ba outline

*********************************************************************I. PARTNERSHIPS

*********************************************************************A. FORMATION OF PARTNERSHIPS

UPA § 6 (1914), § 101(6) (1997) Partnership Defined: Partnership is an association of two or more persons to carry on as co-owners of a business for profit, with or without the intent to do so. No money is required, must be willing to share risk and control. No documents need be written or filed. This lack of formality is the fundamental characteristic that distinguishes the partnership from all other co-owner business organizations, which are statutory in origin and require that a document be filed before an organization can come into existence. Partnerships are seen as a default form of doing business. It is a widely and deliberately chosen form of doing business for many kinds of enterprise including lawyers, doctors, and accountants.

General PartnershipPartnerships can be governed by statutes, but mostly they are creatures of common law. A GP is an association of two or more persons to carry on as co-owners of a business for profit. Note, the owners of a business may create a general partnership without intending to do so or knowing they have done so. The GP is the only type of business that can be formed without any sort of filing with a governmental authority. It is the default form of business, so if two or more persons own a business association, they may become partners in a general partnership.

Inadvertent Formation: Because the GP is the default form of business and no filing of any kind with the state is required to form a GP, co-owners may create a partnership without knowing that they are doing so. And certain consequences may result including joint and several personal liabilities for the debts and obligations of the partnership. See Martin v. Peyton.

Written Partnership Agreements are highly desirable, especially if it lasts longer than a year and thus involves real estate as such to be afforded protection under the Statute of Frauds. The UPA, RUPA, and modern partnership statutes mainly provide default rules – rules that govern only if the partners have not agreed to do so. (ex. Preclusion of salary payment to partners, equal division of profits and losses among the partners, even though the partners contributed different amounts of capital). Partnerships are enforceable as contracts.

Partnerships are seen as fragile. It is dissolved automatically when a partner dies or leaves the partnership; it may also be dissolved by any partner by his express will at anytime. Upon dissolution, the withdrawing partners are entitled to receive the value of their partnership interest from the partnership, which may either be wound up and terminated, or continued by the remaining partners and possibly new partners as well. However, the major drawbacks of the partnership are the unlimited sharing of losses and the personal liability of partners for partnership obligations as such they are jointly and severally liable, considering the modern litigious society in which we live. Partnership lacks formalities, management is not centralized but divided amongst the partners, and GP’s do not typically continue beyond the life of the partners. ELEMENTS OF A PARTNERSHIP

Business Associations/Garten/Fall 2008 1

Association – organized body of persons who have some purpose in common. UPA § 18(g) asserts that “no person can become a member of a partnership without the consent of all the partners.”

Persons – this word also includes corporations and other partnerships, not just individuals. Capacity to contract is required because the partnership agreement is a contract.

To carry on as co-owners of a business – ownership is defined in the UPA as the power of ultimate control.

For profit

UPA § 7 (1914) – Rules for Determining a Partnership ;(a) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or part

ownership does not of itself establish a partnership whether such co-owners do or do not share any profits made by the use of the property.

(b) The sharing of gross returns does not in itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived.

(c) The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business, but no such inference shall be drawn if such profits were received in payment: 1) as a debt by installments or otherwise; 2) as wages of an employee or rent to a landlord; 3) as an annuity to a widow or representative of a deceased partner; 4) as interest on a loan though the amount of payment vary with the profits of the business; and 5) as the consideration for the sale of a good-will of a business or other property by installments or otherwise.

UPA § 202(a) (1997) Partnership Formation : (a) The association of two or more persons to carry on as co-owners a business for profit forms a

partnership, whether or not the persons intend to form a partnership.(b) The foregoing rules above are applicable under this Act in determining whether a partnership exists.

For the section (c), there is a slight moderation in language but same meaning. “A person who receives a share of the profits of a business is presumed to be a partner in the business, unless the profits were received in payment: 1) of a debt by installments or otherwise; 2) for services as an independent contractor or of wages or other compensation to an employee; 3) of rent; 4) of an annuity or other retirement or health benefit to a beneficiary, representative, or designee of a deceased or retired partner; 5) of interest or other charge on a loan, even if the amount of payment varies with the profits of the business, including a direct or indirect present or future ownership of the collateral, or rights to income, proceeds, or increase in value derived from the collateral; or 6) for the sale of the good-will of a business or other property by installments or otherwise.

(c) [generally, sharing of gross returns or part ownership do not in themselves establish a partnership]

Key Elements in determining a partnership - Sharing of risk/loss, profits, and control/management. UPA § 202NOTE that the sharing of losses also follows from the sharing of profits.

Uniform Partnership Agreement (UPA) - Partnership law is mostly a matter of state law, and most states have adopted the UPA.

Three types of Partnerships:

1. Partnership by Agreement (contract – written or oral/ express or implied)

2. Partnership by Conduct (no mens rea required)

3. Partnership by Estoppel


Management of Partnership:· Unless otherwise agreed, all partners have equal power· Unless otherwise agreed, all partners are jointly & severally liable· Unless otherwise agreed, all partners have equal rights in the management· Unless otherwise agreed, or if partner received benefit, all partners are bound by a single partner’s actions if those actions are within the scope of the business. (This provision was meant to protect the third parties who complete their respective tasks in accordance to one partner despite the other partners’ contentions. The law looks at the perspective of the third parties > apparent authority: the court determines whether a reasonable person under the circumstances would have foreseen the order as being part of the business as such to complete the task. Ex. Chairs in a restaurant).· § 403 (f) & (j): Ordinary matters must be decided by the majority, while extraordinary matters must be decided by unanimous vote.

Partnership agreements are enforceable in the same way as contracts generally. Thus much of the law of partnerships is contract law. When legal issues arise concerning internal relationships within a partnership the two most basic questions likely to be asked are (1) was there a partnership; and (2) if so, what does the agreement say about the issue in question? Only in the absence of a partnership agreement do we look to the default rules contained in the partnership statutes. In short, as to question involving the internal rights and obligations of the partnership and its partners, the primary source of partnership law is not the statutes or case law, but the partnership agreement itself. While a partnership agreement can govern almost every aspect of the partnership, there are a few mandatory rules in the state partnership statutes that can not be trumped by a partnership agreement. These include: (1) varying the partners’ rights to information regarding partnership affairs, (2) eliminating the duty of good faith and fair dealing, (3) eliminating the partners’ fiduciary duties to another, (4) varying the principle of joint and several personal liability of the partners, and (5) varying a partner’s power to dissociate from the partnership.

I. Partnership Created by Conduct

NO CAPITAL CONTRIBUTION REQUIRED TO BE A PARTNER No need for capital or work contribution A Partnership can be created through conduct, regardless of whether there is a Partnership

Agreement or not. Partnership comes into existence by operation of law without filing any formal papers calling yourself a partnership does not create a partnership

burden of proof for a partnership is on the person claiming the existence of one Sharing of profits does not in and of itself indicate or demonstrate the existence of a

Partnership § 202(c)(3) & no obligation to share in losses suggests no Partnership

Fenwick v. Unemployment Compensation Board (1945)

RULE: “A partnership is an association of two or more persons to carry on as co-owners of a business for profit.”

Statement of the CaseFenwick operated a beauty shop and hired Cheshire to be a cashier and a receptionist. They then entire into a contract stating that they agree to associate themselves as partners for the operation of the beauty


shop. However, Cheshire could not make capital contributions nor did she receive any right to control or manage the business. She bore no risk of the shop’s losses. She was paid a weekly salary with some benefits. Cheshire terminates the contract 3 years later and sought unemployment compensation. The Compensation Board ruled that she was merely an employee. This was an agreement that fixed the compensation of this employee. The New Jersey Supreme Court disagreed and called them partners.

ISSUE: Does an agreement providing a person a potential share in the profits of a business, without conferring a right to control the business or bear a share of the losses, establishes a partnership?

HOLDING: NO. The court analyzed a number of factors to determine a partnership here. The parties’ intent: here, the agreement came to be because Cheshire wanted more money so Fenwick made her salary conditional to the financial success of the business. Second, a partnership involves the partner’s rights to share in the profits. That is established here but as the UPA denotes, that alone will not suffice to form a partnership. Third, a partnership involves an obligation to share losses. This is not the case here. Fourth, partners share ownership and control over the partnership property and business. Here, Cheshire had no rights. Fifth, partners maintain the power to administer business affairs. Cheshire cannot tend any business matters without control. Sixth, the court must consider the language of the agreement. The express terms withholds many of the rights a partner has though they use the term partnership. However, that would not be conclusive. Seventh, the parties’ conduct toward third parties may indicate a partnership. The parties represented to no one that they were partners. Finally, the parties’ rights upon dissolution are instructive. Here, Cheshire gains no interest in the partnership income or assets upon dissolution, but rather the partnership continues as if it has merely lost an employee. After analyzing all the factors, the evidence is undoubtedly clear that Fenwick never intended for Cheshire to be a partner. She was simply an employee with benefits.

Elements and Indicators of Partnership Right to share in profits (not dispositive ie. bank loan). Not every agreement that gives the

right to share in profits is a partnership agreement. Obligation to SHARE IN LOSSES (RISK) (***). Absent here Sharing of ownership and CONTROL of the partnership property and business (***)

§ 18(e) “All partners have equal rights in the management and conduct of the P’ship business.”

Intention of parties Community of power in administration (control over management) Language in the agreement (how rights are allocated) Conduct of the parties toward third parties Rights of the parties upon dissolution “if you act like a partner, you may be treated as one” if no express agreement, default rule is to look at profits. If no profit agreement, then we

assume equal allocation. *** = key factors

II. Partnership Created by Agreement

A. Partners Compared With Lenders Generally, we don’t consider lenders as partners

§ 202(c)(3)(i): A person who receives a share of the profits of a business is presumed to be a partner in the business, unless the profits were received in payment of:


(i) of a debt by installment or otherwisePublic Policy Banks won’t lend if they face Partnership liability for simply trying to protect their investment

if banks are held out as partners, their liability increases and there is less incentive to lend

Martin v. Peyton (1927)

RULE: “A partnership is created by an express or implied contract between two persons with the intention to form a partnership.”

Statement of the CaseA banking firm was in financial trouble so it turned to Peyton for a loan. That loan was not sufficient to cover the firm’s liabilities so the banking firm sought loans from Perkins and Freeman. While discussing this second loan, it was proposed that Peyton, Freeman, and Perkins be partners to the firm. The banking firm rejected this but offered them a collateral speculative securities owned by the firm and 40% of the firm’s profits until the loan was repaid. The agreement also contained an option for the three to join the firm if they choose to do so. Martin, a creditor sough payment form the three of the debt owned him by the banking firm arguing that these three became partners to the firm. Trial court ruled no partnership existed and ruled against Martin.

ISSUE: Does the loan of money in exchange for securities owned by the debtor and a percentage of the debtor’s income create a partnership?

HOLDING: NO, it does not. By receiving the firm’s speculative securities as collateral for the loans, the defendants became mere trustees. As trustees, they have the right to be informed of all transactions affecting the securities and the power to veto and decisions that are detrimental to their value. They have no power to initiate any transaction or bind the firm. Their power is limited to only those transactions that affect their collateral’s value. Also, the provision providing the defendants to a percentage of the firm’s profits does not demonstrate an intent to become partners. All it does is protect the defendants’ loan. Finally, the option to join the firm presents itself as potentially a future partnership, not a partnership to date. Judgment affirmed. The court here focuses on the intentions surrounding the parties’ agreement.

§ 9(1) & § 301(1) Partner Agent of Partnership provides partners the power to bind the Partnership

in this case, the Court found these provisions to be proper lender safeguards and precautions for their loan, not the level of control required for finding of a partnership

NOTE: The risk of liability for Peyton and co. would have been avoided if the law firm had been organized as a corporation. Under that form of organization, the equity investors (the counterparts of partners) enjoy “limited liability” – that is, they are not personally liable for the debts of the firm and therefore stand to lose only the amount they have invested in it. Thus, even if the purported lenders had been treated as shareholders, they would have been shielded from the personal liability that the creditors sought to enforce. The same would be true if they had formed a limited liability company or limited liability partnership.


B. Determining Partners

Southex Exhibitions v. Rhode Island Builders Association (2002)

RULE: “Sharing profits is prima facie evidence of a partnership, which can be rebutted by evidence sufficiently demonstrating that the parties did not intend to create a partnership.” >> The totality of the circumstances test

Statement of the CaseRIBA entered into a 5 year agreement with SEM to act as sponsors and partners in the production of their home shows. They agreed that RIBA would produce only shows sponsored by SEM to persuade RIBA members to exhibit SEM shows and to allow SEM to use RIBA’s name for promotional uses. SEM agreed to secure all leases, licenses, and permits necessary for the shows’ profits, and to provide capital needed to finance the shows. The profits were divided 55% to SEM and 45% to RIBA. SEM’s president clearly did not want any ownership of the home shows because of the uncertainty of the shows’ financial prospects. SEM referred to themselves as producers. 20 years later, Southex acquired SEM and determined that the agreement between SEM and RIBA needed modifications. RIBA was unhappy with the modifications and entered into contract with someone else. Southex brought suit claiming they were partners. The district court found no [partnership.

ISSUE: Did RIBA and SEM enter into a partnership by agreeing to share profits earned from sponsored home shows and mutually contributing time, skill, and intellectual property to the shows?

HOLDING: NO, there is no partnership. Southex asserts there was a partnership since both SEM and RIBA shared profits, maintained control over the business operations, and contributed valuable property to the business. The agreement was not titled a partnership and it did not last for an indefinite time. There is no evidence that the IP contributed by RIBA and SEM was intended to convey a property interest upon the other (Southex, who chose to enter into this contract upon its own name rather than the name of the agreement), especially since the agreement covered only an annual event of a fixed duration. Finally, SEM considered itself to be the producer of the home shows and subsequently denied ownership to their works. Although the parties here referred themselves as partners in the agreement, the evidence in this case suggests otherwise.

NOTE: although the agreement referred to each other as partners, this would not conclusively establish a partnership between them. But such reference could establish a partnership by estoppel. Under the estoppel theory, a partnership is established even if the intended relationship does not amount to a partnership - if the parties manifest to others that a partnership exists and third persons rely upon those manifestations, then a partnership shall be formed.

III. Partnership Created by Estoppel

§ 16 Partner by Estoppel: As a general rule, persons who are not partners as to each other are not partners as to third persons. However, a person who represents himself, or permits another to represent him, to anyone as a partner in an existing partnership or with others not actual partners, is liable to any such person to whom such a representation is made who has, on the faith of the representation, given credit to the actual or apparent partnership. If a person holds themselves out as a partner in receiving credit, they are treated as a partner.


Young v. Jones (1992)

RULE: “A person who represents himself, or permits another to represent him, as a partner in an existing partnership or with others not actual partners, is liable to any person to whom such a representation is made who has, in reliance on the representation, given credit to the actual or apparent partnership.”

Statement of the CaseYoung representing SAFIG relied on an unqualified audit statement prepared by Price Waterhouse-Bahamas and deposited a lot of money into a South Carolina Bank. The audit was prepared with the Price Waterhouse letterhead and signed by them as well. SAFIG later learns that this was fraudulent and thus they all lost their money. Young and SAFIG sued Jones and Price Waterhouse-US and Bahamas who they presume are partners and thus are jointly liable. Price-US presented documents showing they are distinct from Price-Bahamas. The district court ruled in favor of Jones.

ISSUE: Are Price-US and Price-Bahamas partners by estoppel?

HOLDING: NO, there are not partners in fact. Young provided no evidence that Price-US represented itself as a partner to Price-Bahamas. There is no indication the Price-US is liable for the debts of Price-Bahamas or any other affiliates. Furthermore, there is no licensing agreement between the two to provide the nexus between the trademarks or names used. A partnership by estoppel arises only when a third party has given credit in reliance upon a partnership representation. There is no evidence that the plaintiffs have extended any credit to Price-Bahamas or Price-US. Finally no evidence demonstrates that Price-US had anything to do with the preparation or dissemination of the fraudulent audit statement. Absent some involvement or representation from Price-US, it cannot be held liable for the actions of Price-Bahamas.

NOTE: A third party who deals with a business in reasonable reliance upon representations that a partnership exists may hold each individual partner liable for any debts incurred, even if a partnership does not exist.

The key to partnership by estoppel is CREDIT Only protects third-persons who, in reliance upon the representations as to the existence of the

Partnership, gave credit to that Partnership like Promissory Estoppel – look for detrimental reliance

Public Policy to protect 3rd parties (creditors) who do not have actual knowledge that the Partner is acting outside of the scope of his authority in binding the Partnership and relies to his detriment on the representation of such a Partnership.

Do not want to impose a duty of inquiry on the creditor HOWEVER, 1996 Revised UPA shifted the law in favor of Partnerships by allowing

them to file Statements of Partnership Authority § 303 – thereby allegedly placing creditors on constructive notice of individual partners’ ability to bind other partners

Not adopted by many states

P ARTNERSHIP L IABILITY All partners are individually liable for the obligations of the Partnership The UPA fills in the blanks if P/A is vague or non-existent.

§ 13 Partnership Bound by Partner’s Wrongful Act


Partnership is equally liable for any wrongful act or omission of any partner acting in the ordinary course of business (within the scope) of the Partnership that causes injury to a non-partner

§ 14 Partnership Bound by Partner’s Breach of Trust Partnership is liable for individual acts of partners that breach the trust of third parties as such that

the partner must make good of the loss – (a) where one partner acting within the scope of his apparent authority receives money or property of a third person and misapplies it; (misappropriation of funds by individual partner) and (b) where the partnership in the course of its business receives money or property of a third person and the money or property so received is misapplied by any partner while it is in the custody of the partnership; (misappropriation of funds by Partnership).

§ 15 Nature of Partner’s Liability(a) All partners are liable jointly and severally for acts chargeable to the partnership under §§ 13 & 14

§ 301: Each partner’s actions within the scope of their business bind the entire partnership unless the partner had no authority to act for the partnership and a third party knew this or had received a notification that the partner lacked authority.

• Exception; UPA § 301(2) states that a partnership is only bound by acts within the scope of ordinary business. In this case, one partner can not bind the actions of other partners if the act falls out of the scope of its partnership business. Thus, all the partners would be required to act on such issue.

§ 305 Partnership Liable for Partner’s Actionable Conduct Combines §§ 13-15

§ 306 Partner’s Liability(a) all partners are liable jointly and severally for all obligations of the Partnership (b) persons admitted as a partner into an existing partnership are not personally liable for

Partnership conduct that occurred prior to their admission into the Partnership

THE RIGHTS OF PARTNERS IN MANAGEMENT § 18(e) & § 401(f) “absent agreement to the contrary, all partners have equal rights in the

management and conduct of the partnership business”

§ 18(h) & 401(j) “any difference arising as to ordinary matters relating to the partnership may be decided by a majority of the partners” (does not work if only 2 partners; if there are only two partners or an even number of partners, there could be no majority vote that will be effective to deprive either partner of authority to act for the partnership). The majority can deprive the minority partner of something. So, if the supplier is aware of the limitation, an order for break from the minority partner would not bind the partnership or the other partners.

Despite the agreements of partners on who has decision making authority, these decisions are non-binding on the outside world if a partner fucks up and exceeds his decision making limit.

National Biscuit Company v. Stroud (1959)

RULE: “Every partner is an agent of the partnership for the purpose of its business, and every partner’s acts for apparently carrying on in the usual way the partnership’s business binds the partnership, unless the acting partners has in fact no authority to act for the partnership and the person with whom he is dealing knows that he has no such authority.”


Statement of the CaseStroud and Freeman enter into a partnership to operate a store. Nothing in the agreement indicates that Freeman has less authority than Stroud. Stroud told Freeman he would not be liable for any bread purchased from NBC. Though NBC was aware of Stroud’s remarks, it delivered the bread at Freeman’s requests. NBC sued Stroud for payment after Stroud and Freeman dissolved the partnership and all partnership assets and debts were assigned to Stroud for liquidation. The court found Stroud liable.

ISSUE: Is a partner bound to a 3rd party if the partner disagrees with the other partner’s business decision and expresses to the 3rd party his or her intention not to be bound by the other partner’s decision?

HOLDING: YES, the partner is liable. Generally all partners have equal power to bind the partnership and any difference of business opinion must be resolved by a majority vote. Here, Freeman was a general partner with equal powers as Stroud and Stroud could not restrict Freeman’s power to act on behalf of the partnership because the bread purchase was an ordinary business transaction and Stroud did not constitute a majority of the partners. When a disagreement arises between an even division of partners, actions related to the partnership’s ordinary business are not restricted. Because Freeman had the authority to make such purchase, the partnership is liable.

NOTE: As long as both parties act in good faith without violating any fiduciary duties, a disagreeing partner is powerless to veto his or her partner’s ordinary business decisions.

RULE The acts of a partner, if performed on behalf of the partnership and within the scope of its ordinary and legitimate business of the partnership, are binding upon all partners.Exception: (1) when the partner had no authority to bind the Partnership, and (2) the 3rd party had ACTUAL knowledge of the Partner’s inability to bind

Additional Notes:1. Even if notice is given by a partner to a 3rd party, that partner is still liable for contract’s entered into by

other partners because no agreement or resolution of the majority under §401(h)2. Partnership can file a Statement of Partnership Authority - § 303 which may place creditor’s on

notice of Partner’s ability to bind the corporation in certain transactions (property)3. Partnership can control partner’s ability to bind through contract4. BUT contract will not limit liability to unaware 3rd party creditors (will only allow Partnership to be

indemnified) 5. When no contract, the court looks to the Fiduciary relationship and the duties that it carries6. Public Policy is to protect 3rd parties (creditors) who have no reason to know that the Partner is

acting outside of the scope of his authority. Burden is on partners. Revised UPA 303(a)(2) give a way out to partners: limit the authority of partners. Partnership Authority

B. FIDUCIARY DUTIES OF PARTNERS

§ 404 General Standards of Partner’s Conducta) only fiduciary duties a partner owes another are loyalty and careb) a partner’s duty of loyalty to the partnership and other partners is limited to the following:

1) to account and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct of partnership business or by use of partnership property; to share profits, or advantages of a partnership opportunity;


2) to refrain from dealing w/ partnership on behalf of a party having an adverse interest to the partnership

3) to refrain from competing w/ the partnership before dissolution

c) A partner’s duty of care in conduct of business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law in conducting partnership business.

d) A partner shall discharge duties with the obligation of good faith and fair dealing. (Here when you want out you have to do it in an upstanding not sneaky way… don’t try to hurt the partnership… do it Fare. Again Meehan (the lawyers did things secretly, lied about starting their own partnership, secretly took employees and clients in ways not proscribed by the partnership agreement. Court found that they didn’t purposefully hurt the partnership by killing the cases, but were underhanded in the way they obtained the clients)

e) Partner does not violate a duty or obligation merely because the partner’s conduct furthers the partner’s own interest.

f) A partner may lend money to and transact other business with the partnership, and as to each loan or transaction, the rights and obligations of the partners are the same as those of a person who is not a partner.

Partners owe each other a fiduciary duty of “utmost good faith, loyalty, and fair dealings”

DUTY OF DISCLOSURE: LOYALTY

A PARTNER HAS A DUTY TO DISCLOSE, ON DEMAND, A TRUE AND FULL DISCLOSURE OF INFORMATION ON ALL THINGS AFFECTING THE PARTNERSHIP TO ANY OTHER PARTNER.

IF YOU HAVE SPECIAL INFO, YOU GOTTA GIVE IT UP this idea is similar to the Corporate Opportunity Doctrine a partner’s exclusive control and power of direction charges him w/ a greater duty of disclosure to his

fiduciaries, b/c only through disclosure could opportunity be equalized Joint adventurer (partner) only needs to act reasonably in the course of disclosure advise co-

adventurer of new opportunity.

Meinhard v. Salmon (1928)

RULE: “Like partners, joint adventurers owe one another the duty of loyalty.”

Statement of the CaseSalmon and Meinhard entered into a joint venture upon the lease he entered to with Gerry to convert a hotel into a shopping mall. Each party bore equally any or the business’ losses but Salmon possessed all management rights. When the lease ended, Salmon entered a new lease with Elbrige, who had acquired the rights to the territory from Gerry in developing a new building. Salmon never informed Meinhard of this. When Meinhard heard this, he demanded the lease to be for the joint venture. Salmon refused and thus Meinhard sues.

ISSUE: Does a joint adventurer breach his or her duty of loyalty by seizing an opportunity for the joint venture for his or her own personal gain?

HOLDING: YES; here Salmon held the lease as a fiduciary to Meinhard, his joint adventurer. Not only did Salmon not disclose his plans to Meinhard, he also approached Elbrige as if he was acting alone. If Salmon informed Elbrige of the venture, he would have presented this to Meinhard as well. By failing to disclose this to Meinhard, he deprived him from the chance to compete for the new lease.


Salmon’s duty of loyalty to Meinhard requires a good faith disclosure of the joint venture to preserve his opportunity. Salmon has breached his duty.

NOTE: courts often apply partnership law to joint ventures, although the two business relationships are distinct. A partnership is generally a longstanding relationship with general undertakings designed to generate profit. A joint venture is more limited in duration and generally for a specific undertaking. (Ex. Two lawyers join together to form partnership to share profits; two lawyers join together as co-counsels to defend a client in a specific case as joint adventurers with each contributing time, money, and labor.)

WHAT IS A JOINT VENTURE?A joint venture is a business undertaking by two or more persons engaged in a single defined project. The necessary elements are (1) an express or implied agreement; (2) a common purpose that the group intends to carry out; (3) shared profits and losses; and (4) each member’s equal voice in controlling the project.

NO FIDUCIARY DUTY TO FORMER PARTNERS liability and fiduciary duty is limited to other partners, not former partners

DISSOLUTION

Under the UPA, a partner always has the power to withdraw and thus dissolve the partnership, regardless of what the partnership agreement might otherwise provide. Dissolution does not mean that the business ends or is liquidated. The remaining partners can, and often do, decide to continue the business after dissolution, but the business is continued by a new legal partnership agreement. Under the UPA, the circumstances for continuing the business of a partnership after dissolution depend on (1) the partnership agreement’s provisions on continuing the business after dissolution and (2) if there are no such provisions, the default rules of the UPA apply. Under the default rules, if there is no term specified in the agreement or if the term specified has expired, then the partnership business can be continued by other partners only if all of the partners, including the partner who dissolved the partnership, agree that the business can be continued. If they agree to continue, the withdrawing partner is paid the value of its interest in the business § 42. If the partner leaves before the end of the term specified in the agreement, then the partnership can be continued if they agree to do so. The withdrawing partner must be paid the value of its business. If the partners do not decide to continue the business, the business is liquidated under UPA § 37 and § 40. The partnership winds up and assets are sold and distributed to creditors.

Under RUPA (Revised UPA), the term dissociation is used rather than dissolution. However, § 103 in RUPA asserts that dissociation does NOT trigger dissolution. Next, RUPA § 801 provides that a partner’s dissociation during a term partnership triggers dissolution only if at least half of the remaining partners so agree. Partners can waive dissolution § 802. RUPA distinguishes between rightful and wrongful acts of dissociation. The wrongful ones are (1) breaches of express provisions, (2) early withdrawal, (3) wrongful conduct that adversely affects the partnership business, and (4) willful breach of a duty of care, loyalty, good faith, or fair dealing owed to the partnership under § 404.


The partnership’s business does not end with dissolution under either statute. UPA and RUPA provide that dissolution does not terminate the partnership; instead, the partnership continues until the winding up process is complete. Winding up involves selling the partnership’s assets and using the proceeds of the sale to pay the partnership’s debts and settle the partner’s accounts. In winding up, outside debts as to creditors are paid first prior to inside debts as to the partners acting as creditors then to capital contributions. If the proceeds from liquidation are not enough to pay creditors, the partners must contribute toward payment of the debt in the same proportion in which they share losses. Dissolution occurs first – it is the point in time when partners cease to carry on business together. Then there is winding up – this is the period between dissolution and termination where all partnership affairs are being settled. Termination is the point in time when all the partnership’s affairs have been wound up.

PLANS OF SEVERING THE PARTNERSHIP . . . UPON DEMAND, YOU MUST DISCLOSE

§ 20 UPA (1914). Duty of Partners to Render InformationON DEMAND, partners shall render TRUE & FULL INFORMATION of all things affecting the partnership to any partner or the legal representative of any deceased partner or partner under legal disability.§ 403(c)(1) & (2) UPA (1997). Partner's Rights and Duties with Respect to Information (c) Each partner and the partnership shall furnish to a partner, and to the legal representative of a deceased partner or partner under legal disability:(1) MANDATORY VOLUNTARILY DISCLOSURE : without demand, any information concerning the partnership's business and affairs reasonably required for the proper exercise of the partner's rights and duties under the partnership agreement or this [Act]; and(2) REQUIRED ON DEMAND - on demand, any other information concerning the partnership's business and affairs, except to the extent the demand or the information demanded is unreasonable or otherwise improper under the circumstances.

§ 306 Partner’s Liability Partners are jointly and severally liable for all obligations of the partnership unless otherwise provided

How are losses allocated?1. partnership agreement2. in absence of agreement, losses are allocated according to the allocation of profits § 401(b) partners who put in no capital but still carry’s on co-owner is still liable if share losses, then liable UPA is the default mechanism to be reasonably interpreted in absence of partnership agreement

Liquidating Partnerships § 807 (1996) or § 18 (1914 clearer)1. All assets are sold and what is raised goes to outside creditors – sale of assets2. repay partners capital contribution capital contributors are subordinate creditors3. Partnership losses are shared among partners

Bane v. Ferguson (1989)

RULE: “The fiduciary duties owed by one partner to another terminate when the partnership is dissolved.”


Statement of the CaseBane was part of a firm that offered retired partners a pension plan. The plan was to terminate in the event the firm was dissolved. Four months later, Bane retired and got his pension. However, several months later, the firm merged with another firm and dissolved without forming a new entity. The pension plan ceased. Bane sues that the firm was negligent in merging and it was mismanagement.

ISSUE: Does a retired partner have either a common law or statutory claim against the firm’s managing council for acts of negligence that, by causing the firm to dissolve, terminates his retirement benefits?

HOLDING: NO; first off, the UPA protects partners from liability from their partners’ negligence. Secondly, Bane retired and was no longer a partner. His former partners owed him no fiduciary duty upon retirement. The termination of partnership relationships terminates any duty owed. Furthermore, even if a duty existed, the managing council’s decision would have been protected by the “Business Judgment Rule.”

NOTE: Retired Partners lose all rights and privileges as a partner. Their former partners owe them no fiduciary duty. However, if there was a contract that outlined their legal rights, then the retired partners can be compensated only through a breach of contract.

GRABBING AND LEAVING

General Rule: “A partner has a duty to disclose, on demand, a true and full disclosure of information on all things affecting the partnership to any other partner.”

A partner has the duty to: § 20 “render on demand true and full information of all things affecting the partnership to any

partner or legal representative of any deceased partner or any partner under legal disability”

§ 403(c) “Each partner and the Partnership shall furnish to a partner and to the legal representative of a deceased partner

(1) Without demand, any information concerning the Partnership’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties under the partnership agreement; and

(2) On demand, any other information concerning the Partnership’s business and affairs to the extent that it is reasonable and proper.

Meehan v. Shaughnessy (1989)

RULE: “A partner must render on demand true and full information of all things affecting the partnership to any partner.”

Statement of the CaseMeehan and Boyle were partners to the firm PC. Meehan and Boyle were dissatisfied with PC and left along with Cohen. They did this all confidentially. Within a period of a month, they offered associates position within their firm and told them to keep quiet about it. Prior to leaving and getting a good number of associates to defect from PC, Meehan and Boyle wrote to their clients notifying of them of the changes and thus requested authorization to remove them. Before leaving, other partners of PC confronted the defects and asked them whether they were leaving, and they said no. Then Meehan, Boyle, and several others gave in their notice of separation. The defects removed about 2/3s of the cases from PC. The defects now sue PC for the amount of profits owed them for the cases they removed.


ISSUE: Does a partner breach his fiduciary duty of good faith and loyalty to his partners by inducing the partnership’s clients to withdraw their business from the partnership without ample time for the partnership to compete to retain the business?

HOLDING: YES; as a partner, each person owes his partners the duty of good faith and loyalty and must refrain from self-dealing or participation in a transaction that benefits oneself instead of another who is owed a fiduciary duty. Here, Meehan and Boyle breached their duty by secretly selecting those clients they sought to remove to their new firm and failing to disclose their method of obtaining the clients’ consent to PC. On several occasions, the defects failed to render or disclose their plans to their former partners. Meanwhile, they were communicating with clients and referring attorneys to obtain consent to remove their cases. After giving their notice of separation, they continued to use their position of trust to place the partnership at a competitive disadvantage. They delayed the PC’s request for a list of cases to be removed until they obtained consents from all clients on the list. The letters they sent to the clients did not give them a choice as to whether to stay with PC or go with the new firm. Plus, by sending those letters too soon after separation, the defects deprived PC from effectively presenting the quality of its services to those clients. The defects here have breached their fiduciary duty to PC.

NOTE: Courts typically prohibit partners from grabbing the partnership’s customers and taking them to a new business venture. However, when there is a partnership agreement that allows such, which is here, the court will enforce the agreement provided that the departing partner does not breach a fiduciary duty to the partnership.

“Fiduciaries may plan to compete with the entity to which they owe allegiance, ‘provided that in the course of such arrangements they do not otherwise act in violation of their fiduciary duties.’”

Partners owe each other a fiduciary duty of the utmost good faith and loyalty. As a fiduciary, a partner must consider his or her partners’ welfare, and refrain from acting

for purely private gain.

PARTNERS HAVE A RIGHT TO EXPEL OTHER PARTNERS: EXPULSION § 31(d) dissolution may be caused by the expulsion of any partner from the business bona fide in accordance with such a power conferred by the agreement between the partners.

§ 601. Events Causing Partner's Dissociation. UPA (1997)A partner is dissociated from a partnership upon the occurrence of any of the following events:(2) an event agreed to in the partnership agreement as causing the partner's dissociation;(3) the partner's expulsion pursuant to the partnership agreement;(5) on application by the partnership or another partner, the partner's expulsion by judicial determination

because:(i) the partner engaged in wrongful conduct that adversely and materially affected the partnership business

Policy: If a partner engages in conduct that makes it impossible to carry on the partnership business, or if the other partners feel he is a threat, they can vote to expel him.

NO DUTY TO REMAIN PARTNERS- If I Don't Trust You, We're Not Partner

A partnership can expel partners to protect relationship between the firm and clients Concurrence: When a situation arises when a partner acts on what he believes was his ethical duty to

disclose unethical conduct, it may not necessarily result in liability. However, here the charges were unfounded; therefore the expulsion was grounded because it was based on a serious error in judgment.


Lawlis v. Kightlinger & Gray (1990)

RULE: “When a partner is involuntarily expelled from a business, his expulsion must be in good faith for a dissolution to occur without violating the partnership agreement.”

Statement of the CaseLawlis was part of the partnership of K&G. Twelve years later, Lawlis underwent treatment for alcohol abuse but did not disclose this to the partnership. When he did tell the other partners, the partners amended the agreement to accommodate his condition so that he would receive continued treatment and therapy. Lawlis complied with the conditions but his annual units were reduced following the amendments. Lawlis asserted he met all the conditions and wanted his units to increase. However, the partners less than a month later expelled him from the partnership. The agreement allowed Lawlis to stay on as partner for six more months where would obtain salary and benefits to make the smooth transition. Lawlis refused and sued for breach of contract.

ISSUE: When a partnership agreement provides for involuntary expulsion of a partner without cause, may the expelled partner recover damages for wrongful expulsion absent a showing of bad faith?

HOLDING: NO; first off, Lawlis cannot claim breach of contract when he remained on as partner for every vote and thus was still compensated. Secondly, he cannot claim for a breach of fiduciary duty. The partnership expressed concern for Lawlis though his work had become unproductive. The partners attempted to work with Lawlis to solve his personal problems so he could return as a senior partner. Though it did not work out, they expelled him but also allowed him to stay on for six more months for a transitory period. The expulsion here was in the best interests of the partnership. There was no bad faith here upon these facts.

NOTE: Courts look to the partnership agreement to determining the means of expulsion. In the absence of an agreement, the law generally requires only that the partnership act in good faith. No notice or cause is generally required, although proof of bad faith by the partnership can create a cause of action for damages.

No cause expulsion: Where the remaining partners in a form deem it necessary to expel a partner under a no cause expulsion clause in a partnership agreement freely negotiated and entered into, the expelling partners act in “good faith” regardless of motivation if that act does not cause a wrongful withholding of money or property legally due the expelled partner at the time expelled.

C. SHARING OF PROFITS AND LOSSES

THE SHARING OF LOSSES (partnership contributions go into the losses – compare what the partners put in to what they owe)

§ 401(b) “Each partner is entitled to an equal share of the Partnership profits and is chargeable with a share of the Partnership losses in proportion to the partner’s share of the profits”

• In the absence of a partnership agreement, profits and losses are administered based on a proportional share of each partner’s interest. If there is no disparity in interest, or no arrangement has been made, profits and losses are divided equally.

NOTE: this section also overrules Kovacik since it stipulates that proportionality is maintained even if one partner only invests services and not capital.


§ 18(a) “Each partner shall be repaid his contributions, whether by way of capital or advances to the Partnership property and share equally in the profits; and must contribute towards the losses sustained by the Partnership according to his share in the profits.”

NO capital contribution is required as long as (1) risk, and (2) control is shared

BUT [MINORITY VIEW] “where one partner contributes the money capital as against the other’s skill and labor, neither party is liable to the other for contribution for any loss sustained”

Each party valued his contributions to be equal, and thus have sustained equivalent losses (one financial, one labor)

When a partner contributes services (no money), he is not liable to the other partners for partnership losses.HOWEVER, that partner is still liable to the CREDITOR for his portion of the losses.POLICY: The courts will not undervalue expertise. All contributions (whether monetary or expertise) have value

Kovacik v. Reed (1957)

RULE: “If one partner or joint adventurer contributes the money capital and the other contributes the skill and labor necessary for the venture, neither party is entitled to contribution from the other.”

Statement of the CaseKovacik engaged into a joint venture with Reed where he acted as the superintendant and estimator on kitchen remodeling jobs. Kovacik informed Reed he would invest the money for the jobs and split the profits equally. There was no discussion as to who would bear the losses. After the year, both completed remodeling jobs but at a loss. Kovacik demanded Reed to compensate for the loss in which he refuses. Kovacik sues Reed for an accounting and Reed’s proportionate share of the losses.

ISSUE: Is a capital contributor to a joint adventure entitled to recover one-half of the business losses from a joint adventurer who contributed his labor?

HOLDING: NO; generally in the absence of an agreement, each partner or joint adventurer shares equally in the profits and losses of the business venture. However, if one partner or joint adventurer contributes the money and the other contributes the skill and labor, neither party is entitled to contribution from the other. In the event of a loss, each party loses the value of his contribution. The party contributing money loses his monetary investment and the party contributing services loses his time and labor. Here Kovacik is not entitled to contribution for his lost capital.

NOTE: The UPA issues a default rule that differs from Kovacik. Under the UPA, each partner shares losses in proportion to their share of the profits. § 401 of the UPA does not base the burden of losses on the type of contribution made by each partner, but rather on the share of profits each partner is entitled. However, elsewhere in the UPA, losses realized upon dissolution are treated differently. § 807 provides the comment that the parties may agree to share operating losses differently than capital losses in the event of dissolution. Here, a court could determine an implied agreement that a partner contributing only his services would not bear liability for capital losses.

THE SHARING OF PROFITS (all these people have to be paid first before you can realize your profits)


§ 401(b) Rules for DistributionThe liabilities of the Partnership shall rank in order of payment as follows:

I. creditors other than partners,II. partners other than for capital and profits, (a partner can also be a creditor and thus would

have to be the first paid partners after creditors)III. partners in respect of capital contribution,IV. partners in respect of profits

BUYOUT AGREEMENTS

G&S Investments v. Belman (1957)

RULE: “Under the UPA, a court may dissolve a partnership when a partner becomes incapable of performing under the partnership agreement, when a partner’s conduct tends to affect the business prejudicially, or when a partner willfully breaches the partnership agreement’s terms.”

Statement of the CaseG&S entered a partnership to operate an apartment with Nordale and others. After being subjected to drugs, Nordale became suspicious of others and began threatening his partners for things they did not do. He disrupted the tenants and refused to pay rent. He insisted on unreasonable business decisions amongst the partnership. As a result, G&S filed suit for dissolution against Nordale to buyout his interest. Then Nordale died and Belman, a representative to Nordale assumed his estate.

ISSUE: May a surviving partner continue the partnership business upon the death of a partner with payment of the deceased partner’s interest to his estate as determined by the partnership agreement?

HOLDING: YES; dissolution occurs only when decreed by the court. The agreement asserts for the partnership to continue upon any partner’s death. Here, the parties intended to measure a capital account using the value of the assets on the partnership’s books.

A partnership buy-out agreement is valid and binding even it the purchase price is less than the value of the partner interest, since partners may agree among themselves by contract as to their rights and liabilities.

NOTE: A buyout agreement allows a partner to end his or her relationship with the other partners and receives a cash payment or series of payments or some assets of the firm, in return for her or his interest in the firm.

General Partnership- a general partnership is created when two or more people associate to carry on a business as co-owners to share profits and control. It requires no legal documentation. UPA § 6. A profit-sharing arrangement creates a presumption of a partnership even if the parties do not intend to be partners. UPA § 7. A general partnership dissolves upon the death, bankruptcy, or withdrawal of any partner. UPA § 31. Absent an agreement, any partner may withdraw and demand that the business be liquidated. UPA § 38(1).GARTEN: UPA 306. All partners are liable jointly and severally for all liability; a creditor can go after any or all of themLosses are shared in the same was as profits. If the parties agree to share the profits equally, the law presumes the losses will be shared in the same manner.

LAW PARTNERSHIP DISSOLUTIONS

Two Fiduciary Duties:Business Associations/Garten/Fall 2008 17

Each former partner has a duty to wind up and complete the unfinished business of the dissolved partnership. §807(a)

No former partner may take any action with respect to unfinished business which leads to ensure personal gain

§807 Settlement of Accounts and Contributions Among Partners (asserts a responsibility to wind up/ governs conduct)

(b) In settling accounts among the partners, profits and losses that result from the liquidation of the partnership assets must be credited and charged to the partner’s accounts (therefore after paying all debts, the profits get credited equally amongst the partners)

The partnership shall make a distribution to a partner in an amount equal to any excess of the credits over the charges in the partner’s account.

