business associations outline danoff

8/6/2019 Business Associations Outline DANOFF

http://slidepdf.com/reader/full/business-associations-outline-danoff 1/124

1

Business Associations Outline

(1) Small firms first question - differences between modern RUPA, UPA and partnerships and LLCs

(probably planning questions about OAs suggest what should be in it) or a litigation question

(badly put together small business you figure out who gets sued)a. Def ault rules: why they should modif y them and which of the small entities we should use

(2) Large firms second question

a. Exam distinguish civil, criminal and derivative actions; get through proxy fights

TERM DEFINITION

AffiliateSomeone who is controlling the company or under

common control of some other company

Agency

An agreement by one person (an agent) to act for

a principal at the principals direction and control

AgentSomeone who is authorized to act on behalf of the

principal

Beneficial title

Own Stock: Buy stock in IBM and get it from

Merrill Lynch you are owner of the beneficial

title, while legal title is still owned by Merrill Lynch

Bona fide purchaserSomeone who gives consideration, acts in good

f aith, and who is not on notice of an adverse claim

C CorporationAny corporation that hasn't elected the status of

an S corporation

Callable Can be redeemed at the option of the issuer

Capital

Productive capacity: tangible assets (equipment

and buildings), intangible assets (intellectual

property and human capital), money

Common stock

Residual interest in a corporation: including the

right to elect directors and receive dividends anddistributions

ConvertibleAffiliate Someone who is controlling the company

or under common control of some other company

Corporation by estoppel Doctrine that prevents personal liability for an

obligation entered into in the name of a non-



3

Fiduciary duty

A fiduciary duty is a legal or ethical relationship of

confidence or trust between two or more parties,

most commonly a fiduciary and a principal .

Flow-through Tax vehicle all partnerships, LLC, S Corps.

General partnershipA partnership in which all partners are general

partners

Limited liability corporation

A business entity that has the limited liability

benefits of a corporation with the tax benefits of a

partnership

Limited liability partnershipA type of general partnership with some limitation

of liability under state law

Mutual fundsA publicly held open end investment company which will redeem its shares at net asset value at

any time

Preemptive rights

Rights that give existing shareholders the chance

to buy part of a new issue of shares before the

general public can, thus protecting them from

dilution of value and control

Preferred stockShares that have preferential rights to dividends or

distributions over common stock

Principal The person owed a fiduciary duty

Promoter This is a person who brings together labor, capital,

and management to start a business enterprise

Proxy Written permission to have another shareholder

vote on your behalf

Proxy agent A shareholder may send a proxy agent to vote on

his or her behalf pro rata

Quo warranto A proceeding to determine "by what right"

someone holds a corporate office

REIT Real estate investment trust

Officers Partnership PIC Poison pill Registered

form Respondeat superior Revised Model



4

Business Corporation Act Rule 10b-5 Security

title Servant-agent Shareholder derivative action

Shareholders Sole proprietorship State court

receivership Stock transfer books Straight debt

Straight voting Subchapter C Subchapter K

Subchapter S Suretyship Tender offer

Business Associations Lawy Formation: Formation, operation and dissolution of business entities

y Legal Issues: Rights and obligations of the participants;

y Internal v. External: Key is to distinguish internal and external participants

y Topics Covered:

o (1) Agency Law

o (2) Small Business Entities

o (3) Corporations

Coverage of a Firm

Internal: Business Associations External: Other Courses

Investors: Provide capital y Equity (ownership)

y Debt (Loans)

External: Customers Suppliers y Fraud and Consumer Law

Managers: Provide skills

y Top

y Sub-managers

Antitrust and Other Competitors; Regulatory

Authorities like Public Utilities, Banking, Insurance

and Environmental

Employees: Provide labor

y Coverage is limited; Labor and

Employment Law

Consultants: Investment bankers, Accountants,

Lawyers



5

Agencyy Agency Defined: People act on behalf of the business to bind

the business in relationships to 3rd

parties;

o Law: The rights of others against each other

y Formation: Consent of both parties, unless agency is equitably implied by the courts

y Agency v. Debtor/Creditor: Creditors promises to 3rd

parties create apparent authority and

management of debtors business aff airs establishes control over debtors, leading to an agency

relationship.

Agency Law1. Defined: Body of law that defines the

legal rights of those affected by

delegations of power to act

2. Three Basic Parties:

a. (1) Principal

b. (2) Agent: independent contractor

or employee (servant)

c. (3) Affected third party: contracts

with agent or is injured by agent

3. Sources: Common Law and Restatement

of Agency (2nd

and 3rd

)

a. No statutory codes

b. Specific statutory provisions for those agents with checkered past

Creating Authority: Agency1. Two Basic Elements for Creations:

a. (1) Consensual (Contract): Oral or written agreement (manifestation of consent of one

and consent by the other that may be express or implied either ex ante (before act) or ex

post (ratification; af ter the act and relating back)

b. (2) By Matter of Law (Equity): May have apparent authority (constructive) or authority

by estoppels (cannot deny)

2.

