Co. (Ohio 1996) a. HOLDING: court said that an OH company with 100 shareholders and not traded on an exchange wasnt a close corporation and therefore the rule of Crosby didnt apply to it b. Limited to cases where majority shareholders utilize their majority control to their own advantage without letting minority shareholders share in benefit c. To Dent, it appears that under Crosby, 99.9% of all derivative suits brought against insiders can be brought as direct suits in a close corporation 6. N.B. DE court might go the same way: under Tooley, one of the questions for deciding whether an action is derivative is who would receive the benefit from recovery; if the recovery would go back to the wrongdoers, then the DE courts might allow a direct suit in this case, too, but its unclear with the new law CASE STUDY: Bagdon v. Bridgestone/Firestone, Inc. (p. 929) (7th Cir.) 1. Recognized that not all states follow the rule of Crosby; OH, like a few other states, has expanded the special injury doctrine into a general exception for closely-held corporations, treating them like partnerships, but at the time DE didnt CASE STUDY: Glenn v. Hoteltron Systems, Inc. (NY App.) 1. Lower court found Schachter liable for diverting Ketek assets and opportunities to Hoteltron Systems, Inc., a corporation wholly owned by Schachter; held that Hoteltron profits should be awarded to injured corporation Ketek, rather than innocent shareholder Kulik; P argues this result is inequitable b/c D, as a shareholder of Ketek, will share in the damage award 2. HOLDING: the benefit to the wrongdoer doesnt require a different damage rule for close corporations; awarding the asset directly to a shareholder could impair the rights of creditors whose claims may be superior to that of the innocent shareholder; affirmed 3. REASONING: if you own 80% of stock, it doesnt make sense for you to give up that money to the shareholders b/c 80% of the money you stole was your won; makes sense to only allow individual shareholders to get their pro rata share The Contemporaneous Shareholder Rule 1. It is always true that a shareholder who brings a derivative suit must be a shareholder at the time the suit is brought and must be a shareholder at the time of the proceeding 2. The contemporaneous shareholder rule says that a shareholder must also have been a shareholder at the time the harm occurred 3. REASONING: it is unseemly to purchase a lawsuit by buying shares after the harm occurred 119

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120 4. OH Civ. R. 23.1 and Del. 327 dont apply the contemporaneous shareholder rule, so for exam purposes, theres no contemporaneous shareholder rule; but apparently, it does still apply in DE 5. Subsequent shareholders will benefit from any recovery 6. Also, a later shareholder can be injured by a past wrong 7. The rule conflicts with the idea that a derivative suit is brought on behalf of the corporation, not on behalf of the individual shareholders 8. CASE STUDY: Rifkin v. Steele Platt a. Not even a derivative suit; someone bought a control block of stock in the Boiler Room, Inc. from the Ds, and after the sale, the Ps, being in control, caused the corporation to sue Ds; D says new shareholders wouldnt be able to bring suit themselves under contemporaneous shareholder root, so they shouldnt be allowed to get around that limitation by causing corporation to sue b. HOLDING: court remands to determine if purchase price reflected prior wrongdoings; if it does, then Ps knew what they were getting into and the court must dismiss breach of fiduciary duty claim; if it didnt, then corporation damage aware must stand P. Demand on Board Requirement and Litigation Committees 1. Rule 23.1 in DE, OH, and Federal Rules of Civil Procedure all require that a complaint in a derivative suit describe Ps efforts to obtain the action she desires from the board of directors a. Just describe efforts; no requirement to make efforts 2. Reasons for Requiring Demand on Board a. Management of company is entrusted to board of directors i. The whole idea of a derivative suit is that its an exception to this general rule b/c insiders wont sue themselves ii. It doesnt make sense to make a demand on the wrongdoers b. Judicial economy i. Shareholders should be required to make a demand on board so board has opportunity to redress alleged wrong and save time of lawsuit ii. Usually, the board is hostile; knows all about allegations before suit is filed; board doesnt need a demand in order to be apprised of allegations c. To protect against strike suits (i.e., nuisance suits-easier to settle than litigate to the end) d. Board is in a better position to prosecute the suit 3. Demand is ALWAYS refused a. If the idea is judicial economy, and the board says no, then the shareholder should be allowed to sue b. If management is committed to the board of directors, and it says no, then you shouldnt be allowed to bring a suit, but then you have a rule that says no derivative suits 4. When is Demand Excused? a. GENERAL RULE: demand on the board is required unless demand would be futile b/c majority of board is interested or dominated and controlled by people who are interested b. CASE STUDY: Drage v. Procter & Gamble (Ohio App. 1997) i. Alleged that 6/19 directors approved wrongful investment, but there was no showing that these 6 controlled board 5. Litigation committee issue arises when demand is excused a. RULE: demand is excused when board isnt disinterested and independent b. Once demand is excused, the corporation appoints a committee of the board comprised of directors who are disinterested and independent and charge the committee with investigating the suit and deicing what disposition of the suit is in the best interests of the corporation c. Almost invariably, the committee decides that the interests of the corporation are best served by having the suit dismissed d. How can a committee selected by one of the parties be disinterested and independent? 6. Analysis for Demand Cases a. First, is demand required? 120