Dissolution of the Partnership (§ 807) - Liability is first paid off through the sale of partnership assets. The income from the sale of the assets is distributed to:1. outside Creditors2. inside Creditors (ex. Partner)3. Repayment of Partners’ Capital Contributions4. Debts to 3rd Parties

Steps in partnership dissolution: (1) assets are sold to repay creditors; (2) any money left goes to repay the partners capital contributions (last to get paid back). If there isn’t enough to go around, losses are shared among partners according to their contributions.Example: Chair dealer needs 100,000, A needs 250,000 (capital contribution), B needs 100,000 (capital contribution), C contributed nothing. Total = 450,000 loss that must be shared equally among partners. Each partners loss is 150,000 (450,000 divided by 3). So A is owed 100,000, B must pay 50,000, C must pay 150,000.

Jewel v. Boxer (1984)

RULE: “In the absence of a partnership agreement, the UPA requires that attorneys’ fees received on cases in progress upon dissolution of a law partnership are to be shared by the former partners according to their right to fees in the former partnership, regardless of which former partner provides legal services in the case after the dissolution.”

Statement of the CaseJ, B, and L were partners in a law firm without an agreement. Upon mutual agreement, the partnership dissolved and J and L formed two new firms. The agreement failed to allocate legal fees earned after dissolution on cases in progress while the old partnership existed. Thus B sent a letter to his active clients announcing dissolution and asking them to sign a substitution for counsel. J and L did the same for their clients. J and L then filed suit for an accounting claiming their interests in fees as members of the former partnership. The court issued a quantum meruit which considered the time spent on each case, the source of each case, and the result received.

ISSUE: Should post-dissolution legal fees generated from cases originating with a former partnership be allocated to all former partners based on their respective interests in the former partnership?

HOLDING: YES; The UPA provides that the partnership continues until the winding up of all unfinished business, and any income generated from unfinished business is shared among the former partners. Courts in other states have held that legal fees generated on cases originating in the old


partnership should be distributed according to the former partners’ interests in the partnership and not as quantum meruit. This is the rule that will govern here.

NOTE: An accounting is a legal action to compel the defendant to account for and pay over money owed to the plaintiff but held by the defendant. Quantum Meruit is the reasonable value of services; damages awarded in an amount considered reasonable to compensate a person who has rendered services in a quasi-contractual relationship.

Law firm is dissolved and disagreement erupts over distribution of profits resulting from cases finished after the insolvency of the firm.

Rule: If not stipulated in the P/A, the share of profits from attorney’s fees from cases in progress at time of dissolution is split in the same proportion as fees were split before the dissolution of the firm. Rule: Absent a contrary agreement, any income generated through the winding up of unfinished business is allocated to former partners according to their respective interests, regardless of which former partners actually provides legal services after the dissolution.Note: Partners are free to contract around this holding in the P/A.Public Policy- The rule in Jewel prevents partners from competing for the most lucrative cases during the life of the partnership, and discourages partners from seeking physical possession of the most lucrative files upon dissolution of the firm.

Avoids mad scramble to pick lucrative projects during the winding up period [§ 807 Settlement of Accounts and Contributions Among Partners]

D. OTHER TYPES OF PARTNERSHIPS (LP, LLP, & LLC)

Limited Partnerships (LP) (there must be a partnership agreement)/ (not allowed for law firms – this form is limited in use)

Definition of Limited Partnership- Must have at least one General Partner that retains unlimited liability for all of the debts of the partnership and one or more limited partners who are only liable for their capital contributions (no personal liability for partnership debts). However, if a negligence claim prevails against a Limited Partner, that partner alone is responsible for the damages in excess of his capital contribution. Makes sense for passive money investors. As a trade off, LPs cannot take control of the business management (exertion of control may make them a de factor general partner – Holzman v. De Escamilla)

LPs are creatures of statutes. In order to form this, a General Partner must execute a Certificate of Limited Partnership and file it with the appropriate state official, usually the Secretary of State.

RULPA §201: there must also be a written agreement among all the partnersThe certificate must set out the name of the LP, the address of the registered office and registered agent for service of process, the name and address of each general partner, etc. Once the certificate has been filed and fees paid, The LP is thus formed. The partners typically enter into a LP agreement which is executed by all general and limited partners. LPs are governed by contract law. The LP agreement may contain provisions governing matters such as the admission of new general and limited partners, remedies for breach of the partnership agreement and the manner and process for dissolution and wind up of the LP. It will also likely to contain provisions pertaining to contributions and distributions. It will also set out the manner in which the profits and losses will be allocated amongst the members. If the agreement is silent, under the statute, the profits and losses will be allocated on the basis of the value of the partners’ contributions to the LP.


Limited Partner: is a partner who received profits from the business but does not take part in managing the business and is not liable for any amount greater than his or her original investment.

Limited Partnership: a partnership composed of one or more persons who control the business and are personally liable for the partnership’s debts (called general partners), and one or more persons who contribute capital and share profits but who cannot manage the business and are liable only for the amount of their contribution (called limited partners). However, modern limited partnership statutes permit limited partners to participate in management in limited circumstances without becoming personally responsible for its debts. Note that management is centralized in the general partner.

Note: A Limited Partner (have a voice in the matter of huge things that may affect the nature of their partnership) gets no control and he will lose his status if he actively takes part in the control of the business (management). The exact definition of control use to be vague, but now we know that Limited Partners may: choose other partners and vote out General Partners; and vote on the nature of the business. § 303(b): Advising & counseling do not constitute control.

Limited Partners can perform the following actions WITHOUT being deemed to be participating in the management or control: (1) Being a contractor for or agent or employee of the limited partnership or a general partner;(2) Being an officer, director, or shareholder of a corporation that is a general partner;(3) Acting as a surety, guarantor or endorser for the limited partnership;(4) Serving on a committee of the limited partnership or the general partner; and(5) Participating (usually by voting) in a variety of decisions relating to the limited partnership, including the removing of a general partner, changing the nature of the business, dissolution, etc.

ALSO, ESTOPPEL CAN APPLY TO LIMITED PARTNERS as such that if an LP does business as an GP in the eyes of a third party, nothing shall prevent the LP in being liable as a GP to the Limited Partnership.

Types of Partners: 1. General Partners - where each partner has a right to exercise control, but is also liable for losses -

shared liability2. Limited Partners - where each partner has a right to profits, but liability is limited to the amount

contributed to the partnership.

IF A LIMITED PARTNER EXERCISES CONTROL AND THUS VIOLATES THE NO PARTICPATION RULE, HE BECOMES A GENERAL PARTNER - SUBJECT TO SHARED LIABILITY FOR LOSSES- Holzman v.DeEscamilla

Benefits: Limited partners are only liable for their capital contributions"LIMITED PARTNERSHIPS" - There is NO PERSONAL LIABILITY FOR PARTNERSHIP DEBTSLimited partnerships are required to have at least one general partner, who is subject to unlimited debt for partnership debts.


Holzman v. De Escamilla (1948)

RULE: “A limited partner is not liable as a general partner unless, in addition to exercising his rights and powers as a limited partner, he takes part in the control of the business.”

Statement of the CaseRussell and Andrews enter into a LP with De Escamilla. Pursuant to the agreement, De Escamilla was a GP and the other two were LPs. They often had discussions as to what crops to plant. Sometime later, Russell and Andrews called for the resignation of De Escamilla who was replaced by another person. Bank transactions for the business required signatures of two of the three partners; however, De Escamilla was no longer a GP. Thus the bank, Holzman, sued the two remaining partners as general partners.

ISSUE: Do limited partners who give business advice and dictate business transactions have sufficient control of the limited partnership’s business to convert them into general partners?

HOLDING: YES; Here, Russell and Andrews clearly took control of the control of the business. They were free to dictate business transactions through their own initiative and could veto any business transaction by refusing to sign checks. They actively chose the crops to be planted and replaced De Escamilla with a suitable successor. Because they took control of the business, they are liable as general partners for the partnership’s debts.

NOTE: A limited partner is liable as general partner only if, in addition to exercising his rights and powers as a limited partner, he participates in the control of the business. Therefore, to hold a limited partner liable for the partnership’s debts, a court must draw a line between activities in control of the business and those in control of the limited partner’s investment. Actions such as consulting with general partners, acting as a general partner’s agent, voting or conferring on business decisions that relate to financing or dissolution, or deciding on a charge in the business do not establish control over the business sufficient to hold the limited partner liable as a general partner.

F: Limited Partnership provided that the General Partner could not withdraw money from the accounts without the signature of one of the Limited Partners.RULE “a limited partner shall not become liable as a general partner, unless, in addition to the

exercise of his rights and powers as a limited partner, he takes part in the control of the business.”

R: A limited partner who participates in control is liable “only to persons who transact business with the limited Partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.” [Revised Uniform Limited Partnership Act - § 303(a)] – similar to an estoppel theory – there must be reliance R: A limited partner does not exert control by simply advising the general partner [Revised Uniform Limited Partnership Act - § 303(b)]

Limited Partnerships today are extensively used in three areas: (1) tax sheltered investments (i.e. oil and gas drilling deals and real estate ventures, (2) deals put together by leveraged buy-out firms and venture capital firms, and (3) as an estate planning tool (I.e. family limited partnerships).

Limited Liability Partnerships (LLP) – people do this because nobody wants to carry the full negligence


Definition of Limited Liability Partnership - Organization where partners have limited liability with respect to negligence and similar misconduct (excluding contract obligations). A partner’s direct misconduct may lead to his own liability and subject to unlimited liability, not uninvolved partners. This organization requires filing the Partnership Agreement with a state official and including the “LLP” on all letterhead so that creditors know of the limitation. There are also fees that must be paid and are thus valid for one year in most states and would have to be renewed annually.

LLPs are authorized in about 20 states. This partnership provides innocent partners protection against malpractice or similar tort claims arising from actions of other partners. In some states, an LLP election also protects innocent partners from contract claims as well as torts.

This organization is generally a subset to general partnerships. They have limited in common to LPs.

Limited Liability Partnership (LLP) [Partners are limited to their liability and that of the firm]

Creation: § 1001. UPA (1997) Statement of Qualification

(b) must be approved by vote necessary to amend a general partnership

(c) must file a statement of qualification, to the effect that the partnership elects to be a limited liability partnership

(stationary must identify partnership as a limited liability partnership with the words, "Registered Limited Liability

Partnership," "Limited Liability Partnership" or LLP

Benefits: Liability of Limited Liability Partners is limited to 3d parties for negligence attributable to the conduct of other parties

1) Eliminates partnership liability for the negligent acts (malpractice/tort) of the partners

2) LLP partners may actively participate in management

Detriments/negatives: May act as a negative indication of firm culture - eliminates the "we are all in it together' mentality

Typical use: LLP's are typically used by law firms, accounting firms, etc.

Law firms:

this type is big for firms

LLP develops exclusively for law firms where the concern was malpractice

Must tell clients, creditors, 3d parties so it counts as notice to 3d party creditors

Even though reasons not to become LLP, many going in this direction b/c of reality of crushing burdens of malpractice

Why would a law firm choose to remain a general partnership?

change to LLP might reflect a different culture of firm

unlimited liability [general partnership] fosters trust & relationship when they are share losses

all are taxed as equals

How to choose the type of partnership?

If you need $, limited partnership makes the most sense because then you can raise a lot of money without sacrificing control Real estate, venture capital markets

For a small business , general partnership makes more senseBusiness Associations/Garten/Fall 2008 22

Sharing liability is bonding experience and causes partners to act in best interest of partnership

LLP doesn’t offer much protection because still wholly liable for K breaches

UPA §1001 Eliminates Partnership liability for the negligent acts (malpractice, tort claims) of partners. Only

protects against tort liability, not criminal. Used mostly by legal and accounting firms Can allocate profits anyway you want. Allows limited liability May act as a negative indication of firm culture – eliminates the “we are all in it together mentality” – no

partner is not responsible for what the other partners do) LLP partners may actively participate in management Required to have insurance and set aside funds for malpractice

NOTE: Limited Liability Partnerships are hybrids between a general partnership and a limited partnership. It allows individual partners to limit their own liabilities to third parties for negligence or misconduct of other partners. In contractual claims, the partners are jointly and severally liable, but for tortous claims, the actual tort-feasor is fully liable and the others, though not involved, would be liable for their amount capital contributions to the partnership. However, nothing would be coming out their pockets since their insurance policy would cover this. All partners get control with limited liability.

Limited Liability Company (LLC)Definition of Limited Liability Corporation- Organization where members have greater control than in regular corporations but are protected from liability and obtain tax advantage. The investors are called members

LLC is analogous to a limited partnership but composed only of limited partners. However its internal structure may closely resemble that of a corporation. It is created by filing a document with a state officer called “articles of organization that is patterned after corporate articles of incorporation. An LLC may also adopt regulations or an operating agreement that is patterned after corporate bylaws. LLCs provide limited liability for all its members. Unlike a LP, members of an LLC can freely participate in the management of the business without incurring personal liability for the obligations of the business. LLC statutes permit the internal management to be structured after a corporation or a general partnership. LLC statutes permit each LLC to decide whether to be member-managed or manager-managed. A member-managed LLC is governed in a manner similar to a partnership where the members manage the business. A manager-managed LLC is governed in a manner more analogous to a corporation where the members elect one or more managers to manage the business. The attractiveness of the LLC combines (1) limited liability for all members, (2) flexibility of management structure (in contrast to a partnership or a corporation), and (3) most importantly, a desirable income tax treatment, similar to a partnership. Almost all LLCs are closely held businesses because if they were publicly held, their tax rules would change as such to be taxed as a corporation.

LLCs differ from corporations in that they do not obtain a charter or franchise from the state, for the purposes for income tax classification. Limited Liability is provided to members of an LLC simply by a statutory provision that states that limited partners are not personally liable for the organization’s debts in most circumstances. LLC’s are governed by contract law through its operating agreement.

Limited Liability Company (LLC)* This is not a corporation; it is a business entity where by the owners/members can


a) Participate in managing the entity's affairs, butb) Has the limited liability of a corporation

Duration: May exist indefinitely or for a fixed duration. Ownership interests may generally be structured as members desired, and there is no limit on the number or type of owners. Managers and owners own limited liability

Water, Waste & Land, Inc. v. Lanham (1998)

RULE: “If a limited liability company’s agent fails to inform a third party that he is acting as the company’s agent, the LLC Act’s notice provision does not relieve the agent of liability to the third party.”

Statement of the CaseWWL does business as a land developer and engineer. Lanham and Clark were members and managers of a LLC. Clark contacted WWL to do work for them. Clark gave WWL a business card that showed Lanham’s address as Clark’s place of business. The LLC’s name was not on the card, nor was LLC. Clark and WWL reached an agreement for services and thus told WWL to send the proposal to Lanham. Lanham and Clark did not return the contract to WWL and thus told WWL to start the work. When finished, WWL billed Lanham but Lanham did not pay them. WWL filed suit against Clark, Lanham, and the LLC. The trial court ruled that Clark was an agent of both Lanham and the LLC, that WWL dealt with Lanham and Clark as individuals, and because WWL believed Clark was Lanham’s agent, Clark was not personable liable.

ISSUE: Is a member of an LLC personally liable under a contract if the other party to the contract was not aware that the member was negotiating on behalf of an LLC?

HOLDING: YES; the statutory notice provision applies only to parties looking to impose personal liability on the members or managers of an LLC when they know the individuals have formed an LLC. Here the court found that WWL had no knowledge that Clark was an agent to the LLC. WWL believed that Clark was Lanham’s agent. Because Clark and Lanham failed to disclose the LLC, they remain liable as individuals. The fact that the LLC filed papers with the secretary of state does not put WWL on notice that it was dealing with a LLC. The act’s presumption prevents a third party from pleading ignorance only once it knows the entity’s name.

NOTE: Unless the third party and the agent agree otherwise, an agent who makes a contract on behalf of a disclosed principal is not a party to the contract. In contrast, an agent who makes a contract for an unidentified principal becomes a party to the contract unless the third party and the agent agree otherwise. These rules recognize that a contracting party often needs to evaluate the other party’s creditworthiness.

OPERATING AGREEMENT

Elf Atochem N. America, Inc. v. Jaffari (1999)

RULE: “A LLC is bound by the terms of an operating agreement that is signed by some of its members and that defines the LLC’s governance and operation, even if the LLC did not execute the agreement.”

Statement of the Case


Elf makes manufactured chemicals that mask odors. Because these chemicals are hazardous, Elf entered into a joint venture with Jaffari using the LLC to operate the enterprise. Elf had 30% ownership in the LLC and Jaffari had 70%. After filing the operating agreement, the two entered into another agreement as such for Elf to be the exclusive distributor for Jaffari. Jaffari was manager of the LLC. The members also signed an extensive operating agreement, not the LLC. The agreement asserted for arbitration to be the means for settling any action individually or derivatively. Elf sues Jaffari and the LLC for mismanagement and fraud.

ISSUE: If an LLC fails to execute its operating agreement, are the provisions nevertheless binding on the LLC?

HOLDING: YES; the agreement requires all LLC members to consent exclusively to the jurisdiction of California state and federal courts for any action arising out of the rights and privileges contained in the agreement provided the claim is not required to be arbitrated. Here the LLC members signed the agreement and the LLC Act provides that an operating agreement is an agreement by LLC members regarding the company’s business operations. Thus, the members are the real parties in interest. Elf agreed to settle his issues through arbitration under the exclusive jurisdiction of the California courts. He has no derivative action in Delaware, neither does the agreement make a distinction between what’d direct and what’s derivative. This court will not allow a party to avoid arbitration by characterizing its claims as derivative.

NOTE: An operating agreement is drafted for the member’s benefit. The agreement is binding.

PIERCING THE “LLC” VEIL

Kaycee Land and Livestock v. Flahive (2002)

RULE: “The common law doctrine of piercing the corporate veil is not abrogated by the LLC Act and may be used against LLC members in appropriate cases.”

Statement of the CaseFlahive was a managing member of an LLC which negotiated a lease with Kaycee for real estate. Kaycee contended that the LLC member Flahive contaminated the property. Kaycee attempted to pierce the corporate veil by reaching Flahive’s personal assets.

ISSUE: May a court pierce the corporate veil of a LLC to reach its members’ assets?

HOLDING: YES; courts have long recognized the common law doctrine of piercing the corporate veil as an equitable remedy. Here although the LLC act generally prevents personal liability, nothing restricts a court from piercing the veil if the LLC is used improperly. The facts here are somewhat limited in ascertaining whether fraudulent activity exists. Judgment remanded.

NOTE: Some states like Minnesota and Colorado allow courts to pierce the corporate veil to an LLC. Because tax or other financial considerations drive most choice-of-entity decisions, it makes sense to treat all entities alike, and if misused, to allow creditors to make claims directly against the LLC membership for moneys owed.

FIDUCIARY OBLIGATIONS


McConnell v. Hunt Sports Enter. (1999)

RULE: “LLC members are bound by the terms of their operating agreement, and if the agreement expressly allows them to engage in any other business venture of any nature, they are not prohibited from participating in a competing venture.”

Statement of the CaseWealthy individuals, such as McConnell and Hunt, and their LLC invested in a new hockey team for the NHL in Columbus. The investors needed an arena for the team in which the voters rejected. Nationwide expressed an interest in building an arena and leasing it. Hunt, acting for the LLC met with Nationwide to discuss a lease proposal. Hunt rejected the proposal. As the NHL deadline approached, McConnell contact Nationwide and agreed to their proposal. The LLC and Hunt disagreed with the terms. Thus McConnell favored it and signed the agreement. Afterwards, he filed suit seeking to exclude Hunt and the LLC from the franchise under the terms of the operating agreement.

ISSUE: Should a court allow extrinsic evidence of the meaning of an operating agreement’s terms that purports to do away with the fiduciary protections ordinarily afford the members of a business organization such as a LLC?

HOLDING: NO; courts permit extrinsic language only if the language is not clear or if the agreement’s circumstances suggest the contract language has special meaning. Here the agreement asserts that the parties agree that its members will not be restricted from engaging in any business of any nature, even a business that may compete with the company’s business. Generally fiduciary obligations prohibit members from competing with one another in the same business. However here, the agreement eliminates this protection. Furthermore, the agreement does not designate Hunt as the operating member and because Hunt lacked authority to act, his conduct does not deserve protection as an official duty. In light of Hunt’s knowledge that the agreement required a majority vote before he acted on behalf of the company, he acted willfully when he filed his answer and counterclaim without a vote.

NOTE: The primary concern when an officer, director or other fiduciary competes with its company is the existence of good faith. Courts have frequently not found bad faith when a fiduciary later secured a missed corporate opportunity. If a fiduciary misappropriated a business opportunity, the corporation may ask the court to impose a constructive trust within which it may accumulate the fiduciary’s profits to be distributed to the corporation.

DISSOLUTION

New Horizons Supply Co-op v. Haack (1999)

RULE: “A LLC member may be responsible for the company’s debts if the member fails to take the appropriate steps to dissolve the company when it winds up its operations.”

Statement of the CaseHaack signed an agreement to New Horizons where she would be responsible for all fuel purchased on the credit card. An LLC that Haack is associated with was named on the agreement. Thus when the account became delinquent, New Horizons contacted the LLC. New Horizons was told that the LLC has dissolved and that Haack as partner would take responsibility for the company and start making payments the next month using the business assets. Haack never made the payments so New Horizons sued the LLC.


ISSUE: Should a LLC member who fails to take the appropriate steps to dissolve the company be permitted to defend against an action to recover against her personally by establishing that the debts in question were the LLC’s obligation?

HOLDING: NO; the doctrine of piercing the corporate veil has been adopted in the state’s LLC law. Here, Haack did not keep her obligations separate from the LLC’s obligations and thus took no steps to insulate herself from liability for the company’s debts. Hack offered no evidence that the articles were filed. On dissolution, there were no formal steps taken to wind up the LLC. In winding up, all creditors must be paid. With no evidence that the company was properly wound up, Haack remains liable for the obligation to New Horizons.

Assume we are looking to expand the business. If people want to invest in this partnership, does it make sense to bring them in as general partners at the same status as A, B, and C from the previous example?

Probably not b/c A, B, & C don’t want to give up any control. There are three choices: General Partnership, Limited Partnership, and Limited Liability Partnership.

What about a LIMITED PARTNERSHIP? A limited partnership would give a share of the profits to the partner, but the losses are limited to the

partner’s contribution. So, if D contributes 100k, then this will be the extent of the possible losses. Predictable loss and D doesn’t have to exercise any control; in fact, he is not allowed to exercise any control.

Limited partners are now given some control over the business without becoming general partners. However, day to day operations are usually still left to the general partners in a business.

Members are liable for only their investment All members are able to take part in control Complex to form – requires filing an “operating agreement form” Entity may choose to be taxed as a corp. or a Partnership (to avoid double taxation, most choose

Partnership) What happens to fiduciary duty concept with LLCs? Courts don’t seem to apply fiduciary

duty as strongly in LLCs b/c LLCs structure through contracts, so Courts do not want to intervene and add additional duties

There are no separate directors, books, officers, etc. because you aren’t trying to maintain business entity

GP small businesses where everyone is expected to participateLP’s venture capitalists – seek investment w/o controlLLP’s limits Tort liability from the whole partnership but not to the individuals (malpractice) ideal for law & accounting firms (must register w/ state)LLC’s hybrid that permits (1) members to limit liability to amount invested, and (2) entity can choose to be

taxed as a corp. or a Partnership. Complex to form – requires filing an “operating agreement.” LLC’s must have insurance

PARTNERSHIP V. CORPORATION

Type CREATION LIABILITY TAXPARTNERSHIP * Conduct Each partner is

individually liable for the debts of the

Each person/partner pays tax on their individual income

*However, the partner may off set


partnership his pro rata share of firm losses*Tax return filed by the partnership

is informational only

CORPORATION * Must incorporate in

stateFile Charter/

Certificate of Incorporation with the Sec. of

State

Limited LiabilityShareholders are

limited to the extent of their contribution

(limited to shares)

Corporation is a separate tax entity.

Double Taxationa) The corporation pays income tax,

andb) the shareholders' dividends are

also taxed individually.

To get tax break, use LLC- Shareholders get limited liability, while having the tax status of the

general partnership

NOTES

The selection of business forms today largely revolves around two core issues: limitation of personal liability of owners for debts of the business and the proper classification of the business for purposes of the federal income tax law. Of these two, tax treatment is the most important simply because this is something that every business has to face almost constantly. It involves real dollars that must be paid each year whereas limited liability is only a possibility or a risk that may never mature.

Today, many of the unincorporated businesses provide limited liability for some or all owners and yet remain eligible for partnership type taxation under the Kintner regulations. The determination of whether an unincorporated business entity is eligible for partnership type taxation under these regulations rests on the question whether the entity has a predominance of non-corporate characteristics. There are four characteristics that determine whether an entity should be classified as a corporation – continuity of life, centralization of management, limited liability, and free transferability of interests. An unincorporated business that has three of the four characteristics will be taxed as a corporation.


*********************************************************************II. CORPORATIONS

*********************************************************************A. FORMATION OF THE CORPORATE ENTITY

In a corporation, the fundamental idea is that ownership of business is separated from control. The fundamental attributes of a corporation are (1) separate legal entity status – separate person in the eyes of the law from its shareholders and board of directors as such that it can sue in its own name, be sued, and convey property from its own name; (2) Limited liability to the owners of the corporation or shareholders flows from the concept of separate entity status of the corporation. The directors and officers also are not personally liable for the obligations of the corporation; this flows from the business judgment rule. Generally the corporation itself can be held liable for corporate obligations. A corporation would be a good business to start if you are protecting your personal assets; the shareholders will not be held liable for the unsatisfied debts of the corporation; (3) double taxation – means that the corporation itself pays taxes on the income it earns and the owners pay taxes on the income they receive as dividends; and (4) centralized management - the owners of the corporation, shareholders, annually elect a board of directors to set policy for the corporation. The board would then appoint officers to carry out the day to day functions of the corporation. Other than electing the board, shareholders have no authority to manage. They do have veto power in situations where the corporation maybe dissolved, the capital structure changes, or making an acquisition. (5) Free Transferability of ownership – a shareholder can transfer his share to whomever they want at whatever price whenever they want. However, transferability can be restricted by agreement which is typically popular in closely held corporations where management decides who can join their business or not.

GENERAL

The Corporation is treated as an independent entity. Every Shareholder has Limited Liability because corporation is treated as a separate person, and thus

only entity is responsible for debts. Two Basic Rights of Common Stock Shareholders

1. Right to vote (Board, changes to Articles of Incorporation & Bylaws, fundamental changes not in the ordinary course of business-merger); Shareholders have to consent /vote for amendments to the charter.

2. Right to dividends (issuance is subject to BJR however)

INCORPORATION

DGCL § 101 – Incorporators; how corporation formed; purposes(a) any person or entity w/o regard to state of residence, domicile or state of incorporation, may

incorporate by filing w/ the Division of Corporations in the Dept. of State

DGCL § 102 – Contents of certificate or articles of incorporation(a) The certificate of incorporation shall set forth:

(1) Name (including identifier of incorporation) – evidence of incorporation (I.e. Corp. or Inc.)

(2) address of registered office in this State (were service of process may be made – lawyers office)


(3) nature of business or purposes to be conducted or promoted (can be as broad as “to make money”)

(4) if one class of stock: total # of shares corp. can issue and par value for each; if more than one class: total # of shares of each class, and par value (identify the type of stock the company is authorized to issue as such to be enjoyed by the shareholders)

(5) name and mailing address of incorporator(s)(6) name and mailing address of persons to serve as directors until first annual meeting of

stockholders or their successors are elected (7) Some states requires that the size of the corporation must be included here, others say the

bylaws would be sufficient.(b) may also contain:

(1) Any provision limiting or defining the rights and obligations of the corp. actors. Good place to exert control prior to requiring shareholder approval Pre-emptive rights “more than 50% voting requirements Limitations on corporate existence Limitations on liability for breach of FD By-law provisions

DGCL § 106 – Commencement of corporate existence Upon filing and proper execution with the Secretary of State, incorporator(s) shall be and constitute a corporate body, by the name set forth in the certificate

Selection of State of IncorporationMost corporations choose Delaware because of its corporate friendly laws; however, a large publicly held

corporation can choose any of the 50 states to be incorporated. See Del Gen Corp Law § 101-02 for rules of incorporation. Why Delaware? (1) It has a broadly permissive statute – empowers managers with great discretion to carry out the affairs of the corporation; (2) its law is very stable – Delaware Constitution provides that general corporate law cannot be amended without 2/3s vote of all the sitting legislators of the state.; (3) large body of case-law interpreting statutory provisions – attorneys have a more certain law in advising their clients as to what actions they can engage in; and (4) it has a special court of chancery – lawyers of corporate practice migrate here then eventually to the Supreme Court of Delaware.

Mechanics of Incorporation1. File Articles of Incorporation or Certificate of Incorporation or charter w/ Secretary of State2. Articles are reviewed by State officials3. If approved, the secretary issues the certificate and a corporation is formed4. Should have Bylaws to govern internal affairs – not filed or made part of the public record

If the Articles conflict w/ the Bylaws, the Articles control

IncorporatorsThe person or persons who execute the articles of incorporation are called incorporators. The incorporators can either (1) execute and deliver the articles to the secretary of state; (2) they can receive the charter or certificate of incorporation back from the secretary of state; (3) they can either meet to complete the organization of the corporation or can call the first meeting of the initial board of directors named in the articles as which the organization of the corporation is completed; (4) they can voluntarily dissolve the corporation if the corporation


has not commenced business and has not issued any shares; and (5) they can amend the articles by unanimous consent if the corporation has not commenced business and has not issued any shares.

Articles of Incorporation (once a corp. is legally in existence, it is called a De Jure Corporation)

This document filed with the Secretary of State must have the following: (a) the name of the corporation; (b) the period of duration which may be perpetual; (c) the purpose or purposes of the corporation, which may be generally described as for any lawful business purpose; (d) the number of shares authorized to be issued, including information about the rights and preferences of such shares; (e) the address of its registered office and the name of its registered agent at that office; (f) the number of directors and the names and addresses of the members of the initial board of directors; and (g) the names and addresses of each incorporator.

As a result of concern about the liability imposed on directors in the case Smith v. Van Gorkom, the corporation statutes of many states have been amended to permit the shareholders to limit the personal liability of directors for monetary damages for violation of the duty of due care. Bylaws are generally not filed with the secretary of state and are not a matter of public record. The corporate seal is not required either.

Ultra ViresThe term means “beyond the power.” They refer to illegal acts performed by the corporation such as bribes, political contributions, charitable donations, etc. The corporation has exceeded its authority and its corporate purpose. The main use of this doctrine was to disaffirm contracts. Today, this doctrine is no longer relevant since corporations now have (1) broad purpose clauses as such to engage in any lawful activity, and (2) modern corporate statutes have provisions that state no contract or conveyance shall be invalid because it was beyond the scope of the corporation’s power. The policy implication for rejecting this doctrine is that corporations might get too big and powerful, but that is why antitrust laws are still in existence today.

NOTE: THE CHOICE OF LAW RULE IS THE INTERNAL AFFAIRS DOCTRINE – THE LAW OF THE STATE THE CORPORATION DOMICILES…THIS MUST ALSO BE FILED WITH THE SECRETARY OF STATE

DIFFICULTIES WITH INCORPORATION PROCESS/ DE FACTO INCORPORATION DOCTRINE SITUATIONS WHERE THERE IS A MISTAKE IN INCORPORATION

Southern-Gulf Marine Company v. Camcraft, Inc. (1982)

RULE: “A defendant may not interpose as a defense to a breach of contract that a plaintiff corporation lacked the capacity to contract because it was not incorporated at the time it executed the contract, unless the failure to incorporate actually harmed the defendant.”

Statement of the CaseSouthern was designated as a company to be formed and thus executed a letter of agreement to purchase a vessel from Camcraft. The presidents of both companies signed the agreement in which Camcraft had to purchase the parts for the vessel and deliver it to Southern who in turn would give them the money. Due to financial concerns, Southern decided to incorporate in Cayman, the British West Indies and thus


assured Camcraft that this would not affect their negotiations in which Camcraft consented to. Camcraft however did not deliver the vessel in time. Southern sues for breach of contract. Camcraft contends that the contract was unenforceable since the plaintiff was not incorporated at the time.

ISSUE: Does a party’s failure to have incorporated before signing a contract with the defendant render the contract unenforceable?

HOLDING: NO; since the defendant agreed to build the ship, it should not be permitted for them to escape their obligations under such theory of un-incorporation unless the un-incorporation affects the defendant’s rights. Nothing showed that the lack of the plaintiff’s corporate status affected the defendant adversely. The reason Camcraft rejected to build the vessel was because it could have sold it to another person for a higher price. The plaintiff’s status is not relevant here and thus cannot be used to avoid the contractual obligations.

RULE “where a party has contracted with what he considers to be a corporation, and is sued upon the contract, neither is permitted to deny the existence or legal validity of such corporation” and is estopped from denying its corporate existence, particularly when the obligations are sought to be enforced. NOTE: Most states have abolished this doctrine.

What to do when a Client wants to proceed with a deal with a not yet incorporated entity? Require that all parties sign the letter in a personal capacity and create provision to transfer

liability when incorporation is achieved Include a provision to void contract if Incorporation is not achieved by a specific date – may

require you to eat losses up to that point

De facto Corporation vs. Corporation by EstoppelThese two terms are noted to be defenses to personal liability for the debts of a business that was defectively incorporated.

De facto corporation provides that persons who purport to act as or on the behalf of a corporation knowing that there was no incorporation are liable for all liabilities created in so acting. It follows that persons who do not know that there was no incorporation will not be liable. It is a partially formed corporation that provides a shield against personal liability of shareholders for corporate obligations. When this doctrine is invoked, the court is saying that it will treat the business as if it was a corporation for purposes of adjudicating the rights and duties of private parties, even though all of the statutory formalities were not met. To invoke this doctrine, these three elements must be established: (1) colorable compliance: the organizers of the corporation attempted to comply with the applicable statutes, but failed to do so; technical defect or single defect; (2) good faith: (pure heart, empty head standard) the organizers were unaware of the defect that kept the corporation from being formed; and (3) use of corporate power: the company carried on as though they believed the corporation existed, by issuing stock, holding meetings, entering contracts, etc. If these three elements are met, shareholders will be shielded from personal liability. (applied in contracts and tort cases) NO one will be liable for a defect unless they have knowledge of the defect.

Corporation by Estoppel provides that persons who treat an entity as a corporation will be estopped from later claiming that the entity was not a corporation. The doctrine can be applied either to an outsider seeking to avoid liability on a contract with the purported corporation or to a purported corporation seeking to avoid liability on a contract with an outsider. It is an equitable defense from that of de facto corporation. Here, a third party who has dealt with an entity as though it were a corporation and without any expectation that the shareholders will be personal liable for the corporation’s debt will


be estopped from holding the shareholders liable when it is subsequently discovered that the corporation was not properly formed. Therefore, the party asserting the defense must have acted in good faith and not affirmatively misled the other party. The requirements for equitable estoppel are (1) there must be a false representation or concealment of a fact from a person ignorant of the truth (2) with the intention by the person making the representation of causing reliance, and (3) actual reliance by the innocent party on the basis of the false representation. (applied in contract cases) . . . even though the corporation acted as if it was a corporation and thus acted in good faith to do so, the third party honestly contracted with the corp. as if it was a corporation and now wants to break the contract, this third party will be estopped from asserting that the corp. was not duly formed

Assuring and Determining the Validity of Incorporation When contracting with a Corporation, the party should check that the Corporation has been duly

incorporated and remains in good standing and to make sure there is no dissolution statement. Obtain a copy of the Corporation’s certificate of incorporation and/or contact state tax department to

assure that taxes have been paid The lawyers job to give an opinion as to whether the Corporation is in good standing

B. PIERCING THE CORPORATE VEIL – REACHING THE SHAREHOLDERS

The law permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability, but the privilege is not without its limits. The courts will disregard the corporate form and pierce the corporate veil whenever necessary to prevent fraud or to achieve equity. The court will not allow a corporation to evade liability if it has been used as an alter ego or instrumentality. In other words, the courts will hold the shareholders, officers, or directors personally liable for corporate obligations because the corporation is abusing the legislative privilege of conducting business in the corporate form. This doctrine counterbalances the de facto and estoppel doctrines since the validity of corporate existence is ignored as a means of equity to serve the ends of justice.

2 theories of liability: Piercing the corporate veil makes the owner liable. (look to see if the party has intermingled funds

between personal and company accounts) Enterprise Liability - Make the owner of the tanker liable, since they are essentially one company.

(Look to see if funds are intermingled between companies). Sort of like reverse piercing. The parent and subsidiary fails to follow corporate formalities

o Clincher – no interest loan from 1 company to another.

Normally: Courts will refer to the legal fiction that a properly formed corporation is an entity, separate and distinct from its officers and stockholders and the individual stockholders are not personally responsible for the debts of the corporation.Creation of the corporation will normally shield the shareholders from personal liability for the corporation's debt. Thus, shareholder's liability is limited to their investment.


Piercing the Corporate Veil: However, the fiction should be disregarded when it is urged with an intent not within its reason and purpose, and in such a way that its retention would produce injustices or inequitable consequences.

Despite adequate formation of a corporation, individual shareholders may be personally liable for the corporation’s obligations / the corporate veil may be pierced, when it is necessary to "prevent fraud or injustice” Also note that creditors are more likely to pierce the veil than are shareholders.

When the veil of limited liability is pierced as such the corporate entity is ignored, active persons meaning persons who were active in management or operation of the business will be held liable. However, passive investors who acted in good faith will not be liable.

Exception- Courts are reluctant to pierce the corporate veil in contract cases because the contracting party had an opportunity to investigate and bargain. Contractual parties assume the risk and thus had an opportunity to investigate the capitalization.

Shareholders are liable for corporate obligations under either contract or tort law. Under contracts, shareholders often assume personal liability for corporate obligations. A lender may refuse to extend credit to a corporation with limited assets unless one or more of that corporation’s shareholders agree to personally pay the debt if the corporation does not do so. Under tort law, a shareholder will be liable under general principles of tort and agency law if the shareholder commits a tort in the course of the corporation’s business. The courts are more willing to pierce the veil in tort cases rather than in contract cases. People who are injured in a tort claim don’t have the opportunity to investigate the shady corporation before dealing with them while people in a contract claim have the opportunity to investigate and bargain for and employ protective measures before signing the contract

Though not dispositive, the court will be more likely to pierce for the benefit of an involuntary creditor that did not have the opportunity to investigate

3 APPROACHES COURTS USE IN DECIDING WHETHER TO PIERCE THE CORPORATE VEIL(Piercing the Corporate Veil will require more than just ONE of these factors, with exception to only Fraud)

1. LACK OF A SEPARATE CORPORATE EXISTENCE ALSO COMMINGLING OF BUSINESS

FISCAL ASSETS – ALTER EGO APPROACH (NEW YORK Approach)

Commingling of Assets: shareholders co-mingle personal and company funds. This includes a failure to keep separate bank accounts for the corporation and the controlling shareholder and writing checks to cover personal expenses out of the corporate account. It also includes situations in which the dominant shareholder treats the corporation’s bank account as his private piggy back. The personal assets may be so commingled that a third party may think he is dealing with the shareholder rather than a corporation.

Self-Dealing: similar to commingling of assets.


Failure of formalities: shareholders have failed to follow corporate formalities in running the business. Shares are never formally issued, directors’ meetings are not held, no minutes of meetings kept, etc.) Shareholder does not distinguish between corporate property and personal property, and proper corporate financial records are not maintained, etc.

Control or domination: this alone is NEVER sufficient to pierce the corporate veil. There must be fraud, self-dealing, commingling of assets, etc. Control is relevant in telling the court “WHO” has potential piercing liability.

a) Individual shareholders – if the shareholders treat the assets of the corporation as their own, use corporate funds to pay their private debts, fail to keep separate corporate books, and fail to observe corporate formalities (such as holding meetings, issuing stock, and conducting business by resolution),

courts often find that the corporate entity is a mere “alter ego” of the shareholders. The operation of the corporation must result in some basic injustice so that equity would require that the individual shareholders respond to the damage they have caused.

b) Parent-Subsidiary Corporations (Enterprise Liability) – a subsidiary or affiliated corporation will not be deemed to be a separate corporate entity if the formalities of separate corporate procedures for each corporation are not observed, as such there is an overlapping of identical directors and officers, same meetings of the directors and officers, corporate policies are similar, etc. The plaintiff here is seeking to hold the parent corporation liable for the subsidiary corporation’s debts. Factors considered in piercing the veil here are: (1) the relationship is so structured that all profits of the subsidiary inure to the benefit of the parent, (2) there is no clear delineation as to which transactions are the parent’s and which are the subsidiary’s, (3) the parent does not allow the subsidiary to have adequate capital, or (4) the board of directors of the parent makes decisions for the subsidiary.

c) Affiliated Corporations – if one person owns most or all of the stock in several corporations, a question arises as to whether one of the corporations, although not formally related to the other, should be held liable for the other’s liabilities. Dominating stock ownership alone is not enough in such a case, unless the majority shareholder dominates finances, policies, and practices of both corporations so that both are a business conduit for the principal shareholder.

POLICY: It gives some certainty to shareholders, especially to dispersed or passive shareholders. They know what to do to avoid liability. They are the beneficiaries of this rule. This formalized test has nothing to do with 3rd parties. This alter-ego approach is a pro-certainty approach, which is a pro-shareholder approach. It is also a small price to pay to get this limited liability benefit.

2. INSUFFICIENT CAPITALIZATION – (CALIFORNIA Approach) –NOT ENOUGH TO PIERCE THE CORPORATE VEIL…THIS PLAYS A SUPPORTING ROLE (usually fraud and/or lack of corporate formalities is necessary here)

The corporation veil should be pierced when there’s capital insufficient to meet liabilities which are certain to arise in the ordinary course of the corporation’s business. It is generally accepted that shareholders will be personally liable for their corporation’s obligations if at incorporation they fail to provide adequate capitalization. The shareholders must “put at the risk of the business unencumbered capital reasonable adequate for its prospective liabilities.” Undercapitalization cannot be proved merely by showing that the corporation is now insolvent. However, if insolvency occurs soon after incorporation, it may be a primary indicator of undercapitalization.


When there is undercapitalization of the corporation, the corporate veil should be pierced. (CALIFORNIA RULE)

Undercapitalization is used to protect the assets of the corporation. By not having sufficient funds the financial liability of a corporation is limited.