Creating Authority: An act

a. (1) written or spoken works or other conduct of the PRINCIPAL which is

b. (2) reasonably seen to CAUSE THE AGENT to believe that the principal wants agent to act

on principals account

3. Creating Apparent Authority: An act created as to a 3rd

person

a. (1) written or spoken words or other conduct on principal

Business

Law => Rights of Each Against Each Other

(P) Investors(owners) Legal

Entity (P)

Managers (A)

Third Parties

Labor

Customers

Suppliers

Consultants

(money)

Capital

return

Hires

Contracts

Benefits



6

b. (2) reasonably seen to CAUSE 3rd

PERSON to believe the principal consents to have the

act done on his behalf by the person purporting to act for him

Agents Power: Source to Subject Principal to Torts1. Consensual Agency Relationship

a. Distinguish gratuitous bailee

b. Distinguish independent contractor

2. Within Scope: Agency must acts with scope of employment to create injury

3. Actual: Ex Ante or Ex Post

a. Can be express OR

b. Implied in f act (Jenson Farms)

4. In Equity: Implied in Law or Constructive Agency Court over looks lack of actual authority

a. Apparent Authority (Nogales Service Center)

b. Agency by Estoppel

c. Hybrid: Inherent Authority (by title)

Gorton v. Doty: agency arising from use of car

1. Facts: G was coach driving team to play in other city and offers car to use to help take plays to

game. G was in accident in s car and players f ather () sues on behalf of sons injuries. Jury

awards $5,000 to .

2. Issue: Was G an agent of while driving her car?

3. Held: Yes. Evidence showed that the relationship of principal and agent existed between and

G. was an independent contractor not a gratuitous baliee.

4. Reasoning: An agency relationship results when one person allows another to act on her behalf

and subject to her control.

a. Control consented to G acting on her behalf because she volunteered the car with express condition that G drive it; didnt say anything about G LOANING the car and did

not say anything about BORROWING it

b. Precedent ownership of a car alone, regardless of presence, establishes a prima f acie

case against the owner because there is presumption that driver is owners agent

c. In order to establish an agency relationship benefit is not specifically required

5. Incentive to Insure: Know your hit by lawsuit for letting someone borrow your car, shif t liability

onto insurance company.

Agency: Analysis of Question

1. Key: Necessary to determine when an agent can bind the principal, when the principal is liablefor the wrongful acts of the agent and what duties obligations of agents are to their principals

and vice versa.

2. Analysis: Determine three types

a. (1) Is the problem between the agency and principal?

b. (2) Does it involve a 3rd

party trying to hold the principal to an agreement based on the

agents conduct or an express agreement?



7

c. (3) Does it involve a third party trying to hold a principal liable for the agents tort?

3. Proving Agency

a. Burden: Person claiming there was principal-agent relationship has burden

b. Intent: Whether an agency relationship has been created is not dependent on intent of

parties involved; can arise even if the parties do not intent to be in relationship and may

not arise even if the parties do intend to be in it if certain conditions arise

c. Formation: Factual elements are key, must be an agreement between parties that the

agent will undertake some act on behalf of the principal, with the understanding that

the principal is to remain in control of the undertaking

4. Fiduciary Relationship: Every agent is a fiduciary and owes a high standard of care to her

principal. Must avoid conf licts of interest, self-dealing, disloyal acts and so on; similar to duty a

trustee owes her trustor and beneficiaries.

5. Gratuitous Agents: Agents who perform their services without gain and cannot be compelled to

perform the duty they have undertaken; the principal still may be liable for the torts of

gratuitous agents

6. Principals Duty to Agent: Under duty to compensate agent, including paying back for

expenses, unless contract out of it also has duty to cooperate with agent and aid in performing

duties assigned

Who is an Agent?

1. Relationship Defined: Fiduciary relationship that results from the manifestation of consent that

one person (agent) shall act on behalf of subject to control of another person (principal)

2. Manifestation of Consent: Objective

a. Does not matter what intentions of principal may be depends on what the agent

believed the principal intended

b. May arise even where the principal subjectively intended no relationship and without

true mutual consent

3. Creation of Relationship: Several different ways

a. (1) By agreement

b. (2) By ratification: occurs where principal accepts benefits or affirms the conduct of

someone purporting to act for the principal, even though no actual agency agreement

exists

c. (3) Agency by estoppels: principal acts in such a way that a 3rd

party reasonably believes

that someone is the principals agent

Gay Jenson Farms v. Cargill: creditor control over debtor 1. Facts: Jenson, , large global grain dealer, has K with Warren in MN (grain elevator, small

business). loans money to W and W appointed grain agent with CCC. has right to 1st

refusal. W gets money and paid back from draf ts drawn on through MN banks. Imprinted

with both s and W names and money went to . W gives yearly reports, keep books. W has

problems says reports were f ake. W f ails and 86 f arming s sue to get $2M in payments for



8

grant from BOTH W and . Jenson was claimed as principal with W as agent and was jointly

liable for Ws debt. Jury finds W was s agent.

2. Issue: Is liable as principal on contracts made by W by virtue of its course of dealing with W?

3. Held: Yes, they were principal with W acting as agent.

a. Control and Inf luence: s control and inf luence over W made them principal with

liability for deals of agent. It is OK to prove relationship with circumstance evidence

showing a course of dealing between two parties.

b. Creditor v. Debtor: Creditor who assumes control of debtors business may become a

liable principal for the acts of debtor in connection with business; whatever the terms of

K are, when creditor takes de f acto control over debtor, he becomes a principal.

c. Control and Continuous interference with internal aff airs: (1) W needed permission to

make capital improvements, declare a dividend or buy stock; (2) continually reviewed

Ws work and expenses; (3) recommendations that certain actions take place; (4) gave

W draf ts and forms with s name on them; (5) held right of entry to W premises with

intent to carry on period checks and audits

d. Consent: Principal must be shown to have consented to the agency relationship

consent occurred by directing W to implement its operational recommendations; W

fulfilled its part by acting on s behalf in obtaining grain.

e. Buyer-Supplier: To show non-agency, must prove that a supplier has an independent

business before it can be concluded that he is not agent. Evidence shows that W entire

operation was financed by and that W sold almost all grain to there was no

independent business.