121 i. For answer, look to Aronson, Grobow, and Beam v. Stewart b. If demand is made and refused i. Business judgment rule ii. Look to Zapata (p. 969, note 10): when stockholders, after making demand and having their suit rejected, attack the boards decision as improper, the boards decision falls under the business judgment rule and will be respected if the requirements of the rule are met c. If demand is excused, there are two possibilities i. Board appoints a litigation committee a. Committee almost always decides the suits should be dismissed, and makes a motion to dismiss in court b. How motion is treated is determined by Zapata, Kaplan, and Oracle ii. Company doesnt set up a litigation committee a. P is free to sue 7. U.S. Supreme Court has held that demand requirement is governed by state law in federal question cases 8. Recall that business judgment rule applies when theres no self dealing, so when you put that with the litigation committee review, Ps in a derivative suit almost always allege some type of self-dealing or personal profit b/c if theres no self-dealing, business judgment rule applies 9. One of the perverse results of the special litigation committee is that it makes it hard for Ps with truly meritorious suits, but leaves unscathed the shysters who bring frivolous strike suits 10. CASE STUDY: Zapata Corp. v. Maldonado (DE) a. Board of Zapata accelerated the final exercise dates for options held by offers, permitting optionees to save a considerable amount of taxes, but prevented Zapata from enjoying a correspondingly higher tax rate; P brought a derivative action for directors breaches of fiduciary duty; independent investigation committee found that action should be dismissed b. HOLDING: case was remanded for further proceedings consistent with ruling c. RULE: in DE, when reviewing findings of a litigation committee, the court should follow a two-step test (p. 973) i. (1) Court should inquire into the independence and good faith of the committee and the bases supporting its conclusions a. Zapata doesnt define independence b. But, recently in Oracle (p. 981) court said that b/c of the special features of the special litigation committee, the standard of independence has to be more stringent c. Have to look to cases and try to piece definition of independence together ii. (2) Court should determine, applying its own independent business judgment, whether the motion should be granted a. Court is to consider matters of public policy in addition to the corporations best interest b. Should be asking whether the committees decision is reasonable c. Subsequently in Kaplan v. Wyatt (Del), the DE Supreme Court has said that this second step of Zapata is discretionary iii. P can get limited discovery to oppose motion to dismiss iv. Burden of proof is on company seeking dismissal d. Law in Other States i. Some states omit the second step of Zapata and only require the first ii. Other states, like NC, think the whole idea of special litigation committees is crap 11. CASE STUDY: Aronson v. Lewis (p. 974-975) a. RULE: in determining demand futility, the court should decide whether a reasonable doubt is created that i. The directors are disinterested and independent, AND 121