What is adequate capitalization?—enough to cover any liabilities. The only corporations that would be hurt by such a rule would be those that should be held liable for under capitalization.

However, if adequate capitalization is whatever you can be sued for, then this is not a workable standard. When you charter a company there is no general minimum capitalization requirement. As a practical matter, courts tend to stay away from insufficient capitalization in determining whether to piece the corporate veil.

Ultimately, there needs to be a balance between protection of consumers & encouraging investment in business.

Inadequate capitalization may occur when the corporation is set up with adequate initial capital, but the Defendant Shareholder DRAINS OUT or SIPHONS all of the profits/capital through salaries, loans, etc.

when the share holder invests no money whatsoever in the corporation (ZERO CAPITAL or CORPORATE SEHLLS), courts are likely to pierce the veil

Uncertainty is the real reason that this is not the majority’s approach. Courts avoid making under capitalization a measure for piercing the corporate veil because they are unprepared to set an ultimate standard of what level of capital is adequate. It is theoretically appealing, but largely impractical.

o Parent-Subsidiary Corporations – a parent corporation’s inadequate capitalization of a subsidiary corporation may constitute constructive fraud on all persons who deal with that subsidiary. One additional test should be applied here: whether the subsidiary may reasonably expect to achieve independent financial stability from its operation.

3. FRAUD or DECEPTION – (ILLINOIS Approach) – THIS IS ENOUGH ON ITS OWN TO PIERCE THE VEIL

The corporate entity will be disregarded any time it is necessary to prevent fraud or to prevent an individual shareholder from using the corporate entity to avoid his existing personal obligations. Note that the mere fact that an individual chooses to adopt the corporate form of business to avoid personal liability is not, of itself, a reason to pierce the corporate veil. The corporate veil will be pierced whenever the avoidance of personal liability through the information of a corporation operates as fraud on creditors or other outsiders. Fraud also occurs where there is a siphoning of corporate assets which leaves little in the company to pay the creditors

Totality of the Circumstances Test : This incorporates the two-part Van Dorn Test: Was the corporate form the vehicle for 1) Alter Ego - Where the shareholders fail to deal with the corporation as a separate, distinct entity, the corporate shield will be disregarded (incorporates the New York and California Approach), 2) Fraud (Illinois Approach)

Sea-Land Services, Inc. v. Pepper Source (1991) – Alter Ego Plus (Illinois) Theory

RULE: “In order to pierce the corporation veil and impose individual liability, a creditor must show (1) there was such a unity of interest between the individual and the corporate entity that


separate identities no longer existed, and (2) that a failure to do so would promote injustice in some way beyond simply leaving a creditor unable to satisfy its judgment.”

Statement of the CaseSea-Land engaged in business with Pepper Source. Pepper refused to pay Sea-Land for shipping so the trial court ruled that Pepper had to pay damages. Sea-Land tried to collect these damages but Pepper had dissolved for failure to pay its franchise taxes. Thus in order to claim his damages, Sea-Land brought suit against Marchese, the shareholder of Pepper and 5 of his businesses. Sea-Land attempted to pierce the corporate veil by arguing that all these businesses were Marchese’s alter egos.

ISSUE: Should the corporate veil be pierced simply to prevent the injustice that would result from a substantial debt going unpaid?

HOLDING: NO; based on the record, these companies are Marchese’s playthings. Only one of the companies has ever adhered to corporate formalities. All the companies share same legal expenses, accounts, and were used to provide loans to Marchese. Here, the first element of the Van Dorn case is satisfied – unity of interest. However, in order to pierce the veil, the plaintiff had to show that honoring separate existences would promote a fraud or injustice. Sea-Land expounded on the notion of injustice by asserting it would be unjust to allow Pepper to avoid his debt. The level of proof for injustice is less than fraud. However, injustice cannot be shown through an unsatisfied debt. There must be something more like unjust enrichment or intentional scheme to defraud creditors.

Alter Ego Plus Theory: that the corporation was not kept as a separate entity and there was fraud or unfairness.

o Basically: all of these corporations “are alter egos of each other, and hide behind the veils of alleged separate corporate existence for the sole purpose of defrauding P and other creditors.”

REVERSE PIERCEo attempt to not only hold the shareholder who is employing the corporation as

an alter ego personally liable, but also to reach the other corporation entities that he maintains as further alter egos

Court found that this piercing was NOT appropriate because Van Dorn’s second prong had not been satisfied; the case was remanded for the second prong: In order to pierce

the corporate veil, the Plaintiff must show that: Van Dorn Test:1. there is a unity of interest and ownership that the separate personalities of the

corporation and the individual [or other corporation] no longer exista) failure to comply with corporate formalities

i. shares not issuedii. shareholder’s and director’s meetings not held

iii. financial records not maintainedb) commingling of funds or assetsc) undercapitalizationd) one corporation treating the assets of another corporation as its own; and

2. That adherence to the fiction of separate corporate existence would sanction a fraud (intentional wrongdoing) or promote injustice.

An unsatisfied judgment is NOT enough to show that injustice would be promoted

Need to show on remand that Marchese used these corporate facades to avoid responsibility to creditors and unjustly benefited.


How do you satisfy these prongs?(1) Check corporate records for: formalities (corporation run with undue dominion or control); commingling of assets (moved in and out of corporation with reckless abandon, under-capitalization (insufficient funds in corporate account to satisfy any judgments).(2) Check to see if judgment in Defendant’s favor would result in some wrong beyond a creditor’s ability to collect. Check to see if common rules of adverse possession would be undermined or if there would be unjust enrichment. You can also check to see if assets have been intentionally placed beyond a reach of judgment.

Walkovsky v. Carlton (1966) – New York Rule: Alter Ego Theory

RULE: “Absent an allegation that the defendant was conducting business in his individual capacity, a complaint charging that an individual defendant organized a fleet of taxicabs in a fragmented manner solely to limit his liability for personal injury claims is insufficient to hold the individual liable for the claim.”

Statement of the CaseWalkovsky was injured when he was struck by a taxicab owned by Seon Cab Corporation and driven by Marchese. Carlton is a stockholder in 10 taxicab corporations including the one at fault. Walkovsky sued each of the 10 companies because each company shared the same financing, supplies, repairs, employees, and garages all with minimum insurance. Walkovsky’s injury resulted in more damages then the insurance policy allocated by the taxi company.

ISSUE: May a plaintiff recover against individual stockholders if a corporate structure limits the corporations’ liability for personal injuries, even if there is no showing that the stockholders used the companies for personal, rather than corporate gain?

HOLDING: NO; although the law permits individuals to incorporate solely to avoid personal liability, courts disregard the corporate form as needed to prevent fraud and ensure equity. In deciding whether to pierce the corporate veil, the courts are guided by general agency rules. If an individual controls a corporation for personal gain rather than the corporation’s gain, the individual is responsible under respondent superior for the corporation’s acts in commercial dealings and in tort claims. The plaintiff fails to establish whether the defendants were acting in their individual capacities. There are no allegations that the stockholder here commingled funds, that the companies were undercapitalized, or that the stockholder is operating the business without regard to corporate formalities. The plaintiff alleges fraud when no evidence exists of that.

NOTE: Alter Ego is a corporation used by an individual in conducting personal business, the result being that a court may impose liability on the individual by piercing the corporate veil when fraud has been perpetrated on someone dealing with the corporation. Alter Ego Rule is a doctrine asserting shareholders to be treated as the owners of a corporation’s property, or as the real parties in interest, whenever it is necessary to do so to prevent fraud or to do justice. The corporate veil is the legal assumption that the acts of a corporation are not the actions of its stockholders, so that the stockholders are exempt from liability for the corporation’s actions. Piercing the Corporate Veil is a judicial act of imposing personal liability on otherwise immune corporate officers, directors, and stockholders for the corporation’s wrongful acts.

o MINORITY RULE (California approach):o inadequate capitalization IS enough for an involuntary creditor to pierce the corporate

veil ; no fraud or failure to follow corporate formalities is required Business Associations/Garten/Fall 2008 38

o Hard to determine what adequate capitalization is and may discourage the corporate form because the chance that the court may deem the corporation undercapitalized and pierce it, thereby rendering Shareholders personally liable.

PIERCING THE CORPORATE VEIL IN A PARENT-SUBSIDIARY CONTEXT

Parents are generally not liable for the debts of subsidiary if: (1) proper formalities are observed, (2) the public is not confused about dealing w/ sub or parent, (3) the subsidiary is operated in a fair manner for profit, and (4) there exist no manifest unfairness

DELWARE COURTS DO NOT require a finding of fraud or like misconduct if o a subsidiary is found to be the mere instrumentality OR o alter ego of its sole stockholder (especially in a Tort action w/ an unaware

creditor) MAJORITY RULE: Van-Dorn Test

o (1) ALTER EGO (New York Rule)o (2) FRAUD (Illinois Rule)

If a corporation is so controlled as to be the alter ego or mere instrumentality of its shareholder, the corporate form may be disregarded for the sake of justice.

Roman Catholic of San Francisco v. Sheffield (1971) – Van Dorn Test to Enterprise Liability

RULE: “To impose personal liability under the alter ego theory, a corporation must not only be influenced and governed by the individual, but there must be such a unity of interest and ownership that the separateness of the person and the corporation has ceased, and the facts must be such that adherence to corporate protections would sanction a fraud or promote injustice.”

Statement of the CaseIn Switzerland, Sheffield visited a monastery operated by the Roman Catholic Church where he agreed to purchase a dog. According to the agreement, he would pay $125 up front for the dog including shipping and the remaining payments by installment till $175. After paying, the dog had not arrived to his home in Los Angeles. He brings a breach of contract claim against the Catholic Church in San Francisco, the Pope, the Vatican, etc. claiming they were all alter egos and thus shared a unity in interest.

ISSUE: Is the Roman Catholic of SF the alter ego of the Pope, the Vatican, and the Roman Catholic Church?

HOLDING: NO; Alter ego theory is imposed in situations involving an abuse of corporate privilege, holding the equitable owner of a corporation to be liable for the corporation’s actions. The facts must show a commingling of assets, one company holding itself as liable for the other’s debts, identical equitable ownership of the two entities, use of the same offices and employees, and the use of one entity as a conduit for the affairs of the other. The issue here is whether the Archbishop controls the Canons Regular, not the Pope. The ego theory imposes liability upon the parent for the liability of its


subsidiaries. One subsidiary cannot be liable for another subsidiary’s actions merely because the parent controls both. Injustice cannot be shown here by suing the church here than from abroad.

NOTE: Parent corporations utilize subsidiary corporations for a variety of legitimate business objectives. As long as both parent and subsidiary observe proper corporate formalities and act as distinct, though related, entities, the alter ego theory will not apply. If however, the parent uses the subsidiary corporation to conduct business transactions or otherwise act on the parent’s behalf, the parent risks liability for the subsidiary’s misconduct. (Parent Corporations have a controlling interest in the subsidiary corporation and usually owns a majority of the voting stock).

ENTERPRISE LIABILITY (Brother-Sister Corps) if the various pieces are, for all economic Purposes, a single business, the court may treat all the pieces as coming from one pot, from which all creditors may be satisfied. Spin off of respondent superior.

o Viewed as a single enterprise despite the existence of corporate formalities.o mixing pot of all subsidiaries idea

In re Silicone Gel Breast Implants (1995)

RULE: “If a parent corporation uses a subsidiary as its alter ego, as demonstrated by shared common directors or business departments, consolidated financial statements and tax returns, and an inadequately capitalized subsidiary, a plaintiff may assert its claims against the parent.”

Statement of the CaseBristol Myers Co. bought MEC and it is its sole shareholder. Bristol Myers sits on the board of directors of MEC. Bristol acts as MEC’s banker, sets its employment policies and wages, approves upper management hires, permits MEC employees to participate in Bristol Myers’ pension plans, funded tests on implant safety, monitored FDA regulations, audited MEC, tested MEC’s manufacturing process, and included MEC’s income on its federal tax returns. Plaintiffs brings products liability suit against Bristol Myers.

ISSUE: If a parent corporation exercised almost total control over the activities of its subsidiary, should the court allow the plaintiffs to pierce the corporate veil between the parent and its subsidiary?

HOLDING: YES; the court notes that when a corporation has a single shareholder, the potential for abuse is great. In determining the existence of an alter ego, a court should consider whether the entities had common directors or officers, common business departments, or consolidated financial statements and tax returns. The court may also consider whether the subsidiary is adequately capitalized or relies on the parent for its business, whether the parent pays the subsidiary’s expenses or uses the subsidiary’s property as its own, whether the subsidiary has separate daily operations, and whether the subsidiary observes basic corporate formalities. Evidence here concludes that these factors existed here to show that MEC was Bristol Myers’ alter ego. Here, the defendant is also liable for negligent undertaking which includes rendering services to another that are used to protect a third party. Under this theory, if a third party sustains an injury, the party indirectly involved may be liable for the harm that results from an absence of due care if the actor increases another’s risk of harm, performs a duty owed to another, and cause harm to a third party who relied on the actor to perform his actions properly. Bristol Myers allowed its name to be placed on the packages to boost customer confidence. It cannot complain now when it assumed the risk of purchasing MEC and thus putting its name on their products.


NOTE: Usually, the parent-subsidiary relation alone is never sufficient to hold a parent responsible for its subsidiaries’ torts. However, this case brought an exception since their activities were too inter-related.

Rule: When a corporation is so controlled as to be the alter ego or mere instrumentality of its stockholder, the corporate form may be disregarded in the interests of justice. (There is NO NEED to show fraud or misconduct in alter ego subsidiary cases.)

1. Totality of Circumstances: The totality of circumstances must be evaluated in determining whether a subsidiary may be found to be the alter ego or mere instrumentality of the parent corporation. Although the standards are not identical in each state, all jurisdictions require a showing of substantial domination. Among the factors to be considered are whether:

1. The parent and the subsidiary have common directors or officers2. The parent and the subsidiary have common business departments3. The parent and the subsidiary file consolidated financial statement and tax

returns4. The parent finances the subsidiary5. The parent caused the incorporation of the subsidiary6. The subsidiary operates with grossly inadequate capital7. The parent pays the salaries and other expenses of the subsidiary8. The subsidiary receives no business except that given to it by the parent9. The parent uses the subsidiary’s property as its own10. The daily operations of the two corporations are not kept separate11. The subsidiary does not observe the basic corporate formalities, such as

keeping separate book and records and holding shareholder and board meetings.

2. Negligent undertaking: (Tort) One who undertakes, gratuitously or for consideration, to render services to another which he should recognize as necessary for the protection of a third person or his things, is subject to liability to the third person for physical harm resulting from his failure to exercise reasonable care to perform his undertakings, if

i. His failure to exercise reasonable care increases the risk or harm, orii. He has undertaken to perform a duty owed by the other to the third person, or

iii. The harm is suffered because of a reliance of the other or the third person upon the undertaking

How can parent avoid the result in In re Silicon? The result could be avoided by maintaining separate entity identity before the public, keeping separate boards, meetings and policies. Parents should probably also make sure subsidiaries are adequately capitalized.

Parents have subsidiaries because:1. People like to invest in companies they understand2. Tax Reasons3. Regulatory Reasons4. Public Appearance Reasons5. Other reasons (mergers, etc…)

LLCs are pierce-able where there is an issue of fraud. This may occur when there is no separate bank account.


Frigidaire Sales Corporation v. Union Property, Inc. (1977)

RULE: “Limited partners are not liable for the debts of a LP simply by their statues as officers, directors, or stockholders of the corporate general partner as long as they conscientiously keep the corporate matters separate from their personal business and no fraud or manifest injustice results.”

Statement of the CaseFrigidaire contracted with Commercial Investors, a LP. Mannon and Baxter were limited partners who served as officers and directors on Union Prop. These two ran the day-to-day affairs of Commercial. When Commercial breached its contract with Frigidaire, Frigidaire sued Union Prop., Mannon, and Baxter. Frigidaire asserts that Union Properties is the alter ego to Commercial and that Mannon and Baxter are to be treated as general partners.

ISSUE: If a limited partnership’s general partner is a corporation, whose controlling members are also the limited partners in the partnership, may a creditor treat the limited partners as additional general partners?

HOLDING: NO; Limited partnership statutes allow a corporation to be an LP’s general partner. Minimal capitalization of the general partner does not necessarily mean that the limited partners must incur general liability because they control the general partner. If the general partner has been inadequately capitalized, a creditor may without remedy pierce the corporate veil to recover its loss. Frigidaire must look to Commercial and Union Properties to recover. Frigidaire knew UP was the general partner of Commercial and did not ask for the personal guarantees of the individual defendants. Commercial signed the contract and the plaintiff was not misled into believing the defendants were acting as anything other than corporate officers.

C. THE CAPITAL STRUCTURE OF CORPORATIONS

Corporate capital comes from the issuance of many types of securities. Securities describe many obligations including equity (shares of stock) and debt obligations (bonds). A debt security represents a creditor-debtor relationship with the corporation, whereby the corporation has borrowed funds from an outside creditor and promises to repay the creditor. A debt security holder has no ownership interest in the corporation. These obligations usually have a stated maturity date and a provision for interest. Debt obligations may be secured (a mortgage bond) or unsecured (a debenture) and may be payable either to the holder of the bond or to the owner registered in the corporation’s records. These bonds may convert into equity or may be redeemed at a specified price before maturity of the obligation.

An equity security is an instrument representing an investment in the corporation whereby its holder becomes a part owner of the business. Equity securities are shares of the corporation, and the investor is called a shareholder.

D. THE ROLE AND PURPOSE OF CORPORATIONS

All statutes provide that a corporation may be formed for any lawful purpose. Many state statutes still require that the articles specify what the corporation’s purpose or purposes are, but permit a general


statement such as the corporation is formed for general business purposes or to engage in any lawful business. At one time charitable donations were thought to be outside the scope of any business purpose, but most states now allow corporations to make these donations. Also, some courts formerly held that corporations did not have the power to make loans to employees, officers, or directors. Today, most states allow such loans.

General Rule- Corporations exist for the benefit of the shareholders

CHARITABLE DONATIONS Charitable donations are NOT ULTRA VIRES

o Ultra Vires is anything not within statute or articles of incorporation CL RULE: donations are a reasonable way to promote corporate objectives unless manifestly

unreasonable

A.P. Smith MFG v. Barlow (1953)

RULE: “A corporation may make charitable contributions, even in the absence of express statutory provisions.”

Statement of the CaseA.P. is a company that contributes regularly to colleges and the local community. The board donated $1500 to Princeton University and the shareholders rejected. The president thought this was sound business practice in promoting good will in the community. The donation also ensured interest by some of its top graduates. The shareholders argue that this act goes against the business purpose in the certificate of incorporation and that the statute the board relies on should not be applied retroactively.

ISSUE: May a corporation make charitable contributions in the absence of any specific authorization in the company’s charter or the state’s statutes?

HOLDING: YES; early in history it was believed that the corporation must derive a benefit from its contributions. However, since corporate economic wealth increased, many seek for these contributions. In times of crisis, corporations have provided donations to maintain societal survival. The law does not demand contributions, it encourages them and public policy supports these laws. The contribution was a lawful exercise of power.

DGCL § 122 “every corporation created under this chapter shall have the power to . . . (9) make donation for public welfare or for charitable, scientific or educational purposes, and in time of war or other national emergency in the aid thereof”

Public Policy Wealth has shifted to Corp. and we therefore need to encourage contributions for the arts and the benefit of society.

• There is no such thing as a Right to Dividends, they are discretionary

Dodge v. Ford Motor (1919)


RULE: “Although a corporation’s directors have discretion in the means they choose to make products and earn a profit, the directors may not reduce profits or withhold dividends from the corporation’s shareholders in order to benefit the public.”

Statement of the CaseFord was incorporated with sizeable money. Its majority shareholder was Henry Ford and its minorities were the Dodge brothers who received extraordinary dividends as the rest of the minority holders. The dodge brothers received 1 million in dividends. Hennery however wanted to use the profits to purchase an iron ore plant to make its own metal parts and he wanted to lower the price of his cars for the public good. Because of this, he lowered the shareholder dividends down to 120,000 dollars per year. The dodge brothers sued.

ISSUE: May courts interfere with a corporation’s internal operations by reviewing a board’s decision and ordering the payment of dividends to its shareholders?

HOLDING: YES; the court found that because Ford was receiving astronomical profits year to year and it furthermore practices the declaration of large dividends, the reduction of such dividends here is arbitrary. The court here did not find Ford to be making charitable contributions. A corporation is organized for the benefit of its shareholders. While a corporation’s directors may exercise discretion in deciding how to reach that goal, it cannot divert profits from its shareholders and devote them to other purposes. It is not lawful for a company to direct profits from the shareholders to others. As for its future goals, the court cannot interfere in such judgment.

RULE it is up to the BD’s to declare dividends. “Courts of equity will not interfere in the management of the directors unless it appears that they are guilty of fraud or misappropriation of corp. funds, or refuse to declare a dividend when the corp. has a surplus of net profits which it can, with out detriment to its business, divide among its stockholders, and when refusal to do so would amount to a abuse of discretion as would constitute a fraud, or breach of the good faith which they owe shareholders.” Decision to pay dividends must be based on the interest of the entire C, not individual SH.A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the non-distribution of profits among stockholders in order devote them to other purposes.Additionally, management may consider the long term interests of the corp. over the short tern interests of SH. C is not engaged in doing humanitarian work.

Shlensky v. Wrigley (1968) – Business Judgment Rule

RULE: “A shareholder fails to state a cause of action unless it alleges that a corporation’s directors’ conduct was causing financial loss to the shareholder and was based upon fraud, illegality, or conflict of interest.”

Statement of the CaseShlensky is a minority shareholder of the Chicago NL Ball Club which manages the Chicago Cubs. The club also manages Wrigley Field and is responsible for television and radio broadcasts, concession sales, etc. Shlensky claims that the cubs are the only team that plays in the daytime and that because we play in the day, we lose revenue. The last four years, the cubs have sustained financial loss which can be attributed to poor attendance. Shlensky believes management should install lights and thus upgrade the


facility. Wrigley however refused this advice due to his concern about the quality of the neighborhood surrounding the park. Wrigley said if they relocated, the cubs would be able to play at night.

ISSUE: Does a shareholder’s action that seeks to overturn a board’s decision and does not make allegations of fraud, illegality, or conflict of interest state a cause of action?

HOLDING: NO; courts have historically given broad discretion to corporate managers for making policy decision and typically give due regard for the board’s decisions unless the decisions are tainted. Here, Wrigley chose not to install lighting due to the neighborhood that surrounds the park. Without some showing that the defendant’s actions are based on fraud, illegality, or a conflict of interest, a court should not interfere, especially because the plaintiff did not prove that the Cubs’ revenues would increase with night games. With no correlation between installing lights and an increase in the company’s revenues, the plaintiff has failed to establish serious and irreparable harm to the shareholders. Directors are elected for their business judgment and courts cannot order their decisions to be disregarded simply because others may disagree.

o Rule: The case stands for the proposition that courts are not going to interfere in companies’ short term decisions involving questions of policy and business management. The directors are chosen to pass upon such questions and their judgment unless shown to be tainted with fraud, illegality or conflict of interest. You can find a reasonable short or long term profit motive, court will leave you alone.

NOTE: conflict of interest is a real or seeming incompatibility between one’s private interests and one’s public or fiduciary duties.

Public Policy: Justifications for the Business Judgment Rule include : 1) Slippery slope if the court entered the board room2) Courts are in the business of law, not business; courts are poor judges of business reality. 3) The market is the best judge of business decisions4) Courts do not want directors to fear liability when making business decisions-would deter risk taking, which would affect the overall economic performance of corps. A certain amount of risk taking and innovation is essential for businesses to grow and proper.5) Shareholders assume the risk voluntarily (Shareholder sovereignty)

If it’s really bad for the Company, shareholder can:• vote the directors out of office• sell their shares• They should be the one to do something when they do not like their behavior (but shareholders have many procedural handicaps.)

6) After the fact litigation is not a good way to evaluate business decisions gone bad. A reasoned decision may seem a wild hung viewed years later against a backdrop of perfect knowledge.7) Judicial Economy: fewer lawsuits

*********************************************************************III. THE DUTIES OF OFFICERS, DIRECTORS,

and SHAREHOLDERS *********************************************************************

A. THE OBLIGATIONS OF CONTROL: THE DUTY OF CAREBusiness Associations/Garten/Fall 2008 45

BUSINESS JUDGMENT RULE THE EXAMINATION OF THE FIDUCIARY DUTY OF CARE AND DUTY OF LOYALTY

Under Delaware law, the Business Judgment Rule is the offspring of the fundamental principle,

codified in § 141(a), that the business and affairs of a Delaware corporation are managed by or under its board of directors…. The rule itself is a “presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company and therefore even though they make decisions that give rise to financial losses to the corporation, they are not personally responsible for that loss. This encourages risk-taking. If liability would incur, there would be no directors due to fear of lawsuit. The genius of corporate law allows the board of directors to do what they do best, which is manage the business > Passive investors committing their funds to an enterprise which then will be run under the direction of the board of directors who then appoint officers who take care of the day-to-day tasks of the corporation.

NOTE: The Duty of care is the objective standard as such that it is measured as to what a reasonable director or officer would have done in that predicament. The breach of such care is triggered by some wrong action by management or by no action or omission resulting form inattention. Exception: Special skills heighten the standard. Examples include CPA, lawyer, banker, etc… If one of these professionals learns of facts that would make someone in his position suspicious, he must investigate those facts. Defendants will not be responsible if they relied on the report or opinion of an expert. BUT- reliance must be reasonable

Who makes the decisions? If there is a fundamental decision as to dissolution, sale of all assets, amending the articles of incorporation, mergers and acquisitions, etc., the board of directors cannot make this decision on its own. Shareholders have the ability to act when their interests are being substantially affected which is provided in the statute.

The dichotomy of powers between the board of directors and shareholders – shareholders elect board of directors…this is a proper subject for shareholder action, not officer issues as to the day-to-day affairs of the corporation. Shareholders may propose amendments to the bylaws; some have the power to amend the bylaws in certain states.

Board of directors is required to provide shareholders with notice for meetings, quorum, and voting requirements.RULE it is not the function of courts to resolve for corporations questions of policy and business management. The judgment of the Board of Director’s enjoys the benefit of the presumption that it was formed in good faith and was in the best interests of the corporation.

“In actions by stockholders, which assail the acts of their directors or trustees, courts will not interfere unless the powers have been illegally or unconscientiously executed; or unless it be made to appear that the acts were fraudulent or collusive, and destructive of


the rights of the stockholders. Mere errors of judgment are not sufficient as grounds for equity interference, for the powers of those entrusted with corporate management are largely discretionary.” Leslie v. Lorillard.

“Courts will not interfere with such discretion unless it be first made to appear that the directors have acted or are about to act in bad faith and for a dishonest purpose. It is for the directors to say, acting in good faith of course, when and to what extent dividends shall be declared… The statute confers upon the directors this power, and the minority shareholders are not in a position to question this right so long as the directors are acting in good faith.” Liebman v. Auto Strop Company.

ALI § 4.01(c) A director or officer who makes a business judgment in good faith fulfills the duty of care of the director

1. is not interested in the subject of the business judgment (no conflicting self interest)

2. is informed w/ respect to the subject of the business judgment to the extent the director or officer reasonably believes that it is appropriate under the circumstances (adequately informed)

3. Rationally believes that the business judgment is in the best interests of the corporation (not a wholly irrational response). There must be no fraud, illegality, or conflict of interest.

Though high deference is granted to the directors of a corporation, the Business Judgment Rule is NOT absolute.

Burden on the plaintiff. If the plaintiff rebuts the presumption, then you force the directors to justify their conduct and the case would go to trial.

Scrutinizes the process by which the director makes his decision while giving very little examination to the decision itself “Business decisions made upon reasonable information and with some rationality do

not give rise to discretional liability even if they turn out badly or disastrously from the standpoint of the corporation.” Other than in special situations like MERGERS and PUBLIC OFFERINGS where DUE DILIGENCE of investigation is required, the directors can rely on the information provided them by officers and other employees, as long as the reliance is REASONABLE and in HOOD FAITH.

It is a process orientated analysis, does not address the wisdom of the decision itself – even when procedures are not followed, most courts impose liability only in cases of gross negligence or recklessness. And conflict of interest.

MORE THAN IMPRUDENCE OR MISTAKEN JUDGEMENT MUST BE SHOWN TO FALL OUTSIDE BUSINESS JUDGMENT RULE

courts will only interfere with a board’s decision to issue dividends when FRAUD, OPPRESSION, ARBITRARY ACTION OR BREACH OF TRUST is established


Kamin v. American Express Company (1976) – Duty of having a rational basis (Duty of Care)

RULE: “A complaint alleging that some course of action other than that taken by the board would have been more advantageous does not give rise to a cause of action for damages.”

Statement of the CaseShareholders brought a derivative action, asking for a declaration that a certain dividend in kind was a waste of corporate assets.

ISSUE: Are directors liable to stockholders for losses if a different action than that taken would have been more advantageous?

HOLDING: NO; directors are liable only if their actions were illegal or unconscionable. Errors in judgment do not warrant suits in equity. In order for a director to be negligent for his decision-making process, the plaintiff must show that fraud, dishonesty, or malfeasance was present. The board had a rational basis for its decision as such that it said if we sold the shares, and recognized the loss, it would have a depressing effect on our stock price. The plaintiffs allege that it was not compelling. However, it needs not be compelling; it needs to be supported by one school of thought.

NOTE: Public Policy concerns – if potential for liability were expanded to include situations in which other avenues turned out to be more advantageous, the liability could encompass virtually every decision made in a corporate setting. If a director is to be open to liability for his or her uncompromised decisions, few people will seek out or accept a position on a board.

REQUIREMENTS IN APPLYING BUSINESS JUDGMENT RULE: If there is within the business judgment of the directors, there is a presumption that the decision is correct and the court will not interfere. Court will first look to see if proper procedures have been followed:

(1) THERE MUST BE NO SELF DEALINGo If a director is a party to a transaction or otherwise has some financial stake in the outcome that

is adverse to the corp’s stake, BJR does not apply.

(2) THE DECISION MUST BE INFORMEDo the director or officer must have gathered at least a REASONABLE AMOUNT OF

INFORMATION about the decision before me made ito a totality of the circumstances will be examined in deciding whether or not a decision was

informed o the standard is grossly negligent

Smith v. Van Gorkom (1985) – Duty to make a reasonable investigation (Duty of Care)

RULE: “The Business Judgment Rule presumes that when making business decisions, directors act on an informed basis in good faith and in the company’s best interests.”

Statement of the Case The process of becoming informed is extremely important to invoke BJR.


Director Defendant was approached with an offer to sell the corporation for $55 a share while shares were selling for $39 on the open marketWhen Director Defendant presented this opportunity to sell to the Board of Directors, they hastily made the decision to sell without being well-informed on the topic. Initially, they dissented but eventually agreed due to the persuasion by Van Gorkem when he made several amendments. Prior to finalizing the deal, Van Gorkem did not consult with the board about the financing of their shares, nor did he want the comptroller to do the same. Van Gorkem thought it was good to sell the company to Pitzer. There were no investment bankers present. Here the Investment bankers hired too late and for the wrong purpose (to solicit competing bids instead of appraise the one already offered).the board was not shown a proposed merger agreement Board of Directors passively relied on Director defendant’s oral statements in making their decision Board of Directors didn’t even know the actual value of their own company which can be obtained through a FAIRNESS OPINION (in this opinion, a reliable third party renders the value of the company)Director defendant made the offer, not the acquirerBoard of Directors made no real attempt to learn the intrinsic value of the corp. by conducting due diligence (availing themselves of all relevant informationBoard of Directors made the decision to sell in a 2 hour meeting with no advance notice

ISSUE: Is a board negligent in approving a proposed cash-out merger, if the merger was not the product of informed business judgment, the board acted in a grossly negligent manner in approving amendments to the proposal, and the board failed to disclose all material facts that they knew or should have known before obtaining the stockholders’ approval?

HOLDING: YES; a party alleging that the board’s decision was not informed must rebut the presumption that it is well-informed. To do so, the directors must have considered all information reasonably available to them before making the decision. If they do not make an informed decision, they must cure any defects in their decision as soon as they learn the problem. Here, the directors approved the merger without determining Van Gorkem’s role in the process. The board did not know of the corporation’s intrinsic value, nor did it have prior notice. The board here was not properly informed nor did they cure the defects in its decision. They approved amendments without waiting for them to be drafted for review.

Court found GROSS NEGLIGENCE despite the fact that the selling price was much higher than the market price for shares ever was. No informed decision. The meeting lasted only 2 hours as such the board could never propose any analytical questions as to the sale of their company; there was no materials circulated in the meeting in regards to the sale; the board never received inside or outside reports as to their actual stock value

Consequences of Smith v. Van Gorkem- Boards immediately hire investment

bankers today before making any deals (FAIRNESS OPINIONS). Also, states have changed their laws to limit liability or shield ONLY directors, NOT OFFICERS from personal liability for breach of their duty of care (NOT LOYLATY). Del. Corp. Law § 102(b)(7)- allows corporations to limit liability for breach of Duty of Care in charter except in cases of self-dealing or intentional misconduct. However, liability limited only to shareholders, not to 3rd parties. Statutory change in response to exorbitant increase in insurance costs.

PUBLIC POLICY : Directors must often make quick decisions with huge impacts. Directors must trust that if their decision looks poor in hindsight, they cannot be sued if


they made their best efforts to understand the factors relating to the issue. If they are not shielded from liability in those situations, business decision making processes will be hindered by directors worrying whether they have adequately covered their steps.

(3) THE REQUIREMENT OF A RATIONAL BELIEFo the director must have RATIONALLY BELIEVED that his business judgment was in the

corp.’s best interest

BJR only protects directors from personal liability for negligence if they have not violated their duty of loyalty to the corp.

P must show fraud, illegality or conflict of interest

Exceptions To Business Judgment Rule:

1. when the corp. decision lacks a business purpose2. when the corp. decision is tainted by a conflict of interest3. when the corp. decision is so egregious to amount to a no-win

situation4. when the corp. decision results from an obvious and prolonged

failure to exercise oversight or supervision

JUST BECAUSE A CORP MADE A BAD DECISION MEANS DOES NOT MEAN IT’S GUILTY. BJR PROTECTS AGAINST THIS

DUTY OF CARE

“A director’s duty of care does not exist in the abstract, but must be considered in relation to specific obliges. In general, the relationship of a corporate director to the corporation and its stockholders is that of a fiduciary. Shareholders have a right to expect that directors will exercise reasonable supervision and control over the policies and practices of a corporation. The institutional integrity of a corporation depends upon the proper discharge by the directors of those duties.”

The duty of care has three distinct elements: the obligation to be attentive, the obligation to carry out a reasonable investigation (must be informed under a reasonable basis), and the obligation of having a rational basis for your decision. The burden is on the plaintiff in proving that this presumption is inapplicable because there is a prima facie case for a breach of fiduciary duty of care. The plaintiff also has to prove that the losses were the proximate cause of the breach of duty.

Definition- The law imposes on a director or officer a duty of care with respect to the corporation’s business.

Procedure – Director is given the presumption of good faith and Plaintiff has the burden of presenting a prima facie case of breach of duty. If that is shown, then the burden shifts to the Director to show that they just made the right business decision.


Success – Breach of duty of care cases are generally successful ONLY when there is reckless, or grossly negligent behavior.

NOTE: a knowing violation of a criminal statute automatically removes the protection of the business judgment rule from the directors and officers. That does not mean they are automatically liable unless the plaintiff can prove that there was a net loss – if the company has benefitted from the criminal violation as such to exceed its losses, no harm, no foul, thus no recovery. The plaintiff has to prove that crime did not pay.

States Attempts to Limit the Duty of Care:· Some states allow articles of incorporation to include limitations on liability · Some states require outrageous conduct for a breach· Some states limit the amount of money damages that can be awarded· Most states allow the corporation to indemnify for liability

Officers & Directors are required to behave with the level of care that a reasonable prudent person in a similar situation would use

Shareholders often assume the risk of bad business judgment, after the fact judgment is an imperfect device to evaluate business decisions, and if liability were imposed too readily it might deter many persons from serving as directors.

Officers & Directors may be held personally liable for money damages to the corporation (through a derivative suit), if their breach of the duty of care causes loss to the corporation

Corporations however protect their Officers & Directors by purchasing insurance Rare that courts find a violation of the duty of care, most successful actions

against Officers & Directors are based on breach of duty of loyalty Courts should not look into the content of Director’s decision, only the process (BJR)

To bring an actionable claim, P must show when fraud, oppression, arbitrary action, or breach of trust is established

Director’s duty to monitor – a lack of monitoring requires sustained and systematic overlook of the board.

DUTY TO MAKE INFORMED DECISIONS REGARDING THE CORPORATION Officers & Directors must act in an informed basis, availing themselves to all

material info reasonably available Officers & Directors may not passively rely on info provided by other Officers &

Directors duty to make further investigations on credible info provided by competent

individuals Smith v. Van Gorkom

DUTY TO DISCLOSE: A combination of the fiduciary duties of care and loyalty gives rise to the requirement that a director disclose to shareholders all material facts bearing upon a merger vote.


DUTY RE: COMPENSATION OF OFFICERS & DIRECTORS:

Brehm v. Eisner (2000) – Can be applied to Duty of Loyalty

RULE: “In order to constitute waste, an exchange must be so one-sided that no person of a reasonable mind would have entered into it.” – THE WASTE TEST IS VERY STRINGENT

Statement of the CaseEisner, CEO for Walt Disney hired Ovitz to be President. Ovitz has no managing experience. However, he was rewarded a very lucrative contract with favorable provisions. Upon resigning, he received over 15 million dollars under the provisions of his contract and the vesting of 3 million A-stock shares. A derivative suit was brought by Brehm and other shareholders due to the extravagant and wasteful employment package Ovitz received. Plaintiff alleged that the Board failed properly to inform itself about the total costs and incentives of the Ovitz employment agreement, especially the severance package.

ISSUE: Are corporate directors personally liable for lack of adequate care in the decision-making process that results in a waste of corporate assets?

HOLDING: YES; if the directors fail to use adequate care in decision making process and waste corporate assets, they are personally liable to the corporation for their breach of fiduciary duty. The waste test is stringent so the courts grant enormous deference to the officers and directors. The size and structure of executive compensation are matters of judgment, so waste regarding executive compensation generally involves squandering money irrationally or giving away corporate assets. Each director has a duty to be informed of all information material to his or her decisions. Here, the board relied on expert testimony in determining financial pitfalls. The board’s decision here does not constitute waste.

NOTE: Courts will not use the doctrine of waste to punish directors simply because a decision results in economic hardship to the corporation or its stockholders.

Rule: Legal presumption that the board’s conduct was a proper exercise of business judgment. That presumption includes the statutory protection for a board that relies in good faith on an expert advising the board. Rule: In making business decisions, directors must consider all material information reasonably available, and that the directors’ process is actionable only if grossly negligent. This does not mean that the board must be informed of every fact. The board is responsible for considering only material facts that are reasonably available, not those that are immaterial or out of the board’s reasonable reach.

In order to pass the Waste Test, Plaintiff must allege particularized facts and show that:

• the directors did not in fact rely on the expert;• their reliance was not in good faith;• they did not reasonably believe that the expert’s advise was within the expert’s professional competence;


• the expert was not selected with reasonable care by or on behalf of the corporation, and the faulty selection process was attributable to the directors;• the subject matter that was material and reasonably available was so obvious that the board’s failure to consider it was grossly negligent regardless of the expert’s advice or lack of advice;• That the decision of the board was so unconscionable as such to constitute waste or fraud.

Waste Test: an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.

DUTY TO KEEP INFORMED AND TO OBJECT at a minimum, Officers & Directors should acquire a rudimentary understanding of the

business a lack of understanding cannot be a defense

Basic Obligations of Officers & Directors (1) Continued obligation to keep informed (attend meetings)(2) General monitoring of corporate affairs and policies

even where the Board has no prior reason to detect wrong doing, they are required to have in place reasonable control systems to detect wrongdoing

(3) Familiarity of financial status (or be informed about the performance of the company)(4) Be vigilant and make the appropriate degree of inquiry(5) Duty to object

correct conduct/ resign when illegal conduct is discovered failure to do so amounts to “passive negligence” or nonfeasance

(6) Act for the general welfare of the corporation

Francis v. United Jersey Bank (1981) –Duty to be attentive

RULE: “Directors have the duty to act honestly and in good faith and with same degree of diligence, care, and skills that a reasonable prudent person would use in similar circumstances.”

Statement of the CaseLillian Pritchard inherited 48% interest in P&B Company from her husband. She was the largest shareholder and director but was not active in the business and knew nothing of its dealings. She also paid no attention to her duties as director and she also had alcohol problems. Her sons Charles and William were also directors and owned the remaining shares. Charles was the manager. The sons withdrew a large sum of money in the form of loans in which they should have been held in trust for its clients. (Embezzlement) The company went bankrupt after the misappropriation of the funds. Lillian died thereafter and made no effort to ensure that the company’s policies and practices complied with industry custom or laws. The corporation’s bankruptcy trustee sued to recover the funds for the benefit of the bankrupt estate.

ISSUE: Can an inattentive and uninterested director be held liable for a corporation’s actions?


HOLDING: YES; corporate directors are usually afforded broad immunity for their decisions and actions related to corporate matters. However, the director of a corporation stands in a fiduciary relationship to both the corporation and its stockholders. Inherent in this role is a duty to acquire a basic understanding of the corporation’s business, and a continuing duty to keep informed of its activities. This entails an overall monitoring of the corporation’s affairs, and a regular review of its financial statements. Such a review may present a duty of further inquiry. Pritchard had a duty to protect the clients of company against policies and practices that would result in the misappropriation of money they had entrusted to the corporation. She breached and blatantly ignored that duty to the shareholders, which included basic knowledge and supervision of business.

NOTE: When a director has no working knowledge of a business, a director may either make an inquiry to gain the necessary knowledge or the director may refuse to act and step down. It is obvious that if the director refuses to act, someone needs to act in his or her place. However, the director must make a wise choice if delegating duties and must closely monitor persons making decisions on the corporation’s behalf.