K ey Issues: Jenson v. Cargill1. Other Potential Causes of Action: Refusal to Fund Line of Cases

a. Breach of implied contract to continue to fund bankruptcy trustee as standing in

shoes of W (getting for f armers as creditors)

b. Misrepresentation: if reps to f armers (we will back W) f armers as s (e.g. held itself

out as guarantor)

2. Effects of Decision: Nullified because there was unique f abric in the relationship and Court says

this case is unique, special and one of a kind

a. (1) Fewer lender control provisions in loan agreements less monitoring of elevator

operators, which means lenders would pull plug f aster on elevator loan def aults

f armers lef t as unpaid creditors and loans would be more risky

b. (2) Cargill owns elevators or stipulates that independent elevators are agents and

controls all prices for grain lower grain prices?

3. Mistakes of Jenson Court: Evidence and finding of effect of Cargill Representations to f armers is

missing what did the f armers reasonably believe? They had to reasonably believe that W was

an agent of Cargill.

a. Control equals responsibility: a f alse premise (corporations have limited liability) and

even so how much day-to-day operational control was in evidence because Cargill

didnt approve W grain purchases from f armers not approve excessive expenses



9

Transactional Lawyer: Lender Liability

1. Goal: Lower the interest charge by giving lenders control without liability

2. Solutions and Instructions for Client:

a. Stipulations: require W to stipulate it is not an agent and to include disclaimers of

agency in all W documents seen or signed by f armers

b. Name: do not let W use Cargill name in deals with f armers

c. Payments: no direct payments from Cargill to f armers

3. Risky Advice: Distinguish Jenson case a limited to grain merchants and not for bank loans; if so,

then case doesnt affect customer financing in supply contracts and bank financing

Distinguish Actual from Apparent Authority1. Actual: Conferred by contract; Apparent: conferred in equity

2. Close Case: Distinguish implied in f act actual authority from apparent authority

a. Both cases principal may be honestly surprised

b. Point of reference is key: distinguish reasonable view of agent (contract) from

reasonable view of third party (equity)

Liability of Principal to Third Parties in Contract

1. Authority: af ter establishing agency, 3rd

part wanting to hold the principal liable must show the

scope of the agents authority to act for the principal

2. Actual Authority (Mill Street v. Hogan): May be expressly conferred OR reasonably implied by

custom, usage or conduct of the principal to the agent

a. Express Authority: actually contained within the agency agreement

b. Implied: Comes from words or conduct between principal and agent; of ten labeled on

how it arose (1) incidental to express; (2) implied from conduct; (3) implied from

custom and usage and (4) implied from emergency.

3. Apparent Authority: Results when principal manifests to a 3rd

party that an agent is authorized

and the 3rd

party reasonably relies on the manifestation

a. Holding Out: must be some holding out by the principal that causes a third party to

reasonably believe the agent has authority and the 3rd

party MUST reasonably rely on

the principals manifestations

4. Inherent Agency Power (Wattau v. Fenwick) : Thought to be similar to doctrine of respondeat

superior in torts

a. Authorized Harm: It is inevitable that in course of performing duties, either by mistake,

negligence or misinterpretation of instructions, an agency may harm a 3rd

party or deal

with one in an unauthorized manner

b. Arises even in absence of actual or apparent authority or by estoppels from

designation by the principal of a kind of agent who usually possesses certain powers

c. Reasonable Foreseeability Test: Test is whether the principal could reasonably foresee

that an agent would take the action she did



10

M ill Street Church of Christ v. Hogan: Implied In Fact Authority from Past Conduct

1. Facts: Elders of Church, , hire BH to paint church. BH done many jobs for church in past and

had hired his brother, the , for them of ten. Painted most portion was high, spoke to elder

and asked for help. says hire G, but said it may be hard and never said MUST hire him. BH

hired brother instead and he worked for a while until fell and hurt arm. BH reported accident

and paid them both for hours worked. says was not an employee and that BH had no

implied or actual authority to hire him.

2. Issue: Did BH have authority to hire as an assistant?

3. Held: Yes, BH reasonably believed that the principal wished him to act in the scope of the way

he had acted.

a. Must determine whether the agent reasonably believed that principle wished him to act

in a certain way or to have certain authority Hogan reasonably believed he had

authority to hire to help him finish even though asked to hire GP but didnt require it

b. Prior dealings between principal and agent and nature of the task are f actors to consider

did it before, church even paid for the short time he had worked before the accident

Dweck v. Nasser: Apparent Authority

1. Facts: N, CEO, fired D, President, and members of board for operating competing businesses out

of their officers. Af ter cannot settle suit D hired Wachtel to help, although N had Heyman on

record, Shib. (another attorney for N for 20 years) executed settle onNs behalf requiring D to

pay 52.5% of profits and another $1.05M to N. N was to pay D for 30% interest in Corp. N says

not bound since Heyman didnt execute it.

2. Issue: Did Shiboleth have authority to bind Nasser into a settlement Agreement?

3. Held: Yes. Court says attorney had actual authority, implied authority and apparent authority.

a. Actual: because of 20 year relationship; N told him to do what he wants with K and both

S and H testified N granted authority to S to settle.

b. Implied: course of dealings over 20 year period of time including S settling many cases

for N before and N allowing S to speak on his behalf and directing to him to settle action

c. Apparent: because N knew S was working with H on settlement and S thought he had

the authority to act on Ns behalf

T hree-Seventy Leasing Corp. v. Ampex Corp.: Apparent Authority to Accept Contract

1. Facts: sues Ampex for breach connecting to sale of computers. J owns and was only

employee. K was salesmen of and fired of J. J meets with K and M, K boss, to talk sale of six

computers from to . M tells J could sell computers if could pass s credit

requirements. Negotiations continue K submits documents outlining sale to J for $100,000each with $150K down and rest in 5-years. Two signature lines, one for and . s line was

blank when J saw it K sent J letter confirming delivery. claimed no contract but only an offer

which required acceptance and.