122 ii. That the challenged transaction was otherwise the product of a valid exercise of business judgment b. The mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge either the independent or disinterestedness of directors, although in rare cases a transactions may be so egregious on its face that board approval cannot meet the test of business judgment 12. CASE STUDY: Grobow v. Perot (p. 975) a. GM acquired Perots company, EDS, and as part of the deal, they putt Ross Peron on the board, but he wasnt a team player; after a lot of friction, the board agreed to buy GMs stock back from him at a big premium; shareholders sued, claiming this was improper and that board was just paying him hush money to stop criticizing them and disclosing information b. RULE: reasonable doubt of business decision must be decided by the trial court on a case by case basis employing an objective analysis; court must way the presumption of the business judgment rule that attaches to the boards decision against the well-pleaded facts alleged in the Ps demand-futility complaint; burden is on P to prove bad faith c. PROBLEM: usually, on a Ds motion to dismiss, the court assume the Ps allegations are true; here, you dont assume theyre true; also, P cant get discovery on a motion to dismiss 13. CASE STUDY: Beam v. Stewart (DE) (p. 979) a. P was a minority shareholder, alleging that Martha Stewart had breached her fiduciary duties of loyalty and care to MSO by illegally selling stock she owned in another company and mishandling the medial attention that followed; P didnt make a demand on board before suit b. HOLDING: DE Supreme Court affirmed trial courts finding that three outside directors were independent despite personal friendship with Martha and even though Martha had 94% of companys voting power, but made clear that in an appropriate case, strong ties of personal friendship or other non-financial relationship could lead to a conclusion that a director lacked independence c. RULE: allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a directors independence Q. Demand on Shareholders 1. OH, DE, and Federal Rule of Procedure Rule 23.1 all require P to make a demand on shareholders if necessary before filing a derivative suit 2. Demand is excused when futile (ie majority of wrongdoers hold the stock) 3. Its unclear what the effects of a shareholder vote to reject a demand are 4. Demand is rarely required in public companies for practical purposes 5. Fraud can be ratified only by a unanimous vote; P obviously doesnt approved, so there cant be a unanimous vote, so if P can prove fraud, no shareholder vote is needed 6. DE never requires a demand on shareholders 7. CASE STUDY: Claman v. Robertson (OH 1955) a. HOLDING: P had to make a demand on shareholders b/c action was approved by shareholders, but otherwise OH law is unclear R. Damages in Derivative Suits 1. Derivative suits are generally like class actions for Ps attorneys feels; a successful Ps attorney is entitled to fees paid by corporation, beneficiary of litigation 2. Security-for-Expenses a. Some states require a P to post a security either for Ps expenses, Ds expenses, or both b. Purpose is to deter strike suits, but tends to deter meritorious suits as well b/c you never know what will happen in litigation and you dont want to get stuck paying expenses c. Acts under federal law dont require security for expenses d. DE doesnt require security for expenses, neither does OH 122

123 3. Derivative suits usually get started b/c firms who special in this type of law look at articles about alleged wrongdoing in a corporation and keep a list of potential disgruntled shareholder to add as a P and tell them about it later S. Defenses 1. Any defense that can be asserted against corp can be raised against a P-SH in derivative suit 2. Participation/Ratification: P/SH could be barred if she participated in or acquiesced in or voted to ratify wrongful activity. Or in some cts, bought stock knowing the wrongful conduct occurred/continued to occur 3. Motive: ct may dismiss if P cant fairly rep interests of SH 4. Procedural issues: failure to make demand on SH or board. T. Indemnification 1. PROBLEM 13: Harman was prosecuted under antitrust laws; pled nolo contendere to avoid publicity; he was convicted and paid a substantial fine; can the corporate indemnify him; does it have a right to give indemnification if the board denies it? a. May the company indemnify? i. DE Sec. 145(d) governs indemnification for a suit by or in the name of a corporation, but this are criminal proceedings ii. DE Sec. 145(a): company has power to indemnify if Harman acted in good faith and in best interests of the company and didnt have a reason to think his acts were unlawful a. The fact that he pled nolo contendere doesnt in and of itself create a presumption that he doesnt meet standard of good faith; even if he were convicted, that wouldnt create a presumption that he acted in good faith b. Company may indemnify him if it follows the right procedure b. Would Harman have the right to indemnification? i. DE Sec. 145(c): right to indemnification if he was successful ii. Plea of nolo contendere wasnt successful iii. CASE STUDY: Meritt-Chapman & Scott Corp. v. Wolfson (p. 1014) a. RULE: escape from an adverse judgment or other determine, for whatever reason, is determinative; the only question a court may ask is what the result was, not why it was; theres a success as to charges that are dropped c. If necessary, could he get a court to award him indemnification? i. DE doesnt provide expressly for court-awarded indemnification ii. DE Sec. 145(d): any indemnification under Sec. 145(a) and (b) unless awarded by court, which suggests that a court could award indemnification iii. Court could probably award indemnification if it thought board had abused its discretion in refusing to award indemnification (e.g., exonerated but liable for some trivial amount) d. OH law is essentially the same on indemnification i. OH Sec. 1701.13(E)(1) covers non-derivative suits like this one ii. Pleading nolo contendere doesnt create a presumption that you didnt act in good faith iii. OH Sec. 1701.13(E)(4) requires certificate by an independent quorum of board that standard of (E)(1) can be met a. Or if no quorum, by the shareholders b. Or independent legal counsel c. Or a court 2. CASE STUDY: Waltuch v. Conticommodity Services, Inc. (NY) a. Charter required corporation to give indemnification unless party was adjudged to have been acting negligent or was guilty of misconduct; private lawsuits against P were dismissed with prejudice with any payment of assumption of liability by P; company paid settlement for him 123