Informed decision: The business judgment rule shields directors or officers of a corporation from liability only if, in reaching a business decision, the directors or officers acted on an informed basis, availing themselves of all material information reasonably available. Therefore, under the business judgment rule there is no protection for directors who have made “an unintelligent or unadvised judgment.” DL § 141(e)

DUTY TO SUPERVISE/MONITOR A director’s obligation includes a duty to attempt in good faith to assure that a corporation’s

information and reporting system (in which the Board concludes as adequate) exists; and the directors have an affirmative duty to set up monitoring systems to prevent illegal acts by employees, even before they suspect illegal activity.

o failure to do so under any circumstances may render a director liable for losses caused by non-compliance with applicable legal standards

Absent grounds to suspect deception, neither corporate boards/officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company’s behalf.

BUT Even where the Board has no prior reason to detect wrongdoing, they are required to have in place

reasonable control systems to detect wrongdoing If an officer or director are put on notice of facts that would make a reasonable

person suspicious that wrongdoing is taking place, they must act.

In re Caremark International Inc. (1996)

RULE: “Although directors have a duty to monitor a corporation’s ongoing operation, they are not liable for wrongdoings of which they had no real or constructive knowledge.”

Statement of the CaseCaremark’s shareholders have brought an action claiming that Caremark’s Board of Director’s breached their fiduciary duty of care by failing to adequately supervise the conduct of the Caremark employees whose violations initiated the suit.

ISSUE: Are directors always liable for breach of duty for their failure to monitor the corporation’s ongoing business operations?


HOLDING: NO; directors are not liable for activities they know nothing about or have reason to know about. If directors have no grounds to suspect deception by their employees, they cannot be liable for assuming their employees are acting honestly and diligently on their behalf. The degree to which directors monitor employees at each level is a question of business judgment, best left up to the corporation. No evidence here shows that Caremark’s directors knew of any wrongdoings or that they should have known of such wrongdoings. Caremark’s managers believed the employees were not doing anything illegal.

NOTE: Requiring directors to manage the day-to-day activities of each employee would waste resources and is not feasible in large corporations. Also constant monitoring would hinder workplace progress.

Directors are protected from liability if their decision was the product of a process that was either deliberately considered in good faith or was otherwise rational.

Absent cause for suspicion there is no duty upon the directors to install and operate corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.

Breach of duty of care for lack of monitoring requires a sustained or systematic failure of the board to exercise oversight.

The level of detail that is appropriate for the requisite information system is a question of business judgment.

ESTABLISHING A CAUSE OF ACTION FOR A BREACH OF DUTY TO SUPERVISE/CONTROL

the directors knew or should have known that violations of the law were occurring, and in either event that the directors took no steps in a good faith effort to prevent or remedy

the situation and that such failure was the proximate cause of the alleged loss

DGCL §102(b)(7): Provision eliminating/limiting the personal liability of a corp. director or its Shareholders for monetary damages for breach of fiduciary duty as a director, provided that such provision not eliminate or limit the liability for (i) breach of duty of loyalty to the corp.; (ii) for acts of omissions not in good faith or which involve intentional misconduct or a knowing violation of the law (iii) relating to the payment of dividends or (v) for any transaction from which the director derived an improper personal benefit

allows corps to limit the liability of their Officers &Directors for breach of duty, BUT NOT BREACH OF LOYALTY

Passive negligence: A director will not be liable merely for failing to detect wrongdoing by officers or employees. However, if the director is on notice of facts suggesting wrongdoing, he cannot close his eyes to these facts. Also, in large corporations, it may constitute a violation of due care for the directors not to put into place monitoring mechanisms (e.g., stringent internal accounting controls, and/or an audit committee) to detect wrongdoing. Joy v. North• Absent directors are held to the same standard as directors who attended the meeting during which the board approved a particular action.


B. THE DUTY OF LOYALTY

A director owes a duty of loyalty to her corporation and will not be permitted to profit at the expense of the corporation. The problems in this area involve the (1) director’s dealings with corporation and their potential conflict of interest; (2) their dealings with third parties and their usurpation of a corporate opportunity; and (3) their dealings with shareholders, which may raise insider trading issues. Directors are obligated to act in a manner to advance the interests of the corporation. Thus they must act in good faith. In sum, the officers and directors breach their duty of loyalty by acting greedy – they put their own financial interests ahead of the interests of the corporation or its shareholders.

NOTE: The Duty of Loyalty looks at a director’s intent, motives, and purposes, and if they are in conflict with the corporation, then a director will be seen to have violated his duty of loyalty. This is a subjective standard. Immunity shields in state statutes protect directors from breaches in a duty of care, not loyalty.When is the Duty of Loyalty invoked?

1) Interested Contracts2) Corporate Opportunity3) Defection to a Competing Business4) Insider Trading

INTERESTED CONTRACTS (Conflicts of Interest)

NOTE: this precludes the application of the Business Judgment Rule.

§ 144(a) No contract or transaction between a corporation & 1 or more of its directors or officers or between a corporation and any other corporation …shall be void or voidable solely because the director has a financial interest or participates in the meeting of the board that authorizes the transaction, or because his votes are counted, if:

(1) the material facts are known to the board or fully disclosed to the board and the board authorizes the transaction in good faith by affirmative vote of disinterested directors and the interested director abstains from voting; or

(2) same language… disclosed or known to the shareholders entitled to vote and approved in good faith by vote of the shareholders; or

(3) the contract or transaction is fair to the corporation as of the time it is authorized, approved, or ratified by Board, committee, or Shareholders


Interested Director must disclose and abstain under § 144(A)(1) & (2)

If requirements of § 144(A)(1) or (2) are followed, P has the burden of defeating the BJR

much more common than breach of duty

BE AWARE OF THE STRUCTURAL BIAS AND HOW IT MAY COME INTO PLAY there may be an element of “you scratch my back and I’ll scratch yours” within the BOD

§ 144(a) Arises and is invoked in 3 instances(1) Key player and corporation are on opposite sides(2) Key player has helped influence the corporation’s decision to enter the transaction(3) Key player’s personal financial interests are at least potentially in conflict with the financial interests of the corporation

WORKING FOR A COMPETITOR Director may not compete with a corporation where his competing is likely to harm the corporation director violated duty simply by preparing to compete director may have his competing actions approved by disinterested directors, ratified by shareholders

after a full disclosure

• where a director has a personal interest in a transaction which his corporation is considering, he is ordinarily obliged to a) disclose that interest to the entire board of directors; b) refrain from voting upon it; and c) disclose any information indicating that the transaction may not be in the corporations’ best interests (thus the contract must be fair to the corporation).

Old Rule- Plaintiff must prove that the director has an interested stake in the outcome of the transaction so that her advocacy on behalf of the corporation is biased, and that this director had the ability to influence the other directors. Thus a mere showing that a director or officer had a financial stake on both sides of a transaction was enough to void the transaction. It would not have matter whether the corporation benefitted from the transaction. This rule was eventually changed because it is sometimes favorable to have interested parties on the Board.

New Rule- Codified in Del. § 144(a)(1-3): The general approach of these statutes is that even if there is a conflict of interest, the transaction is not voidable if certain statutory tests are met. In Delaware, its statute incorporates a three step process of analysis: (1) Is the transaction within the statute? [A transaction falls within the statute if the transaction is between the corporation and an officer or director of the corporation who has a direct or indirect interest in the transaction] (2) What is required by the statute to avoid voidability? [First, full disclosure of all material facts concerning the conflict of interest and the transaction; second, ratification


of the transaction by a majority of the disinterested directors; third, if cannot get director or shareholder ratification, the interested party can still defeat voidability if one can meet the burden of proving that the transaction was fair. (3) What is the effect of satisfying the statute? [If the requirements of the statute are satisfied, the transaction is not voidable, even though there was a conflict of interest].PLAINTIFF’S BURDEN ProcedurePlaintiff must show that the Board knew of the officer/member’s personal interest (must be financial) and that the decision was approved through a formal meeting and vote amongst only interested parties. If he satisfies that burden, then it shifts to the Defendant to show that their actions complied with § 144(a)(1) or that the decision was fair to the company. If established, BJR attaches and no liability found.

RULE a proponent of the contract must affirmatively establish that the contract was fair and reasonable as to the corporation at the time it was approved by the board § 144(A)(3)

There are three ways of overcoming direct and indirect conflicts of interest: (1) full approval by the board of directors (disclosure) and by a majority approval of the disinterested board members, (2) full approval to the shareholders (disclosure) and approval by a majority of the disinterred shareholders, (3) if neither of these occur, the burden of proof is on the interested party to uphold the transaction as such to show that there was full disclosure of all material facts, it has a benefit to the corporation, and there were disinterested approval. If no disinterested director or shareholder can be obtained, then the transaction can be upheld by showing that it is fair.

· Interested contract is ok so long as the Board is aware of the conflict and the vote is conducted only amongst disinterested parties (disclose & abstain rule)· Interested contract is ok in a closely held corporation so long as the director tells the shareholders and abstains from the vote.· Interested contract is ok if it is fair to the corporation at the time it is authorized, approved or ratified by the Board, committee, or shareholders.

Standard Does director have personal stake? Did this stake lead him to make bad decisions? Did it sway his judgment? Did director have enough clout to sway the whole Board (Structural Bias)? Is there an “appearance of impropriety?”

a director’s dealings with the corporation are subjected to rigorous scrutiny burden is on the director to (1) prove the good faith of the transaction, and

(2) show the inherent fairness from the point of view of the corporation

Bayer v. Beran (1944)

RULE: “A director does not breach his or her fiduciary duty by approving a radio advertising program in which the wife of the corporate president, who was also member of board of directors, was one of the featured performers.”

Statement of the CaseCCA has been advertising its products at a high rate, but also got one of their directors to campaign by singing. This director is the wife of CCA’s president. When the FTC announced that all of their


products had to be labeled rayon, they believed it would hurt their sales so they had to advertise to the public to gets their message across. They spent 1 million per year. Bayer and other shareholders brought a derivative action for breach of fiduciary duty in approving this radio advertising program.

ISSUE: Does a director breach his fiduciary duty by approving a radio program in which the wife of the corporate president, who is a member of the board, was one of the featured performers?

HOLDING: NO; directors have no duty to act out of self-interest, which is known as the rule of undivided loyalty. The rule’s purpose is to prevent fraud. The court may apply the rule in situations where the director stands to benefit personally from the transaction or works so closely with the third person that he may take advantage of that person for his own benefit. The directors here did not breach that duty. The evidence does not show that program was to enhance the wife’s career or give her financial benefit. She is only one of several performers on the program and is well-known before the program campaign. Her wages were comparable to other performers. Furthermore, the show was successful and produced revenue for the corporation. Though there was no disclosure of the program campaign, it was nonetheless inherently fair.

o Court found under the modern day §144(a)(3) standard that although he didn’t disclose and abstain to the board his conflict, the contract was still fair for the corp.

o The general rule is that Board members acting separately cannot bind the company. Here, subsequent actions of the full Board indicated that the decision was approved. However, the Board was required to observe the formalities in the future. BUT than what is the point of having a formal board and strict rules of corporate formality? * CONFLICTS of INTEREST * hurt the Shareholders of a corporation. To find a

conflict, you ask: 1. does the director have a personal stake (substantial interest) that will bias a business decision and 2. Does the interested director have the clout to sway other independent directors to share the same bias?

If a plaintiff can show the director has a bias and the directors went a long with that bias, a court may still allow the interested contract to stand.

Lewis v. S.L. & E. Inc. (1980)

RULE: “A transaction in which a director has an interest, other than as the corporation’s director, is automatically suspect and subject to further review.” – DIRCTORS MAY NOT ENGAGE IN SELF-DEALING

Statement of the CaseLGT occupied SLE premises through a lease. Managers of LGT were also shareholders of SLE and SLE shareholders have not met in quite sometime. LGT ignored the corporate existence to SLE, not taking into account its other shareholders and their needs though most decisions made by SLE largely benefited LGT.

ISSUE: Do directors commit waste by failing to charge adequate rent for property out of self-interest?

HOLDING: YES; a director’s interest in a transaction other than the corp.’s interest is subject to review unless the director can prove it is fair and reasonable to the corporation. Here Ds’ failed to prove that the rental paid by LGT to SLE was fair and reasonable. There was no evidence that the parties tried to uncover the fair rental value. SLE had a strong interest in the amount of money LGT paid them since they were not on the corporate board for LGT and LGT sat on their board.


o Rule: BJR presupposes that there isn’t a conflict of interest. Directors may not immunize their actions under the BJR where a shareholder demonstrates a conflict of interest.

o Rule: a contract between a corporation and an entity in which its directors are interested may be set aside unless the proponent of the contract shall establish affirmatively that the contract or transaction was fair and reasonable as to the corporation at the time it was approved by the board.

CORPORATE OPPORTUNITIES (DISCUSS BOTH AMERICAN LAW INSTITUTE AND GENERAL TEST)

This doctrine only applies in cases where the fiduciary’s seizure of an opportunity results in a conflict between the fiduciary’s duty to the corporation and the self-interest of the director. PUBLIC POLICY: You don’t want directors to exploit the board for personal reasons/interests

Seizing a corporate opportunity violates the basic rule that directors and officers cannot utilized their positions with a corporation to whom they owe fiduciary duties to profit personally at the expense of the corporation. However, this may be difficult to apply since courts try to strike a balance between 2 conflicting policies (1) discouraging disloyal behavior by directors and officers toward the corporations they serve; and (2) permitting directors and officers of corporations to engage in entrepreneurial activities in their individual capacity. Over the years, courts have not developed a clear test to determine which opportunities belong to the corporation and which opportunities the directors and officers may take for themselves.

FIVE major approaches of determining whether an opportunity is a corporate opportunity:

(1) Interest or expectancy – imposes the least demands on the directors or officers in terms of seizing the opportunity; thus, this restricts a director or officer from taking property or a business opportunity for himself where the corporation has an existing interest in the property or opportunity or has an expectancy growing out of an existing interest, i.e. leasing space in a building, (2) Line of business test (General Test) – wide/liberal test – an officer or director must turn over to the corporation any opportunity which is in, or relates to, the corporation’s business (what are the activities the company is currently engaged in or likely to engage in).

If a corporate officer or director is presented with a business opportunity which the corporation is financially able to undertake, is in line with the corporation’s business, is of practical advantage to it and is one in which the corporation has an interest, the self-interest of the officer or director will be brought into conflict with that of the corporation, the law will not allow him to seize the opportunity for himself.

“If there is presented to a corporate officer or director a business opportunity which the corporation is financially able to undertake, is from its nature, in line of the corporation’s business and is of practical advantage to it, is one which the corporation has an interest or a reasonable expectancy, and, by embracing the opportunity, the


self-interest of the officer or director will be brought into conflict with that of the corporation, the law will not permit him to seize the opportunity for himself.” Guth v. Loft.

GARTEN DOESN’T LIKE THE GENERAL TEST because how can you determine if a corporation is financially able to undertake the venture?

its not fair that decisions can be made by a single individual with everything to gain without going to board first

that’s why the ALI approach is preferable in this analysis they can always raise funds or take on a debt to seize the corporate

opportunity DAMAGEScourt may impose (1) a constructive trust – transferring the property attached to the

opportunity to the corp., and (2) an accounting for profits

(3) Fairness test – seizing a corporate opportunity is a matter of fairness. Courts apply several factors such as (1) did the information come to the defendant by reason of his position with the corporation, (2) how important the opportunity was to the corporation, (3) was the corporation seeking the opportunity, (4) whether the defendant used corporate funds or facilities in acquiring or developing the opportunity, and (5) whether the corporation had the resources to develop the opportunity.

(4) Multi-factor test (2 step test) – this test combines the line of business test with the fairness test. The court first determines whether the opportunity is within the corporation’s line of business, if it is within the line of business, then the court considers whether it was nevertheless fair for the defendant to pursue the opportunity. The burden of proof is on the plaintiff as to whether the opportunity falls in line with the business. If the plaintiff meets this burden, then the burden shifts to the defendant to show that despite being in the same line of business, defendant’s taking of the opportunity was fair based on equitable considerations.

(5) ALI Test – defines a corporate opportunity as a business opportunity that (1) the director of officer becomes aware of in his corporate capacity or through the use of corporate information or property, which the director or officer should reasonably know is being offered to the corporation or reasonably believes would be of interest to the corporation; or (2) the director or officer knows is closely related to a business in which the corporation is engaged or expects to engage. If there is a corporate opportunity, then question becomes whether the taking of the opportunity was approved in a manner which generally requires the officer or director to make full disclosure and give the corporation the chance to take or reject the opportunity. (DISCLOSE & WAIT RULE). Director to whom the corporate opportunity has come may only act after full disclosure to the corporation and their (a majority of disinterested directors or shareholders) decision not to take action in exploiting it

“A corporation’s directors, officers, and employees are precluded from using information gained in corporate capacity to take personal advantage of any business opportunity that the corporation has an expectancy right or property interest in, or that in fairness should otherwise belong to the corporation.”

When a director or senior executive seizes for himself a business opportunity that is found to belong to the corporation, the doctrine will preclude such action since it breaches his fiduciary duty to the shareholders and the corporation. The fiduciary duty of loyalty requires Officers, Directors, full-time directors and controlling shareholders NOT TO DIVERT a corporate opportunity that properly belongs to the corporation for their own benefit. A key player must first offer the opportunity to the corporation.


Under this theory, a director is obligated to refrain from gaining any personal advantage to the detriment of his company as a consequence of information derived through his corporate position.

DEFENSES : If the corporate opportunity is offered to the corporation with full disclosure and an impartial board declines to take the opportunity, thus this alone will be a complete defense from suit. Thus the inquiry comes into play as to whether the board was in fact IMPARTIAL and whether there was FULL DISCLOSURE.

REMEDY : The remedy to a corporate opportunity seized is to place the property or opportunity wrongfully acquired and any profits derived there from in a constructive trust for the benefit of the corporation.

Courts will consider:1. Whom and when did the opportunity present itself to and in what capacity

(individual or corporate manager; outside director or full time employee). 2. Whether the company was financially capable to exploit the opportunity

(controversial b/c corps can always raise funds OR creates an incentive for executives to prevent raising of cash and may encourage them to divert funds)

3. Did the corp. have an interest or expectancy of the opportunity (corp. may have an expectancy to renew corp. lease)

4. Is the opportunity closely related to the corps existing or prospective line of business (is there a functional relationship between the corps current line of business and the opportunity)

5. Is the corp. unable to exploit the opportunity – legal (antitrust) or refusal (of offeree)

6. Was the opportunity fully disclosed and rejected by a majority of the disinterested Directors or shareholders (formal presentation creates a “safe harbor”

Broz v. Cellular Info. Systems, Inc. (1996)

RULE: “Under the doctrine of corporate opportunity, a corporate fiduciary must place the corporation’s interests before his or her own interests in appropriate circumstances, but a corporate fiduciary does not breach his or her fiduciary duty by not considering the interests of another corporation proposing to acquire the corporation in deciding to make a corporate purchase.” – DIRCTORS MUST PUT A CORPORATION’S INTERESTS BEFORE THEIR OWN INTERESTS

Statement of the CaseBroz is the President and sole stockholder of RFB Cellular, Inc (RBC). At the time of the conduct at issue, Broz was also a member of the board of directors of CIS. The conduct before the Court involves the purchase by Broz of a cellular telephone services license for the benefit of RBC. CIS brings suit for breach of fiduciary duty alleging Broz to put his interests before that of CIS.


ISSUE: Does a corporate fiduciary breach his or her duty by not considering the interests of a corporation proposing to acquire the corporation in reaching a decision to make a corporate purchase?

HOLDING: NO; Broz as a fiduciary to CIS must put the corporation’s interests first, not his. However, CIS did not have a valid expectancy interest in the license. CIS was not offered an opportunity to purchase Michigan-2, RBC was. Michigan-2 did not have an equity interest in CIS. Furthermore, acquiring Michigan-2 did not create any duties that conflicted with his obligations to CIS nor did it seize any opportunity that CIS was willing and able to pursue.

There are two exceptions to the Business Opportunity RuleRefusal to Deal as a Defense: Refusal to deal has not been favored as a defense, for diverting a corporate opportunity, unless the refusal has first been disclosed to the corporation. Without full disclosure it is too to verify the unwillingness to deal and too easy for the executive to induce unwillingness. Two requirements: (1) unambiguously disclose refusal to corporation and (2) fair statement of reasons for that refusal.

In re eBay, Inc. Shareholders Litigation (2004)

RULE: “The fiduciary duty of loyalty requires directors and officers to offer investment opportunities derived from corporate business to the corporation before acting on them individually.” – OFFICERS AND DIRCTORS MAY NOT SEIZE A CORPORATE INVESTMENT OPPORTUNITY

Statement of the CaseIndividual eBay directors and officers accepted high-profit IPO investments from Goldman Sachs as an incentive for maintaining a future business relationship. The shareholders alleged that this profit rightfully belongs to eBay and that the directors and officers seized a corporate opportunity. The shareholders filed for a derivative suit against the directors and officers.

ISSUE: Did the eBay shareholders state a claim for breach of duty of loyalty and for aiding and abetting the breach?

HOLDING: YES; shareholders alleged that the directors and officers took a corporate opportunity that was not in line with eBay’s business, but rather presented them with individual wealth. Here, the defendants were extended an offer as inducement to continue doing business with them. Acceptance clearly creates a conflict of interest between them and the corporation. Even if it was not an opportunity, the defendants nonetheless breached their duty of loyalty to the shareholders by accepting individual offers. Furthermore, Goldman Sachs aided and abetted the situation when they knew first hand what type of business eBay deals with and that they were a corporation that owed certain duties to their shareholders.

CONTROLLING or DOMINANT SHAREHOLDERS

The obligations of a controlling shareholder in which they exercise influence over the corporation arise in two contexts: (1) dealings between a parent and a majority-owned subsidiary, (2) freeze-out merger transactions (DISCUSSED LATER), and (3) selling control or sale of control (DISCUSSED LATER).Control may be identified as the majority stockholder in a corporation, usually 51% or more. In close corporations, it is likely that such majority is required whereas in a publicly held corporation, a plurality


may be necessary for control. A control person may be a parent corporation, an individual or a so called control group, etc. DE FACTO CONTROL TEST – if a person can walk into a room and say they want certain things done and what he wants gets done without argument, that person is a control person.

Rule- Normally, a shareholder owes no duty to the Board of Directors or other shareholders. However, a controlling shareholder serving as a member of the Board owes fiduciary obligations to the corporation. Even when the controlling shareholder does not serve as a Board member, he may owe a fiduciary duty to the minority shareholders and the corporation in general. A controlling shareholder may not use his control to obtain special advantages, or to cause the corporation to take an action that unfairly prejudices the minority. A control shareholder’s fiduciary duties do not parallel those of officers and directors but rather depends on the nature and scope of a transaction and whether the corporation is publicly held or closed.

Parent vs. Subsidiary: A parent corporation dictates how the subsidiary will operate and usually

executives of the parent control the board of the subsidiary. This creates multiple conflicts of interest and often raises this question: Should the questioned transaction be given a presumption of propriety under the business judgment rule or should the transaction be subject to fairness review as a conflict of interest situation? Usually, the latter issue will take course. When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the

terms, the test of intrinsic fairness, with the resulting shifting burden of proof, is applied (e.g., the basic situation for application of the rule is the one in which the parent has received a benefit to the exclusion and at the expense of the subsidiary).THE PARENT SUBSIDIARY CONTEXT

The Paying of Dividends (BJR Analysis) the parent, by virtue of control will control the subsidiary’s dividend policy as long as the dividends are paid pro-rata to the subsidiary’s minority shareholders, its OK the payment of dividends to the parent and minority shareholders of the subsidiary will be

viewed under the BJR BJR applies to dividends because dominant shareholders receives nothing from the corporation

to the exclusion of the minority shareholders – everyone regardless of % of ownership is receiving the same dividend

Self Dealing Between Parent and Subsidiary (Intrinsic Fairness Analysis) the minority shareholders of subsidiary can get a self-dealing transaction struck down if they can

demonstrate that it was not fair to the sub and not approved by the disinterested dir Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the

subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment of, the minority shareholders of the subsidiary.

when the parent is benefiting to the detriment of the sub, the parent must prove intrinsic fairness to exonerate themselves

The interested party (dominant shareholder) has the burden to prove fairness.

Intrinsic Fairness Test (OPPOSITE ANALYSIS OF THE BJR) – When the parent has received a benefit to the exclusion and at the expense of the subsidiary, the parent has burden of showing the intrinsic fairness of its decision.

Applies only when there is a true disparate impact o Will not apply when parent gains and the subsidiary does not lose


“Transactions between parent and subsidiary companies are subject to FAIRNESS REVIW only if the minority shareholders show SELF DEALING in which the controlling parent prefers itself at the expense of the minority shareholders.” In other words, this standard is applied where the parent has received a clear benefit and the subsidiary’s minority shareholders suffered a detriment. (BENEFIT-DETRIMENT ANALYSIS)

Sinclair Oil Corp. V. Levien (1971) – Intrinsic Fairness Test: (exercising influence over the corp.)

RULE: “If, in a transaction involving a parent company and its subsidiary, the parent company controls the transaction fixes the terms, the transaction must meet the intrinsic fairness test.” – A TRANSACTION BETWEEN A PARENT AND ITS SUBSIDIARY MUST BE INTRINSICALLY FAIR

Statement of the CaseSinclair owned 97% of the shares to Sinclair Venezuela. The subsidiary had to pay a huge amount of dividends at one point to its parent. Sinclair then created International for the purposes of coordinating all of Sinclair’s foreign affairs. Sinclair then made Sinclair Venezuela enter into contract with International to sell all of its crude oil and refined products to International which in turn International would have to purchase a minimum. International was late with payments and did not purchase the fixed minimum of goods in the contract. Pursuant to the contract, Sinclair received Sinclair Venezuelan products but the Levien and the minority shareholders did not share in the profits and thus brought suit for breach of contract and for damages since Sinclair denied Sinclair Venezuela industrial development.

ISSUE: If in a transaction where the parent company controls the subsidiary, must the transaction be intrinsically fair?

HOLDING: YES; under the intrinsic test, the dominant company must prove that its transaction with the subsidiary was objectively fair. The test is invoked only if the parent company is on both sides of the transaction with its subsidiary and self-dealing is suspect. Self-dealing will be deemed to be present if the parent company uses its power to enter into a transaction with the subsidiary and the parent received a benefit from the subsidiary to the subsidiary’s detriment. Minority shareholders here were paid the same dividend percentages per share that Sinclair received. The dividend payments were not self-dealing. However, Sinclair forcing both the subsidiaries to engage in contract was self-dealing. Sinclair caused the sale to happen and Sinclair received the products form the sale. The shareholders received little from this transaction. Sinclair failed to prove that the transaction was intrinsically fair.

Rule- A parent does owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings. However, to invoke the intrinsic fairness standard – similar to the conflict of interest test under 144 (higher burden of fairness) in lieu of the BJR, it must be shown that the parent is dealing on both sides of the transaction to the detriment of the subsidiary.

Disparate impact here where the wholly owned subsidiary benefited at the expense of the partly owned subsidiary. Looking at impact. The inquiry is basically a showing that


money is being taken out of the subsidiary to the benefit of the parent. However, this is difficult to prove because the parent company has control over the subsidiary and you can argue BJR.

Majority vs. Minority Shareholder: Majority shareholders owe a duty to minority shareholders that is similar to the duty owed by a director, and when a controlling stockholder is voting, he violates his duty if he votes for his own personal benefit at the expense of the stockholders. Examples are Dodge v. Ford and U.S. Steel

When is the Intrinsic Fairness Test Used? - Notion of creating FD of controlling SH to minority shareholders.1. In situations involving a parent and subsidiary, with the parent controlling the transaction and fixing its terms. 2. Parent must receive a benefit to the exclusion and expense of the subsidiary. One party must be benefiting at the expense of the other. 3. There must be a fiduciary duty coupled with self-dealing.

CONTROLLING SHAREHOLDER RELATIONSHIP WITH MINORITY• A controlling shareholder or a controlling block of stock. = A person has effective “control” if he has the

power to use the assets of a corporation as he chooses. When a controlling shareholder deals with a group of non controlling shareholders,

he owes the latter the duty of complete disclosure with respect to the transaction When a director (controlling shareholder) votes for the benefit of an outside

interest, rather than for the benefit of the shareholders as a whole, there has been a breach of duty.

When voting as a stockholder, a controlling stockholder may have the legal right to vote for personal benefit; but when he votes as a director he represents all the stockholders in the capacity of a trustee for them and cannot use his office as a director for his personal benefit at the detriment of the minority stockholders.

Zahn v. Transamerica Corp. (1947) – Hostile Takeover

RULE: “If a stockholder who is also a director is voting as a director, he or she represents all stockholders in the capacity of a trustee and cannot use the director’s position for his or her personal benefit to the stockholder’s detriment.” – A STOCKHOLDER VOTING AS A DIRECTOR MUST VOTE IN ALL SHAREHOLDER’S BEST INTERESTS

Statement of the CaseStockholders of the Axton-Fisher Tobacco Company sued Transamerica (who claimed 72% of class B stock and 66% of class A stock in Axton-Fisher) claiming that they cause Axton-Fisher to redeem or cash in their class A stock at a well low price instead of allowing them to participate in the liquidation of company assets, in which case they would have received 240 dollars per share.

ISSUE: May a stockholder use the director’s position for his personal benefit to the stockholder’s detriment?


HOLDING: NO; the directors knew of Axton’s right to call shares of Class A stock for redemption because it was in the charter, but the right was not expressly disclosed to the stockholders. Axton was an instrument to Transamerica and thus were voting in their interests. There was no reason for Axton to liquidate after the redemption of class A stock, other than to ensure that class B holders would benefit from the liquidation. The redemption of the class A stock was not necessary for the financial welfare of the company. The decision to call class A stock was made by Class B shareholders, right before liquidation sale, so that as a result, on class B holders profited.

To whom did the directors owe a duty? To common shareholders because they take more risk. They are in the back of the line. No rights except rights under common law. So, arguable, when directors face a choice between creditors and shareholder, choose shareholders. Between groups of shareholders, directors should prefer a group with least amount of power and rights. As such, B is junior class who assuming greater risk. Thus directors owe them a duty. Third circuit dismisses this. Key to this is director’s motive. They had to choose an option

that wasn’t going to benefit them. As such, the duty runs to group to whom they are not beholden.

Neither approach is satisfactory because someone is getting hurt. Transamerica should have told them about the intent to liquidate. That may have been the key

piece of information. What’s unfair was that Transamerica didn’t reveal its future plans, in which case a shareholder would have made an informed decision.

Court treats the case as a failure to disclose case because Transamerica failed to reveal the true valuation of the company assets. Thus, a controlling shareholder owes a duty to minority shareholders that are similar to the duty owed by a director. He has the burden of proving (1) good faith of the transaction and also (2) fairness to minority interests.

When a director votes for the benefit of an outside interest, rather than for the benefit of the SH as a whole, there has been a breach of duty.

The Court said even though Class B has the reduced rights, we look at this situation as a majority/minority distinction, and the duty of the directors is not to disadvantage the minority in favor of the majority and to maximize the profits of A, not to enrich itself in favor of the minority. The 3rd Cir. says they aren’t going to get into who the duty is owed to but will rather look at the motive and in this case, Transamerica acted in its own self-interest and not for the shareholders.

S HORT -SWING PROFITS

The Securities Exchange Act contains a prophylactic rule banning insider trading in § 16(b) where “officers, directors, and 10% shareholders must pay to the corporation any profits they make, within a six-month period, from buying and selling the firm’s stock.” This section penalizes insiders for trades unrelated to non-public information and misses many trades based squarely on such information.

There are two requirements under Section 16, (1) statutory insiders must file information regarding their trades in their company’s stock with the SEC, (2) if you make profits on those shares by a purchase and sale or sale and purchase within 6 months of each other, then you must give up those profits to the corporation > Short-Swing Profit Provision.

Two types of Markets:1. Primary Market securities sold directly through the company that created the shares


Controlled by the Securities Act of 1933 – with two goals (1) mandating the disclosure of material information to investors, and (2) the prevention of fraud

initial public offerings take place in the primary market regulation began - “Blue Sky Law” in Kansas (1911)

2. Secondary Market investors trade securities w/o any significant participation of the original issuer

Controlled by the Securities Exchange Act of 1934 Insider trading, securities fraud, short-swing profits, regulation of shareholder

voting via proxy solicitations, and regulation of tender offers

SHORT-SWING PROFITS – ENFORCED BY THE CORPORATION

IN ANALYZING SECTION 16(B), THREE ELEMENTS MUST BE PROVEN: (1) DOES THE FEDERAL GOVERNMENT HAVE JURISDICTION (IS THE COMPANY LISTED ON A NATIONAL STOCK EXCHANGE; DOES THE SHARES OF THE COMPANY HAVE 10 MILLION DOLLARS OR MORE OF THOSE ASSETS (2) IS THERE A STATUTORY INSIDER (OFFICER, DIRECTOR, OR BENEFICIAL OWNER), AND (3) ARE THERE SHORT-SWING PORFITS (SALE FOLLOWED BY A PURCHASE WITHIN SIX MONTHS). NOTE OFFICERS AND DIRECTORS MUST BE SUCH FROM THE BEGINNING TO END OF PURCHASES AND SALES.

§ 16(b) 1934 Securities Exchange Act§ 16(b) – provides that for the purpose of preventing the unfair use of information, a corporation may recover for itself any profits realized by a director, officer, or 10% shareholder (beneficial owner), from a purchase and sale (or sale and purchase) of its stock within any six-month period, irrespective of intention, provided that the owner held more than 10% (of any class) “both at the time of the purchase and sale.

Officers, Directors and 10% shareholders (at both ends) must pay to the corp. any profits they make, within a 6 month period, from buying and selling the shares

Rationale: we want directors to own stock so that their interests are aligned with shareholders, but we don’t want them to speculate.

Debentures are treated as shares under § 16(b) Officers and Directors need only hold that position at either side of the sale or purchase for

§ 16(b) to apply Beneficial owners must hold 10% on both ends of the transaction Applies only to companies that register their stock under § 12 of the 1934 Act – typically publicly held

corporations Companies that (1) w/ stock traded on a national exchange, (2) w/ assets of $5 million and

500 or more shareholders – (thus likely does NOT apply to close corps)

Generally: Section 16(b) of the Securities Exchange Act of 1934 contains a "bright line" rule by which all "short-swing" trading profits received by insiders must be returned to the company. The gist of § 16(b) is that if a statutorily-defined insider buys stock in his company and then resells within six months, or sells and then re-purchases within six months, any profits he makes must be returned to the corporate treasury. This rule applies even if the person in fact had no material non-public information.

Section 16(b) applies to any "officer," "director," or beneficial owner of more than 10% of any class of the company’s stock.


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Public companies: Section 16(b) applies only to the insiders of companies which have a class of stock registered with the SEC under § 12 of the ’34 Act. Thus a company’s insiders are covered only if the company either: (1) is listed on a national securities exchange; or (2) has assets greater than $5 million and a class of stock held of record by 500 or more people.

Who may sue: Suit may be brought by the corporation or by any shareholder. But any recovery goes into the corporate treasury. (The incentive is to the plaintiff’s lawyer, who gets attorney’s fees out of the recovery.)

Plaintiff must continue to be stockholder: P must not only be a stockholder in the corporation at the time she files suit under 16(b), but she must also continue to be a stockholder as the suit progresses. However, if P is forced to exchange her shares for shares in a different corporation as the result of the target corporation’s merger, P may continue her suit as long as she keeps the shares in the surviving corporation. Gollust v. Mendell.

Public filings: To aid enforcement, any officer, director, or 10%-owner must file with the SEC (under 16(a)) a statement showing any change in his ownership of the company’s stock. This must be filed within 10 days after any calendar month in which the level of ownership changes.

Who is an insider?"Officer": Two groups of people may be "officers" for § 16(b) purposes: (1) anyone who holds the title of "President," "Vice President," "Secretary," "Treasurer" (or "Principal Financial Officer"), or "Comptroller" (or "Principal Accounting Officer"); anyone (regardless of title) who performs functions that correspond to the functions typically performed by these named persons in other corporations. "Beneficial owner": A person is a beneficial owner covered by § 16(b) if he is "directly or indirectly" the beneficial owner of more than 10% of any class of the company’s stock (he need not own 10% of the overall equity).

Attribution: Stock listed in A’s name may be attributed to B. A person will generally be regarded as the beneficial owner of securities held in the name of his or her spouse and their minor children (but usually not grown children). Thus a sale by Husband might be matched against a purchase by Wife; similarly, a sale and purchase by Wife might be attributed to Husband if Husband is a director or officer.

Deputization as director: A corporation may be treated as a "director" of another corporation if the former appoints one of its employees to serve on the latter’s board. (Example: ABC Corp owns a significant minority interest in XYZ Corp. ABC appoints E, its employee, to serve on the board of XYZ. ABC will be deemed to have "deputized" E to serve as director, so ABC will be treated as a constructive director of XYZ, and any short-swing trading profits reaped by ABC in XYZ stock will have to be returned to XYZ.)

When insider status required ?

Director or officer at only one end of the swing: If D is a director or officer at the time of either his sale or his purchase of stock, § 16(b) applies to him even though he does not have the status at the other end of the trade.

10% owner: But the same rule does not apply to a 10% owner. A person is caught by the "10% owner" prong only if he has the more-than-10% status at both ends of the swing.






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Purchase that puts one over: The purchase that puts a person over 10% does not count for § 16(b) purposes. (Example: D has owned 5% of XYZ for a long time. On January 1, he buys another 10%. On February 1, he sells 4%. There are no short-swing profits that must be returned to the company.)

Sale that puts one below 10%: In the case of a sale that puts a person below 10% ownership, probably we measure the insider status before the sale. (Example: D already owns 15% of XYZ. He then buys another 10% on January 1. On February 1, he sells 16%. On March 1, he sells the remaining 9%. Probably D has short-swing liability for 16% sale, but not for the second 9%, since we probably measure his insider status as of the moment just before the sale.)

What is a "sale," in the case of a merger: If the corporation merges into another company (and thus disappears), the insiders will not necessarily be deemed to have made a "sale." D will escape short-swing liability for a merger or other unorthodox transaction if he shows that: (1) the transaction was essentially involuntary; and (2) the transaction was of a type such that D almost certainly did not have access to inside information.

Example: Raider launches a hostile tender offer for Target. On Feb. 1, Raider buys 15% of Target pursuant to the tender offer. Target then arranges a defensive merger into White Knight, whereby each share of Target will be exchanged for one share of White Knight. The merger closes on May 1, at which time Raider (like all other Target shareholder) receives White Knight shares in exchange for his Target stock. On June 1, Raider sells his White Knight stock on the open market for a total greater than he originally paid for the Target stock. Raider does not have any § 16(b) problem, because the overall transaction was essentially involuntary, and was of a type in which Raider almost certainly did not have access to inside information about White Knight’s affairs.

10% SHAREHOLDERS The purchase that places a person over 10% does not count in the § 16(b) analysis – to

applicable, the buyer must have already owned 10% at the time of the purchase In a purchase-sale sequence, a beneficial owner must account for profits only if he was a beneficial

owner before the purchase.

Reliance Electric Company v. Emerson Electric Company (1972)

RULE: “A corporation may recover the profits realized by an owner of more than 10% of its outstanding shares from a purchase and sale of its stock within any six month period, provided the owner held more than 10% at the time of both the purchase and the sale.”

Statement of the CaseEmerson tried to takeover Dodge but only acquired 13.2% of its stock in June at $63 per share. Dodge then merged with Reliance. In attempt to protect its shares from liability under the act, Emerson reduced its holdings to less than 10% of Dodge’s shares in August. Then Emerson sold the rest of its shares on September. Reliance demanded the profits on both sides but Emerson sought a declaratory judgment as to its liability under 16(b).

ISSUE: Are the profits from two sales, each of which constitutes less than 10% of a corporation’s outstanding shares, recoverable by the corporation under 16(b)?

HOLDING: NO; the rule imposes strict liability on any transactions occurring in six month by preventing insiders from purchasing large quantities of stock in their company based on private




information and then quickly dumping the stock when the information goes public and the stock increases. Emerson’s intent is irrelevant here. Once the shareholder owns less than 10%, any additional sales are not governed under 16(b). Emerson is not liable from profits arising under the second sale. a particular purchase will not be the first of a buy-sell short swing unless the buyer already

owned more than 10% before the purchase o the purchase that lifts the buyer over 10% cannot be matched against a subsequent sale

w/in 6 months

Foremost-McKesson, Inc. v. Provident Sec. Company (1976)

RULE: “A corporation may capture for itself the profits realized on a purchase and sale of its securities within six months by a director, officer, or beneficial owner, but a beneficial owner is accountable to the issuer only if it was a beneficial owner before the purchase and before the sale.”

A Beneficial Owner is a corporate shareholder who has the power to buy or sell the shares, but who is not registered on the corporation’s books as the owner.

Statement of the CaseProvident dissolved and liquated its assets. Foremost was interested in its purchase. The parties entered into agreement where Foremost would buy 2/3’s of Provident assets in exchange for 4.24 million in cash and 49.75 million in debentures. Foremost then delivered 2.5 million debentures to an agent and 7.5 million to Provident, representing the balance of the purchase price. The debentures were converted into over 10% of Foremost’s common stock. A couple days later, Provident, Foremost, and a group of underwriters sold 25 million debentures. Provident distributed the profits to its stockholders and then dissolved. Foremost brought suit to recover profits realized on the sale of debentures to the underwriters.

ISSUE: Is a beneficial owner accountable to the issuer for profits if it was not a beneficial owner before the purchase?

HOLDING: NO; in a purchase sale sequence, a beneficial owner must account for profits only if it was a beneficial owner before the purchase. Historically, 16(b) applied to shot term purchase and sale sequences by a beneficial owner if it had that status before the purchase. This should not change. Congress had a reason to impose a 10% threshold ownership for insider abuse. The court may not impose liability on the basis of a purchase made when the percentage of ownership required for beneficial ownership had not been reached before the sale. Short-swing transactions by a director or officer are always suspect whereas a shareholder only becomes suspicious if he owns large quantities of stock.

Examples (p 519)o (1) X is an investor w/ 200,000 shares of SCLI that she has held for several years

she sells all her shares on 1/1 for $50 p/share she buys 50,000 shares on 5/1 at $10 and 110,000 shares on 5/2 16(b) not in effect because she is not a 10% holder

her next transaction would fall under 16(b) (2) X owns 200,000 shares for several years

sell all shares on 1/1 at $50 buys 110,000 shares on 5/1 for $10 buys 50,000 shares on 5/2 for $10


16(b) in effect for 50,000 shares because she obtains 10% status after purchasing 110,000 shares

the 50,000 shares are taxed (3) X has owned 200,000 shares for several years

she sells 110,000 shares on 1/1 at $50 sells remaining 90,000 shares in 1/2 at $50 buys 300,000 shares on 5/1 for $10 p/share 16(b) not in effect because she just obtained 10% status again

When a holder of more than 10% of the stock in a corporation sells enough shares to reduce its holdings to less than 10%, and then sells the balance of its shares to another buyer within six months of its original purchase, it is NOT LIABLE to the corporation for the profit it made on the second sale.