2. Issue: Did , through conduct of agent K, show acceptance of the contract?

3. Held: Yes, affirmed.



11

a. On f ace, document doesnt show that had intent necessary to form a contract in that

the signature line was blank for s. In order to have valid contract, must find some act

of acceptance on part of , which comes in form of Ks letter for delivery dates.

b. says only supervisors have authority to contract for company non-issue because this

f act was never conveyed to , nor were any other f acts giving any reason to believe

that K did not have the authority to speak for and contract for . K was salesmen.

c. Apparent Authority Scope: An agent has apparent authority to do those things that are

usually and proper in the conduct of the business he is employee to conduct; in this case

it is reasonable for a third party to believe a salesmen has the authority to bind his

employer to sell

W atteau v. Fenwick: Inherent Authority

1. Facts: H owned bar called Victoria Hotel and sells to but still managed bar liquor license was

always in H name and had H name painted on door. Under contract with , H only had authority

to buy bottled ales and water for bar. Over years delivers cigars and other supplies, which H

orders, sues to get payment for these. was liable. 2. Issue: Is an undisclosed principal liable for the acts of an agent taken in the ordinary course of

business even if the principal did not authorize the agent to act, nor held the agent out as his

agent?

3. Held: Yes, even without apparent authority.

a. Generally when person carries out business through manager, he holds out his own

credit and is liable for goods supplied even if manager exceeds authority (need proof of

agency in f act in order to make the principal liable)

b. Distinguished here there was not holding out by the principal and the business was

carried out in agents name and supplied on agents credit

c. Complications of Undisclosed Principal: indicated that he gave credit to H alone andhad never heard of (had only heard of Humble) so actual authority is not workable

4. Rule: Principal is liable for all acts of the agent that are within the authority usually confided to

an agent of that character regardless of limitations put on that authority by the principal.

a. 2nd

Restatement of Agency: undisclosed principal is liable for acts of an agent done on

his account if usual or necessary in such transactions, even if they are forbidden by the

principal. An undisclosed principal who entrusts his agent with management of his

business is liable to 3rd

parties with whom the agent enters into deals in the usual course

of business even if the agents actions are against the principals directives

Practical Issue: Lack of Express Authorityy Attorney of Record Confusion

y Actual/Implied Confusion

y Implied/Apparent Confusion

s Lawyer: Principle is Bound If:

1. General Direction Only: Specific power implied in f act. Actual authority



12

2. Explicit Reservation of Authority Disregarded (No Implied Authority): Must show apparent or

inherent authority

a. Inherent Authority = Undisclosed principal (Watteau)

3. Contractual Formalities Fail (Authorized Agent doesnt sign): Cannot use actual authority

a. Must show apparent or authority of employee (Ampex)

Transaction Lawyer: Recommendations - What should a lawyer tell a client to do to control oral

promises by employees?

1. Develop customer forms for use by employees that contain limits

2. Develop info packets for customers that disclose limits and disclaim oral agreements

3. Develop procedures to monitor employee contracts

Litigators Problem: When do I have the authority to settle? Good Practice:

1. Rarely, if ever, sign or agree, on behalf of client; time pressure or availability?

2. Normally I will present whatever we negotiate to my client for a final approval. Lawyer

represent he has authority to pass on bargaining positions (notif y other side if client is fickle?) 3. Can lawyer promise to recommend it to my client to judge or opposing counsel?

Distinguish Actual from Apparent AuthorityActual Authority Apparent Authority

How Conferred? By Contract In Equity

Point of ReferenceDistinguish reasonable view of

agent

Distinguish Reasonable View of

Third Party

Situations

y Actual or real contract y May be oral or written

y May be express of implied in

f act

y Apparent authority y Estoppel

y Ratification

y Close Call: Distinguish Implied in Fact Actual Authority from Apparent Authority

y Key is Point of Reference: Reasonable view of who?

o Agent: Contract

o Third Party: Equity

Ex Post Authority: Ratification

1. Ratification: Principal affirms and agrees to be bound by past acts of otherwise unauthorized

agent professed to be done on principals behalf .

a. May be express or implied in f act

2. Situations: A person may affirm or ratif y a prior act supposedly done on his behalf by another

that was not authorized at the time it was performed.

3. Effect: Causes the agents act to be treated as if the principal had authorized it at the outset

4. Requirements: Intent and full knowledge



13

5. Examples of Ratification

a. Express: if agent of corporation makes a deal outside scope of employment and

corporation still takes the money from the deal, the corporation has expressly ratified

the agents authority in the deal and are liable

b. Implied in Fact: did the principle impliedly agree to ratif y the deal?

Botticello v. Stefanvicz: Apparent Authority by Ratification

1. Facts: Husband and Wife, s, own f arm as tenants in common and makes $75K offer to buy.

Wife tells should couldnt sell for less than $85K and then and husband agree to $85K for

lease with option to buy. Agreement prepped by husbands lawyer and signed by and

Husband. s attorney didnt perform search on property and was unaware of wifes interest.

Husband never indicated to or attorneys that he was acting as wifes agent. took possession

and improved it. Attempted to use option to buy and s refuse to honor. sues for special

performance. Court finds for .

2. Issues:

a. (1) Do the f acts and law support a finding that husband acted as an agent for his wife?b. (2) Did wife ratif y the contract by her subsequent conduct?

3. Held: (1) No, not an agent. (2) No, judgment reversed no ratification.

4. Rule: Existence of an agency relationship is a question of f act and cannot be proved merely by

marital status, nor by joint ownership. For agency, must be shown that

a. (1) the principal consented to the agent acting for her

b. (2) that the agent accepted the undertaking

c. (3) that the parties understand that the principal would be in control of the undertaking.