124 b. HOLDING: NY Sec. 145(f) doesnt allow a corporation to bypass the good faith requirement; when P achieved his settlement gratis, he achieved success on the merits or otherwise; P walked out without liability and without making a payment, which constitutes a success; he is entitled to indemnification under Sec. 145(c) for his expenses pertaining to private law suits 3. DE Sec. 145(f) and OH 1701.13(E)(6) permit other types of indemnification, which seems to allow other types of proceedings other than court proceedings; indemnification not exclusive of any other right 4. Indemnification not usually allowed for amounts paid to settle 5. Issue of Insurance a. DE 145(g) and OH 13(E)(7) both allow insurance policies and seem pretty open ended, but a court could find it is forbidden as a matter of policy b. All of the standard insurance policies exclude amounts paid for adjudged liability, fines, etc. U. Right of a Shareholder to Discontinue Suit 1. In the old days, you would sometimes see companies offering to buy the Ps stock in a derivative suit for much greater than true value, so they would no longer be a shareholder, and suit would be dismissed 2. Many jurisdiction now require judicial approval of either a settlement of a case or of a voluntary dismissal, which includes a dismissal b/c of Ps sale of his stock (p. 1026) XVIII. Valuation A. Book value and net asset value mean the same thing 1. Book value = assets liabilities 2. Appears under heading on balance sheet as shareholders equity 3. Shareholders equity isnt a fund you can show people; its just a mathematically calculation; theres no independent way of confirming shareholders equity 4. Problems with using book value a. Might not be true value of assets b/c it doesnt include intrinsic value, good will, or inflation b. Book value is determined under generally accepted accounting principles (GAAP), which dont necessarily have anything to do with reality i. Assets are valued on basis of lower of cost or market a. E.g., if you bought a piece of land for $50,000 and real estate appraisers say its now worth $2 million, it would be recorded on the balance sheet as $50,000 ii. Convention dont have anything to do with reality a. E.g., accountant are required to record a finance charge for depreciation every year for 20 years, but they dont look at the building an test the mortar iii. Accountants value a company by adding up how much each asset is worth, but people really want to own a company to make money, so a companys true value lies in its future earnings and its ability to turn a profit iv. Accounting convention is to record the value of a patent as $1, regardless of how much money it might make 5. As a general rule, dont just look to the book value and say thats the value of the company 6. Also, one years earnings may not be typical of a companys performance 7. Why do people use book value? a. Ignorance b. It usually, but not always, produces a low value c. Replacement or reproduction value of assets i. But, would you ever want to replace it? ii. Might be quite costly to reproduce something but not worth anything as a going concern, so you could never really replace it B. Some people try to solve the problems of book value by adding good will 1. There is no very good, agreed definition of good will 2. Usually defined as the value of the company over and above its book value 124