Most insider trading cases are brought under the SEA §10(b) because there isn’t a 6-month limitation.

Class Notes: (p. 503)

Problem 1. Why relevant stock registered under 1934 Act because only applies to public company whose shares are exchanged in the stock exchange/NASDAC*. When it comes to 16b taking large co not family owned companies; types who shares can go out and buy in the market.

(a) Does 16b cover this situation? Yes, chief CEO thus officer and therefore law applies and he is a 16b defendant. Moreover, bought/sold shares in 6 months. What are his damages? $40 x 200,000 shares - ? = profit $ 8million so how much must return to shareholders.

(b) Same result – no matter split sale since still looking is there director buying and selling within the six month period thus exactly the same result – does not matter sells all at one or split it up

a. What till June 2 to sell remaining shares – would this effect result? Yes, past 6 month window – only within 6 month period. Still on the book for share sold on May 1. 100,000 x 50 = 5.5 million; 1.1 million= profit 4.4 milliom. Must match actual shares. Tell him as advisor to hold on to share until June 2 so can hold on to profits.

(c) Does resignation get him off the hook? Director when purchased but his argument is not a director when sold other 90,000 shares – so is he off the hook for the second share of sales. Only need to be officer or director on one side of train; regardless still director when does sell so long within sex months liable for all profits and *it works the other way around as well – if buys and then becomes director still liable for both sales since sufficient if director on sales side, intent not to director when sold stock irrelevant. So if d/o on either of the trades liable. Rules straight forward when d/o – must be cognizant of 6 month window.

**16(b) Issue- who is an officer: 16b says any officer – so the question becomes who is an officer. Depends on where you are and the court (Most require senior responsibility with access to information; Scalia type judge says if officer in title then officer; problem comes in when lawyer of corporation – should they be treated as officer; one way to avoid liability is not to take officer title).

Problem 2. (a) Renee is not o/d so is she subject to 16(b). Yes, if 10% +1 shareholder of company stock.

At first transaction she was a 10% shareholder – moment before transaction she was at least a 10% holder (20% exactly). Second transaction, she did not holder any shares moment before. Third transaction, moment of transaction only owned 5% shares. Not as 10%


shareholder when made purchases. *Have to have owned 10% at the time of both transactions – buying. (See reliance + forense case). She is off the hook because she was not 10% shareholder at the time of the other two transactions.

(b) 10% holder when sold; not 10% holder when bought on May 1st; but 10% holder when bought stock on May 2nd because moment before transaction had 12% share. Two transactions covered under 16(b) and both took place within six month period.

a. If match two transactions (# of shares) – lang of 16b penalizes any purchases and sales or sale and purchase – chron irrelevant. # of share involved in transaction is what we consider. Profit of 2million that she will have to give up – 200,000 x $50 bought - $ 10 x 50,000 sale. Will not get her for purchase. Must limit to 50,000 shares.

Problem 3. Director and has everything within six month so liable under 16b. But did he make a profit in his transaction? 16b would say he made a profit. Under law can match any sale with any purchase but also can in … ignore – match lowest purchase with highest sale and ignore the rest. 16b profit of 2 million – 100,000 purchase w/ 100,000 sale at higher price. Do not take losses into account just find a profit and ignore every other transaction.

Why do we do this? Maximize penalty in order to discourage trading – they should not be doing this is the bottom line. This is why corporate executives hate 16b so much.

Problem 4. 16b covers stock – trading profit and stock and debentures are a form of debt – but these are convertible – exchangeable in to stack – treat them as if all ready own there shares. Thus she is treated as owner of 500,000 shares.

**16b always interpreted in way benefits company the most; to detriment of d/o.How would a corporation ever find out of such transactions? 16(a) must report to sec about all transactions in their company stock. In the new lately – use to have lag time; now since amendments last year must report electronically virtually simultaneously. Reason is market finds it interesting when o/d trading their own stock. Otherwise took time to get this information. Hope with sim reporting people who follow can get early notice. *Recent reform.

Damages Example:A, the CEO buys 1,000 shares at $10 on May 1.On Aug 1, A sold 1,000 shares at $20.Profits = 20,000 – 10,000 = 10,000 The court will use any purchase and sale within a six month period to create a profit – “maximum

possible profits”o In instances of multiple purchases and sales w/in a 6 month period, the court will match the

lowest purchase price w/ the highest sale price to create a profit to determine damages.

Creating Profits (assume that X is a O&D:Transaction Date Price Date

Buy 200 $10 Feb.1Sell 200 $5 March 1Buy 100 $20 Apr. 1Sell 100 $15 May 1

Though X experienced an overall loss of $1,500 the court will find a profit of $500 (bought 100 for $10 [$1,000] and sold 100 for $15 [$1,500] = $500)


UNORTHODOX TRANSACTIONS IN 16(B)General Rules of § 16(b)-

· The rule only applies to corporations that register their stock under the SEA, including companies with stock traded on a national exchange, and companies with assets of at least $5 million. · Officers and directors are subject so long as they occupied their position either at the time of the purchase or sale. · You may be liable if you deputize an officer to sit on the board of another corporation and you profit from stock trades of that corporation within a 6 month period.· The rule aggregates all classes of stock so that you cannot immunize yourself if you own 9% of one and 1% of another.· Applies to equity securities and convertible bonds· Can be enforced derivatively· Can possibly apply to mergers, acquisitions, and liquidations, but won’t apply if the party could not have had inside information and therefore is not a speculator (See Kern County).

Two Part Test to Determine if Unorthodox Transactions (merger) Qualify as Sales Under §16(b):1. was the transaction involuntary; and 2. did the key player have access to insider information

thus if a takeover target arranges a defensive merger to avoid takeover after a hostile bidder has compiled shares, the unsuccessful bidder may surrender his shares within 6 months of acquiring them w/o facing § 16(b) liability (even if the raider owned 10% prior to acquiring additional shares in its tender). Unsuccessful raider may not however sell his shares on the open market and remain protected b/c that would make the sale voluntary, instead he should want and redeem

C. DERIVATIVE SUITS

DIRECT v. DERIVATIVE ACTIONS (they are brought on behalf of the Corp. or a shareholder for the benefit of the Corp. or the shareholder for breach of Fiduciary Duty)

The Basic Tests: (1) who suffers the most immediate and direct damage? (2) To whom did the defendant’s duty run?

• Shareholders enjoy dual personalities in that they can sue directly or derivatively. A shareholder’s derivative suit is a suit in which the shareholder sues on behalf of the corporation, on the theory that the corporation has been injured by the wrongdoing of a third person, typically an insider.

The derivative action is often described as a representative action, since the shareholders are enforcing the rights of another, the corporation. Recovery in derivative actions goes to the corporation rather than to the shareholder bringing the suit. To commence or maintain such action, a shareholder must have (STANDING) been a shareholder of the corp. at the time of the act or omission complained of or has become a shareholder through a transfer. The corporation is named as a defendant though it also is the party of interest. Furthermore, if the corp. finds in good faith through reasonable inquiry that partaking in such litigation is not in the best interests of the corp., they can motion to dismiss the suit. Reasons for dismissal might be the fact that there is no likelihood of prevailing or that the damage to the corporation from litigating would outweigh any possible recovery. To prevent dismissal, the plaintiff shareholder has the burden of proof in asserting that the decision was not made in good faith after reasonable inquiry.


In derivative suits, the shareholder sues the corporation in equity, seeking to force the corporation to bring suit against the directors and officers for violating their fiduciary duties.

Direct Action shareholder Plaintiff must allege more than an injury resulting from a wrong to the corporation; plaintiff sues the corporation to enforce her rights as a shareholder.

Plaintiff must state a claim that is separate and distinct from a claim that may be suffered by other shareholders or a wrong involving a contractual right of a shareholder which exists independently of any right of the corp.

Direct claims include:o action to enforce voting rights

A breach of fiduciary duties owed to the shareholder by an officer or director of a corp. is a proper subject for a shareholder’s direct action against that officer or director. However, it is important to note the distinctions between breaches of duty owed to a shareholder versus the duties owed to the corporation. If the duty is to the corp., the action is derivative, not direct.

Illustration of derivative suits (equitable and procedural suits) : Most cases brought against insiders for breach of the fiduciary duties of care or loyalty are derivative. All monetary recovery goes to the corporation. The corporation is a necessary party defendant.

Examples include:

(1) Suits against board members for failing to use due care;

(2) Suits against an officer for self-dealing;

(3) Suits to recover excessive compensation paid to an officer; and

(4) Suits to reacquire a corporate opportunity usurped by an officer

(5) Suits to recover against conflicts of interest

Illustration of direct actions: Here are some of the types of suits generally held to be direct:

(1) An action to enforce the holder’s voting rights;

(2) An action to compel the payment of dividends;

(3) An action to prevent management from improperly entrenching itself (e.g., to enjoin the enactment of a "poison pill" as an anti-takeover device);

(4) A suit to prevent oppression of minority shareholders; and

(5) A suit to compel inspection of the company’s books and records.

(6) Suits for misrepresentations instead of perpetrating directly upon investors

(7) Suits to enforce your preemptive rights

(8) Suits to compel the corporation to declare a dividend

(9) Suits of the appraisal remedies

(10) Suit to compel the corporation to dissolve

Eisenberg v. Flying Tiger Line, Inc. (1971)

RULE: “An action seeking to overturn a reorganization and merger that deprived an acquired corporation’s shareholders from having a voice in the surviving corporation’s business


operations is a personal action rather than a derivative action under the New York statute requiring the posting of security for the corporation’s costs.”

Statement of the CaseFlying Tiger formed FTC as its subsidiary. A month later, FTC organized its own subsidiary FTL. In a reorganizing plan issued by management in Flying Tiger, Flying Tiger was merged into FTL and Flying Tiger ceased to exist. After a while, FTL renamed itself as the former Flying Tiger and thus continued their operations. The shares traded in this new organization were also shares in FTC, the holding company for FTL. The holding company’s stockholders were the owners of the former Flying Tiger. Eisenberg brought a derivative suit to enjoin the plan of reorganization and merger since their corp. ceased to exist due to the merger. Under NY Law, Flying Tiger Line requested the plaintiff to post a bond.

ISSUE: Is an action seeking to enjoin a reorganization and merger brought by the former stockholders of the corporation to be acquired, a derivative action subject to the rules requiring the plaintiff in a derivative action to post security?

HOLDING: NO; Eisenberg asserts that the reorganization deprives P and other minority SHs of any voice in the affairs of their previously existing operating company. The essence of Eisenberg’s claim is that the reorganization, a transfer of shares to a holding company whose only asset was Flying Tiger, deprived him and fellow shareholders of their right to vote on Flying Tiger’s affairs. Since this right never belonged to Flying Tiger, and belonged to stockholders, it is not derivative. It’s also not derivative because the company itself is not being hurt. P’s loss of voting rights is the injury so it is a direct suit. The court here found the suit to be not derivative but a direct suit.

Derivative vs. Non-derivative Actions: The test formulated to distinguish between derivative and non-derivative suits is “whether the object of the lawsuit is to recover upon a chose in action belonging directly to stockholders, or whether it is to compel the performance of corporate acts which good faith requires the directors to take in order to perform a duty which they owe to the corporation, and through it, to the shareholders.” Eisenberg v. Flying Tiger Line, Inc.

Critiques of Derivative Suits Plainitff’s lawyer’s economic interest drives this suit. Most states have c/l to say that you have to be shareholder at the time of the harm, and through the

duration of the suit. This prevents lawyers from buying 3 shares and initiating their own derivative suits.

Shareholders can just sell their stocks.

Three General Requirements to Maintain a Derivative Action:1. contemporaneous ownership at time of breach2. ownership at time of adjudication3. demand or excusal

SECURITY FOR EXPENSE STATUTES certain states require plaintiffs to post a bond to guarantee that if the corp. incurs expenses in connection

with the derivative suit this is intended to dissuade “strike suits”


DE DOES NOT REQUIRE THE POSTING OF A BOND OR DEPOSIT FOR COSTS - MORE PLAINTIFF FRIENDLY.

Cohen v. Beneficial Industry Loan Corp. (1949)

RULE: “A New Jersey statute that requires a holder of less than 5% of a corp.’s outstanding shares who brings a derivative suit to pay all expenses of defending the suit and that requires security for the payment of these expenses should be enforced in cases prosecuted under federal diversity jurisdiction.”

Statement of the CaseCohen brought a derivative suit against the managers in his respective corp. because they were engaged in a plot to get rich at the corp.’s expense. This mismanagement has led to fiscal waste and diversions. Cohen owed about 100 shares which equated to .0125% ownership of the company. New Jersey passed a law asserting that a minimal shareholder who brings a derivative suit must be responsible for their defense if unsuccessful and must indemnify the corp. against those costs before proceeding. Beneficial required Cohen to post a bond.

ISSUE: Must a federal court hearing a stockholder’s derivative suit based only on diversity apply the law of the forum state and require the plaintiff to provide security for the payment of costs if he or she is ultimately unsuccessful?

HOLDING: YES; New Jersey passed this law to prevent nuisance claims of small owners abusing their rights to a derivative suit. Derivative actions are intended to help stockholders in large corporations in making their managers stop wrongful conduct. Small stockholders must provide security in the event they are unsuccessful.

H: Use of the NJ statute ok. You look to state of incorporation for substantive law and forum state for procedural law.

state is not forbidden to use the amount of one’s financial interest, as some measure of the good faith and responsibility of one who seeks at his own election to act as custodian of the interests of all stockholders

Found to be constitutional as a measure of good faith given the nuisance value courts want to protect corporations from harassment suits. While the derivative action concept serves a valid purpose, the process can be long, drawn out and expensive.

Even at this early state, business judgment rule protects directors against lawsuits. So, plaintiff has to allege that directors were acting in self-interest; self-dealing; breach of loyalty. You would frame the suit as breach of duty of care.

Mismanagement and other misfeasance that gives rise to breach of duty generally harms corporations directly and shareholders indirectly. The harm also affects other constituents in the corporation.

Corporation is an independent entity for the purpose of law and legal obligations; thus, it’s the primary victim. Thus, if harmed, the right to sue belongs to the corporation; it’s up to beneficial to sue. As a matter of corporate company bring lawsuit? Board of directors would have to authorize an officer to sign the complaint. Problem: directors would be asked to sue themselves. This led to the authorization of derivative claim: breach of duty by own directors or by third party. Derivate standing in the shoes of company allows shareholders to sue the company, in the name of the company.


DGCL § 145(b) – The corporation may indemnify a defendants’ expenses only if the court determines that “despite the adjudication of liability but in view of all the circumstances of the case, [the defendant] is fairly entitled to indemnity.”

THE DEMAND REQUIREMENT

The demand requirement rests on the notion that it gives the board of directors, which is charged with managing the corporation, an opportunity to decide whether or not a suit is in the corporation’s best interest.

Demand on board: Plaintiff must make a written demand on the board of directors before commencing the derivative suit. The demand asks the board to bring a suit or take other corrective action. Only if the board refuses to act may Plaintiff then commence suit. (But often the demand is "excused," as is discussed below.)

Demand excused: Demand on the board is excused where it would be "futile." In general, demand will be deemed to be futile (and thus excused) if the board is accused of having participated in the wrongdoing.

1. Delaware view: In Delaware, demand will not be excused unless Plaintiff carries the burden of showing a reasonable doubt about whether the board either: (1) was disinterested and independent; or (2) was entitled to the protections of the business judgment rule (i.e., acted rationally after reasonable investigation and without self-dealing).

A. Difficult to get: But Delaware makes it very difficult for P to make either of these showings. For instance, he must plead facts showing either (1) or (2) with great specificity. Also, it is usually not sufficient that P is charging the board with a violation of the duty of due care for approving the transaction; usually, a breach of the duty of loyalty by the board must be alleged with specificity.

2. New York: New York makes it much easier than Delaware to get demand excused. For instance, demand will be excused if the board is charged with breaching the duty of due care, not just the duty of loyalty. Also, New York requires less specificity in the pleading.

The Demand Requirement is an Intra-corporate remedy : Corporate affairs are done under the control of the board. One of the affairs of the board of directors is simply to prosecute its own causes of actions, so there is a procedure in corporate law which allocates a voice to the board of

directors in determining whether the suit should be brought or maintained. As a predicate to a stockholder bringing a derivative suit, a demand must either be made on the board of directors or the demand on the board must be excused. If the


demand is made on the board, the board’s response is typically protected by the Business Judgment Rule unless it is not a decision that is reasonable or in good faith. It is very unlikely for the board to approve this suit. Absent that proof that the board acted without reason or in good faith, the decision of the board stands. A demand on the board is excused when a court is persuaded by the pleadings that the demand on the board would be futile. What evidence does a plaintiff have to bring in to establish futility? A lot of states hold that the plaintiff must show very strong facts of other bias or self interest by a majority of the directors to be able to excuse the demand.

The Demand Requirement in PerspectiveThe demand requires the plaintiff to write a letter to the board of directors demanding that they bring suit. The letter must allege the wrong and the relevant facts supporting the allegation in much the same way as is done in a complaint. When the board receives the demand letter, they have 2 obvious choices: (1) accept the demand and bring suit (RARE), or (2) reject the demand/not sue. If the board accepts the demand and decides to sue, there is no need for the derivative suit. The board will hire its own lawyer and take over the suit. If the board rejects the demand and can show that the rejection was made IN GOOD FAITH and BY AN INDEPENDENT BOARD, then the derivative suit cannot go forward. The decision to reject the demand is given the presumption of propriety under the BUSINESS JUDGMENT RULE.

If the board rejects the demand, the plaintiff’s attorney is faced with the tough burden of overcoming the business judgment rule. He must show that the board was NOT INDEPENDENT (EX. A majority of the board was involved in the wrongdoing) or that THERE WAS NO RATIONAL BASIS FOR THE DECISION NOT TO SUE. This burden is insurmountable. Thus the plaintiff can try to get around this burden by showing excuse.

The Excuse Requirement in Perspective – The Demand ExcusedThe main ground for excusing demand is futility. There are three approaches followed:

(1) The Delaware Approach - Aronson v. Lewis asserts that Demand is excused if the plaintiff can state with PARTICULARITY, facts that create a reasonable doubt (1) that a majority of the directors on whom demand would have been made are disinterested, or (2) that the challenged transaction which constituted waste on its face and was self-dealing was not protected by the Business Judgment Rule. Thus in other words, the plaintiff under this TWO-PART TEST must show (1) the


board is not disinterested or independent, or (2) the underlying transaction was improper as tested under the Business Judgment Rule.

(2) The Model Act Approach - …. NOT APPLICABLE

(3) The New York Approach – Marx v. Akers asserts that Demand is excused if any of the following is alleged with PARTICULARITY in the complaint: (1) a majority of the board is interested in the challenged deal; (2) the board did not fully inform itself about the challenged deal; or (3) the challenged deal was so unfair on its face that it could not have been the product of sound business judgment.

In sum, to file a derivative suit, a shareholder must either:1. make a demand upon the BOD, that the Board assert the corporations claim, or2. Claim excusal –SH can show that such a demand would be futile because the board has

participated in the breaching conduct and there exists a reasonable doubt as to whether: basis of excusal.

a. A majority of the board has a material financial or familial interestb. A majority of the board is incapable of acting independently for some other reason

such as domination or control – accused board member holds undue control over the other shareholders (Pres hand picked the BOD). Structural bias isn’t enough; you need to show undue influence.

c. The underlying transaction is not the product of a valid exercise of BJR. This is basically saying that the Plaintiff has to demonstrate that he has a case on the merits even though the discovery phase has not yet begun.

d. Show with particularity that Board’s decision to reject claim was rendered in bad faith.

If a demand is made and rejected, the Board is entitled to protection under BJR. following the rejected demand, the shareholder is precluded from continuing w/

the derivative action

Valid Possible Reasons Why the Board Would Reject A Demand fear of bad publicity – may lead to drop in stock price court and litigation costs may be frivolous litigation may paralyze the Board and operations of the company

Justifications for the Demand Rule- The demand is useful because it affects a cost-benefit analysis of bringing the suit. These suits almost always affect the company’s stock market value. Also, derivative suits present an internal conflict because the Board is running the company while being sued by it.

NOTE: If you bring suit in the name of the corporation, for some act that gave rise to a derivative suit, you should go to the BOD first and determine if they want to bring the suit.

WRONGFUL REFUSAL


When a BOD rejects a shareholder’s demand to bring suit, the shareholder’s only form of redress is a

wrongful refusal claim The court will then only scrutinize the process through which the demand was refused.

Demand required and refused: If demand is made and rejected, the board rejecting to the demand is entitled to the presumption of the business judgment rule unless the stockholder can allege facts with particularly creating a reasonable doubt that the board is entitled to benefit of the presumption. Further, Plaintiff, by making a demand, waives his right to contest the independence of the board; a shareholder who makes a demand can no longer argue that demand is excused.

Grimes v. Donald (1996)

RULE: “A shareholder need not make a demand that a company’s board institute a lawsuit before bringing a derivative suit on behalf of the corporation on a showing the demand would be futile, and if a demand is made and rejected, a shareholder may still proceed by establishing that the board’s refusal was wrongful.”

Statement of the CaseDonald entered into agreement to manage DSC. The agreement gave him employment till the age of 75 allowing him to quit without cause if either the board or management interfered with his management. Upon termination, Donald would receive a generous severance package. Grimes, a shareholder asked DSC to annul this agreement. The board refused his demand claiming that Donald’s compensation is fair and his duties do not an impermissible delegation of the board’s duties.

ISSUE: Must a shareholder make a demand of the company’s board before pursuing a derivative claim if he or she has no reason to believe the demand would be futile, and may the shareholder pursue his or her claim if the board’s decision is not the result of considered business judgment?

HOLDING: YES; the delegation here is protected by the judgment rule. Grimes must make a demand of the corporation before instituting his own action, and his complaint must either allege that the board denied his request or offer a reason why the demand would be futile. The demand is excused only if the shareholder has reasonable doubt that the board could exercise appropriate judgment. If the shareholder’s demand is rejected, the presumption is that the board acted properly unless the shareholder can allege a basis from which reasonable doubt would be raised. If evidence suggests that the board did not act properly, the shareholder can bring his claim based on wrongful refusal. The plaintiff here made a pre-suit demand and cannot later contend that the demand was excused. Because DSC made an effort to review Grimes’ claims, its decision is protected under the BJR.

Golden Parachute (granting upper management lucrative severance benefits): often challenged; legal basis of suit – breach of duty of loyalty if you find conflict of interest. In the absence of conflict, you can allege corporate waste, breach of duty of care.

If there is reason to doubt that the board acted independently or with due care in responding to the demand, the stockholder may claim wrongful refusal in a direct action.

Rule- The Board may refuse suit and be protected under the BJR unless the shareholder can allege with particularity and create a reasonable doubt that the Board is not entitled to the benefit of the presumption. How? By showing that a majority of the Board had a personal interest, stake or benefit in the underlying transaction.

Rule: Directors may not delegate duties which lie at the heart of the management of the corporation.


Rule: An informed decision to delegate a task is as much an exercise of business judgment as any other. Thus, business decisions are not an abdication of directorial authority merely because they limit a board’s freedom of future action.

THREE (3) INSTANCES WHERE DEMAND IS EXCUSED o The majority of the board has a financial interest; the Court examines the directors’ stake

in the underlying transaction that is the subject of the litigation (Ex: the directors have no financial interest in a Golden Parachute suit). Garten says this is a high threshold to meet

o When there is doubt the board will make a reasoned decision (BJR) because of the domination or control of other board members or someone they

o If there is any reasonable doubt that the underlying transaction is a product of the valid exercise of reasonable business judgment. Garten says this seems like making the plaintiff prove a likelihood to prevail on the merits.

SPECIAL LITIGATION COMMITTEES

If the demand on the board has been excused because it was futile, courts will still allow demand to come in indirectly through Special Litigation Committees. It arises in demand-excuse cases. In the 1970s, corporate defense attorneys came up with a way for the “innocent minority” of directors to make the decision whether the corporation should sue the other board members. The board creates a committee consisting of some or all of the directors not implicated in the alleged wrongdoing and delegates to that committee the power to decide if the corporation should pursue a lawsuit against the majority. Thus, this committee speaks for the board of directors.

The composition is critical. Often, the committee is composed of people who are NOT directors at the time of the alleged wrongdoing. This committee typically hires counsel to investigate the facts that lead to the derivative suit. The committee, with the aide of the attorney and other experts, than investigates the facts and evaluates the merits of the case – projected costs, potential benefits to the corporation, etc. the committee then incorporates its findings into a report which it submits to the court with the committee’s recommendation as to whether the suit should be continued or terminated – couched in terms of the best interests of the corporation. Usually, it is to dismiss the suit. Because of this, skepticism often develops as to whether the committee was unbiased and whether its recommendation is based solely on the best interests of the corporation. Directors are judging their own. This skepticism has led to three main approaches:

(1) The (Majority Rule) Delaware Approach – Zapata Corp. v. Maldonado asserts that (1) the defendants have the burden of proving the committee members’ independence and the procedural completeness of their investigation; basically, committee must establish its independence (individuals who are on the committee are not involve in the wrongdoing that is alleged in the suit complaint and that they are not subject to the control, either financial or to family ties, to the defendants in the suit), its good faith (thoroughness of its investigation of the facts and law), and that its recommendations are supported by reasonable basis (suit lacks


merit, the cost of proceeding with the suit outweighs the benefits, the continuance of the suit has a negative morale on the corporation, it’s a huge deflection of employee time, etc.) and (2) if the special litigation committee’s recommendation passes the first part of the test, the court exercises its own independent judicial discretion or business judgment in determining whether or not it is the corporation’s best interest to dismiss the suit; thus, the court is asked to stand back and make an evaluation as to whether under the totality of the circumstances, would it appear that the dismissal is in the best interest of the company. The court will not dismiss the suit on the second level if the first level is established.

(2) The New York Approach – Auerback v. Bennett asserts that unless the plaintiff can prove that the Special Litigation Committee LACKED INDEPENDENCE or FAILED TO OPERATE ON AN INFORMED BASIS, the committee’s recommendation is entitled to the presumption of propriety afforded by the business judgment rule. Thus if the committee meets regularly, systematically reviews the facts, relies on opinions of independent counsel, makes a detailed record, has a rational basis for their decision, shows the potential claim lacks merit, litigations expenses might exceed potential gains to the corporation, the suit would create bad publicity for the corporation or damage the corporate image, the court will follow the recommendations and dismiss suit.

(3) The Minority (Iowa) Approach – Miller v. Register and Tribune Syndicate asserts that if the board is disqualified from recommending dismissal, than any committee appointed by that board would be likewise disqualified.

The law of the state where the corporation is formed determines whether they adhere to the Auerbach approach or Zapata approach or something else in addressing a special litigation question.

§141(c): allows a board to delegate its authority. Committees set up to evaluate suit and make suggestion for Board’s decision after being presented with demand. Must be comprised of insider directors who have FD to shareholders.

created to test validity of a SHs request for derivative action while preserving the appearance of disinterested independence of the Board Members

disinterested independence exists when the Special Committee Members have no direct financial stake in the litigation

made up of non-implicated or new “independent” directors (who happen to be chosen by the defendant directors, thereby creating an obvious conflict of interest)


The decisions of independent Special Litigation Committees are protected by BJR shareholder will claim wrongful refusal when committee chooses not to proceed

Business Judgment Doctrine: The action of the special litigation committee is comprised of two components: (1) the selection of procedures appropriate to the pursuit of its charge and (2) ultimate substantive decision. The latter, substantive decision falls squarely within the embrace of the business judgment doctrine and to this extent the conclusion reached is outside the scope of the court review. As to the methodologies and procedures best suited to the conduct of an investigation of facts and the determination of legal liability, the courts are well equipped by long and continuing experience and practice to maker determination. Auerbach v. Bennett

Auerbach v. Bennett (1979) – New York View (plaintiff assumes the burden of proof)

RULE: “A special litigation committee’s determination forecloses further inquiry into a matter, provided the committee’s investigation is bona fide.”

Statement of the CaseGTE conducted an investigation to determine whether bribes had been paid to public officials or political parties. Based on the report, matters were brought before the GTE board and they referred the matter to an audit committee. Several months later, the group asserted and filed with SEC that GTE and its subsidiaries had made foreign payments of more than 11 million and that some of the transactions were handles by GTE directors. After those reports, Auerbach filed a derivative suit seeking to have those officials reimburse GTE for the bribes. Afterwards, GTE created a special litigation committee after the scandal to represent them. The committee found that GTE performed its audit in good faith, it found no self-dealing, and that absent valid claims against the defendants, this suit would pose a drain on management’s time and resources. GTE won below.

ISSUE: May a board appoint a special committee to investigate the allegations contained in a derivative suit and to determine whether the lawsuit should be dismissed?

HOLDING: YES; the judgment rule holds that business is in better position than the courts to determine their best course. The rule will shield the committee’s decisions only if the members are found to have a disinterested independence. Based on the facts here, it is clear the committee members were independent of the transactions. The board chose a committee that was excluded from personal prejudice. This was prudent business practice. To have the board have no members of its board on the committee would make the board powerless it their decision to forego a derivative suit. Again, such judgments made by this committee are shielded under the rule. However, the court may review the process and methods the committee used to reach its decision to ensure the committee exercised good faith in its investigation. Proof that the investigation was a sham would raise questions of good faith that would not shield the committee under the rule. The plaintiff here offered no evidence in establishing a lack of good faith.

Reasoning: That committee promptly engaged eminent special counsel to guide its deliberations and to advise it. The committee reviewed the prior work of the audit committee, testing its completeness, accuracy and thoroughness by interviewing representatives of Wilmer, Cutler & Pickering, reviewing transcripts of the testimony of 10 corporate officers and employees before the Securities and Exchange Commission, and studying documents collected by and work papers of the Washington law firm. Individual interviews were conducted with the directors found to have participated in any way in the


questioned payments, and with representatives of Arthur Andersen & Co. Questionnaires were sent to and answered by each of the corporation’s management directors. At the conclusion of its investigation the special litigation committee sought and obtained pertinent legal advice from its special counsel.

Rule: The BJR does not foreclose inquiry by the courts into the disinterested independence (people nominated by board to act on behalf of the corporation MUST be independent of the board’s control and not tied to the matter at issue) of those members of the board chosen by it to make the corporate decision on its behalf. Indeed the rule shields the deliberations and conclusions of the chosen representatives of the board only if they possess a disinterested independence and do not stand in a dual relation which prevents an un-prejudicial exercise of judgment.

Zapata v. Maldonado (1981) – Delaware View (defendant assumes the burden of proof)

RULE: “While a majority of a board may lack the independence to evaluate a derivative claim, the taint of self-interest is not necessarily sufficient to prevent the board from delegating the evaluation to an independent committee comprised of disinterested board members who may recommend dismissal of a shareholder’s action.”

Statement of the CaseMaldonado sued Zapata officers and directors charging them for a breach of fiduciary duty to the company. The plaintiff did not demand Zapata to bring forth the action for it may be futile since all the directors were named as defendants and all had participated. Four years later, four of the directors were no longer on the board and thus they replaced them with 2 outside directors. The board then created a committee to investigate the plaintiff’s case. The committee decided not to go ahead with the litigation.

ISSUE: Must a trial court, when facing a motion brought by a committee appointed by a corporation’s board of directors, demanding the dismissal of a shareholder suit, grant that motion notwithstanding the fact that members of the board may have had an interest in the committee’s result?

HOLDING: YES; the trial correctly ruled that when a shareholder’s demand is refused, he or she obtains an independent right to pursue a derivative action. The plaintiff failed to make demand. However, a board’s decision can be overturned upon showing that the decision was wrongful. Note that deference is granted to the board under the judgment rule. Unless the board was wrongfully refused or the plaintiff brought the action without consent because of futility, a shareholder cannot override the company’s decision. However, this rule is irrelevant here. Statutes permit the board to delegate a committee in deciding whether to litigate. Allowing a corporation to use committees to stop plaintiffs takes the power away from a derivative suit but at the same time it is undesirable dealing with frivolous suits. The court must find a balance between the two. Thus, if the committee determines in good faith that the action must be dismissed, then the court is to oblige, absent bad faith, a lack of independence, and an inadequate investigation. More than a business judgment must be shown to excuse the suit. The committee must present to trial court its recommendations including its investigations, findings, proof of independence and good faith. The trial will determine under its discretion whether to dismiss the claim or not.

A demand, when required and refused (if not wrongful), terminates a stockholder’s legal ability to initiate a derivative action. But where demand is properly excused, the stock holder does possess the ability to initiate the action on his corporation’s behalf.


The procedures that a SLC uses to come to its decision are not protected by the BJR, but their substantive decision is.

§141(c) allows a board to delegate all of its authority to a committee. Accordingly, a committee with properly delegated authority would have the power to move for dismissal or summary judgment if the entire board did.

As a matter of policy, courts want directors to make decisions wherever possible. Courts do not want to impose their own judgments.

DELAWARE VIEW IN DEMAND-EXCUSED CASES ONLY Zapata Corp. v. Maldonado

If Plaintiff is arguing that demand is excused, and the committee petitions the court to dismiss the case, the following analysis will occur. Here, the court went further than Grimes and Auerbach and examined the substance of the SLC decision:

o The Court looked at whether the board members in the SLC are independent and the Court required the board members to show that they are INDEPENDENT and the plaintiff shareholder does not have to make this showing anymore

o The plaintiff must plead with particularity, facts that raise a reasonable doubt that either the directors are disinterested or independent or plead with particularity that the challenged transaction based on the facts is beyond the business judgment rule; on its face it constituted a non-rational basis or waste action since it was too extreme.

o Must show a self-dealing transaction

Why the shift in Zapata ? The new rule lets corporations know that they cannot get away with bad behavior. It may also be useful by letting more suits get into the courtroom so that the law can be clarified in unsettled areas. The obvious problem is that most suits settle so this really isn’t a great justification!

Pros and Cons of SLC allows “strike suits” to be terminated at an early stage a SH can always argue that a “structural bias” is unavoidable when Committee Members are

appointed by the Board that has been implicated

In re Oracle Corp. Derivative Litigation (2003) – Delaware Case (Zapata applies)

RULE: “A director’s lack of independence turns on whether the director is, for any substantial reason, incapable of making a decision with only the best interest of the corporation in mind.”

Statement of the CaseOracle shareholders filed a derivative suit against Oracle directors, which an Oracle special litigation committee sought to dismiss.

ISSUE: Has the SLC established its independence from the Oracle board of its directors?


HOLDING: NO; here the ties between the SLC, the trading defendants, and Stanford University are so strong that independence cannot be proven. The defendants here have an extensive history together and it is without doubt that bad faith was involved in dismissing the suit.

INDEMNIFICATION AND INSURANCE

Indemnification Rights of officers of directors – if they are successful, they would be indemnified from the expenses incurred (attorney fees, court fees). If they are unsuccessful, the court will analyze whether or not to grant the officers indemnification nonetheless. Waltuch v. Conticommodity Services, Inc. – the party seeking indemnification must act in good faith as such that the officer did not knowingly violated the law or regulatory provision.

Indemnification: All states have statutes dealing with when the corporation may (and/or must) indemnify a director or officer against losses he incurs by virtue of his corporate duties.

1. Mandatory: Under most statutes, in two situations the corporation is required to indemnify an officer or director: (1) when the director/officer is completely successful in defending himself against the charges; and (2) when the corporation has previously bound itself by charter, law or contract to indemnify.

2. Permissive: Nearly all states, in addition to this mandatory indemnification, allow for "permissive" indemnification. In other words, in a large range of circumstances the corporation may, but need not, indemnify the director or officer.

a. Third party suits: In suits brought by a third party (in other words, suits not brought by the corporation or by a shareholder suing derivatively), the corporation is permitted to indemnify the director or officer if the latter: (1) acted in good faith; (2) was pursuing what he reasonably believed to be the best interests of the corporation; and (3) had no reason to believe that his conduct was unlawful. (Example: D, a director of XYZ, acts grossly negligently, but not dishonestly, when he approves a particular corporate transaction. XYZ may, but need not, indemnify D for his expenses in defending a suit brought by an unaffiliated third person against D, and for any judgment or settlement D may pay.)

b. Derivative suit: If the suit is brought by or on behalf of the corporation (e.g., a derivative suit), the indemnification rules are stricter. The corporation may not indemnify the director or officer for a judgment on behalf of the corporation, or for a settlement payment. But indemnification for litigation expenses (including attorney’s fees) is allowed, if D is not found liable on the underlying claim by a court.

c. Fines and penalties: D may be indemnified for a fine or penalty he has to pay, unless: (1) he knew or had reason to believe that his conduct was unlawful; or (2) the deterrent function of the statute would be frustrated by indemnification.

3. Who decides: Typically, the decision on whether D should be indemnified is made by independent members of the board of directors. Also, this decision is sometimes made by independent legal counsel.

4. Advancing of expenses: Most states allow the corporation to advance to the director or officer money for counsel fees and other expenses as the action proceeds. The director or officer must generally promise to repay the advances if he is ultimately found not entitled to


indemnification (but usually need not make a showing of financial ability to make the repayment).

5. Court-ordered: Most states allow D to petition the court for indemnification, even under circumstances where the corporation is not permitted or not willing, to make the payment voluntarily.

INDEMNIFICATION The corporation reimburses the officer and director for expenses and/or judgments he incurs relating to

his actions on behalf of the corporation. Pros promotes employee moral; employers will not be able to retain w/o protectionCons if an employee may escape liability, he may be prone to be more negligent

a corps indemnification provisions are most likely found in the corps bylaws In DELAWARE, indemnification is provided “on the merits or OTHERWISE

o DGCL §145(c) affirmatively requires corporations to indemnify its officers and directors for the “success on the merits or otherwise.” Success means escape from an adverse judgment or other detriment – like settlement w/o direct payment by the shareholder.

o § 145(a) fixes the outer boundaries (good faith) of a corp.’s ability to indemnify further under §145(f)

§ 102(b)(7) DELAWARE protective provision that applies only to the liability of a director to the corporation or its shareholders for monetary damages for breach of fiduciary duty as a director

§ 145(a) allows indemnification (in direct suits) in certain circumstances for expenses, judgments, fines and amounts paid in settlement when the Officer, Director, or employee has acted in “good faith” and in the interest of the corporation – the Board will conduct a case-by-case analysis

If acting in good faith and in the Company’s best interest, may get indemnified for everything. But if you engage in criminal conduct, Company can’t indemnify.

§ 145(b) allows indemnification for expenses in derivative suits (judicial approval of indemnification is required if the employee is found liable – NOT often granted often because would lead to circular recovery)

§ 145(c) expenses must be reimbursed if you are successful on the merits OR otherwise (has escaped adverse judgment)

if corp. pays settlement on behalf of defendant employee, he is deemed otherwise successful and qualifies for indemnification

some courts allow pro rata indemnification when multiple charges are being brought§ 145(d) Board has the right to determine if an employee should be indemnified – protected by the BJR

If the Board denies indemnification, the employee will likely bring a breach of fiduciary duty claim.

If indemnification is granted the Board will usually be sued by the shareholders for breach of fiduciary duty

§ 145(e) allows for advancement in expenses DGCL § 145(e) expressly permits a corporation to advance the costs of defending a suit to a

director. Therefore, a corporation may advance reasonable costs in defending a suit to a director even when the suit will does not satisfy indemnification requirements

• 145(b): can be indemnified under derivative suit. Different standard than 145(a); directors sued under derivative suit are not indemnification if found liable; no indemnification; 145(a) is for direct suits. In a


derivative action, you can get indemnified if you win under 145(c) but if you lose you get nothing under 145(b); if you settle, you may get indemnified; Incentive to settle and for plaintiff to bring suit.

• In general, section 145 isn’t mandatory but….Indemnification is mandatory when: 1. Director/officer is completely successful in his defense against charges2. Corporation has specified particular circumstances when it will indemnify in its charter, K, or law so long as good faith is shown.

Indemnification is permissive when:1. A 3rd party suit is brought and the directors and officers acted in good faith, pursued what he believed to be the best interest of the corporation, and had no reason to believe that his conduct was unlawful.2. A derivative suit is brought and directors and officers are not found liable on the underlying claim, the corporation may indemnify for litigation expenses.3. A fine or penalty is imposed unless the directors and officers knew or had reason to believe that his conduct was unlawful, or the deterrent of the statute would be frustrated by indemnification.

Advancement of Expenses- Defendant may request advancement of litigation expenses in most states with a promise to repay if ultimately not found entitled to indemnification.

Court Ordered Indemnification- Most states allow the D to petition the court for indemnification, even if corporation is unable or unwilling.

How does company decide to indemnify? The Board meets (members must be independent, otherwise delegate to subcommittee) and considers whether it can legally indemnify. Must make sure that D/O acted in good faith otherwise they may be subject to a duty of care case.

Waltuch v. Conticommodity Services, Inc. (1996)

RULE: “A corporation must indemnify its officers, directors, and employees against legal expenses related to the defense of any legal action brought against them by reason of their position or capacity, provided the individual acted in good faith.”

Statement of the CaseWaltuch, VP of CS traded silver for the firm’s clients and himself. Silver prices rose sharply in late 1979 then dropped rapidly causing the silver market to crash. Numerous lawsuits were filed against Waltuch alleging fraud, market manipulation, and antitrust violations since the consumers engaged into silver futures contract with CS prior to the crash. Waltuch agreed to pay numerous fees that resulted from his litigations. He paid more than 35 million to plaintiffs, incurred 1.2 million in defending himself, was fined 100,000 dollars and now incurs a current legal fee of 1 million in which he is seeking to the corp. to indemnify.

ISSUE: Must a corporation indemnify its employees against legal expenses related to the defense of any action brought against them by reason of their position or capacity, even if they did not act completely in good faith?

HOLDING: NO; a corporation may choose to provide its employees with additional indemnification rights and other forms of indemnification, but it is not required to do so.


o It is not the court’s business to ask why a result was reached

Citadel Holding Corp. v. Roven (1992)

RULE: “A corporation may advance a director the costs of defending a lawsuit.”