5. Agency Applied: s admit to sale, wifes statement of selling for no less than $85K is not the

equivalent of an agreement to sell for that amount. Even if husband handled business matters

for f amily, he never signed any document before as agent for wife because wife had ALSOconsistently signed any deed, mortgage or note in connection with the property they held

jointly.

6. Ratification Applied: Ratification requires acceptance of the results of a prior act with an intent

to ratif y and with full knowledge of ALL the material circumstances.

a. Here f acts do not establish that wife had intent required to ratif y or full knowledge of

terms in contract. Even though wife saw using property and improving it and got

payments from , it is not enough to show she had full knowledge of all the material

terms of the agreement

b. No Ratification by Inaction: Because husband had power to lease undivided ½ interest

in property and nothing to show that wife had any reason to believe was for anything

more than that. may proceed against husband for specific performance damages but

not wife.

Implied in Law Authority: Estoppel1. Distinguished from Apparent Authority by Detrimental Reliance AND

a. (1) Cause OR



14

b. (2) Knowledge and f ailure to correct

c. Apparent authority makes the principal a contracting party with the 3rd

party with the

rights and liability on BOTH sides

d. Estoppel only compensates the 3rd

party for losses arising from the 3rd

parties reliance

and creates NO enforcement rights in the principal against the 3rd

party

2. Elements: A principal is estopped from denying the agents authority, when he

a. (1) negligently or intentionally

b. (2) causation: causes a 3rd

party to think his agent has authority to do an act that is

actually beyond his authority AND

c. (3) detrimental reliance: the 3rd

party detrimentally relies on the principals conduct

Hoddeson v. Koos: Estoppel by storeowners negligent surveillance

1. Facts: shopped at furniture store. Approached by man assumed was salesmen and placed

order for $168 without receipt, the goods were never delivered and when called store they

had no record. Store claims that man was not agent but imposter salesman operating without

knowledge or . 2. Issue: Circumstantially, can be liable for acts of imposter even if the imposter was not s

agent?

3. Held: Yes, wins.

a. Burden: when a party seeks to impose liability on a principal for a contract made with

an alleged agent, the burden is on the to prove the agency relationship.

b. Apparent Authority: imposter obviously didnt have express or implied authority to sell

and couldnt prove that appearance of authority was created by the manifestations of

the alleged principal.

c. Appearance of Authority: created by the manifestations of the imposter salesperson

alone and f ailure to prove this element of agency requires a reversal of the judgment. d. Duty of Care for Store: store has duty of care for safety and security of customer which

extends to reasonable care and vigilance to protect the customer from loss by deception

of imposter operating on premises. Tortious dereliction of duty to an invited customer.

e. Fact-Based Analysis: Sale took 30-40 minutes, through s lack of reasonable

surveillance and supervision, imposter operated as f ake for lengthy time.

Agents Liability on Contract 1. General Rule: An agent is not liable on contract executed on behalf of principal but is ultimately

depends upon the status of his principal

2. Status - Disclosed Principal: An agent who purports to contract for disclosed principal is not

personally liable on the contract.

a. Example agent negotiates the contract in the name of the principal and agent is not a

party to the contract.

b. Intent - Parties intent is that the principal be bound.

3. Status Undisclosed Principal: An agent acting on behalf of an undisclosed principal is

personally liable on the contract.



17

3. Controls or Has the Right to Control: Direction vs. Advice is key distinction?

a. Problem: When is advice mandatory when backed by termination power. If so, advice

is always followed.

b. Termination power alone is enough? Right to Control, absence of exercise control not

definitive

Humble Oil Refining v. M artin: Liability is Question of Fact

1. Facts: L lef t car at gas station owned by for service and before anyone there touched car, it

rolled down hill and struck and daughters. sued L for negligence and jury gives damages.

says it was not liable because service station was operated by independent contractor, S.

2. Issue: Do the f acts indicate a relation of master-servant between S and so can be liable for

negligence of S and other service station employees?

3. Held: Yes, S was an employee of not independent contractor f acts show.

4. Question of Fact: Contract between and S, s

exercise of control over operation of station, both show

that S was an employee. a. Contract as Proof : Shows owned station, had

financial control, set hours, provided its own

auto products for sale and set the price of those

products; Also paid 75% stations public utility

bills, gave equipment, ads media and products

and paid a lot of operating costs.

b. Employee Actions: No business discretion

except as to hiring, firing and payment of a small

amount of employees.

Hoover v. Sun Oil: Independent Contractors

1. Facts: was hurt when car caught fire while being filled

with gas at station owned by and operated by B.

Accident was due to negligent of employee, S. sues ,

B and S.

2. Issue: Was B an agent of such that could be liable

for negligent actions of Bs employees?

3. Held: No, f act based.

4. Facts Proving B to be Independent Contractor: B made

no written reports to and alone assumed risk of profit or loss in business operations; he independently set the

stations hours of operation, pay scale and working

conditions of his employees.

a. Typical Relationship: B and had typical company-service station relationship. B

advertised and sold gas and other products with s label. s sales people occasionally

came to station to take orderly, look at restrooms and talk about any problems B had.

Humble Oil v Martin

Humble Oil

Service Station

Public

Products Repair

Schneider

Manis

Martins

Hired

Hired

Tort

Liability??

Schneider paid commissionson products; kept repair fees;

paid some ³rent´

Held: Yes

Hoover v Sun Oil

Service Station

Sun Oil

Barone

Lease

Rent $

Smilyk

Hired

Hoove

Tort

Liability??

Rent payments depended on gas sales inside a

minimum and maximum.

Held: No

Owned



18

b. Suggestions v. Obligations: made suggestions to B to improve sales and marketing BUT

B was under no obligation to follow the advice.