125 3. Market value = book value + good will 4. Good will = market value book value 5. Then, it become circular b/c what were trying to figure out is market value C. Liquidation Value 1. Liquidation value could mean that youre chopping up the assets and selling them off a. Even then, book value might not be totally accurate (e.g., price of a ripped up carpet) b. But, if youre going to liquidate in this sense, then at least an asset-based computation makes sense 2. Liquidation can also mean selling the business in whichever way will give you the most money a. Could mean selling it off in operating units or selling it all as a continuing business b. How much the operating unit is worth depends on how much profit it makes, so a balance sheet approach is really irrelevant D. Investment Value or Earnings Value 1. Look at the future profit 2. We need to discount future profits to present value 3. HYPO: consider the right to receive $108 one year from today a. Rate of Return i. With a fixed sum, youd always rather take the money sooner than later b/c if you get it soon, you can invest it and get some return on it ii. If were going to discount it, at what rate are we going to discount it? iii. RULE: rate of return we use depends on what rate of return the market is giving for investments of this kind iv. Rates of return are determined by market factors, such as supply and demand; therefore, rates of return may vary depending on time and place v. Therefore, if you ask, what is the value of the right to receive $108 one year from today, the beginning of the answer would be it depends on the rate of return that is being given by the market in the particular circumstances vi. Rate of return is also called the capitalization rate vii. Rate of return is simply the inverse of the multiplier or the PE ratio (1/rate of return = multiplier or PE ratio) b. Lets assume the market is giving an 8% annual rate of return for comparable investments; what would $108 a year from now be worth today (i.e., present value)? i. $100 (108/1.08) c. What if there was a 20% rate of return? i. $90 (108/1.20) 4. If you can predict a steady stream of income, you can easily predict the value of a company over time a. HYPO: magic black box turns out $80/year every year into eternity; what is it worth today? i. Assuming the market is giving an 8% rate of return the present value is $1,000 (80/.08) ii. Fore the present value of something that goes on forever = earnings / multiplier iii. MV (price) = $1,000 iv. P/E ratio or multiplier (price per share/ earnings per share) = 12.5 (1,000/80) v. V= E X M 5. Can determine P/E ratios from stock quotations; theyre all over the place b/c of different expectations of future earnings 6. Could say that the value of our non-publicly-traded company depends on the value of comparable investment opportunities a. Could analogize our non-publicly-traded company to one thats publicly traded b. This entails all sorts of assumptions and the value of the result depends on the validity of the assumptions 125

126 7. General Rules a. The greater the risk, the lower the multiplier i. People are generally risk averse ii. A small number of people arent risk averse and might actually prefer risk iii. If you invest in publicly traded stock, you can reduce risk by dividing your investment among several different stocks, so this principle applies to an entire portfolio, not just individual investment in a portfolio b. If the company is illiquid, the lower the multiplier i. When you talk about non-public companies, that are necessarily going to be undiversified and illegal c. If the corporation is likely to grow, the greater the multiplier i. With most companies, we expect profits to rise over time at least at the rate of inflation 8. Inflation is already taken into account in the rate of return the market demands a. Inflation makes people less inclined to invest and more inclined to spend E. Managers dont need to know anything about whether the shareholders horizon is short-term or long term; their job is just to maximize net present value 1. How long youre going to hang onto something doesnt make it more or less valuable, so it doesnt make any difference if were thinking short or long term 2. If you hold the black box in trust for an orphan, you dont have to keep it until the orphan grows up; you can just sell it and reinvest the money F. Market value means something different in corporation law than it doesnt in tax law 1. In tax law, market value means the value a willing trader would be willing to pay for something 2. In corporation law, market value means the price at which something is actually trading in the market G. PROBLEM 2: Harmans must negotiate with Lindsay and Smith about the value to be placed on Amalgamated Box Co. 1. Book value is $132,000 2. Harman will argue that there are great opportunities here, so the investment should be priced accordingly 3. The other side will be saying thats crap; this is really a short in the dark; youre on the verge of bankruptcy; this is very risky, so it should be traded at a very low multiple H. CASE STUDY: Piemonte v. New Boston Garden Corp. 1. P were stockholder in Boston Garden Arena, whose stockholders voted to merge with D corporation; each P was entitled to demand payment for his stock; Ps seek a judicial determination of fair value of their shares 2. Trial judge adopted the Delaware block approach, which calls for a determination of market value, earnings value, and net asset value of the stock, followed by the assignment of a percentage weight of each 3. HOLDING: most of judges determination were within range of discretion, but he erred in three instances; market value may be a significant factor, even a dominant factor, in determining the fair value of shares of a particular corporation 4. N.B. DE block approach is now disfavored; DE has dropped it, but a few states still follow it; DE now uses whatever techniques are accepted in the financial industry I. CASE STUDY: Le Beau v. M.G. Bancorporation, Inc. (P. 408) 1. HOLDING: court accepted Clarkes valuation based on the comparative acquisition method, and concluded, largely on that basis, that the stock was worth $85/share; the DE Supreme Court affirmed on the valuation issue 2. RULE: if a company isnt publicly traded, you can have some comparatively publicly traded approach; look at comparable investment and see what theyre trading at a. But, its clear that if youre talking about a non-public company, its illiquid, so itll be worth less XIX. Capital Structure 126