Statement of the CaseCitadel was a savings and loan company. Roven was a director. He entered into an indemnity agreement with Citadel where it would indemnify Roven in a threatened or actual suit, civil or criminal, etc. However, actions brought under section 16(b) would be a bar to indemnification. The agreement allows Roven to advance costs of defending certain lawsuits as long as Roven pays the advances back. Citadel sued Roven since he violated section 16(b) by purchasing options to buy Citadel stock while as director. Roven contests he did violate the section but is entitled to make advances.

ISSUE: Is an employee party to an indemnity agreement with his or her employer entitled to an advance for costs related to a federal action the employer brought against him?

HOLDING: YES; a corporation may advance to a director the costs of defending a lawsuit. Although the law § 145(e) makes this authority permissive, the parties’ agreement makes it mandatory.

o Under both the statute and the Agreement, the corporation’s obligation to pay expenses is subject to a reasonableness requirement.

o Delaware law applies unless the charter has established greater protection for its employees that are not violative of other states’ statute.

§ 145(f) contemplates agreements that provide greater protections than the statute provides – CAN not circumvent the “good faith rule” of § 145(a)

INSURANCE• Nearly all large companies today carry directors’ and officers’ (D&O) liability insurance. Most states explicitly allow the corporation to purchase such insurance. Furthermore, D&O insurance may cover certain director’s or officer’s expenses even where those expenses could not be indemnified.

1. Typical policy: The typical policy excludes many types of claims (e.g., a claim that the director or officer acted dishonestly, received illegal compensation, engaged in self-dealing, etc.).

2. Practical effect: Insurance will often cover an expense that could not be indemnified by the corporation. For instance, money paid to the corporation as a judgment or settlement in a derivative action can usually be reimbursed to the director or officer under the director and officer policy.

Typically 2 types of insurance to protect directors and officers:1. Directors and officers have their own liability policies paid by company.2. Company has insurance to cover expenses for reasons of indemnification.

• Does it matter what indemnification is? Why not rely on insurance? Cost is an enormous factor. There are certain industries (drug/pharmaceutical) that have no insurance, thus resort to self-insurance (indemnification).• Policymaker: what should they do? Corporate law stands in the middle. Procedural hurdles but you can stay bring it. Safety valve: Zapata case.


Some corporations have combined to form their own captive insurance companies or have established trust funds to pay for damages and expenses.

§ 145(g) authorizes the use of insurance to limit further liability of officers and directorsO allows a corporation to circumvent the “good faith” clause of § 145(a) by purchasing O&D’s

liability insurance

D. THE SHAREHOLDERS

THE SHAREHOLDERS ARE THE CORPORATE OWNERS BUT THEY DO NOT PARTICIPATE IN MANAGEMENT NOR DO THEY HAVE ANY AUTHORITY TO ACT FOR OR BIND THE CORPORATION. THEIR VOTE IS REQUIRED TO APPROVE FUNDAMENTAL TRANSACTIONS THAT AFFECT THEIR INTEREST. THROUGH THIS, THEY INDIRECTLY EXERCISE A GREAT DEAL OF INFLUENCE OVER THE BOARD. THE LAW PROTECTS SHAREHOLDERS BY PROVIDING THEM WIITH (1) THE RIGHT TO VOTE [WHICH IN MOST CORPORATE STATUTES ALLOWS SHAREHOLDERS TO REMOVE DIRECTORS], (2) THE RIGHT TO INFORMATION, AND (3) THE RIGHT TO SUE BOTH DIRECTORS AND OFFICERS FOR BREACH OF THEIR FIDUCIARY DUTIES.

PROXY SOLICITATION – FEDERAL LAW GOVERNS, NOT STATE

PROXY VOTE IS CONFERRING AUTHORITY ON AN INDIVIDUAL TO VOTE SHARES FOR THE PERSON WHO CONFERRED SUCH AUTHORITY, OR SIMPLY A SHAREHOLDER GRANTS THE POWER TO VOTER HER SHARES TO SOMEONE ELSE. THE PARTIES NECESSARY ARE THE PROXY-GIVER, WHICH OWNS THE SHARES AND THEN TRANSFERS THE POWER AND AUTHORITY TO THE PROXY-HOLDER. THE PROXY IS NOTHING MORE THAN AN AGENCY ARRANGEMENT. THE PROXY-GIVER AUTHORIZES THE PROXY-HOLDER TO ACT CONSISTENTLY WITH THE AGENCY, AS SUCH TO VOTE ON BEHALF OF HIM. PROXIES ARE REVOCABLE BY WORD, ACTION, OR DEED UNLESS COUPLED WITH AN INTEREST.

REASONING : Shareholders appoint agents to attend shareholder meetings and vote on their behalf because voting for directors at the company’s annual meeting in a publicly held corporation is typically not a matter of high priority for the overwhelming majority of shareholders. (ex. A company’s annual meeting is held in NYC. It is unlikely that a shareholder that lives in Arizona would make the flight to NY for such meeting). Thus if shareholders vote at all, it is usually be proxy. Management must solicit or request for proxies to obtain a quorum so that business can be transacted at the meeting. The quorum is typically a majority of the shares entitled to vote.

shareholders seldom find it cost-effective to become well informed in corporate disputes, much less to attend any meeting in person

the document by which shareholder appoints an agent is also called a proxy card “Proxy fights” occur in contested elections (which are rare) where an insurgent group tries to oust

incumbent Officers and Directors by soliciting proxy cards and electing its own representatives to the Board of Directors. Non-contested elections involve the usual annual meeting of shareholders where the holders are required by state corporate law to meet and elect directors. The only party soliciting proxies in this situation is management. (THIS IS THE USUAL COURSE OF BUSINESS)

Proxy fights are regulated by § 14(a) of 1934 Securities and Exchange Act which lists what type of information needs to be disclosed in a proxy. These fights are operated much like a political campaign in order to gain operating control.

Section 14(a) does not expressly authorize private actions. However, the U.S. Supreme Court has interpreted implied rights of actions under the proxy rules.


To come within proxy regulation under the federal act, the securities of the corporation must be listed on a national exchange (typically any national market with the name exchange in it), or if they are not listed on the national exchange, the company must have assets of about 10 million dollars or more, 500 or more shareholders of that class of stock at the end of the fiscal year, and either its securities or businesses engage in interstate commerce. – ONLY Publicly Held Corporations fall into these categories.

The proxy rules have three different orientations (1) protocols – these are procedures that the SEC has adopted as rules that make sure that the proxy solicitation is fairly understood to be a proxy solicitation and that investors have the right kind of information before them to be able to decide how they are going to vote their shares in response to proxy solicitation; (2) basic information package – this package changes with the type of proxies; it mandates certain sets of information that must accompany or precede a proxy solicitation that is regulated by section 15(a); (3) pre-filing requirement - proxy materials must be filed with the SEC in advance before mailing them out to investors. So there is a pre-filing requirement which is found in 14(a)-6

Three major exceptions to what is not a proxy solicitations – (1) Section 14(a)-2(b)-2 provides that a communication that is sent to no more than 10 individuals is not a proxy solicitation; (2) Section 14(a)-2(b)-1 provides that public communication through press release or a letter towards someone who one have a fiduciary relation to announcing how one intends to vote their shares at an upcoming meeting is not a proxy solicitation; (3) there is an exemption of a communication that urges a shareholder to vote in a particular matter providing the person writing the letter does not solicit a proxy

Communications through proxy solicitations must be free from any material omissions and misstatements – section 14(a)-9 > this provision broadly prohibits any false or misleading statements with respect to any material fact in regards to the solicitation of proxies.

If a party is attempting to recover damages or seeking to rescind a transaction that was taken on the basis of a misleading proxy solicitation, most circuits require proof of a negligent commission of the omission or misstatement of material fact.

A proxy solicitation that is misleading must have a causal connection of the material omission and misstatement to the transaction in order to bring suit.

The remedies available for violation of the proxy rules include injunctions, rescission and damages, or a combination of these remedies.

Why are Proxies regulated by the Federal Government?The proxy rules are not about raising money or buying and selling stock. They are about corporate governance, an area traditionally regulated by the several states. However, since a lot of corporate activity crosses over several states, it makes obvious sense, especially for large corporations, for the federal government to regulate activity > efficiency.

§ 14(a) of 1934 Act – Proxies Courts construe the concept of “solicitation”

Rules 14a-3, 14a-4, (format) 14a-5, and 14a-11 require people who solicit proxies to furnish each shareholder with a proxy statement containing (1) an annual report, (2) disclosure of any conflict of interests and (3) disclosure of any major issues expected to be raised at the shareholders meeting

Rule 14a-6 requires that parties soliciting proxies file their proxy statements with the SECRule 14a-7 Insurgent’s rights to obtain info from management (distance access rule): grants

incumbent management the choice of (a) mailing the insurgent groups proxy materials out and then charging for cost, or (b) providing insurgent group with shareholder list so they may conduct their own distribution. (Tactical Importance) Those who want to solicit proxy in opposition to management; the dissident prepares its own materials and gives those to management so they can


mail it out to the shareholders. Management can choose not to mail this out, but if it does so, it must available to you the list of shareholders in a publicly held corporation. The dissident has to pay the printing costs and postage which is a lot of money in a publicly held corp.

• Most corps will choose to mail and charge so as to avoid giving up shareholder list and allowing insurgent to learn identities of major players. However, identities of +10% shareholders may be discovered through SEC filings under 16(a)

When do corporations typically need proxies?1. To select the Board (done annually). Usually there is only one slate nominated for the Board. However, occasionally there is a proxy contest where a competing slate seeks nomination. If the contest is successful the new Board may be reimbursed by the corporation for its proxy costs. 2. To select outside auditors3. To vote on shareholder proposals (§ 14(a) (A) discusses when this must be included in the proxy materials)4. To vote on mergers or other changes in corporate structure

ADVANTAGES FOR MANAGEMENT 1) incumbent management also has the ability to use corporate funds to pay for its defense, and have the

advantage of knowing who the shareholders are – thus allowing them to wine & dine the big shots2) Shareholders usually vote for the management3) management usually knows who the shareholders are whereas the insurgents will usually have to litigate to

obtain the shareholder list

SHAREHOLDER PROPOSALS - § 14a-8

Surgical Staple Co. Hypo- This hypo discussed in class involves a company that tests their staples on live dogs. A group of shareholders wants to contest this practice and seeks to do so in a proxy statement. However, the Board wants to exclude the proxy proposal. The issue is under what circumstances a Board can exclude a proposal? § 14(a)(8) deals with shareholder proposals and lists 13 reasons why a company may exclude one. They include:

· Improper shareholder action under state law (where corporation is located)· Proposed action is illegal under state, federal or foreign law· Personal grievance against the corporation or D/O, or if action pertains to a special interest that is not shared by shareholders at large.· Insignificant relationship- the proposal accounts for less than 5% of the issuer’s total assets and for less than 5% of its net earnings and gross sales in the last fiscal year, and is not otherwise significantly related to the issuer’s business. A significant relationship can be financial, social or ethical.· If the proposal deals with ordinary business of the company. Why? Because day to day operations would be inefficient if subject to constant shareholder approval and seeks to micromanage a company which is a task shareholders are not informed enough to do. · Specific amounts of dividends

• For a shareholder proposal under § 14a-8(b)(1) the shareholder must have owned at least 1% or $2,000 in market value of securities for at least a year

• Proposal must be no longer than 500 words• SEC favors the inclusion of social policy proposals


• Proposals are considered non-binding recommendations made to the BOD (SH can not demand that the board follow their determination)• DGCL § 109 – shareholders may unilaterally vote in changes to the corporations by-laws, but at the same time the Board retains the right to unilaterally rescind

BURDEN OF PROOF TO SHOW THAT A PROPOSAL SHOULD BE EXCLUDED IS ON THE CORPORATION

Very few ever succeed, 3% is considered a victory b/c it allows the proposal to be resubmitted May expose issues to the public at large and initiate policy changes

PROPOSAL PROCESS – REQUIRES THE FILING OF A PROXY STATEMENT

Rule 14a-8: this is a method of allowing shareholders to introduce their proposals to stockholders through management proxy statements. A proxy statement is a comprehensive disclosure document which must accurately and truthfully provide all of the information relevant to the matters to be voted on at the meeting. Rule 14a-3 provides that no one may solicit a proxy unless the solicitation is accompanied or preceded by a proxy statement. The rule also requires the proxy statements to be accompanied or preceded by an annual report to shareholders, containing specified financial data. Rule 14a-4 regulates the form of the proxy card on which shareholders indicate their approval or disapproval of each matter voted on at the meeting. Rule 14a-6 requires copies of the proxy statements and form of proxy be filed with the SEC at or before the time they are first mailed to the shareholders. If the proxy statements however relate to other matters rather than election of directors, shareholder proposals, etc., the statement and proxy must be filed at least 10 days with the SEC prior to mailing.

The proposal, which is also regaled by the proxy rules, cannot be in opposition to management, the stockholder must own at least 1% of company stock or must be owner of $2000 market value for a year, then take proposal, which must be a proper subject for shareholder action, and give it to management. If they agree with the proposal, then it rides with their materials, if not, then a proponent is allowed to write a rebuttal letter. This provision can allow shareholders to have his or her materials “piggy back” management materials. The proposals usually address management compensation, environmental matters, discrimination, health issues, etc.

If corporate management believes that a proposal may be excluded from its proxy, it will send a notice setting forth its reasons of its intent to exclude to the SEC and the shareholder. If the company decides to exclude the proposal, the shareholder may appeal to the courts.

If the SEC agrees with the issuer decision to exclude, it will issue a NO ACTION NOTICE

o if SEC determines that the proposal should be included, it will inform the issuer that the SEC may bring an enforcement action

Exclusions Rule 14a-8: Many kinds of proposals are excluded from Rule 14a-8, so management can refuse to include them. Some of the important exclusions generally are:

(1) Proposals that are contrary to state law;

(2) Proposals that violate the law or rules of the SEC,

(3) Proposals that relate to personal claims or grievances,

(4) Proposals that relate to operations that account for less than 5% of the companies business or that have been rendered moot,


http://www.lexis.com/research/xlink?searchtype=lxt&search=17+CFR+240.14a-8

http://www.lexis.com/research/xlink?searchtype=lxt&search=17+CFR+240.14a-8

(5) Proposals similar to proposals previously submitted during the past five years, which received less than a specified percentage of votes.

Exclusions - BREAKDOWN:

a. Beyond Power to Effectuate: A proposal may be excluded if the proposal deals with a matter beyond the registrant’s power to effectuate. (Example: national solution to the problems of growing health insurance costs.) Rule 14a-(8)(i)(6)

b. Not significantly related to corporation’s business: A proposal may be excluded or disallowed if it is not significantly related to the company’s business (i.e., if it counts for less than 5% of the corporation’s total assets and less than 5% of its earnings and gross sales, and is "not otherwise significantly related to the [corporation’s] business"). (Example: A proposal calls for Corp’s widget division to be divested because it has a poor return on equity; if the widget division accounts for less than 5% of Corp’s assets, earnings and sales, the proposal may be excluded.) Rule 14a-(8)(i)(5)

I. EXCEPTION – Ethical/social issues: But ethical or social issues may usually not be excluded for failure to meet these 5% tests, if the issues are otherwise related to the corporation’s business.

Lovenheim v. Iroquois Brands, Ltd. (1985)

RULE: “Under section 14(a) of the SEC, shareholders may include in the company’s proxy statements certain materials that have limited, if any, economic impact on the company as long as they are otherwise significantly related to the issuer’s business.”

Statement of the CaseLovenhein owned 200 shares of common stock in Iroquois and thus wanted a proxy statement included in the materials as to the treatment of geese in their production. He wanted to use the annual shareholder meeting as a forum for his belief that the company is fostering animal cruelty by its sales. He claims to have this right under the act especially in presenting a rebuttal letter. Iroquois refused under the exception above Rule 14a-(8)(i)(5), asserting that its revenue from these sales comes under the 5% threshold.

ISSUE: May an issuer refuse in its proxy materials a shareholder’s information on a proposed resolution if the issuer decides the materials relate to a subject that is not economically significant to the company?

HOLDING: NO; while plaintiff is aware that his resolution may not pass, the loss of an arena to voice his concerns is real and the harm may be irreparable. Iroquois is not likely to be injured by the message. Furthermore, the drafters of the act used the clause “otherwise significantly related to the issuer’s business” which would indicate a distribution of information of a non-economic nature. The court found that the issue here was sufficiently related to the business.

Rule: significance of the shareholder proposal rule is aimed at guaranteeing that SH have access to proxy statements whether or not their proposals are likely to pass and regardless of the immediate force of the resolution if enacted. Absent a preliminary injunction, plaintiff will suffer irreparable harm by losing the opportunity to communicate his concern with those SH not attending the upcoming SH meeting.

c. Ordinary Business Operations: A proposal may be excluded if it relates to the "conduct of the ordinary business operations" of the company. (Example: A proposal that the company charge 10%


less for one of its many products would relate to ordinary business operations, and thus be excludible.) Rule 14a(8)(i)(7)

i. Compensation issues: Proposals concerning senior executive compensation are not matters relating to the "ordinary business operations" of the company, and may therefore not be excluded. (Example: A proposal suggesting that the board cancel any "golden parachute" contracts it has given to senior executives — i.e., contracts that give the executive a large payment if the company is taken over — must be included in the proxy materials.)

d. Personal claim or grievance: A proposal may be excluded if the proposal relates “to the redress of a personal claim or grievance against the registrant or any other person, or if it designed to result in a benefit to the proponent, or the further a personal interest, which benefit or interest is not shared with the other security holders at large. (Example: Company who makes surgical staples invites sales people to come to facility to experiment by surgery on dogs. Group of shareholders did not like such sale tactics. Company refused to include it arguing personal interest and grievance). Rule 14a(8)(i)(4)

NYC Employees’ Retirement Sys. v. Dole Food Company, Inc. (1992)

RULE: “A shareholder’s proposal to form a committee to evaluate health insurance proposals before Congress does not relate to the company’s ordinary business operations, but the corporation must include the proposal’s information in its proxy statements.”

Statement of the CaseNYCERS holds 164,841 common shares in Dole Food. The NYC Comptroller required Dole to include a statement concerning the impact of health care costs on employees’ ability to retire. NYCERS proposed a shareholder resolution on the matter to be included within Dole’s proxy statements. Dole sought input by the SEC which agreed with Dole’s right to exclude the proposal based on ordinary operations.

ISSUE: Must a company include a shareholder proposal seeking to have the issuer create a committee to investigate federal proposals affecting employee health care and insurance with its proxy materials?

HOLDING: NO; under the rule in 14(a)-8, the company must include the shareholder’s proposal unless company can show that an exception applies. SEC asserts that if proposals affect a business’s mundane operations, the company may reject the materials, provided they do not touch on a significant strategic decision or significantly affect the manner in which the company does business. The proposal here does not specifically relate to the health care of the company, thus the exception is inapplicable.

Corporation has the burden of showing that the proposal falls under the exceptions enumerated under 14a-8[i] – “ordinary business operation,” “insignificant relation,” and “beyond the power to effectuate”

1. 14a-8[i](7) – “Ordinary Business Operations” – court finds that the proposal does not concern ordinary business operations

2. 14a-8[i](5) – “Insignificant Relationship” (5% Rule) – court determines that the activity addressed by the proposal, insurance, occupies more than 5% of Dole’s income

3. 14a-8[i](6) – “Beyond Power to Effectuate” – court rules that the proposal does not require that Dole seek to lobby for insurance reform, but only that it study the impact of insurance on Dole – a task that is within there capabilities

Austin v. Consolidated Edison Company of NY, Inc. (1992)


RULE: “Shareholders may not require a corporation to include materials concerning a stockholder proposal supporting an employee’s right to retire with full pension benefits with 30 years of service regardless of their age, because the proposal concerns ‘ordinary business operations.’” Statement of the CaseAustin was employed by Con-Ed. Austin wanted Con-Ed to include in its proxy materials support of a resolution allowing an employee to retire after 30 years of service. This was to be part of the upcoming labor negotiations event with their employees. However, this proposal conflicts with the company’s policy of retirement at age 60. Con-Ed obtained a no-action letter from the SEC.

ISSUE: May an issuer exclude from its annual proxy statement information on a proposal by the issuer’s employees concerning retirement qualifications and benefits?

HOLDING: YES; the SEC has a long record of allowing companies to exclude pension proposal information from the proxy statements. The plaintiff may use collective bargaining to press their issue. While the availability of collective bargaining to address an issue is not determinative, it is a more effective forum to resolve issues such as this.

Con Ed prevailed on exclusions under: Rule 14a-8([i])(7) – relates to ordinary business functions; and Rule 14a-8([i])(4) – may exclude if the proposal relates to the redress of a personal claim or

grievance, or if it is designed to result in a benefit to the proponent, or to further a personal interest, which benefit or interest is not shared with the other security holders at large.

• Burden: In attempting to exclude a shareholder proposal from its proxy materials, the burden of proof is on the corporation to demonstrate whether the proposal relates to the ordinary business operations of the company. (Held, Edison has shown that the proffered resolution comes within the exception for ordinary business operations, there is no need to deal also with whether it is designed simply to confer a benefit on and further personal interest of its proponents)

CLOSELY HELD CORPORATIONS

This is a corporation with relatively few shareholders and no regular markets for its shares. Close corporations usually have never made a public offering of shares and the shares themselves may be subject to restrictions on transfer. The controlling shareholders, who are the seat of power in this corporation, typically elect themselves as directors and officers of the corporation. Thus they run all three tiers of corporate governance. A close corporation can be related to a general partnership since they run the business they own, thus they ignore the corporate formalities imposed by the statute. Nonetheless, if a controlling shareholder is not on the board of directors, that shareholder cannot mange the corporation (as authorized by statute). However, in so small a corporation, the controlling shareholder will usually be on the board. There are four governance problems in close corporations: (1) controlling board decisions, (2) controlling voting by other shareholders, (3) controlling the transfer of shares (LATER DESCRIBED BELOW), and (4) abuse of minority shareholders by majority shareholders.

Characteristics


a small company with a small number of shareholders that were deeply involved in the operations of the business (owner & control unified); participants often want an incorporated partnership of shared governance and limited liability

Directors and managers have a larger stake a lack of marketability of the corporate shares (harder to exit because there is no market for

shares), and Extensive and substantial shareholder participation in management, board of directors, etc. There are super-votes and super-quorums in closely held corporations before action

can take place before shareholder and director/management meetings. The bad thing about this is the ability to move forward because you are at a dead-lock situation (filibuster). This gives shareholders equal political power within the company so they won’t get frozen out. Thus they almost retain a veto power. (IT IS TYPICAL FOR A MINORITY HOLDER TO HAVE POWER HERE AS SUCH THE HOLDER BECOMES THE CONTROLLING SHAREHOLDER)

There is a very high chance for deadlock and oppression in which can be remedied by involuntary dissolution

Close corporation form is often used to take advantage of limited liability that would not be granted under a partnership

Usually in the best interest of the Close corp. shareholders to enter into contractual arrangements to preserve their benefits as shareholders – must counter the absence of a market out – most actions surrounding Close Corporation disputes result from bad lawyering

(a) Ensure employment with the corp. (shareholders profits are achieved through a weekly draw, not dividends [shareholding officer and directors would be taxing themselves twice], so want to contractually ensure employments as a pro rata apportionment)

(b) Severance provisions – corp. or remaining shareholders will buy back by the shares at a fair price(c) Provision that prevents other shareholders from transferring their shares to an outsider who may fuck

with the business(d) Assure participation in important business decisions

In a closely held corporation, the majority stockholders have a duty to deal with the minority in accordance with utmost good faith and loyalty, as in partnerships (case-by-case basis). The majority view is that closely held corporations are likened to partnerships, and the duty of loyalty attaches. The minority’s (Delaware) philosophy is that they made their bed and now they must lie in it.

In Delaware, the articles must state that the company is a close corporation, which is subject to a transfer restriction, and has 30 or less shareholders. The shareholders can make decisions that affect the business of the corporation, unlike publicly held ones.

Courts traditionally decline to intercede in the business affairs of a corporation. However, such noninterference has led to the abuse of minority shareholders under the close corporations.

o This relationship is very similar to a partnership, these people can’t get out unless at an extreme cost as opposed to a shareholder who can just sell.

CLOSELY HELD CORPORATION PUBLICLY HELD CORPORATIONSmall, tightly knit group of participants (no more than 30 to 50) – often family members of former partners that has not issued their shares publicly

Large number of investors (more than 500) – no relationship with each other besides their share ownership that has issued their shares publicly


Active, often informal participation by non-specialized investor/owners in managing the business

Limited participation by shareholders in business through proxy voting at formal meetings; active, specialized management by business executives

Undiversified participants who often look to the corporation for livelihood through payment of salaries or dividends

Diversified investors who look for an investment return from appreciation in market price and dividend income

No ready market for shareholders to dispose of their shares – sometimes contractual limits on transferability

Public trading markets (such as stock exchanges) for shareholders to easily dispose of freely transferable shares

Significance of close corporation status: Close corporations present special problems relating to control. The various devices examined here are mainly ways of insuring that a minority stockholder will not be taken advantage of by the majority holder(s). The primary dangers faced by minority shareholders in these corporations are (1) the liquidity problem, and (2) the threat of oppression and freeze-out.

There are transfer restrictions in closely held corporations: (1) membership (who is going to be a shareholder; this position is consequential in this corporation because they exude a lot of power), (2) liquidity (gives the corporation the opportunity to buy the shares from a shareholder who passes away or leaves), (3) right of first refusal, (4) mandatory sell or buy provision back to the corporation, and (5) consent restriction – a transfer cannot occur without the approval of the board of directors or without the approval of the majority of the remaining shareholders. This is authorized by many statutes now. If a statute does not authorize a restriction, then it is not reasonable and thus does not uphold to the standard of reasonableness.

DUTY OF CARE IN CLOSELY HELD CORPORATIONS

Shareholders in a closed corporation owe each other a fiduciary obligation of utmost good faith. The duty imposed on its shareholders is a lot more stringent than that of publicly held corporations. Courts tend to fuse the duty imposed on corporations with the duty imposed on partnerships in closely held corporations.

Donahue v. Rodd Electrotype Company is the ruling case in establishing fiduciary obligations in a closely held corporation. This rule is denoted to be the “Equal Opportunity Doctrine.” This case held that “stockholders in a close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another. The standard of duty owed by partners to one another is one of ‘utmost good faith and loyalty.’”

DUTY FROM THE MAJORITY TO THE MINORITY (SQUEEZE-OUTS) – ABUSE OF POWER Occurs when the majority refuses to pay dividends and refuses to employ the minority holder so that

the minority has no way to participate in the economic fruits of ownership • This is due to the ability of a majority of shareholders in a close corporation to “freeze out” – “squeeze out” minority holders b/c of the absence of a ready market for close corporation stock

By eliminating employment, he is unable to reap the benefit of his investment to satisfy their duty to the minority, the majority or controlling group must demonstrate a

legitimate business purpose for their actions related to the operation of the businessBusiness Associations/Garten/Fall 2008 99

Could the same purpose be achieved by a different course of action less harmful to the minority holder?

even if majority’s action satisfies a legitimate business purpose, the minority shareholder may than show that the same legitimate objective could have been accomplished through a less harmful alternative course of action

a court will balance the purposes of legitimate business purpose and a less harmful course of action

Wilkes v. Springside Nursing Home, Inc. (1976) – FREEZE-OUTS

RULE: “Majority shareholders acting to freeze out a minority shareholder by terminating his employment without a valid business purpose have breached their duty to act as fiduciaries.’”

Statement of the CaseA company was operated to form a nursing home. There were four owners, Wilkes, Riche, Quinn, and Pipkin. Each was equal owners. As a result of their success, they started to pay themselves an increase of $100 in salary. Thereafter, bad will develops between Wilkes and Quinn because Wilkes forced Quinn to pay a higher price for the Springside real estate that was sold to him. This affected the operations at Springside. As a result, Wilkes continued to fulfill his duties and responsibilities but also gave notice that he wanted an appraisal on his shares so he could sell them. The month later, the board met to set salaries for its officers and employees. Quinn received nothing and they did not reelect Wilkes as an officer or director and told him his services were no longer needed. Wilkes claimed his fiduciary duty was breached. They took action that was inconsistent with his reasonable expectations. The dominant group froze him out.

ISSUE: In a close corporation, in which each shareholder was employed and paid a salary by the company and served as a director, does the board breach its duty if it terminates a shareholder’s employment without a legitimate business purpose?

HOLDING: YES; in discharging the duty in Donahue, shareholders may not act out of avarice, expediency, or self-interest. The dominant shareholders are frequently in a position to freeze out minority shareholders. Secure employment is a motivating factor for many shareholders to make a serious investment in a close corporation, and a salary may be the shareholder’s only return on the investment, so termination effectively frustrates the incentive for the investment. His expectation must be protected. In bringing forth such claim, the court places the burden on the defendants in assessing why they froze out the minority; was their a legitimate business purpose and could they accomplish such feat in a less harmful fashion without injuring the minority shareholder. The minority shareholder is to present evidence of a less harmful disposition as well. Here, the court determines that there was no business purpose for the termination and that Wilkes was not guilty of misconduct. They have breached their duty to Wilkes and his is entitled to compensatory damages.

o The minority stockholder typically depends on his salary as the principal return on his investment, since the earnings of a close corporation are distributed in major part in salaries, bonuses and retirement benefits.

o HOW COULD THIS SITUATION BE RESOLVED WITH LESS HARM TO PLAINTIFF?

(1) Plaintiff could have sold to a total outsider and have him join the closed corp. he could do this to spite the other 3

(2) Other 3 Shareholders could have attempted to buy him out the price offered by other 3 could have been under-valued


maybe 3 others didn’t have enough cash or maybe P just flat out refused to spite them

(3) Garten suggests that 3 others should have attempted to negotiate with Plaintiff in good faith to buy him out EITHER WAY, THERE IS NO MARKET SOLUTION TO THE PROBLEM

RULE Although Majority Stockholders in a closely held corporation does have a right to assert its own business interest, they nevertheless owe minority holders substantially the same fiduciary duty in the operation of the enterprise that partners owe one another and the burden is on the minority to show that the same legitimate interest could have been conducted in a less harmful manner to the minority. • Here, the majority cut his salary and took the real value he was getting out of his shares. Consequently, the other members of the corporation are now receiving that benefit. This now looks like a case of self-dealing which is enough to get past the business judgment rule. So, the court basically treats this as a partnership case, not a corporate case, because they impose a duty of utmost care and good faith to fellow shareholders, which they would never impose on a large corporation.

DUTIES OF MINORITY SHAREHOLDERS TO MAJORITY– ABUSE OF POWER Shareholders in a closed corp. owe one another the same fiduciary duty in the operation of the enterprise

that partners own to one another In average traded corp. – Shareholders don’t owe a duty unless they own a majority and they take

to enrich themselves minority SH has a fiduciary obligation to his co-Shareholders, if the minority has been given veto

power over corp. actions a SH in a closely held corp. may not recklessly expose the corp. to serious and unjustified risks (like a

tax penalty) by exposing a corp. to risk, the SH is not exercising utmost good faith and loyalty

Smith v. Atlantic Props., Inc. (1981) – “anything the majority does the minority can do better”

RULE: “A minority shareholder may abuse his position by using measures designed to safeguard his position in a manner that fails to take into consideration his duty to act in the ‘utmost good faith and loyalty’ toward the company and his fellow shareholders.’”

Statement of the CaseWolfson agreed to buy Norwood and thus told 3 other men about it who too bought one-fourth of the deal. One of the 3 men, Smith, an attorney, formed the articles for the company Atlantic Props. There was a veto provision asserted that Wolfson wanted that can only bind the corporation upon an affirmative vote from 80% of the capital stock. Thus any shareholder can stand in the way of any proposal by others. Disagreements arose between Dr. Wolfson and the other stockholders. Wolfson wanted the profits realized by Atlantic Props. to go to repairs and some existing buildings. The other stockholders desired the dividends. Wolfson stubbornly refused to declare dividends although it was told to him and he knew that the IRS would impose penalties for refusal to declare dividends. Some of the shareholders agreed to some improvements but nonetheless required the dividends. Wolfson disagreed again. The other shareholders brought a derivative suit against Atlantic seeking dividends, Wolfson’s removal as director, and Wolfson’s reimbursement of the IRS penalties.


ISSUE: Does a minority shareholder breach his fiduciary duty to fellow shareholders by relying on a provision in the corporate charter and bylaws that allows him to thwart any action desired by the majority shareholders?HOLDING: YES; in discharging the duty in Donahue, shareholders may not act out of avarice, expediency, or self-interest. Under such case, the court also recognized that the majority shareholders may need protection from the minority. Here, there were only 4 equal holding shareholders, so under the provision, any one can halt the progression of any measure. Though Wolfson did not want the others to gang up on him and thus he had the right to protect himself, his actions here are nonetheless irrational and without reason. The company was exposed to excess charges and penalties by the IRS. Wolfson also did not take steps to minimize the recurrence of these charges. His actions were far from good faith and loyalty.

General principle of not deadlocking a corp. may have been in play Court treated Wolfson as a controlling shareholder by virtue of power to prevent decision

making. HOWEVER, NOTE THAT THIS CASE WAS A MASS CASE AND DELAWARE

TAKES A DIFFERENT APPROACH

DELAWARE APPROACH NIXON V. BLACKWELLo Rule: “a stockholder who bargains for stock in a closely held corporation can make a business

judgment whether to buy into such a minority position and if so on what terms.” o YOU MADE YOUR BED AND YOU MUST LIE IN IT.o Shareholders need not always be treated equally for all purposes o Examine whether or not the decision met the standard of ENTIRE FAIRNESS

DUTY TO DISCLOSE MATERIAL FACTS Close corporations buying their own stock have a fiduciary duty to disclose facts that meets the

standard of materiality. The duty to disclose occurs when SH offers resignation

The corp. does not have to disclose generally to shareholders.

Jordan v. Duff & Phelps, Inc. (1981)

RULE: “If a closely held company withholds from an employee-stockholder material information about possible increases in stock value in breach of its fiduciary duty, the employee-stockholder may be entitled to damages if he or she can show that the nondisclosure cause the employee-stockholder to act to his or her financial detriment.’”

Statement of the CaseJordan got a new job and went to the president to resign. He was not informed of the potential merger that would have increased the value of his stock, that he was forced to sell back upon his severance from the corporation. Jordan later learned of the merger which would have made his stock far more valuable and he filed suit, asking for damages measured by the value his stock would have had under the terms of the acquisition. After the merger fell through he amended his complaint and demanded rescission (wanted stock back).

ISSUE: Does a corporation owe a duty to notify an employee-stockholder leaving the corporation of potential actions that may substantially increase the value of that stockholder’s shares in the corporation?

HOLDING: YES; close corporations buying back their own stock must disclose all information that is material. Rule 10(b) of the SEC and rule 10b-5 require a party to a securities transaction to provide all


necessary material disclosures to avoid fraud (prevents deceptive conduct through omissions and misstatements of material facts). The provisions cannot be changed by contract. Furthermore, Jordan being an at-will employee is not conclusive as to whether a company can or cannot disclose certain materials. At-will employees have contractual rights as well. The company cannot fire the employee to undertake in an opportunistic advantage. The court finds that such non-disclosure raises the possibility of damages.

Rule: The relevance of the fact does not depend on how things turn out. Failure to disclose an important beneficial event is a violation even if things later go sour (didn’t matter that the deal fell through b/c it may have placed J on notice of the true market value of the corp.)

The fact that a buyer thought that the corp. was worth $50 million is a material fact When should a company disclose re: merger negotiations? Should be disclosed early:

Easterbrook. People in the market can decide.

Dissent- Posner argues that the company could have fired him at any point because he was an at-will employee. Easterbrook responds with argument found in Wilkes, that the company has an obligation not to take opportunistic advantage of its employees based on the duty of utmost good faith (conduct a balancing test b/w the uncertainty of the merger occurring and the need for the investor to know). Furthermore, he believes that firing an employee would ultimately lead to the resolution that he may keep his stock.

Materiality is all information which is substantially likely, given all of the circumstances, that the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder and would have been viewed by the reasonable investor as having significantly altered the total mix of information available. Jordan should have been informed because the average investor would have wanted to know and the information would have affected the average investor’s decision.

Book Value = (Net assets listed on bal. sheet) /(# of shares)o Book value may be undervalued b/c value of assets are determined by purchase price of those assetso Utilized when no market value is ascertainable

Two Contrasting Views of Fiduciary Law: 1. To guarantee some objective standard or fairness in corporate dealings2. To supply missing contract terms

Garten’s View- She feels that Smith and Wilkes meet both views of fiduciary law, but Jordan only meets the first because the contract looked complete, but the court ignored it. Case law reveals that the court will usually bend over backwards to ensure that the first view is satisfied.

SALE OF CONTROLObligations of a controlling shareholder arise in two contexts: (1) exercising influence over the corporation, and (2) selling control. In exercising control or influence over a corporation is guided by

Sinclair. The controlling stockholder breaches his fiduciary duty if it exercises influence for the purposes of producing an exclusive benefit to itself and a corresponding detriment to the corporation. This is the benefit-detriment test and it is breached by proving an exclusive benefit reaped by the controlling stockholder but that benefit was a detriment to the minority shareholders.

Sale of Control is exhibited under the case Perlman v. Feldman.


General Rule: A controlling shareholder is free to sell, and a purchaser is free to buy, that controlling interest as a premium price, which is the added amount an investor is willing to pay for the privilege of directly influencing the corporation’s affairs. Zetlin v. Hanson Holding, Inc.A control premium is the excess over and above the market value of a block of stock that comes with controlling the corporation’s business. Control is a valuable commodity; it is the key to the corporation’s assets and earning power.

EXCEPTIONS TO GENERAL RULE: the sale of control here violates fiduciary duties owed by the controlling shareholder to the corporation or the minority shareholders. The two exceptions are (1) a control person cannot sell to a person he has reason to believe will loot the corporation (this boils down to the duty of inquiry regarding the buyer); and (2) a control person cannot divert a corporate opportunity to himself.

Controlling Block number of shares that grant control of the corp. and the power to use the assets of a corp. as he chooses

• Does not have to be a majority – even a minority interest may have effective control if it holds the largest single interest (plurality) and the shareholders are fragmented and dispersed and no other SH is as large.

• Shareholders may enter into agreements that restrict each others ability to dispose of their close corp. shares

“First Option” agreement that no holder may sell shares to an outside party until the corp. has first been given the right to buy them at a predetermined price

“Right of First Refusal” the right to buy the shares of a selling shareholder, by matching the price the outside party is willing to purchase them at

Why would An Outsider Pay A Control Premium To Gain the Controlling Block of a Closed Corp? Though he is paying a higher price than market value, the economic assumption is that it would be

more costly and time consuming to negotiate the purchase of a controlling bloc from minority holders

May have to issue a formal tender offer to acquire a majority bloc, which may be very costly

• A Purchaser of a Controlling Block Is Entitled to an Immediate Control of Management A contract for immediate transfer of management control must be accompanied by a sale of sufficient

stock to carry voting control the courts allow an immediate control of management if the purchased control block allows for it to

promote corporate efficiency and marketability

DGCL § 141(k) – “any director or the entire board of directors may be removed, with or w/o cause, by the holders of a majority of the shares then entitled vote at an election of directors,” with exceptions protecting cumulative voting or unless the certificate of incorporation otherwise provides (for corps who have classes of board), shareholders may remove only for cause.

MERGERS ARE NOT SALES if a corp. merges with another, the stocks are effectively exchanged and distinguished, NOT SOLD


Frandsen v. Jensen-Sundquist Agency, Inc. (1986)

RULE: “A minority shareholder’s right of first refusal that is triggered by the majority stockholders’ sale of their stock does not apply to a transaction in which an acquiring entity purchases the corporation’s principal asset, after which the corporation is liquidated.”

Statement of the CaseJensen owned all of the stock in his agency. His principal asset was the bank but he also owned a small insurance company. Then Jensen sold 52% of his shares to family relatives called the majority bloc. Jensen, a lawyer for the bloc, and the Bank signed an agreement which gave the minority shareholders the right to first refusal in case the bloc decided to sell their shares. Later on, the agency’s president negotiated with First Wisconsin Corporation to acquire the bank for $88 per share. Each agency stockholder was to receive $62 per share. The agency told the minority shareholders to sign a waiver. All did except Frandsen. He chose to invoke the provision in the agreement to buy the shares from the other shareholders for $62 per share. This in effect restructured the agreement so the company would dissolve after the transfer.

ISSUE: Does a corporation owe a duty to notify an employee-stockholder leaving the corporation of potential actions that may substantially increase the value of that stockholder’s shares in the corporation?

HOLDING: YES; close corporations buying back their own stock must disclose all information that is material. Rule 10(b) of the SEC and rule 10b-5 require a party to a securities transaction to provide all necessary material disclosures to avoid fraud (prevents deceptive conduct through omissions and misstatements of material facts). The provisions cannot be changed by contract. Furthermore, Jordan being an at-will employee is not conclusive as to whether a company can or cannot disclose certain materials. At-will employees have contractual rights as well. The company cannot fire the employee to undertake in an opportunistic advantage. The court finds that such non-disclosure raises the possibility of damages. Mergers are not considered sales – b/c shares have been exchanged and extinguished not sold.

In a merger, the acquired firm disappears as a distinct legal entity. In effect, the SH of the merged firm yield up all of the assets of the firm, receiving either cash or securities in exchange, and the firm dissolves. In this case the SH would have received cash. Their shares would have disappeared but not by sale, for in a merger the shares of the acquired firms are not bought, they are distinguished. There would have been no Jensen-Sundquist after the merger and no SH in Jensen-Sundquist.

A sale of the majority bloc’s shares is not the same thing as a sale of either all or some of the holding company’s assets. The sale of assets does not result in substituting a new majority bloc, and that is the possibility at which the protective provisions are aimed. The transfer of a company’s assets is a merger and not a sale of shares, thus Frandsen does

not have a right of 1st refusal b/c the shares in a merger are not bought but rather they are extinguished.

The sale of a holding company’s largest asset does not trigger the Right of First Refusal because they are not selling shares.

P is unable to buy because he still retained something that he bargained for – the “take me along” provision.

Zetlin v. Hanson Holdings, Inc. (1979)


RULE: “In the absence of an allegation that a shareholder is looting corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a shareholder may obtain a premium price for the sale of the controlling block of shares.”