M iller v. M cDonalds: Franchisor Liability (Oregon, 1997)

1. Facts: sues McDonalds () for injuries she got when she bit into stone while eating burger.

That McDonalds was owned and operated by franchisee, 3K. 2. Issue: Was there an agency relationship and 3K that could make liable for s injuries.

3. Held: Yes. Franchise agreement created agency.

a. Agreement Facts: Laid out detailed instructions on how to operate the restaurant.

Periodically sent inspectors to ensure conformity.

b. Jury could find that reasonably retained sufficient control over 2Ks daily operations

such that an actually agency relationship existed

4. Test for Apparent Agency: Whether the putative principal held the 3rd

party out as an agent and

whether the relied on that holding out.

a. Everything about appearance of McDonalds owned by 3K identified it with the and

common image it has created by national advertising, common signage, menus anduniform.

b. said she went to restaurant under belief that it would have same quality of service

and care as other McDonalds around the country

M urphy v. Holiday Inns: Slip and Fall Litigation(VA, 1975)

1. Facts: fell on sidewalk outside of BMH Corp. owned hotel. BMH entered into license with

Holiday Inn to use name subject to terms. provides name, quality assurance, national

advertising and system of operation in return for fees for BMH.

2. Issue: Did exert control over BMH to extent that it would constitute an agency relationship?

3. Held: No, No principal-agent or master-servant relationship exists even with specificrequirement in franchise contract.

4. Reasoning: The franchise agreement was only to standardize the business identity, commercial

service and only for the benefit of both parties. never had control over day-to-day operations,

maintenance, rates, wages, etc. BMH has retained all power that an owner and operator of

business have.

Practical and Policy Questions: Compensation

1. Distinction between Murphy and McDonalds: Person though McDonalds built, owned and

operated as part of business

a. Ignorance of 3rd

Party allows it to sue because they do not know about agency orapparent authority

b. Ignorance sets up apparent authority v. protection of franchisor question if let all

these people sue, franchisors will not come to state

2. DistinguishMurphy/McDonalds v. Humble and Sun Oil: Oil companies owned the stations,

while BMH and 3K owned their business just had contract



19

a. Contract does not control must look to details of control in contract to see if agency

relationship exists

3. Does law discourage company ownership of retail outlets in favor of franchises?

a. Yes, because they already do. If you have control, you lose apparent authority

4. Does this discourage active involvement:

a. Yes, if you are a franchisor and show up and tell franchisee what to do you may be liable

(clean the bathroom liable); cook burgers right are you liable?

b. Business incentives are created by law

5. When is control plus liability less expensive than no control and no liability?

a. Control reduce accident, absorb costs that occur, better marketing, more product sale

b. No control leave accident reduction to operator, avoid liability costs, suffer sloppy

local practices (unclean toilets), fewer product sales

c. Business Decision: What would make me more money?

6. Transactional Lawyer Issues:

a. When is a supplier or franchisor liable for torts of distributor? When controls day-to-

day, maybe, or subjective test.

b. Can a supplier or franchisor limit liability for control agreements at the margin of the

legal test? Make sure documents are in franchisees agreement, make ads mention

franchisees

c. How do we cut off apparent authority? If local customers think McDonalds controls a

local franchisee, are they liable? Use objective test. Real control (sent to clean and they

cleaned) v. Right to Control (had power to inspect but did not)

Scope of Employment Defense1. Defined: For Respondeat Superior to apply, the employee must have committed the tort within

the course and scope of employment.

2. Elements: A reasonably foreseeable act that

a. (1) Must have engaged in work for the employee of a type that he was employed to

perform

b. (2) during work hours

3. Factors: (1) authorization of act by employer; (2) time; (3) place; (4) purpose of act, (5) common

practice; (6) extent to which interest of employer or employee was involved, etc.

4. Intentional Acts: Liability extends to intentional acts if the act is related to carrying on the

employers business

a. Recovery for employees assault may be within scope of employment

b. Serious crimes excluded

c. Miller v. Federated Dept. Stores: interfering with agents duties to principal; agent

responding to interference

d. Issue: Is an employer liable for injuries to a victim of an employees assault.

e. Rule: To relieve himself of liability for injuries from an employees assault, the employer

must show that the assault was in response to the s conduct which was presently

interfering with the employees ability to perform his duties successfully.



23

b. Obey directions and act only as authorized

2. Duty of Loyalty: Restatement Section 387

a. Agent must not compete with his principal anything that an agent obtains as result of

his employment belongs to that principal, barring the retention of secret profits,

advantages and benefits without the principals consent

3. Duty of Candor: Restatement Section 381

a. Duty to give information, keep and render accounts

Reading v. Regem: Secret Profits and Duty of Loyalty

1. Facts: was UK sergeant in Egypt would board truck with unknown contents each week and

escort them through Cairo in uniform. Passes civilian police without inspection and paid large

sums for work. Military finds activities and take money from for crown. Sues to get back.

2. Issue: Is entitled to recover money he made outside the scope of his employment?

3. Held: No, crown justifiably took money.

4. Reasoning: If a servant unjustly enriches himself by virtue of his service without his masters

sanction, the law says he should not be allowed to keep the money and it should be given to his master.

a. Because got the money SOLELY by reason of position he occupied as servant of the

crown uniform and position as servant to Crown were only reasons he was able to

obtain this money which is sufficient to cause him to forfeit it

General Automotive M anufacturing v. Singer: Duty to Disclose Information

1. Facts: was employed by as general manager with contract requiring he not engage in any

other business during his employment and that he not use or disclose any info concerning for

own benefit or to s detriment. Duty as GM was to get work for machine shop he was

successful. Then, took on orders he didnt feel had capacity for and didnt inform that hewould hire another shop to do the work at a lower price than he quoted and would keep the

difference.