127 A. Definition of capital structure: refers to the aggregate of the securities used by the corporationthe instruments, such as shares of stocks and bonds, which represent relatively long term investments in the corporation B. But, there are sources of capital other than the issuance of securities (e.g., retained earnings, personal credit) C. State statutes generally require in the charter only a statement of the number of shares of stock the company is authorized to issue; otherwise, you dont have to say anything about debt instruments D. Corporation has inherent power to borrow money by issuing debt securities E. Functions of Capital Structure 1. Modes of allocating three elements of enterprise a. Risk of loss b. Power of control c. Participation in the proceeds of business i. Owning securities isnt the only way of participating in proceeds of business; could have a job with corporation and draw compensation 2. In other words, capital structure serves every purpose F. RULE: the rights of preferred shareholders and bondholders are matters of contract

G. Securities are generally divided into two categories, but the division is made tow different ways 1. FIRST CLASSIFICATION a. Debt securities i. Bonds: tend to be long-term and secured by some kind of collateral (e.g., mortgage on companys property) ii. Debentures: medium-term and sometimes secured iii. Notes: short-term and not secured b. Stock i. Preferred stock a. Doesnt receive interest, but receives dividends b. Failure to pay dividends on preferred stock isnt ordinarily a default; doesnt give rise to any creditor rights c. Rights of security holder are a matter of contract d. In those ways, preferred stock is stock; its not debt, but it looks a lot like debt ii. Common stock: voting rights 2. SECOND CLASSIFICATION a. Senior Securities i. Bonds ii. Debentures iii. Notes iv. Preferred stock

b. Equity i. Common stock Debt 127

Common Stock

Preferred Stock

128 Risk of Loss Priority: creditors get paid in FULL before stockholders get anything Junior: creditors get first crack if company goes belly up Bond holders are entitled to be paid in full before shareholders get anything. Residual, unlimited, variable Common stockholders dont get anything until the others are paid off, but whatever is left, you dont have to share a penny. Complete, unless Common stockholders elect the entire board; theyre owed fiduciary duties; no fiduciary duties owed to creditors. Priority over common stock

Participating in Income

Prior, limited, and fixed (only entitled to fixed amount on instrument)

Prior, limited, and fixed Get paid before common stock, but amount is limited and fixed by contract. None, unless Common to provide that if dividends arent paid for more than two years, then the preferred stockholders get to elect two directors or something like that.

Right of Control

None, unless If company goes into bankruptcy, then voices of creditors will get more attention in bankruptcy court. Rights are always a matter of contract. Two ways in which creditors can participate in control 1. Right to elect directors 2. Common for lenders to demand certain kinds of restrictive covenants.

H. Possible to have hybrid securities, like convertibles, where holder has an option to turn in security she has in exchange for a different security according to terms of contract I. When a corporation becomes bankrupt and unable to meet its financial obligation, a compromise agreement is usually reached whereby all classes of security holders make some sacrifice 1. Creditors do exercise control b/c if theyre not happy, theyre going to foreclose and assert their creditors rights J. PROBLEM 8: Harmans, Lindsay, and Smith have agreed to value the Amalgamated Box stock at $100,000 for each of the Harmans and to value Lindsays services at $100,000; what capital structure do you recommend? 1. Equal value, so the most obvious capital structure would be 400 shares of common stock, 100 shares to each of the four people a. Lindsay and Smith might start to cause trouble, there will be immediate deadlock and a force for dissolution b. The only one in the picture who has any cash is Smith, so hell have the chance to buy the assets at auction; if Harman had cash, he wouldnt have gone to Smith in the first place c. Smith doesnt know how to run a company, so he teams up with Lindsay, the idea guy, and together than can cause dissolution and force the Harmans out of the company 2. Could give each person 1 share of stock and $99,000 bond secured on the companys property; then when the company goes belly up, the entrepreneurs should get their money back, but this might not work with piercing corporate veil and undercapitalization 128