Statement of the CaseZetlin owed 2% of Gable while Hanson and Sylvestri owed 44.4% in conjunction which is the controlling stock of Gable. The controlling stock sold their shares to Flintkote for $15 per share, which was a lot higher than the market value of $7.38 per share. Zetlin, a minority shareholder sought to obtain the additional profits attained by the controlling stock.

ISSUE: If the controlling shareholders transfer their entire interest in a corporation to a new buyer and receive a price in excess of the market price for their shares, are the selling shareholders obligated to share their premium with the minority shareholders?

HOLDING: NO; minority holders may be protected from abuse and unfair advantage from the majority holders, but they may not inhibit the majority holders’ financial interests. The majority invested a lot more money in the business as such to attain the majority block. Thus a premium on a sale of their control represents a return on their greater investment. Furthermore, a sale of control allows the new owner to implement their decisions and policy. HOWEVER, Courts have held a controlling shareholder who is offered a higher price for his or her shares, must inquire of the buyer’s motives if the premium is excessive, if the corporation’s assets are financing the payment, if the buyers are in a hurry, or if the corporate assets are extremely liquid. Rule: those who invest the capital necessary to acquire a dominant position in the ownership of a corporation have the right of controlling that corporation, and absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that controlling interest at a premium price. Rule: Although minority shareholders are entitled to protection against abuse by the majority SH, they are not entitled to inhibit the legitimate interests of the other stockholders. Thus, control shares usually command a premium price. The premium is the added amount an investor is willing to pay for the privilege of directly influencing the corporations’ affairs.

DUTY OF CONTROLLING BLOCK TO NOT DIVERT A COLLECTIVE OPPORTUNITY

Pearlman v. Feldman (1955)

RULE: “A shareholder with a controlling interest who transfers his or her shares is accountable to the minority shareholders for the amount in excess of the market price if the premium is attributable to the sale of a corporate asset.”

Statement of the CaseFeldman was the chairman and majority shareholder of Newport. Wilport sought to buy the controlling interest of Newport and offered Feldman $20 per share which was higher than the market price of $17 per share. Feldman agreed to the purchase. The minority holders argued that Feldman received payment for a corporate asset with the sale of his shares because Wilport obtained the ability to direct the corporation’s end product to itself.


ISSUE: If a majority shareholder receives a premium for the sale of shares that is attributable to a corporate asset, must the majority holder account for that premium to the other shareholders?

HOLDING: YES; Feldman has a fiduciary duty to the minority holders. By siphoning corporate advantages for personal gain in the form of market advantages, a shareholder acts for personal gain and against the company and its shareholders. When Feldman sold his interests, he received funds that could have been used to make the company more productive, sacrificing the company’s good will. However, the plaintiffs here must bring a direct suit because a derivative one will allow Wilport to benefit too.

NOTE that this case seems to be at odds with Zetlin; however the distinction between this case and that rests in the propriety of the acquiring company’s motive. The Wilport management did not want simply the ability to run the company and make a profit; they wanted to use the company to further their original business, not Newport.

Controlling shareholder breached his fiduciary duty of loyalty to minority shareholders when siphoning off for personal gain corporate advantages derived from favorable market conditions

the control premium D received for his shares was directly due to the premium buyers were willing to pay for steel in a time of shortage and that this premium was therefore essentially a corporate asset that should have belonged to the shareholders’ pro-rata

o with the Feldman plan, the corp. was experiencing profits and when D sold the corp., the plan was dismantled, thereby DIVERTING A COLLECTIVE OPPORTUNITY FROM THE CORPORATION AND SHAREHOLDERS

Rule- A majority many not sell to a group that they know or suspect will loot the corporation. Furthermore, even when the shareholder does not have any reason to know that the group will loot the company, the seller is accountable when he knows or has reason to know that the person intends to use their newly purchased control to prevent the company from realizing profits that it would have otherwise obtained.

How do you determine whether the majority has reason to know that potential buyer will loot? Court will examine the facts- was the sale reasonable? Second, based on all of the facts, would a reasonable, prudent businessperson suspect looting? Third, was it negligent for the majority to fail to recognize the potential for looting?

General RuleA majority stockholder can sell his controlling block to outsiders at a Premium w/o having to account to his for profits.

Exceptions:1. “Looting” controlling shareholder may not knowingly, recklessly, or perhaps

negligently, sell his shares at a premium to one who intends to loot the corp. by unlawful activity. Look for

willingness to pay excess price excessive interest in liquid and readily salable assets insistence on immediate possession of liquid assets

But Is it reasonable to require that the majority block owner investigate

the buying parties’ intention?2. “Sale of Vote” Essex v. Yates – looks to situations where the buyer purchases

directorship positions by having the seller have people resign so the buyer does not have to wait till the next shareholder meaning to exert control – ONLY bad when the new shareholder would not have been able to get the position through vote at subsequent meetings anyway

3. “Diversion of Collective Opportunity” Situations where the control premium is found to belong to the corp. as a whole not the controlling shareholder:


i. when the control premium really represents a business opportunity that the corp. could and should have pursued as a corp. (Perlman v. Feldmann)

ii. when buyer initially tries to gain control through open market purchase of minority shares and the controlling shareholder convinces the buyer to buy his controlling block a premium

In a time of market shortage , where a call on a corp.’s product commands an unusually large premium, a fiduciary may not appropriate to himself the value of this premium. There were various outside circumstances such as the Korean War in need of steel. [Garten say it is not clear what this means]

Essex Universal Corp. v. Yates (1962)

RULE: “If the transfer of shares is sufficient to constitute the transfer of a controlling interest, a seller may lawfully agree to assist the buyer in installing a favorable board of directors.”

Statement of the CaseYates was the president and chairman of Republic Pictures. Essex wanted to purchase somewhere between 500,000 to 600,000 shares. Upon closing, Yates was to deliver the resignation of the majority of his board so that Essex can put their replacements in. Yates told Essex that he could give him 567,000 which is good for 28.3% of the stock (controlling interest). Essex brought bank drafts totaling 1 million for the closing. Essex’s banker endorsed the drafts to Yates, but Yates refused to deal because he believed the change in directors would be held improper. Essex sued Yates demanding a transfer of shares and a loss of 2.7 million in stock appreciation.

ISSUE: Is a contract that provides for the transfer and control of the board of directors illegal per se under NY Law?

HOLDING: NO; NY Law prohibits the sale of corporate office. Here there was a purchase of the controlling stock of the Republic. Essex could have easily elected a majority of the board or installed its own set of directors without Yates’ assistance. But because the directors’ terms are staggered, it had to wait 18 months in order to get official control. The transfer here is immediate. A court usually does not question a shareholder’s ability to completer a transaction. The court here permitted the parties to contract to change the board more rapidly than the new owner could have because there was no air of wrong-doing.

*********************************************************************IV. MERGERS, ACQUISITIONS, AND

TAKEOVERS *********************************************************************

A. MERGERS AND ACQUISITIONS


• In a merger, the boards of directors of the respective corporations formulate a plan of combination under statutory provisions. If the statutory merger procedure had been used, approval by votes of the board of directors and shareholders of each of the two corporations are required. The “plan of merger” or “agreement of merger” or merger agreement will specify which is to be the surviving entity, who is to receive what (in terms of shares of stock of the surviving corporation, or cash), what warranties and representations the parties make to one another, and a myriad of details. • When the articles of merger are filed, the acquired corporation ceases to exist, by operation of law. All the acquired shareholders become acquirer’s shareholders. Note that the shareholders who voted against the merger are entitled to demand to be paid in cash the fair value of their shares. This is called appraisal rights. Sharedolders in a merger situation can also request for their “preemptive rights” since the incoming shares of the target corporation and their shareholders will dilute their stock in their corporation. They must be givcen the right to purchase enough stock for them to maintain their percentage in the company prior to the merger. (Amendments to the articles may be key here, issuance of stock)• If the surviving corporation is to be an entirely new entity, into which both of the constituent corporations are to be merged, the transaction is often called a “consolidation.”

Merger-type v. Sale-type:

• In a merger-type transaction, shareholders in the “target” corporation end up with stock in the acquiring corporation. The acquiring corporation now owns the acquired business as well as the acquirer’s original business. So in a merger, the target shareholders have a continuing stake in the newly-combined enterprise. From the acquirer’s view, their share ownership of business is shared with new people and its shares are diluted. In a merger, the acquirer can issue stock to the target company or they can be paid cash in a cash-out merger, or can be paid a combination of stock and cash. Creditors of the target corporation become creditors of the acquiring corporation.• In a sale-type deal, the target’s shareholders end up with cash (or, perhaps, some type of debt instrument issued by the acquirer, like notes). Those holders thus no longer have any ongoing stake or equity interest, in either the target or the acquirer. From the acquirer’s view, they don’t have to give up any claims to its own assets, it may have more debt or less cash but they still own the entire business and now the target’s business.

Four main techniques that fall into the merger-style category :

1. Traditional statutory merger : by following procedures set out in the state corporation statute, one corporation can merge into another, with the former ceasing to have any legal identity and the latter (surviving corporation) continuing in existence. Shareholder approval needed and requires the consent of board for both companies. By automatic operation of law, acquirer acquires all of target’s assets and all of its liabilities.

2. Stock for Stock Exchange (stock swap) : the essence of the stock swap is that the acquiring corporation, instead of entering into a plan of merger with the target corporation, makes a separate deal with each target shareholder, giving that holder shares in the acquiring corporation in exchange for the shares in the target. The target keeps its separate corporate identity (though it is now a subsidiary of the acquirer). Acquirer can liquidate the target and distribute its assets to itself. No consent needed and no approval needed. Minority interest in the target can disrupt the share for share exchange by simply refusing to tender their shares.


3. Stock for Assets Exchange : TWO STEPS: a) the acquiring company gives stock to the target company, and the target company gives all or substantially all of its assets to the acquiring company in exchange. B) The target dissolves and distributes the acquirer’s stock to its own shareholders. If both steps are carried out, the net result is virtually identical to the result in the true merger scenario. Here, there is no need for acquirer’s shareholder approval, assuming that there were enough authorized but unissued shares to fund the transaction, and assuming that the increase in the number of issued shares that would result from the transaction would be reasonably small. Also, chance to acquire assets without its liabilities.

4. Triangular Mergers : they involve three parties: the acquirer, a subsidiary of the acquirer created especially for the transaction, and the target. This type of merger deals with the new effects of having new assets, new liabilities, and possibly new shareholders.

Sale-Type Transactions : The key distinction between sale and merger ones is that in the sale case the stockholder in the acquired company is effectively cashed out. He gives up his equity interest in the target company for cash, or perhaps a combination of cash and debt. The target company shareholder no longer has a common stock interest in the assets of either the target or the acquiring company.

1. A sale of the target’s assets for cash, followed by a liquidation and distribution to shareholders (asset-sale-and-liquidation): this is carried out by corporate action on the target’s part. The target board approves a sale of all or substantially all of the target’s assets to the acquirer, and this sale is approved by a majority of the target shareholders. The target conveys the assets to the acquirer, and the target receives the cash, or debt, payment from the acquirer. Typically, the target then dissolves, and pays the cash or debt to the shareholders in proportion to their shareholdings, in the form of a liquidating distribution. Here, if the target board doesn’t approve, it can block a sale.

2. A sale by each shareholder of his target company stock in return for cash, perhaps followed by a liquidation of the target (stock sale): Here, no corporate level transaction takes place on the target’s side. Instead, the acquirer buys stock from each target company shareholder. After the acquirer controls all or a majority of the target company stock, it may take the second step of dissolving the target and distributing the assets to itself. If there remain minority holders in the target, the acquirer would distribute assets both to itself and to those other minority holders, in proportion to their stockholdings. To eliminate minority, acquiring company can a) liquidate the target, distribute proportional percentage to minority holders and the balance to itself; b) it can merge the target company in which the minority holders will receive either cash or acquirer’s shares. “Back-end Merger”

a. Tender offer v. individually-negotiated purchases ; there are two ways in which the acquirer might carry out this stock purchase plan: a) by a classic tender offer, in which the acquirer publicly announces that it will buy all of shares offered to it by the target company’s SH; and b) by privately negotiated purchases from some of all of the shareholders.

Elimination of Minority Shareholder: This is a much cleaner way to eliminate any minority interest in the acquired company than does the stock-sale approach because the acquirer pays the consideration directly to the corporation, and receives the assets free and clear of any minority interest. If the acquire buys stock, by contrast, the acquirer may not succeed in getting all of the shares; the acquirer will thus be left with minority stockholders to whom it will owe a Fiduciary Duty. (These might be eliminated by a majority shareholder approved plan of share exchange or by an eventual back end merger of the target into the acquirer. Thus, if the transaction is a friendly one, an asset sale if clearly superior to a stock sale from the standpoint of giving the acquirer complete control over the target’s business.


Short Form Mergers: In a case in which a parent corporation owns 90 or 95% of the shares of a subsidiary, the parent may merge the subsidiary into another subsidiary and the 5 or 10% minority has no voting rights. They are also called practical mergers.

Cash Tender Offer (takeover bids): A takeover bid, or tender offer, is an offer to purchase made directly to a company’s shareholders, for cash or stock, without the intervention of any intermediary, such as a stock exchange. The bid, or offer, has as its objective control, or a measure of control, in the target company. The offer may be conditional on obtaining a certain percentage, only for a certain percent, or for any or all shares tendered. If a tender offer is for less than the entire target company shares (e.g. 50%), and the offer is oversubscribed, the bidder must take up pro rata shares (pro rata take-up rule) tendered in the first 21 days (e.g. 70%). Thus, the bidder may not take up 100% of friends’ or cronies’ shares, ad less of strangers’ shares. In the example, the bidder must take up 5/7ths of each tendering shareholder’s shares.

Cash Takeover: The cash takeover has as its advantages secrecy, speed, simplyPhase one: A bidder usually begins by purchasing target company shares in the market. Purchase exceeding 5% must be disclosed. Phase two: once the 5% threshold has been reached, bidders step up their market purchasing in the ten-day window which follows. The average hostile takeover bidder owns about 14% of the target company by the time it files with the SEC and gives the target company notice.Phase three: is the takeover bid itself. Bidders offer to pay a premium over market price sufficient at least to obtain 51% control. (offer to whom????)Phase four: involves use of the shares, and votes, obtained via the market purchasing and the takeover bid to install the bidder’s own nominees as directors of the target company.Phase five: which doesn’t always necessarily follow, involves the recommendation by the new target company board of a merger into the takeover bidder or a subsidiary of the takeover bidder. This is often called the “back-end” or “second stage” of a two stage takeover bid while the takeover bid is the “front end” of the deal or “first stage.” The merger is a “cash merger” in which the minority shares are offered cash. They are thus squeezed out of the company. No more public shareholder will be left.

Proxy Contest or Proxy Fight: is the other principal means of taking over a company by hostile means. It entails delays, for regulatory fillings with the SEC ad for the actual solicitation process, just like tender offers. Reverse Transaction: the true target, or acquired corporation, is the surviving corporation for legal purposes (that is, is specified in the articles of merger as the surviving corporation).

Sale of Assets: A principal difference from merger is that, in a sale of assets transaction, the target corporation does not disappear by operation of law. After the smoke clears, the target, or selling corporation will still exist, holding the cash or stock received for the assets. It could reinvest those proceeds to go into an entirely new line of business. Or, as is usually the case, it could distribute the shares or cash received to its shareholders. But, even after a distribution to its shareholders, the selling corporation would still exist, if only as a corporate shell. It takes a separate, voluntary act of dissolution for the target to disappear.


Shareholder ProtectionCase law and statutes provide protection for shareholders from the effect of mergers and acquisitions:(1) Sue the directors who approved the merger alleging breach of the duty of care or loyalty [Shareholders who sometimes are dissatisfied with what they receive in a merger sometimes sue the directors, who approved the merger, alleging they breached their duty of care in approving the merger (Smith v. Van Gorkom). Shareholders may also sue for breach of loyalty when a director engages in self-dealing or is on both sides of the deal (Weinberger v. UOP)]; and (2) Vote against the merger and assert dissenting shareholder’s right of appraisal. Appraisal is granted for ONLY mergers and consolidations, NOT sale purchases. [This is a cash-out remedy for those shareholders that who opposes the merger. A shareholder who opposes with the merger and complies with the notice and procedural requirements of Delaware § 262 has more than the right to have her shares appraised or valued. Rather the shareholder can force the company to pay her in cash the fair value of her shares as determined by the judicial appraisal process. NOTE in this process, the shareholders are typically alleging that the corporation stole the shareholder liquidation value or they hindered the corporation’s book value]. Appraisal rights protect shareholders against fundamental nature of ownership interest; Delaware reserves appraisal for private and closed companies because Shareholders can always sell their shares in the open market if in publicly traded company; appraisal protects Shareholders against unfair price. Del Corp Law § 262(b)(1)- Appraisal rights are barred if:

1. Stock is listed on a national security exchange or NASDAQ2. Stock is held of record by 2000 or more people

NOTE HOWEVER - § 262(b)(2) restores appraisal rights for ALL types of corporations if it is a cash merger

Public Policy- You don’t want to force people to own companies that are fundamentally different than the one that they originally bought. Appraisal rights are restricted on publicly traded stock because if a person does not like the new company all they have to do is sell their shares. Second, appraisal rights protect shareholders from being raided because companies won’t force shareholders to accept artificially low price for their stock if they can just force the company to buy it back after the merger.

NOTE: Most mergers today are securities mergers so appraisal rights are rare.

DE FACTO MERGERS

This is a judge made doctrine that typically comes into play in a sale of assets transactions and thus impacts the rights of both shareholders and creditors. The rationale behind this doctrine is that since the end result of a sale of asset transaction is substantially the same as a


merger, the impact on shareholders and creditors should be equivalent. (The law should treat the transaction like a statutory merger, with effect that the purchasing company should automatically assume the debt of the acquired company and the shareholders should have appraisal rights comparable to those in a statutory merger. Furthermore, the shareholders of the selling company can now get the right to vote on such transaction.)See Del. Corp. Law §§ 251, 262, 271

Only occasionally accepted - Only a few courts have accepted the de facto merger theory, and they have done so only in specialized circumstances. They are most likely to do so when the target has transferred all of its assets and then dissolves, and when the target’s shareholders receive most of their consideration as shares in the acquirer rather than cash and/or bonds.

Test: When a corporation combines with another so as to lose its essential nature and alter the original fundamental relationships of the shareholders among themselves and to the corporation, a shareholder who does not wish to continue his membership therein may treat his membership in the original corporation as terminated and have the value of his shares paid to him.

Farris v. Glen Alden Corp. (1958) – minority view/ Pennsylvania

RULE: “If a contemplated transaction’s result is the same as a merger, the transaction is a de facto merger, and the target corporation’s shareholders have the right to dissent and receive fair value for their shares.”

Statement of the CaseGlen Alden has been experiencing a decline in revenues. List Industries own a number of companies and one of its subsidiaries purchased 38.5% of Glen shares which allowed List to put 3 of its directors on Glen’s board. Both companies signed an agreement where Glen would acquire all of List assets and distribute it to their shareholders; Glen would assume List liabilities; Glen must change its name to List Alden; the board of both companies would combine; and List would be dissolved leaving List Alden to operate both businesses. Glen mailed its shareholders a note and proxy statement describing the reorganization and recommending its approval. Farris sought to enjoin Glen since the notice failed to denote the company’s true purpose which was to approve a merger, which in turn did not inform the shareholders of their right to appraisal, and that the company would suffer irreparable harm if such merger occurred. The defendants denied it was a merger.

ISSUE: If the result of a transaction between 2 companies accomplishes the same result as a merger, should the target company’s management be required to treat the reorganization as a de facto merger and permit its shareholders the right to dissent and receive fair value for their shares?

HOLDING: YES; pursuant to section 908 of Penn. Corporate Law, a shareholder in a company proposing a merger is entitled to appraisal. Certain transactions, even if not called mergers do result in one. If the transaction changes the corporate nature significantly that a shareholder may not want to remain, he should be able to leave without economic harm. Under the terms, List Alden is a diversified company, no longer a coal mining business. It will have a lot more debt since it is diversified as such


that the minority holders may suffer net losses. The defendants argue that minority rights are eliminated in reorganization transaction in dealing with asset purchases. The result of the transaction here is a merger, not a sale. AFTERMATH: The Pennsylvania Legislature modified the corporate law to defeat and eradicate de

facto mergers.

Usually rejected: Most courts, including most notably Delaware, reject the de facto doctrine. Court held that in deciding whether a transaction is in fact a merger, a court must look not the

formalities of the agreement but to its practical effect. There is no fairness standard such as in DELAWARE, which gives companies flexibility in structuring their merger.

Rule: When as part of a transaction b/t two corporations, one corporation dissolves, its liabilities are assumed by the survivor, its executives and directors take over the management and control of the survivor, and, as consideration for the transfer, its stockholders are forced to acquire a majority of the shares of stock of the survivor, then the transaction is no longer a sale of assets, but a de facto merger.

Hariton v. Arco Electronics, Inc. (1963) – Majority Rule/ Delaware

RULE: “A reorganization plan that requires one corporation to sell its assets to a second corporation in exchange for stock in the second corporation and that calls for the first corporation to liquidate and distribute the second corporation’s shares to its stockholders constitutes a permissible de facto merger.”

Statement of the CaseArco and Loral engaged in a contract to combine the companies. Arco would sell their assets to Loral in exchange for 283,000 shares of Loral stock and the Arco would hold a shareholders’ meeting to approve the reorganization agreement and then dissolve. Upon dissolution, Arco would distribute the Loral shares to its former shareholders. Hariton, an Arco shareholder, who did not vote at the meeting sued to enjoin the reorganization arguing it was illegal. ISSUE: May two companies agree to reorganize if the result is a de facto merger, using the statutory provisions concerning the sale of assets rather than the provision governing mergers?

HOLDING: YES; in a statutory merger, the target company shareholders retain their rights, but in a transaction, the former company shareholders are left owning only part of a holding company that is removed from the business’ day to day operations. The plan that allows the companies to accomplish indirectly what they preferred not to do directly, is protected under the statute, since the merger and sale of asset statutes are independent provisions.

SALE OF ASSETS

With the sale of assets, one corporation can sell all of its assets to another corporation, in consideration for cash, stock of the acquiring corporation or a combination of the two. This actually has the same effect as a merger, though it is not written or seen as a merger. Furthermore, while state corporation statutes require a corporation to obtain the approval of its shareholders in order to sell all or substantially all of its assets, Delaware and most other states do not provide appraisal rights for the shareholders of the selling corporation. The acquiring company’s shareholders have neither appraisal


rights nor the right to vote on their corporation’s buying the assets. However, unlike mergers where the acquiring company would be liable to the target’s creditors, here, there are no comparable statutory provisions making a buyer of the assets of a corporation liable to that corporation’s creditors. A general common law rule is that the buyer of a corporation’s assets is not liable for the selling corporation’s debts. A sale of assets, whether all or substantially all, does not destroy or terminate the target corporation’s legal entity or legal existence as a corporate entity. Sale of all assets is followed by dissolution, which does not refer to termination. The corporation here is in the process of winding up.

DELAWARE REJECTS DE FACTO MERGER DOCTRINE

Delaware Law- 1. Only the shareholders of the selling corporation get to vote2. Shareholders get to vote on the creation of new shares because the charter needs to be amended to do this 3. Appraisal rights are not conferred under a sale of assets type merger

Sale of assets: A sale of assets involving dissolution of the selling corporation and distribution of the shares to its shareholders is legal. Legislatures tend to place greater scrutiny on mergers than on asset sales. The perception appears to be that the chances of injuring minority shareholders are greater in a merger, especially cash mergers (which can be very abusive). For that reason, restrictions may be placed on mergers that are not place on asset sales.

RULE: In a true sale of assets, the stockholder of the seller retains the right to elect whether the selling company shall continue as a holding company. Moreover, the stockholder of the selling company is forced to accept an investment in a new enterprise without the right of appraisal granted under the merger statute.

If an asset sale meets the legal requirements of such a sale, the fact that it might be a de facto merger should not invalidate.

The sale of assets accomplished through § 271 and resulting corporate reorganization (as well as mandatory plan of dissolution and distribution) is legal.

court reasoned in Hariton that Plaintiff could have taken either an assets for sale liquidation or statutory merger route (the court calls this equal dignity)

o under equal dignity, there were 2 avenues §271 (Sale of Assets) §251 (Statutory Merger)

Under DELAWARE law, you need shareholder approval for §271 and §251Under DELAWARE law, de facto mergers where there is a sale of assets for stock under §271 DOES

NOT INVOKE APPRAISAL.

DGCL § 251 – Merger and consolidation of domestic corporations It does not amend the certificate of incorporation of such constituent corporation Each share is identical to share in surviving corporation after date of merger No shares of the surviving corp. are to be issued or delivered


Shares to be issued or delivered do not exceed 20% of the common stock

DGCL § 271 – a corporation may sell or exchange all or substantially all of its property or assets as its board of directors sees fit for best interests of the corporation if authorized by resolution adopted by a majority of voting shareholders.

EFFECT OF MERGERS ON DEBENTURE HOLDERS

Sharon Steel Corporation v. Chase Manhattan Bank, N.A. (1983)

RULE: “Boilerplate successor obligor clauses that do not permit assignment of public debt to another party in the course of a liquidation unless all or substantially all of the company’s assets are transferred to a single purchaser prevent a purchasing company that acquires only 51% of the liquidating debtor’s assets in the last of a series of sales from becoming the successor obligor.”

Statement of the CaseSharon Steel pays over a million dollars to pay for the steel division of UV. A (debentures) debt instrument of UV is purchased by Sharon Steel under the terms that UV will pay the debenture at a specific rate over a period of time. The face value of the debenture purchased by Sharon Steel was higher than that of the market value because the interest rate on the debenture was lower than other equivalent debentures. When assessing the debt market value, you look at the failure risk associated with the issuer of the debt (in other words you look at the credit risk of the issuing company-will they be able to pay the debt back?), you look at whether you can find a debenture with an equal value, and a same maturity date, that pays a higher interest rate. You value more a company that is a lower credit risk and you value less a company that is a greater credit risk. You value more a company paying a higher interest rate on the same face value.

Sharon Steel may have been willing to purchase the debenture from UV because the interest rate was low and it amounted to a low interest loan. They assumed the debenture and would be able to subtract the debenture from the purchase price of UV’s steel division. UV was a diversified conglomerate with many different industries unified under a single name. UV begins selling industries because selling the assets would allow them to make more money for shareholders (so UV could dissolve and give the cash to shareholders to reinvest in another company). Debt holders of UV (such as Sharon Steel) would not like the selling of assets because once UV dissolves, there is no money left to pay the debt holders during and at the end of the term of the debenture. The selling of assets would leave the company with no money for creditors to be paid on the debts of UV, which makes holding a debenture in UV risky.

UV and Sharon Steel had an agreement that said SS would assume all the debenture obligations of UV if it began to sell its assets off. UV argues that this provision is boiler plate and is not really a term that was negotiated. An Indenture is the contract that sets for the rights and obligations of the debenture agreement and Chase was the Trustee of this Indenture contract. Chase’s role however was miniscule. UV pays the interest payments to Chase and Chase maintains the books and ensures SS get its money. Chase’s legal obligation to the debt holders and debt issuers is very little.

ISSUE: Is a purchasing company deemed to have purchased substantially all of an issuing company’s assets if the purchasing company buys only half the issuing company’s assets as part of the last in a series of sales disposing of portions of the company’s assets? ?


HOLDING: NO; boilerplate successor obligor clauses comes from basic contract law and presents questions of law. A bondholder is generally not protected against the issuer’s actions unless he or she brings an action based on the contract terms governing the indenture. Sharon Steel claims it owns UV since it bought all it assets. However, the bank claimed that Sharon Steel only bought 1/3 of the companies sold off by UV. If UV still owned what it sold to Sharon, this suit would be dismissed since no event would have triggered these clauses. Sharon says the purpose of the clause is to allow the corp. the freedom to merge or sell assets, not protect lenders whereas the bank argues just that, the purpose is to protect lenders by assuring continuity of ownership. Under rules of construction, if there is conflicting interpretations, the court must apply the one that does the least harm to both sides. The bank is the most appropriate here.

Judge Winter says we want the debt to follow the assets and we don’t want debt holders to be left with a shell of a company. If UV debenture holders stick with UV and UV sells all its assets, then the money goes to the debenture holders. On the other hand, if SS holds all of UV’s debentures, then the shareholders get all of the money that occurs when the sale of the corporation occurs. The latter is what UV wanted to occur but SS did not. Judge Winter says management has to think about debt holders in the same way you think about shareholders. Because if the value of debt can be diminished so quickly by this type of transaction, debt holders would never supply debt and the debt market would crash so this judgment is meant to protect the market by putting a duty on a corporation by telling management they cannot overreach to harm debt holders.

A clause in a debt instrument preventing accelerated maturity in the event of a sale of all or substantially all the debtor’s assets is inapplicable if the assets are sold piecemeal. Because such a clause is boilerplate, the term “all or substantially all” means those assets existing before divestiture begins. Fiduciary duty is owed to shareholders, not debenture holders. Debenture has a contract. Doesn’t

deserve extra duties. Purpose of corporation is to make money for shareholders, not debt holders or employees: Dodge v. Ford

rule. Fiduciary Duty runs from Board of Directors to Shareholders. No corresponding duty that runs from BOD to debt holders. Debenture holders are not owed a duty because of conflict of interest in relation to Shareholders. Does this make sense as a business matter? How well did these debenture holders protect themselves? In the event of a merger, consolidation or sale of UV assets, the buyer had to assume debt obligations. This is exactly what Sharon Steel did. Debt holder argued that the clause doesn’t apply to this transaction; no merger, no consolidation and not a sale of substantial assets because Sharon Steel is only buying 1 of 3 assets.

If the debenture holders don’t were not purchased by Sharon Steel, then they would be left with UV; so how are they better off? Because UV would be liquidated and pays off the creditors (debenture holders) then to the remaining shareholders.

The judge bought the argument of the debt holders. SS only bought part of the assets. Is this right? Could UV enter into separate assignment whereby SS would assume the debenture? Look at the contract:

source of debenture holder’s rights and obligations. If nothing is said, then there is nothing to prohibit it, except for one thing: is it fair?

Trustee’s function (chase): they collect the money from UB and distributes to holders. Are people going to buy debt if they know that their value can diminish like it did here? The judge took

the boiler plate and construed it liberally as possible to benefit the holders. Money is coming at the direct expense of shareholders. This case illustrates when debt holders rights are legitimately jeopardized.

RULE no assignment of debentures unless all or substantially all of a company’s assets at the time the plan of liquidation is determined upon are transferred to a single purchaser

o all the assets that the debtor assumes are still available to back the debentures O in this case, the corp. no longer exists after the merger, (as a result of the liquidation) so the

debt must go somewhere


PURCHASE OF STOCK

One corporation buys all or most of another corporation’s outstanding stock. There is a difference between a purchase of stock versus mergers and sale of assets. Only ownership changes. Equally obvious, the purchase of stock does not require any agreement between the board of the purchasing company and the board of the target company. The deal is simply between the acquiring corporation and the individual shareholders of the target corporation. This means the acquisition can go forward even if the board of the target corporation opposes the deal. This is typically a vehicle used in hostile takeovers of publicly held corporations.

HOSTILE TAKEOVER

A hostile takeover is used to describe an attempt to gain control of a corporation over the objection of that corporation’s management. The acquiring company is termed to be the bidder, or better yet, the raider or shark. This shark is after the stock of the target company. Sometimes control of a target can be acquired by buying a controlling block of outstanding shares from a control person or members of a control group. Acquiring control by buying the interest of a control shareholder is a type of friendly acquisition. Hostile takeovers involve situations where the bidder is not able to acquire a sufficient number of shares of the target company to gain control from a single shareholder or an allied group. In these situations, the bidder does not want to pay for any shares of the target company unless it is able to buy a sufficient number of shares to gain control of the target company. If the target is a public company, which is usually the case, the usual process of hostile takeovers is by tender offers, in which the existing shareholders are being asked to tender their shares for sale. In these offers, the bidder offers cash or securities of the bidder (or a package consisting of a combination of cash and securities) to the stockholders of the target company who tender their stock. The tender offer will almost always be conditioned on a sufficient number of the target’s shares being tendered to ensure that the bidder gains control of the target company.

Marathon Oil Company v. U.S. Steel Corp. (1982) – FIRST CLASS CASE

Statement of the CaseMobile Corporation initially instituted a hostile tender offer of Marathon Oil Company for $85 per share. Marathon was vulnerable because its common stock price has been depressed and because the ownership of its common stock was widely dispersed with no one person or institution owning a controlling interest in the company. The board believed this offer to be grossly inadequate. However, Marathon was driven to the wall because they had failed to previously take adequate precautions against hostile takeovers, especially since their bargaining power is completely jeopardized here. Marathon attempted to solicit “white knight” bids. US Steel came to the rescue and presented an offer to purchase 51% of the outstanding common stock of Marathon at $125 per share. The shares not owned by US Steel would be subjected to a fee. US Steel’s plan causes these shares to be converted into notes which


in theory will cause Marathon to dissipate. Since this is a publicly held corporation, the minority shareholders could have easily sold their shares based on any disapproval of merger. However, they decided to stay. In addition, the directors and officers of the Marathon Company had obtained a personal profit not shared by other shareholders. US Steel also had demanded from Marathon that it consented to its “lock-up options” and “poison well” options in order to defeat any other competitive offers. Thus, US Steel has acquired roughly 80% of the company and sought to squeeze out the minority holders. The plaintiff shareholders claim the defendant officers and directors had breached their duty of good faith, care, and loyalty to their company. The acts of the directors and officers were willful, malicious, and oppressive. The shareholders all together brought both a derivative and direct suit. Furthermore, the plaintiffs allege that the merger price did not adequately reflect the company’s market and liquidation value. The directors and officers in here engaged into a quick deal without any reasonable investigation of the matter. (Similar to Smith v. Van Gorkum)

FREEZE-OUT OR CASH-OUT MERGERS (DEALING WITH THE MINORITY)

Freeze Out Mergers- When a controlling shareholder seeks to eliminate the minority shareholder from any participation in the corporation; thus the minority holders will typically receive cash while the majority takes the whole company. NOTE that the minority holders are entitled to receive a fair price for their shares. “Freeze-out” refers to the techniques with which controlling shareholders legally compel the non-controlling shareholders to give up their common stock or ownership. Since a freeze-out transaction will usually involve self-dealing by the insiders, conflicts of interest, and potential for abuse, state courts will closely scrutinize the fairness of the transaction. The court scrutinizes severely here because the majority holders want to pay the minority holders as little as possible for their interests. Thus the common action or remedy is breach of fiduciary duty.

2 step cash out merger : • tender offer• Merger to get rid of minority shareholder

Weinberger v. UOP, Inc. (1983) – Entire Fairness Test: Fair Dealing & Fair Price

RULE: “Minority shareholders in a cash-out merger are entitled to damages based on their shares’ fair value, as determined by taking into account all relevant factors (including damages based on rescission), if the merger’s approval was obtained on less than full disclosure and the merger’s terms were unfair.”

Statement of the CaseSignal Corp. was looking for an investment and saw UOP as its target. The parties agreed that UOP would acquire 1.5 million shares of unissued UOP stock at $21 per share and Signal would purchase 4.3 million shares of UOP stock at the same rate. Thus UOP would have 50.5% ownership of UOP. Signal wanted to obtain more of UOP’s stock and thus had its directors on the UOP board to conduct the study. Signal proposed a cash-out merger to remaining UOP shareholders for $21 per share. UOP president supported the transaction but the UOP directors sought review by the Lehman Brothers to determine its


fairness. After due diligence, they found the deal to be fair as well. The companies’ boards and shareholders approved the deal. The UOP minority shareholders had a slight majority of them who agreed. Weinberger constituted the minority of the minority and thus challenges the merger’s fairness.

ISSUE: In a cash-out merger, must a majority shareholder prove that the minority shareholders received all material facts necessary to evaluate a transaction before casting their vote?

HOLDING: YES; in a cash-out merger, if the plaintiff offers some basis to attack the merger as unfair, the majority shareholders bear the burden of showing that the transaction is fair. Also, if the majority of minority shareholders approve the transaction, the plaintiff must prove the transaction is unfair to the minority. In either case, the majority must show that the information it provided before the vote disclosed all material facts. The record here does not support a finding that all material information was provided, and withholding information is a breach of fiduciary duty. The merger’s terms are not fair. The report Signal authorized asserts the market price max to be at $24 per share, so to charge them $21 was unfair. The study is offensive because Signal had its members on the UOP board preparing the report. If the same directors are on both sides of the transaction, the parties must demonstrate good faith and fairness. For fairness, the court looks to fair dealing and fair price. Fair dealing involves evaluating how the transaction was initiated, structured, negotiated, and disclosed to the directors, and how the directors’ and stockholders’ approvals were obtained. As for price, the court must consider the corporation’s assets, market value, earning and future business. Here, there is impropriety in both respects. Fair dealing encompasses the duty of candor. The motivation of merger came from Signal and was done on their timetable. Though the Lehman Brothers provided a study the directors did not tell that the study was rushed and could be flawed.

NOTE: Signal first sale was legal because it was a purchase as an outsider. However, the second sale provided problems since it now represented a significant amount of shares on the UOP board. Thus, Signal directors became the fiduciaries to UOP and thus owed them a duty of care. Signal decided to save millions at the expense of those whom it owed such duty to, the shareholders.

DELAWARE DROPS THE LEGITIMATE BUSINESS PURPOSE PRONG OF FREEZE OUTS AND JUST EXAMINES FAIRNESS: Intrinsic Fairness Test

o Fairness in a freeze out has three elements: Court’s analysis of Freeze Out Mergers: Basic Fairness Test

(1) Fair dealing which includes the duty of candor to the minority SHs and the directors must disclose all information in their possession germane to the transaction so that the voting is informed. If the majority shareholder acts solely for his own benefit, then fair dealing is not present.(2) Fair price. Fair price is the fair value considering all relevant factors exclusive of the element of value that may arise from the accomplishment or expectation of the merger. This element is narrowly interpreted.(3) Disclosure: must make full disclosure to minority SH. in Weinberger, the court found that there was no fair dealing bc some of the maj BODs

knew that the price could go as high as $24, but they accepted the $21. there was a breach of duty by the Ds by being on both sides of the transaction

and not disclosing the high price Business Associations/Garten/Fall 2008 120

How do you resolve a problem of dual loyalties? Signal could have done their own independent study, or better yet, joint directors could have abstained from involving themselves in the transaction. Lesson of UOP- It seems like it would have been easier to do this all in one step as a straight out merger.

However, UOP would have been able to vote and its Board may have held out and caused problems. If they did this then Signal would have to resort to the two step (coercive tender followed by merger) approach anyway.

in Wilkes, the court will examine a legit business purpose and balance it against a less harmful course of action

DELAWARE RULE

GENERALLY the minority (P) challenging a cash-out merger must allege specific acts of fraud, misrepresentation, or other items of misconduct to demonstrate the unfairness of the merger terms to the minority.

o The burden is then shifted to the majority (D) shareholder to show by a preponderance of the evidence that the transaction is fair.

RULE However, where corporate action has been approved by an informed vote of a majority of the minority shareholders, the burden entirely shifts to the plaintiff to show that the transaction was unfair to the minority.

Freeze-out Techniques

1. Cash-out Merger: This most popular freeze-out technique occurs when the insider causes the corporation to merge into a well funded shell, and the minority is paid cash in exchange for their shares in an amount determined by the insiders.

2. Short Form Merger: Occurs when one corporation owns a large majority of another the former can buy out the minority of the latter in cash instead of stock.

Reverse Stock Split: Company can issue a reverse stock split where nearly all outsiders get a fraction of the ownership that they previously enjoyed. The corporation can then compel the owners of fractional shares to exchange their shares for cash.

Burden: The burden to show fairness is on the majority shareholder. He bears the burden of proving first, that the merger was a legitimate business purpose, and second, that considering the totality of the circumstances, it was fair to the majority.

Business Purpose Test- Some courts will strike down a freeze-out even if basic fairness is found if it does not involve a valid business purpose. Even if insiders pay a fair price, their sole purpose cannot be to eliminate the minority. An acceptable concomitant motive is that the merger will increase corporate assets or income. Companies that merge to go private usually do not pass the business purpose test. Note- Delaware does not use the business purpose test!

Coggins v. New England Patriots Football Club, Inc. (1986)

RULE: “If a company cannot show that a freeze-out merger served a valid corporate objective beyond advancing the majority shareholder’s personal interests, the minority shareholders who were frozen-out by the merger are entitled to relief.”

Statement of the Case


Sullivan bought an AFL franchise for team of Boston and contributed the franchise to the corporation in exchange for 10,000 shares of its common stock. Nine other investors bought this stock as well. Although Sullivan held more than 20,000 shares, he was voted out as president. Eventually, Sullivan regained control by buying all of the company’s voting shares and thus remained the team the Patriots. There was board that he created, favorable to his interests that voted him as president. Sullivan now tried to get rid of all of the non-voting shareholders and thus did this by setting up a new Patriots team that would be merged into the old team. Upon merger, the non-voting stock would be extinguished and their holders would be required to exchange their shares for cash. When Coggins heard of the plan, he voted against it.

ISSUE: If a company cannot show that a freeze-out merger served a valid corporate objective beyond advancing the majority shareholder’s personal interests, are the minority shareholders who were frozen-out by the merger entitled to relief?

HOLDING: YES; if a merger is illegal, the correct remedy is its undoing. However, this merger was in effect for ten years which would make rescission impossible. Sullivan’s freeze out merger was executed in furtherance of his own benefit and to eliminate the interests of the shareholder minority. The merger did not further the interests of the corporation, and Sullivan breached his fiduciary duty to the minority. This case illustrates that the court will scrutinize a transaction more closely if it involves a closely held corporation.

STRICTLY A MASSACHUSETTES AND NEW YORK RULE Defendants bear the burden of proving

(1) the merger was for a legit business purpose includes:

potential cost of dealing with minority even if dividends are not paid out, the costs of conducting meetings, proxies

and SEC filings may be substantial to contribute to a legit business purpose (2) considering the totality of the circumstances, the merger was fair to the minority

fairness must include an inquiry into:(a) fair price(b) fair dealing

o disclosureo how the transaction was timed, structured, negotiated and initiated

A controlling shareholder who is also a director standing on both sides of the transaction bears the burden of showing that the transaction

(1) does not violate fiduciary duties and (2) Not a decision which was personally beneficial.

controlling shareholders and corporate directors does not violate a fiduciary duty to the shareholderso The transaction was entered to further the corp.’s interest (not for the personal interest of the

individual). Fair dealing means that the majority shareholder must act not only for his own benefit, but for the benefit

of the corporation as a whole. It must serve a business purpose. There has to be a business purpose to get rid of minority SH, but not in DE law, where you have to

treat SH fairly and shareholders have the right to challenge in squeezed out transaction.