2. Issue: Did breach his fiduciary duty to by f ailing to inform of the existence of orders

may not have been able to fill?

3. Held: Yes. Breach.

4. Reasoning: was acting as broker for his own profit in a field where he had contractual duty to

work only for . had fiduciary duty as an agent of to exercise good f aith and loyalty BUT

instead acted in self-interest and adversely to .

a. Failure to Disclose by f ailing to disclose the existence of the secret orders, he was in

violation of fiduciary duty to act solely for benefit of and liable for profits earned

Termination of Agency and Grabbing and Leaving1. General Default Terms:

a. Terminable at will of either party

b. Otherwise end of reasonable term or when specific act is performed

c. OR on violation of duty



24

2. Stipulations: if parties stipulate a set term by time or by task

a. Either can breach principal revokes or agent renounces

b. Remedy limited to damages, no specific enforcement or injunction

3. Grabbing and Leaving: Post-termination competition with a former principal is allowed BUT

former agent cannot disclose trade secrets or other confidential information during his

employment solely because he was agent

T own & Country Home v. Newberry: Soliciting Former Employers Clients

1. Facts: was cleaning business and worked for for three years. Af ter leaving, set up own

cleaning business to directly compete and solicited s clients. brings action for injunction and

damages dismissed.

2. Issue: Can enjoin s from soliciting its clients?

3. Held: Yes, the only trade secret that could be involved in a case like this was s list of

customers.

a. Ex-employees solicitation of employers customers, obtained at considerable cost, was

breach of duty of loyalty b. Conspiracy theory of Apellate Court en masse departure

M icrosoft v. Google: High-T ech Industry

1. Facts: Computer engineer Lee lef t Microsof t to work at Google and Microsof t sued under one

year non-compete clause and confidentiality clause in the Microsof t employment contract.

2. Disposition: Case settled, while dirty laundry was aired.

3. High-Techs generally have employees sign multi-layer confidentiality and non-compete

agreements to stop from giving away trade secrets



26

i. Tax Example: for tax purposes, income and losses of the partnership are attributed

to the individual partner the partnership itself doesnt pay taxes although it does

file an information return

b. Entity Characteristics: some purposes, partnership is treated as a separate entity apart

from individual partners

i. Capacity to sue or be sued: jurisdictions vary as to whether partnership can be sued

in own name e.g. if federal question is involved then it can in own name in federal

courts

ii. Ownership of property: can own and convey title to real or personal property in its

own name without all partners joining in the conveyance (UPA § 8)

c. RUPA § 201 (Simplification): unlike the UPA, RUPA expressly states that a partnership is

an entity and simplifies many partnership rules like those on property ownership and

litigation

The Decision to Form a Partnership and Split Equity1. Case Example One: You have capital and need labor, skills and management

a. Option 1 pay an employee (sole proprietorship)

b. Option 2 Split equity partnership (moneybags to pay worker bee)

2. Case Two: Have labor but need money

a. Option 1 borrow money (sole proprietorship)

b. Option 2 split equity partnership

3. When to split equity: Lowest contracting cost business decision

Partnership Formation: Default Rules1. Defined: Partnership is a voluntary association and there must be an express OR implied

agreement in order to form one

2. Actual RUPA § 201: Real or by consent

a. Affirmative: co-owners of a business for a profit

b. Negative: not a tenancy in common, employer/employee relationship (sole

proprietorships) or lendor/debtor relationship

c. Factors: sharing of profits, not gross returns proxy for control?

3. By Law RUPA § 308: Implied in Law

a. Equity

b. Partnership by Estoppel (holding out) 4. Formalities: If the partnership is continued beyond one year, Statute of Frauds states that it

must be written

5. Duration: if no term is specified, then the partnership is terminable at the will of any

partnership

6. Capacity: persons must have capacity to contract to be partner some states hold that

corporations cannot be partners



28

Agreement says no partnership is intended, until loan was repaid, Des were to get 40% of KNK

profits; collateral was given to s in form of speculative securities owned by KNK; all dividends

on securities loaned by s were to be paid to s ; s were to be consulted on all important

matters and had power to inspect and veto assigned interest and had option to join firm at

anytime. Each KNK partner had given letter to resign which could be accepted at anytime by s.

s couldnt initiate any actions or binds firm for their actions.

2. Issue: Has a partnership been formed?

3. Held: No this is a lender-lendee agreement and unpaid creditors cannot collect from s.

4. Reasoning: Sharing of profits is considered an element of a partnership, but not all profit-

sharing arrangements show that a partnership agreement exists.

a. Language saying no partnership is intended is also not conclusive

b. Must look to entire agreement to make the determination and all features of the

agreement are consist with a loan agreement, not a partnership agreement.

c. Return 40% profits capped at $500,000 with minimum of $100K; option to buy up to

50% of firm

d. Protective covenants; collateral; substantial management rights; assignment; right to

control loaned securities

5. OrganizationalNote: If KNK had organized as a Corp., LLC or LLP, the s would have avoided any

risk of liability. Under those forms, as equity investors, s could not have been held personally

liable for the firms debts.

Loan Covenants1. Danger: Martin and Cargill cases show danger of overly aggressive loan covenants

2. Martin result: maybe different if trustees had been aggressive in monitoring KNK under

covenants?

a. Different if the trustees had vetoed investments, fired partnerships, run all distributions

through a controlled bank account?

b. Potentially different because of difference between right to control and exercised

control

Transaction Lawyer: Creditors and Lenders

How could Peyton lawyers have better drafted deal agreements to reduce litigation risk and still

accomplish business goals?