129 3. Need some capital structure to keep protect the Harmans from being forced out a. Could give Harmans some kind of mortgage bond and give Lindsay and Smith half of the common stock b. Lindsay and Smith arent going to like it b/c Harmans will get paid first if company goes belly up c. Harmans themselves might not like it b/c theyre only going to get a fixed amount of money and all the rest of the huge flow of profits will go to Lindsay and Smith 4. No right answer here; it a question of the preferences of the people involved 5. Also, if theres a debt component involved, its going to change the nature of the undertaking b/c now you have interest that must be paid, and cash flow is a problem for most start-up companies XX. Contests for Control: Tender Offers A. A tender offer is an invitation by a bidder directed to the shareholder of the company (target or subject company) inviting the shareholders to tender their shares to the bidder in accordance with the conditions set forth in the invitation 1. A tender offer isnt a merger, but may lead to one 2. By definition, a tender offer is a public invitation, so if you just ask to buy the stock of 11/20 stockholders, that probably wouldnt count as a tender offer B. A raider is a hostile bidder; can also have a friendly bidder C. A poison pill is a measure protecting against takeover instituted in advance; institutional investors dont like them 1. Company adopts SH rights plan saying if anyone buys more than 20% fo stock, then all SH may surrender stock to company for $50 per share. 2. Redeemable by board if friendly raider comes along 3. Tends to reduce value of stock b/c restricts SH rights. 4. Deadhand poison pills: can only be redeemed by board that adopted the pill or a board that is in a direct line descendant from board that adopted the pill. a. Ct condemns this kind of poison pill in DE, but in OH more likely to protect incumbents D. way around a poison pill is to wage a 1. proxy fight a. Poison pills are always redeemable at a nominal sum b. Wage a proxy fight, oust the incumbent directors, install a new board that will redeem the poison pill, and hold an auction to sell the company to the highest bidder c. One potential rule for incumbents to prevent against this; pill can be redeemed only by incumbent directors or successor approved by them; DE Supreme Court said this was going too far 2. bylaw amendments adding that poison pill must be redeemed if it meets certain criteria. 3. Weighted or dual class voting: company amends charter to give 10 votes to each share but whenever a share sold, number of votes would drop to 1 until held for 3 years. a. cts generally OK with it. E. CASE STUDY: Unocal Corp v. Mesa Petroleum Co. 1. Seminal case in this area; Mesa made a two-tiered offer; first, it made a tender offer for 37% of Unocals stock b/c it already owned 13%; if Mesa succeeded, it would then orchestrate a merger in which the rest of the stock would be exchanged for a package of securities, which was supposed to be worth the same amount as tender offer, but they were really junk bonds; Unocal responded by offering to buy back its own stock except the stock Mesa owned; Mesa argued that the price they were offering was much more than it was actually worth 2. Self-tender offer by Unocal was phony b/c it would never happen; it was conditioned on Mesa going through with its offer, but Mesa would never make the offer in the first place if it knows about this self-tender offer 3. HOLDING: Mesa was really trying to create a stampede b/c shareholders would say, even though I dont think terms of tender offer are that attractive, Im going to tender b/c if Mesa 129