Rabkin v. Philip A. Hunt Chemical Corp. (1985)


RULE: “Majority shareholders owe a fiduciary duty to minority shareholders and may not unfairly manipulate the timing of a merger to avoid paying the minority shareholders the price agreed upon as part of an earlier transaction.”

Statement of the CaseHunt merged with Olin Corp. as recommended by Hunt’s board. Before merger, Olin purchased 63.4% of Hunt’s stock in Turner and Newall. Olin agreed with Turner that if Olin bought the rest of Hunt’s stock, then Olin would pay the same price per share as it did earlier ($25 per share). Olin then later considered buying the rest of Hunt’s shares a week before the price commitment period expired. When it did expired, Olin offered the remaining shareholders $20 per share, less than $25 as he offered before. The fairness opinion supported the new price based on Hunt’s earning history and prospects for the next year. Hunt appointed a committee to study the proposal, which asserted the price to be fair but not generous. Hunt sought an increase and Olin refused. Hunt recommended the merger nonetheless to its shareholders and thus made full disclose to them in the proxy statements. Remaining minority shareholders were irrelevant since Hunt owed the majority as such he can pass the proposal on his own. The shareholders sued claiming that the majority in the targeted company purposely timed the transaction to avoid paying the minority shareholders a fair price.

ISSUE: Does an acquiring company’s offer to purchase the remaining minority shares of a target corporation after the expiration of a one year price guarantee constitute a violation of the acquiring corporation’s fiduciary duty to the minority shareholders?

HOLDING: YES; the low court found that Olin always wanted to acquire Hunt’s minority shares but at a lower price. The Weinberger rule did not limit concepts of fair dealing solely to deceit issues. Here the plaintiffs have a contractual right to $25 per share, a right Olin destroyed by delaying the purchase date. A court must examine a majority shareholder’s misconduct carefully. Weinberger holds that many of a transaction’s characteristics, such as timing, structure, negotiation and disclosure, impact fairness; as a result, conduct may be inequitable even though it is legal. Once Olin obtained the majority interest in Hunt, it had a duty to refrain from unfairly manipulating its bargain with the minority holders.

Rule: Delaying a merger to avoid paying a contractual price may give rise to liability to the minority shareholders.

DEFENSIVE TACTICS: SHARE REPURCHASES

While taking over control of a company by acquiring a majority of that target company’s outstanding stock does not require any action by the management of the target company’s board of directors, it usually triggers defensive action by management of the target company to prevent the takeover. Lawyers for companies that have been or are likely to be targets of hostile takeovers have been creative in developing (and naming) responses to takeover threats: “poison pills,” “golden parachutes,” “white knights,” etc. Defensive measures are maneuvers or transactions undertaken for the purpose of making it more difficult for the bidder to acquire control of the target company. When management uses defensive measures to repel a takeover, the action is often challenged on grounds that the officers and directors of the target company breached their fiduciary duties by using specific defensive measures to defend against the hostile takeover.


The courts, particularly Delaware, have developed a body of case law which deals with the standard to apply in reviewing challenges to these defenses. These opinions are adjudicated on the facts. These cases present conflict of interest problems. Officers and directors of a target company who oppose a takeover to their company will have a conflict of interest. There is a high likelihood they will lose their jobs in the event of a takeover. Management of the target company are typically opposing the takeover for reasons they honestly and reasonably believe are in the best interests of the target company. Or basically, they are opposing the takeover to save their jobs.

1. Lock-up- Device designed to protect a bidder (usually friendly) against competition from other bidders. Normally, the favored bidder is given an option to buy a valuable asset at a good price given a certain set of circumstances.

2. Crown Jewels- Lock-up or sale of the most valued asset of a corporation to prevent or discourage a takeover. The hostile bidder may obtain control, but of a company that has lost value because of the options exercise.

3. Poison Pill- Device adopted by potential takeover target to make stock less attractive. One way is to give shareholders a right to redeem or cash in their stock at an inflated price in the event of a takeover. Another way is to give the existing shareholders the ability to buy shares at a discount price. Both mechanisms deter takeover by making it more costly. Thus shareholders here are granted the right to acquire equity or debt securities at a favorable price to increase the bidder’s acquisition costs.

POISON PILLS Widely used, highly complex plans designed to provide varying degrees of protection against takeovers. Most are based on a form of security known as a “right.” When adopted, (usually by the board of directors) the rights attach to the corporations outstanding common stock, cannot be traded separately from the common stock, and are priced so that exercise of the option would be economically irrational.

a corporation’s right to poison pills is included in their articles of incorporation Form of security known as a “right” or typically as a warrant, granting the holder the option to purchase

new shares of stock of the issuing corporation at a discount when exercised. Exercise is economically irrational until a distribution event, which is the acquisition of, or

announcement of an intent to acquire, some percentage of the issuer’s stock by a prospective acquirer. Flip-in element is triggered by actual acquisition of a specified % of the issuer’s common stock.

o If triggered, the shareholder of each right except the acquirer and its associates gets to buy two shares of the issuer’s common stock at half price.

o essentially diluting the shares by making more shares available Flip-over is triggered if, following the acquisition of a specified % of the target stock, the target is

subsequently merged into the acquirer. Then the holder of each right becomes entitled to purchase stock of the acquiring company at half-price.

4. Junk Bond- A bond with an unusually high risk of default, coupled with an unusually high rate of return. This is issued by a company with a credit rating below investment grade. (Play Big, Win Big!).

5. No Shop Clause- When a corporation agrees not to pursue other merger opportunities; in other words, it is a stipulation prohibiting one or more parties to a commercial contract from pursuing or entering into a more favorable agreement with a third party.

6. Green Mailing- When a targeted company buys out the acquirer- meaning, it buys back its stock from the acquirer at a premium. Basically, it is a way to buy off a potential buyer. It is the act or practice of buying


enough stock in a company to threaten a hostile takeover and then selling the stock back to the corporation at an inflated price; the money paid for stock in the corporation’s buyback; a shareholder’s act of filing or threatening to file a derivative action and then seeking a disproportionate settlement.

To be a good candidate for takeover and subsequent liquidation, the corporation must have a high liquidation value and a low book/market value. Because a takeover bid is an episodic development in the life of a company, and one in which directors share jurisdiction with shareholders, it is unlike a type of decision where directors have a exclusive jurisdiction. Accordingly, the adoption of takeover defenses must be governed by a modified and less deferential version of the business judgment rule.How far can management go in their defensive measures without violating their fiduciary duties?

This answer depends on the MOTIVES or SUBJECTIVE STATE OF MIND of the officers and directors, which is later denoted in Unocal and Revlon. However but in Cheff v. Mathes, courts readily accepted almost any business justification for defensive tactics. The target board had only to identify a policy dispute between the bidder and management.

Burden of Reasonable Grounds: Corporate fiduciaries cannot use corporate funds to perpetuate their control of the corporation. Directors can satisfy their burden by showing good faith and reasonable investigation; the directors will not be penalized for an honest mistake of judgment, if the judgment appeared reasonable at the time the decision was made.

Cheff v. Mathes (1964)

RULE: “If a company’s board sincerely believes that buying out a dissident stockholder is necessary to maintain proper business practices, the board is not liable for the decision even if, in hindsight, the decision may not have been the best course.” Statement of the CaseCheff (Holland) meets with Maremont to discuss a merger. Cheff later declined any further negotiations with Maremont due to their sales practices. A month later, Maremont informs Cheff that it bought 55,000 of Holland’s shares. Holland checks Maremont’s background and found that it liquidated its corporation a number of times and its corporate image was not highly regarded. Maremont bought more shares and it grew to 100,000 and now demanded to be on Holland’s board. The target board denied. This pressure led to several key Holland employees to leave. Holland now started to buy their own stock causing the shares’ price to increase. Then Maremont offered to purchase Holland’s other company, Hazelbank in which a number of the board of directors there agreed. Now Holland met with Maremont to discuss the purchase of Holland stock. Holland’s board authorized the purchase at a high market price. Cheff brought a derivative suit asserting that Holland’s dealing in its own stock was undertaken solely to allow the directors to retain control of their company.

ISSUE: May a board of directors trade its own stock to frustrate an outside investor’s efforts to liquidate the company or change its character to the detriment of the company and its shareholders, if the directors acted on their belief that the outside investor had a reputation for ruining targeted companies?


HOLDING: YES; Delaware statutes give corporations the right to trade in their own stock. Courts do not permit a board to use corporate funds merely to further the board’s desire to stay in power. However, if the directors believe that buying out a dissident shareholder is necessary to maintain proper business practices, a court will respect the board’s decision. The burden of proof lies with the plaintiff as the board is presumed to have acted in good faith, but if the board members are also shareholders, they have a conflict of interest that requires them to show that the stock purchase was motivated by the corporation’s best interests. The conflict of interest was present so the board must meet the test. The ultimate concern was whether the board had a reasonable basis for believing that Maremont would pose a danger to Holland’s corporate policy. If the board engaged in reasonable investigation, any honest mistaken judgment does not support a finding of blame.

The court comes up with its own test- The Board must show that they have reason to believe that the takeover poses a danger to corporate policy and effectiveness. The court found that the Board met its burden because:1. Potential buyer was looking to get rid of the retail sales force2. Potential buyer had a history of takeover and liquidation (This actually may be a good thing for the shareholders because they would share in profits from liquidation)3. Company posed by potential buyer would cause employee unrest. (Again, this is problematic because by accepting this argument the court is saying that the Board has an additional duty to company employees aside from their duty to shareholders)Rule- Corporation can buy its own stock at a higher price to fend off a potential takeover so long as the reason is not for the Board to keep their positions. Business judgment rule: In Delaware, the target and its management will get the protection of the business judgment rule and thus their defensive measures will be upheld (Cheff v. Mathes). The fact that the target management can bring forth any defensive tactic led to a storm of judicial response. For one, several courts imposed heightened standards of deliberative care in takeover fights. Thus this requires directors to probe into the business and financial justifications for takeover defenses which puts teeth in the reasonable investigation standard. Thus the presumption of the business judgment rule was curtailed thereafter as evidenced under the following circumstances summarized in Unocal Corp. v. Mesa Petroleum Co.: which incorporated the procedural and substantive heightened standards of intrinsic fairness and rational basis.

Unocal Corp. v. Mesa Petroleum Co. (1985) – what defensive measures are proper?

RULE: “A board may use corporate funds to purchase its own shares to remove a threat to corporate policy and may deny the dissident shareholder the right to participate in the self-tender offer provided the actions are motivated by a genuine concern for the company and its shareholders and provided that the proposed defensive measures are not out of balance with the treat’s significance.”

Statement of the CaseBusiness Associations/Garten/Fall 2008 126

http://www.lexis.com/research/xlink?searchtype=lxe&search=493+a2d+946

http://www.lexis.com/research/xlink?searchtype=lxe&search=493+a2d+946

Mesa owned 13% of Unocal. Mesa made a 2-tier offer to buy 54% of Unocal at $54 per share. The remaining shares would be eliminated under an exchange for stock for junk bonds. Goldman Sachs noted that the offer was inadequate and informed them of defensive strategies to thwart the takeover, such as a self-tender to itself of 6 to 6.5 billion shares. Though it would create debt, it would be viable. The board rejected Mesa’s proposal and then later reconvened and made an offer for $72 per share under a purchase agreement that asserts if Mesa obtained 64 million shares, Unocal would buy 49% of the remaining shares and exchange them for debt securities. The board prohibited Mesa from tendering any of Unocal’s shares. Mesa brought suit challenging the agreement. Goldman Sachs told Unocal to waive the restriction down to 50 million shares and suggested that the board should tender their own shares. The board ruled that its exclusion of Mesa was justified in order to prevent their shareholders from receiving junk bonds and ensured that their assets won’t be used to fund Mesa’s inadequate capital.

ISSUE: Is a company’s purchase of its own shares in an effort to remove a take-over threat protected by the business judgment rule if the purchase is reasonable in relation to the threat posed and is supported by a thorough evaluation of the takeover bid?

HOLDING: YES. Unocal’s board decided to exclude Mesa in good faith on an informed basis and in the exercise of due care. Therefore, it is entitled to protection under the business judgment rule. The board’s authority to act comes from three sources: (1) its inherent power to manage the corporation’s business; (2) its statutory power to trade in its own stock; and (3) its fundamental duty to protect the company and its stockholders. The BJR protects a board’s decision to thwart a takeover if the decision has a rational business purpose. The board must determine that the offer is in the best interests of the company and its shareholders. The directors must show that they have a reasonable belief, based on good faith and a reasonable investigation, that the takeover poses a danger to corporate policy and that they are acting in the stockholders’ best interests, not solely to keep their offices. The Unocal board concluded that Mesa’ offer was inadequate and unfair to their shareholders. The board’s distrust of Mesa was reinforced by Mesa’s reputation as a corporate raider.

NOTE: the case represented a TWO-TIER OFFER by Mesa. A Two-tier offer is a technique by which a bidder tries to acquire a target corporation where the first step involves a cash tender offer and the second step involves usually a merger in which the target company’s remaining shareholders receive securities from the bidder.

TWO-PART (UNOCAL) TAKEOVER TEST IN ADOPTING A DEFENSIVE TACTIC(BURDEN OF PROOF ON DEFENDANTS) After a reasonable investigation, the…

1. BOARD OF DIRECTORS MUST DEMONSTRATE THAT THE RAIDER POSES A THREAT TO THE CONTINUED EXISTENCE/WELFARE OF THE CORPORATION. THIS MUST BE SHOWN IN GOOD FAITH UPON A RATIONAL BASISFirst, the board and management must show that they had reasonable grounds based on a reasonable investigation for believing that there was a danger to the corporation’s welfare from the takeover attempt. In other


words, the insiders may not use anti-takeover measures merely to entrench themselves in power — they must reasonably believe that they are protecting the stockholders’ interests, not their own interests. (Some dangers that will justify anti-takeover measures are: (1) a reasonable belief that the bidder would change the business practices of the corporation in a way that would be harmful to the company’s ongoing business and existence; (2) a reasonable fear that the particular takeover attempt is unfair and coercive, such as a two-tier front-loaded offer; and (3) a reasonable fear that the offer will leave the target with unreasonably high levels of debt.).

2. THE THREAT MUST BE PROPORTIONAL TO THE REACTION

The anti-takeover defenses must represent a response that is “reasonable to the threat posed” (element of balance); Factors that may be examined are: adequacy of the price, timing of the offer, nature of the bid/bidders, impact on constituents aside from shareholders (creditors, employees, customers), risk of deal falling apart, quality of securities or cash offered, interests of short term speculators that may self-deal and push the deal to the disadvantage of long term investors. (1) To meet the proportionality requirement, a defensive measure must not be either "preclusive" or "coercive." A "preclusive" action is one that has the effect of foreclosing virtually all takeovers (e.g., a poison pill plan whose terms would dissuade any bidder or the granting of a "crown jewels option" to a white knight on way-below-market terms). A "coercive" measure is one which "crams down" on the target’s shareholders a management-sponsored alternative (e.g., a lower competing bid by management, if management has enough votes to veto the hostile bid and makes it clear that it will use this power to block the hostile bid).

Note: The court cuts back a little from the test implemented in Cheff because it imposes a reasonable and

proportionate requirement.

after applying the 2 Part Unocal Test, everything else falls under Business Judgment Rule EXCLUSIONARY REPURCHASES (buy back everyone’s shares except for the threat’s shares)

target tries to repel a hostile two-tier front loaded tender offer by embarking on its own aggressive program of share repurchases that excluded the repurchase of the hostile bidders shares

O if the target offers a higher price for its shares than the bidder, target holders will less likely tender to the bidder


target has the right to exclude the bidder from participating in the share repurchase program (Unocal v. Mesa)

GREENMAIL (buy back the threat’s shares)The target may pay "greenmail" to the bidder (i.e., it buys the bidder’s stake back at an above-market price, usually in return for a "standstill" agreement under which the bidder agrees not to attempt to re-acquire the target for some specified number of years).

The purchase by a corporation of a potential acquirer’s stock, at a premium over the market price.o §160 grants a corporation power to purchase and sell shares of its own stock

in demonstrating the threat a raider poses to the continued existence and welfare of the corp., BOD may argue that the shareholders are better off in the long term over short term when fulfilling fiduciary duty to act in the interests of the shareholders

o Use the Wrigley argument of long term being an acceptable reason

under a breach of loyalty, shareholders will argue that the board prevented them from liquidation and further diluted the value of their shares by repurchasing more shares with debt

o in terms of sheer economics, shareholders are probably better off with liquidationo further, there is an inherent element of self interest for the board

they could be providing greenmail to preserve their own jobs rather than pursuing the corporation’s best interests

if they greenmail to protect their own positions, they have breached their duty of loyalty greenmail payment will be OK when the board can demonstrate that the hostile

takeover will damage the corporation’s existence or business policies, and buying back the raider’s shares at a premium in return for a standstill agreement will prevent the hostile takeover,

o NOTE HOWEVER, if there are no justifiable fears other than the desire of the board to retain their position, greenmail will be struck down

A repurchase is a form of self-dealing, and therefore the burden should be on the directors to show that there was a legitimate business purpose by showing good faith and reasonable investigation. Cheff v. Mathes

Greenmail has been upheld in every court it has been challenged in

Two-Tier Front Loaded Tender Offer the bidder can offer to pay an attractive premium for a majority but not all of the target’s shares Bidder can further tell target’s shareholders that if successful in acquiring a majority at a premium price,

he will subsequently conduct a back-end merger of the balance at a less attractive price. The merger is a “cash merger” in which the minority shares are offered cash. They are thus squeezed out of the company. No more public shareholders will be left. The reason for the “squeeze out” merger transaction is so that the bidder may fully get its hands on the assets and cash flow of the target company.

such an offer has a coercive effect on shareholders (shareholders here have appraisal rights) they are afraid of what will happen on the back end, not because they want to be bought out

CONSEQUENCES OF NOT SELLING if successful, the bidder can implement a SHORT FORM MERGER ex: if ABC Corp owns 90% or more of XYZ Corp, then in most states at ABC’s request,

XYZ can be merged into ABC with all XYZ shareholders paid off in cash


Rule 133-4(f)(8) – after Unocal, the SEC amended the rules to prohibit issuer tender offers other than those made to all shareholders, but not pills.

Decision to sell the company: Once the target’s management decides that it is willing to sell the company, then the courts give "enhanced scrutiny" to the steps that the target’s board and managers take. Most importantly, management and the board must make every effort to obtain the highest price for the shareholders. Thus the target’s insiders must create a level playing field: all would-be bidders must be treated equally.

DEFENSIVE TACTICS: AUCTIONS

Revlon v. MacAndrews & Forbes Holdings, Inc. (1985) – when must the target give up the fight?

RULE: “Delaware law permits agreements to forestall or prohibit hostile forces from acquiring a company, but the methods may not breach a director’s fiduciary duty, so that once the sale appears inevitable, board must work to maximize the company’s value to ensure the highest possible price.”

Statement of the CasePantry Pride wanted to acquire Revlon. Pantry and Revlon discussed plans for acquisition at $40 -50 per share. Revlon said it was inadequate and asserted that Pantry would need Revlon’s consent to purchase their stocks. Revlon’s investment banker warned them that Pantry would try to buy the company with junk bonds and then break it up which would give Pantry a good profit. Revlon’s counsel recommended two defensive tactics: a self-tender offer for up to 5 million shares and a Note Purchase Rights Plan containing a POISON PILL which allowed each of Revlon’s shareholders to exchange a share of stock for a $65 note bearing 12% interest. The pill would kick in whenever someone acquired 20% of Revlon’s shares. A hostile buyer could not partake in the agreement. Pantry offered $47.50 per share and the board rejected. Revlon started their self tender offer. Pantry made a revised offer up to $56.25 per share. Then Revlon approved a leveraged buyout (the purchase of a publicly held corporation’s outstanding stock by its management or outside investors, financed mainly with funds borrowed from investment bankers or brokers and usually secured by the corporation’s assets) with Forstmann Little in which shareholders receive $56 per share and the management would receive stock in their new company under their golden parachutes. Revlon cashed in on their notes and waived the NPRP conditions to Forstmann. Eventually, Revlon stock prices fell after the deal which made shareholders upset. Pantry continued bidding. MacAndrews, on behalf of Pantry challenges the Forstmann deal.

ISSUE: In the face of active bidding for a company where the sale of the company appears unavoidable, may the target company’s board continue to thwart take over attempts instead of ensuring a maximum sales price for its stockholders’ shares?

HOLDING: NO; the BJR protects a company’s board’s defensive actions to a takeover ONLY if the board observes principles of care, loyalty, and independence in reaching its decisions. Actions taken by a board in defense of a takeover bid are presumed to be motivated by self-interest. The board has the burden of proving it was motivated by a belief that the takeover posed a threat to the company’s welfare and that its response was proportional to the threat posed. Revlon had the power to enact the poison pill. The question


is whether the measure was reasonable. Revlon claim that the $45 offer was inadequate and so it adopted the pill to protect themselves from hostile takeover while maintaining their ability to analyze better offers. A board’s steps must be strictly scrutinized to ensure no fiduciary duty was breached. When Pantry’s offer reached $53 per share then it was fair and Revlon’s breakup would be inevitable. Thus, the board must make every effort to maximize the price per share. Instead, they provided concessions to Forstmann at their shareholders’ expense.

Holding: This case involves an asset lockup option conceded by Revlon’s Board to white knight (a person that rescues the target corporation from an unfriendly takeover by acquiring a controlling interest in the target or by making a competing tender offer) bidder, Forstmann Little. A Board must assume the role of an auctioneer once a sale or breakup becomes inevitable. (Revlon imposes the Duty to Auction). As a result, the Board failed as an auctioneer with their lockup option because it ended the auction with very little improvement in the final bid.

NOTE: this case represents that the court will investigate the board’s motives with strict scrutiny. There is a difference in the court’s analysis between first and second stage defensive tactics. The first was found to be reasonable since the offer was indeed inadequate. As to the second stage, once Revlon’s Board asked management to find a white knight, the Board’s duty shifted because the sale of the company became inevitable. Before the company is going to be sold the directors have a great amount of discretion to determine what is best for the company. This is ironic because it is at this point that the Directors may take their own self-interest in retaining their position over the interest of the shareholders whereas when the company is up for sale this is less likely because they are going to lose their jobs either way. However, it is still possible because they could still look for a management friendly buyer. Key to the decision here is that the Board favored Forstmann because he would have taken care of the debt note holders. Once the Board decides to sell, it is up to the shareholders to determine which offer to take. Once a corporation is up for auction the Board’s sole duty is to maximize the profits that will be received by shareholders in return for their shares. Once the corporation is up for sale the Board cannot favor one bidder over another, nor can it take into account non-shareholder constituencies.

Defensive tactics against a takeover are acceptable, subject to Unocal, until a corporation seeks a white knight, thereby inevitably putting the corporation up for sale

o Board of Directors’ duties changes from preservation of the corporation bastion to the maximization of the company’s value at a sale for the stockholders’ benefit

o Board of Directors’ role changed from defenders to auctioneers.

Revlon represents a limit on director’s discretion and draws the line on where defensive tactics must stop and maximizing shareholder profit must commence. Also, duty to find someone less demanding on the conditions; affirmative duty for directors to obtaining the best price and least restrictive conditions, etc.

Once the Company is in play or sold, leave it to the shareholder to make the decision who is giving the best offer because when a Company is for sale, the only decision is who is offering more money.

Revlon duties are triggered under two circumstances (1) When a corporation initiates an active bidding process seeking to sell itself or to effect a reorganization involving a clear break-up of the company ( Revlon )


(2) When, in response to a bidder’s offer, a target company abandons its long-term strategy and seeks an alternative transaction involving break-up of the company. ( Time v. Paramount )

• In other words, Revlon duties attach when a sale or breakup of the target company becomes inevitable. lock-ups will not be per se illegal under DELAWARE law BUT they must be used to expand the

competition, not destroy it o for example, if a lock up were the only way to induce a second bidder to enter the competition, it

might well be legal since it would be shareholder-value-maximizing • Although Unocal permits consideration of other corporate constituencies, provided there

are rationally related benefits accruing to the stockholders, such concern for non-stockholders is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder.

The duty of loyalty and care changes when a company is being sold because the action of attaining the corporation may be a conflict of interest when it is inevitable that it will be sold. The shareholders’ best interest would be to maximize their profits. The search for the “white knight” in this circumstance breached a fiduciary duty to the shareholders.

CLEARING UP UNOCAL AND REVLON

The main consequences of the Revlon case are (1) if the target company is in the Revlon Mode (this occurs when it is CLEAR from the facts that the company will no longer remain independent in its present form), management has to give up the fight but (2) the converse is also true > which is until the company gets into the Revlon Mode it can use defensive measures, thus management can fight to make it more difficult for the bidder to acquire their company. The Unocal case sets the limits on the kind of defensive measures the target company’s management can take prior to getting into the Revlon Mode. It is often asserted, “Until you get into the Revlon Mode, a target company can invoke its Unocal defenses – accordingly to the test laid in the case.

The Unocal test requires management to show that it took defensive measures for the purpose of protecting the company’s interests, rather than for the purpose of protecting managements’ jobs or negotiating a better severance package.

FIDUCIARY DUTIES OF MANAGEMENT

Court gave management leeway and that was the conventional wisdom in DELAWARE – very broad discretion by management to prevent hostile bids. This was the general trend until REVLON!

In defining the duties owed by management, the court attempts to find a balance between giving managers the flexibility to run the business and hold the managers accountable to the owners of the


business. The duties owed my officers and directors are the same. They owe to their corporations (1) the duty of care and (2) the duty of loyalty. (BOTH ARE MENTIONED IN GREATER DETAIL EARLIER)

Paramount Communications, Inc. v. Time Inc. (1989)

RULE: “If a board is pursuing a merger for strategic reasons beyond merely the sale or acquisition of another company’s assets, it may decline to entertain a competing bid that may yield a higher short-term gain for its shareholders in favor of merger that ensures greater long-range goals.”

Statement of the CaseTime sought to expand into the entertainment industry. Time met with Warner to discuss a joint venture that was strongly recommended by Time’s board. The board for Time approved a plan to expand with Warner as long as Time retained control of the resulting entity so it could remain true to its journalistic commitments. Time deemed Warner the prime candidate. Time wanted an all cash acquisition but Warner wanted a stock for stock exchange in which Time agreed. Warner would own 62% of the new company. Both boards approved the merger. Time received letters from lenders as such not to finance any transactions that would interfere with the merger. Before the final vote, Paramount offered to purchase Time for $175 per share provided they broke from Warner. Time’s board discussed the offer and declined. Time then restructured their agreement with Warner providing for the purchase of 51% of Warner’s stock at $70 per share with the remaining shares to be obtained later. Paramount increased offer to $200 per share but Time rejected again believing that Paramount’s culture was not a good fit. Paramount filed suit arguing that Time-Warner agreement was an effective sale of Time requiring its board to maximize short term shareholder value. Paramount is arguing under the standard in Revlon.

ISSUE: If a second merger proposal presents a higher per-share price than the transaction being pursued by the company’s board, is the board obligated by its fiduciary duty to pursue the second proposal to maximize benefits to its shareholders?

HOLDING: NO; Time did not put itself up for sale by entering the agreement with Warner. Time’s original shareholders are not in a minority position in the new venture to establish existence of a sale. Paramount argues the directors here failed to maximize the shareholder profits as in Revlon. The court ruled that Revlon considerations are relevant ONLY IF evidence shows that the contemplated transactions will result in the company’s break-up. The board anticipated Time’s continued existence, and Revlon does not apply if a transaction simply has some characteristics in common with a sale. A court must determine whether sufficient evidence exists to find that the Time-Warner agreement was made in the proper exercise of business judgment. Time said Paramount did not present a strategic business combination in the long run. Furthermore, this offer came right before decision as such to capture and sway its shareholders away from their plans. The board here conducted a reasonable investigation before it began conducting business with Warner. The board’s decision to reject Paramount was made in good faith. Directors are not obliged to take a better short term offer for their shareholders if to do so would harm long range plans.

NOTE: This case also echoed Cheff v. Mathes in which the board in Time was concerned that if the outsider was successful, the business as it was known in the market would cease to exist. Time wanted to


maintain its reputation and integrity of its journalistic publications. Thus it never intended to sell its company. The court specified that Revlon duties are only triggered when a target initiates an active bidding process or seeks a breakup of a company. Because the deal would not result in a breakup and ownership would remain public, the court did not find a change of control necessary to induce the auctioneering duty. Furthermore, the court found that excluding the shareholders’ voice in the deal did not violate the proportionality test in Unocal because the shareholders were not as knowledgeable about the prospects of the Paramount deal as the Board and outside Directors.

The decision by Time board of directors to merge with Warner is upheld under the BJR. The Unocal standard was applicable here.

o If the directors arrived at the decision to reject an offer after appropriate analysis and consideration of legitimate factors, a court will not substitute its judgment for that of the directors. Long term growth is ok versus short-term profits because the corporation was NOT for sale.

• REVLON MODE - Change in control: When a corporation undertakes a transaction which will cause: (a) a change in corporate control; or (b) a break-up of the corporate, the directors; obligation is to seek the best value reasonably available to stockholders. Therefore, a break-up of the company is not essential to give rise to this obligation where there is a sale of control.

Enhanced Scrutiny Test: The key features are: (1) a judicial determination regarding the adequacy of the decision making process employed by the directors, including information on which the directors based their decision; and (2) a judicial examination of the reasonableness of the directors’ action in light of the circumstances then existing. The directors have a burden of proving that they are adequately informed and acted reasonably.

Paramount Communications, Inc. v. OVC Network Inc. (1994) – STANDING CURRENT LAW

RULE: “A board selling its corporation has a duty to obtain the best value for its shareholders and cannot give preference to one of the competing bidders.”

Statement of the CaseViacom and Paramount formed an alliance to thwart an unsolicited tender offer by OVC. This offer was made to Paramount. Paramount renewed its efforts to negotiate with Viacom. QVC was interested in Paramount and Paramount told QVC they are not for sale. Through due diligence, Paramount and Viacom approved a merger that would convert Paramount stock into Viacom shares and Paramount exempted the transaction from its POISON PILL provisions. This attempted to ward off other buyers by imposing a NO-SHOP provision where Paramount would not negotiate with any other buyer and Viacom would receive $100 million termination fee if the companies’ merger cancelled. It also granted Viacom an agreement that allowed Viacom to purchase 24,000,000 shares of Paramount’s stock at $69 per share if the triggering event occurred. The merger was announced but QVC was persistent. QVC presented a tender offer for 51% of Paramount shares at $80 per share, with remaining shares to be purchased in a stock for stock exchange. Viacom realized that the QVC deal was better so it renegotiated with Paramount. Thus they reached a new agreement, a little better, but not better than QVC. QVC remained persistent but the Paramount board denied since the proposal had too many


stipulations and because the Viacom deal was better. QVC sought to have the court enjoin the merger. The low court issued the injunction against the merger.

ISSUE: Is a board that agrees to the sale of a corporation or transfer of control obligated to obtain the best price for the shares?

HOLDING: YES; the law recognizes that managing the company’s affairs is protected by the BJR. However, a court must closely scrutinize the board’s conduct if the transaction being considered results in a sale of the corporation or if the actions are designed to defend a threat to corporate control. In this case, the transaction will create a new majority shareholder and is effectively a grant of control to the purchaser. Therefore, the stockholders should be paid for the loss of control. If a board decides to resist an acquisition, the decision must be well-informed, but if control is for sale, the board must insist on obtaining the best value for its stockholders. Deciding the best value may be more than simply the price, so the transaction must be analyzed as a whole, with any non-cash component quantified. A court must review a board’s action with enhanced scrutiny anytime there is a diminution of voting power, the sale of a control premium, or an action to impede a stockholder’s voting rights. Only after the decision passes the enhanced scrutiny will the BJR protect the board’s decision. The court’s enhanced scrutiny must include a review of both the directors’ decision-making process, including an examination of the information used by the board, and the reasonableness of the directors’ action in light of the circumstances. The directors have the burden of proving they were adequately informed and acted reasonably. Paramount argues that such scrutiny is inapplicable in a merger case that does not breakup the corporation. This court however disagrees. If a corporation leads to a transaction that leads to a change in corporate control or a break-up of the corporate entity, the directors’ obligation is to seek the best value for the stockholders. Here, the agreement shifts control of Paramount to Viacom. Once Paramount directors decide to sell control of the company, they must determine that all material aspects of the Paramount-Viacom transaction are in the Paramount’s best interests. Though the contract precludes Paramount from outside offers, such measures will nonetheless be invalidated if they conflict with fiduciary duties. Paramount had a duty to decide the best offer for their shareholders. Here, it was plainly QVC but Paramount decided to remain blind to the better offer.

The deal is not a merger of equals but a sale of control. Paramount would gain a new controlling shareholder. Because the transaction involved a sale of control, Revlon duties to seek the best price devolved upon the Paramount directors. • The Board has a duty to evaluate alternatives and seek the best value reasonably available. • Court says the use of Revlon is not for just the breakup of companies but for a change of control.

Expand Revlon Test from being invoked upon sale of corporation to WHENEVER A CHANGE IN CONTROL OCCURS Why wasn’t Time-Warner a change in control?

o Because Viacom is controlled by a sole-shareholder and thus when the Viacom-Paramount deal goes through, it will transform a publicly held company to a closely held corporation

o Court also changes the application of the Revlon Test by stating that the director’s fiduciary duty during the auctioneer process does not require him to only consider the highest cash value, but other factors as well


o directors may consider the value of a given strategic alliance and the synergies that come along with it

o QVC is a middle ground between Time and Revlon

APPLY UNOCAL TEST UP UNTIL THE POINT OF INVOKING REVLON.REVLON IS INVOKED WHEN:

(1) corporation initiates an active bidding process seeking to sell itself(2) in response to a bidder’s offer, the corporation “abandons its long term strategy and seeks

an alternative transaction also involving the break up of the company”(3) change in control (added by Paramount v. QVC)

Note: Paramount here refused to consider price and long term debt. Paramount could not justify that the merger represented a chance for the company to improve its long range market objectives.

The Unocal-Revlon-QVC Test:

When (1) change of control, (2) an active bidding process for corporate sell, or (3) a corporate abandoning of a long term strategy which may lead to a break-up is bound to occur, the directors of the target company have a fiduciary duty to find the best value for their shareholders and at the same time consider other factors as such to enhance the shareholders’ interests. And if it is a change of control, the board must consider the long term goals of the corporation.

“The court asserted the duty to seek the best value – the Revlon auction duty – arises not only when the company initiates a bidding process or when its breakup is inevitable, but also when there will be a change in control.”


KAPLAN AUDIO

Corporation – artificial business entities authorized the state statute. They draft their articles and bylaws. It authority is derived by statute, articles, bylaws, and the board’s resolution. It can only act out of one of these doctrines. If it does not, the ultra vires doctrine is triggered. Corporation is separate and distinct from its owners/investors as such they are not responsible for their debts or obligations. Organization of corporation: (1) how is limited liability attained to the shareholders, and (2) once its there, how do the creditors pierce the veil. Look for a situation where the shareholders are not seeking to be liable for their debts which triggers either a De Jure Corporation, De Facto Corporation, or Corporation by Estoppel. The articles must include the name, the business purpose which will authorize and limit what a corporation can do, and capital stock issuance. Also, there must be a registered agent to get service of process (notice). De Facto and Estoppel have the same elements however, estoppel has one more, the 3rd party had reasonably relied that they are a corporation and thus later cannot claim they are not a corporation. These doctrines no longer exist in a large number of states. Piercing the Veil: the corporation will clearly be liable where there is a breach of contract or tort; thus, are the shareholders are liable? (1) Fraud doctrine – if the corporate entity is used as a vehicle to defraud someone or promotes injustice, the corporate veil will be disregarded; (2) Under-capitalization doctrine – was this corporation given enough capital or money to conduct their business at the offset? Shareholders are responsible for capitalizing the corporation. Loans do not count also furthermore, the court is more likely to go after a tort victim than a contract breach because contractual issues are more of an assumption of risk; and (3) alter-ego doctrine/enterprise liability doctrine – 3rd party must know whether they are doing business with a shareholder or its corporation. Corporate formalities must be maintained. The corporation should use its own name, no commingling of assets, filing of reports and keep minutes of meetings, etc. When formalities are not followed, the identities tend to merge. When this occurs in a multiple corporate setting, enterprise liability is triggered – Brother-Sister corporations.

It is important to note who are they testing you on and in what capacity is he in. In a closely held, it is typically the shareholder holds all positions.

Promoters – act on behalf of the corporation or solicit business that is not in existence yet.

Shareholders – (stockholders) – collect dividends only if the board of directors declares them. (1) Shareholder rights – voting and inspection

Shareholders vote at an annual meeting and a special meeting. The special meeting may be called at anytime by a beneficial owner, directors, or officers. Notice requirement is mandatory. The shareholders can attend in person or by sending someone else in their place or proxy, which must be in writing, signed by the giver and it will expire in 11


months. They are easily revocable unless coupled with an interest. This irrevocable proxy has been given with consideration; the interest was bought.

Voting Mechanism: shareholders vote straight (the number of votes casted must be proportional to the shares allotted to that shareholder) or cumulatively (votes may be casted all for one candidate). The bylaws decide whether to use what type of voting.

(2) Shareholder agreements – is the agreement is valid? If so, it is enforceable. Voting shareholder pooling agreements (combine their interests to be a powerful political force in “pooling” their interest to vote a certain way against directors); voting trusts (must be in writing and are valid for 10 years) – to be valid, if the pooling agreement or voting trust is acting within the shareholder’s sphere of authority, it is valid. (Board elects officers – not in shareholder sphere; shareholders cannot declare dividends; etc.) Sphere of authority does not matter in a closely held corporation. Stock sale agreements (typically in close corporations) – restrict ability to sell stock in order to keep stock in-house. Here, the test is whether or not the agreement is reasonable. If it is not, it is not valid. (ex. Consent of all shareholders is impossible and unreasonable)

(3) Enforcement of shareholder rights (derivative suit) – look for a situation in which the corporation has been harm by either a tort or contract etc. Shareholder has to been a shareholder at the time the cause of action arouse and throughout the litigation (contemporaneous ownership). Some states require a bond to put up to prevent frivolous lawsuits. Shareholders must make a demand upon the directors that they cause the corporation to bring the lawsuit or show that the demand would be futile. If the demand is made in good faith and the corporation has decided not to take the suit, that decision will be barred by the judgment rule unless the plaintiff can show wrongful refusal.

(4) Controlling shareholder – a person who owns enough stock to elect a majority of the board. Typically there is a majority owner or a plurality of the stock. This triggers a special responsibility on them. They are fiduciaries to the corporations and the other shareholders. Thus they cannot take action to benefit of themselves and that is to the detriment of the corporation. Simply having a benefit is enough to trigger a breach. However, the equal opportunity doctrine says do not take anything that is only going to benefit you without sharing it with the several shareholders of the corporation.

Board of Directors – they run the business organization

(1) Selection & retention – shareholders elect the board of directors. Removal of directors requires a majority vote by the shareholders with or without cause. If you are seeking to remove less than the entire board, then you need to ascertain the minimum percentage necessary to elect one board member. Also if the number of votes cast against removal is sufficient to keep the director on the board, then the director is not removed.

(2) Director authority and powers – when they act, they act as a board. A director can never act on their own. They do not act as an agent or employee of the corporation. The board acts upon the majority of the quorum or majority. (Ex. 9 directors, 5 directors show up to meeting, quorum is met so 3 are necessary to pass a corporate resolution). They bylaws can always change the voting requirements and restrictions.


(3) Director’s duties (care and loyalty) – the duty of care is a test on competence (the board as a whole acts upon a situation) in office. The fiduciary duty of loyalty tests fairness and loyalty (usually here one director is always acting). The duty of care requires the “prudent person standard” under the business judgment rule. Directors are required to act in good faith, non-negligently, and in the corporation’s best interests. The duty of care and the business judgment rule are interchangeable. The directors have defenses as to if they breached their care. These are their cures: (1) submission to the shareholders for them to ratify a transaction; and (2) blame another person, typically an expert who they brought in to analyze the situation – they must have relied on the expert in good faith. The duty of loyalty occurs when a director takes a personal action or is solely profiting. There are four ways it can be breached: (1) common law rules for stock transfer liability – special facts doctrine; (2) interested contract – where a conflict of interest exists: the director is buying something from or selling something to the corporation – director is sitting on both sides of the transaction since he benefiting personally but also is at odds with the board since he sits there as well. 3 saving mechanisms here: (1) interested director discloses the information to the other directors and the disinterested ones must approve; (2) disclosure to the shareholders and they approve the transaction; and (3) the transaction is deemed to be fair – this is when the shareholders and disinterested directors disapprove. (3) Seizing a corporate opportunity – there is a business opportunity for the corporation but took it himself. The corporation can recover profits, damages, constructive trust, or recover the opportunity at cost and repay the director for what he paid. To be a corporate opportunity, it must be related to the line of business and the corporation must be able to finance it. (4) Direct competition – the recovery is injunction, damages, etc.

(4) Corporate Officers – they are appointed by the directors as fiduciaries. An officer is both an officer and an agent of the corporation. What capacity was the officer acting in? Officers’ actions can bind the corporation.

Corporate Fundamental Changes – standard approval procedure: (1) the board must pass a resolution, (2) the shareholders must approve the transaction (each class must approve by a 2/3s majority), and (3) filing papers with payment of fees to the state. In a merger, one corporation absorbs another – the acquiring corporation survives and the target is dead. In a consolidation, both corporations come together while their existence extinguishes and a new one emerges. Statutory Short form merger arise when there is a parent subsidiary relationship. This merger occurs when the parent has 85% or above of the subsidiary’s stock where the parent’s company must approve the merger. Standard approval procedure is necessary to amend the articles of incorporation for any major issues. Liquidation is the gathering of corporate assets and distributed to the shareholders (the governments get paid first, the creditors would be next (first secured then unsecured), and then finally the shareholders (preferred stock – liquidation preference and then finally general shareholders). Voluntary Dissolution requires the following of the standard approval procedure. Involuntary Dissolution may be a remedy to fraud, deception, deadlock, or gross mismanagement. This is done by the courts.


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