130 succeeds, Ill end up with the junk bonds; court found Unocals defense was reasonable here b/c of Mesas grossly unfair two-pronged offer 4. RULE: Unocal enhanced scrutiny test (p. 1130) a. Board must show reasonable grounds for believing that danger to corporation policy existed i. Must show good faith and reasonable investigation ii. Proof enhanced by approval of board with majority of outside directors b. Defense must be reasonable in relation to threat posedproportionality requirement i. Has come to mean that board can use its discretion c. The test as it has evolved is closer to the business judgment rule than to the strict scrutiny test 5. PROBLEM: Unocals lollipop offer will never happen, so the shareholders miss out on getting a premium for their stock from Mesa F. Duty to Auction 1. Once a company is for sale, directors must deal even handedly w/ all bidders to get the best sale price for SH. 2. No Shop Clauses a. Prevents target from going around and seeking higher bidders G. CASE STUDY: Revlon v McAndrews and Forbes Holdings 1. Facts: Rights Plan = poison pill. Trading in share for junk bonds if an offer would mean more than 20% of stock bought by a raider, unless buyer offered to buy all the shares for cash only at a price above $60. The plan is a defensive measure to protect the shareholders. Revlon then agreed with Forstman for a leveraged buyout-a buyout of the company using debt. Forstmann was an investment banking firm was which an industrial company (not a financial firm); Forstmann would never have the capacity or interest in running the company (so the board could continue to run it) but if Pantry Pride took over, it could take over and try to run the business. 2. HOLDING: The court here found the lockup wasnt valid because it was clear what was going on and that Forstmanns bid was simply a bit higher in light of the lockup. It also said the boards duty changed from the preservation of the corporate entity to the maximization of the companys value at a sale. H. CASE STUDY: STROUD v. GRACE 1. Shareholder vote approved the new board member requirements. The shareholders tried to sue saying it was illegal to use this criteria for the board. But the Supreme Court upheld all the amendments and said it was an informed vote and there was no fraud, waste, or manipulative or inequitable conduct. Intrinsic fairness test usually applies to self-interested transactions, and here these are just voting rules so that doesnt trigger the intrinsic fairness test. The court says that this case is distinguishable, pg. 184, because in the other cases boards tried deliberately either to frustrate or completely disenfranchise a shareholder vote. In this case, the defendants owned over 50% of the stock so there is not threat to their control, so how can you consider it an interested transaction? An informed majority of the shareholders approved the decision-this shifted the burden to the plaintiffs to prove the transaction was unfair. XXI. Par Value, Dividends, and Legal Capital A. In every corporate deal, youll find a sentence saying, the companys authorized capital consists of X shares of common stock, par value $__, Y shares of which are legally issue and outstanding, fully paid, and non-assessable. 1. Authorized capital: shares company has authority to issue under charter 2. Legally issued: corporation took necessary legal steps to sell shares (i.e.., meet of board sans sale of shares for value consideration) 3. Outstanding: issued shareholders havent been repurchased by corporation but are still owned by shareholders 130

131 a. Treasury stock: shares repurchased by corp. technically authorized and issued but not outstanding. 4. Par value: matter of definition; feature of common stock; an amount expressed in dollars and cents a. It is a purely arbitrary figure; has no relation to the economic condition of the enterprise b. Generally stated in charter c. In the old days, sharpsters would say the par value of this stock is $100/share, which suggested that was the price they intended to sell it, and then they would sell themselves stock at 1 penny/share d. Courts got this notion that there was something wrong with selling stock for less than its par value, so lawyers saw par value as only a liability e. There was never a rule against selling stock at more than par value f. Practical solution is to set par value very low; dont set it at zero b/c there its unclear what courts will do in that case g. If youre stuck with a company that has a high par, rely on old statements that the company has never sold stock below par h. CA, DE, and OH have gotten rid of the concept B. The law says you cant pay dividends except out of surplus, which is anything that can be paid out without registering the company insolvent XXII. Thinking Like a Deal Lawyer (mimeo. p. 99-100)
A. Factors to Consider When Structuring a Deal
1. Money 2. Risk 3. Control 4. Standards 5. Endgame These arent exclusive categories; theyre overlapping Business people think of lawyers as deal-breakers, not deal-makers; think they start squabbles among parties who were getting alone fine before the lawyers showed up As a result, business people often keep lawyers out of negotiations as long as possible, not leaving them enough time to run up a bill or screw up a deal Need to know what your clients want and what issues are important to her In many cases, deals involve parties working together, and if the negotiations are so acrimonious that the parties cant trust each other, you arent going to reach a deal

B. C. D. E. F.

131