1. Use Limited Liability Vehicle

2. Use more Traditional loan covenants on management rights trust indenturea. Can be very powerful veto rights

a. There are grave dangers to novel deal terms

Debt/Equity Distinction: Introduction1. Tax Effects: interest deduction v. no dividend deduction



29

2. Liability Effects: Assume Insolvent Firm

a. Partnership: in creditor pool claiming share of lef t-over assets v. paying all unpaid

creditors as well as losing investment contribution

b. Limited Liability Entities: Asset distribution priority creditor pool v. residual equity pool

Southex Exhibitions v. Rhode Island Builders: Service Contract or Partnership? 1. Facts: s entered into agreement with SEM, predecessor-in-interest to s regarding future of

s shows in RI arena. Agreement stated that wishes to participate in shows as sponsors and

partners and have 5 year fixed terms, renewable by mutuality. agrees to sponsor and endorse

only SEM, to persuade members to have exhibits at SEM shows and to allow SEM to use name

for promos. SEM agreed to obtain licenses, leases, permits, etc., indemnif y for show related

losses; could accept/reject any potential exhibits, audit show income and advance necessary

capital to finance shows. Mutually determine show dates, prices, bank.

2. Issue: Does a partnership exist between the parties?

3. Held: No. Not a partner, totality of the circumstances test and lack of dissolution rights (renewal

obligation) showed non-partnership. a. Producer absorbed all losses; management rights uneven

b. Also no public self-identification (e.g. no partnership tax return; no partnership

contracts with third parties)

4. Reasoning: Evidence of profit sharing is prima f acie evidence of partnership, and f ailed to

show any enumerated exceptions, BUT without any intent to form a partnership a finding of one

is not compelled.

Lawyers: Renewal Rights

1. Normal Situation: This is a more normal situation than Fenwick

2. Good Litigator: suggests to client af ter-the-f act that a partnership structure is possible and has litigation advantages

a. Client thats good, we were partners, then.

b. Contemporaneous self-declaration is think because no partnership tax returns, no name

or title sharing. Court sees through it.

3. How could Southex better protect renewal rights?

a. Contract language on good f aith

b. Renewal expectations in agreement leave little open to interpretation

Partnership by Estoppel

1. Liability of Alleged Partner: One who holds self out to be partner, or who expressly or impliedly consents to representations that they are partner, is liable to any 3

rdperson who extends credit

in good f aith reliance on such representations (UPA § 16)

a. Example A represents to C that she has wealthy partner in B in order to get credit; B

knows of the representations and does nothing to tell C she is not partner; C makes loan

for purposes of the loan, B will be held to be a partner with A but has no other rights

to participation in As business



30

2. Liability of Partners who Represent Others to be Partners: If in above example A were part of

actual partnership, then she would make B an agent of the partnership by her representation

that B was also a partner in this case, B could bind A as though they were f actually partners

but only those other partners of A who made or consented to As representations would be

bound

Y oung v. Jones: Liability of Affiliated Company (DSC, 1992)

1. Facts: PW-B is Bahamian general partnership and PW-US is NY GP. s invested $550K in SAFIG

based on unqualified audit letter on SAFIG by PW-B. Af ter funds disappeared and s learned

that SAFIG f aked statements s allege that two are partners by estoppel because of

letterheads and signatures and similar names.

2. Issue: Do a US firm and its foreign affiliate operate as partners by estoppel when the foreign

affiliate uses the firm name and trademark, and the US firm makes no distinction in its

advertising between itself and foreign affiliates?

3. Held: No, case dismissed.

4. Reasoning: Two firms are organized separately, there is no partnership in f act. a. UPA § 16 says that a person who represents himself or allows another to represent him

to anyone as partner in an existing partnership or with others who are not actual

partners are liable to anyone whom relies on this representation in good f aith

b. An exception to the rule that persons who are not actual partners as to each other are

not partners as to 3rd

parties

c. This case s do not contend they saw the PW-US brochure or that they relied on it in

investing nor does it say that affiliated entities are liable for each others action. Must

show actual reliance.

Partnerships: Governance, Dissociation, Dissolution andLiquidation

1. Governance and Default Rule UPA § 401(j): Ma jority of partners have power to make all

business decisions within the ordinary course of partnership business

a. Minority dissenting partner cannot opt out, even by informing third party of dissent

b. Third party cannot rely on authority of minority; dissenting partner to bind partnership

c. Problem: apparent authority?

2. Dissociation, Dissolution,Winding Up and Liquidation - Default Rule for At Will Partnerships

(RUPA § 801(1)): Any partner can walk and force liquidation absent other circumstances

(partnership agreement denies option/bad behavior)

a. Duty of Confidentiality

b. Duty to Account Survive

c. Def aults: problem for modern business too easy to leave without no capital lock up;

leaving means that remaining equity owners must reconstitute entire business

3. DissociationWrongful or Not Wrongful?



31

a. Not wrongful: at will partnership RUPA § 601(1) no term or task Death, Bankruptcy,

Court Order

b. Wrongful: breach of partnership agreement (even if partnership is at will) OR short of

agreed term of task

4. Effects of Wrongful or Not Wrongful Distinction: Can remaining partners continue partnership

or may partnership dissolve? RUPA § 801.

a. At Will Partnership Dissociation: Liquidation unless wrongful or plus, kicking out on

proper grounds by unanimous vote or on more general grounds by court order,

bankruptcy of partner, death or incapacity must liquidate

b. Term or Task Partnership: special rules

c. Damages?

M einhard v. Salmon: Duties with Regard to Outside Opportunities

1. Facts: G leased hotel to for 20 years; with agreement, had to spend $2M in improvements

shortly af ter, entered joint venture with to pay1/2 of money needed to alter and manage

property receiving 40% of net profits for 5 years and 50% af ter. had sole power to manage,interest in lease never assigned to . End of deal tried to put deal together to level all property

to put up large building but f ailed and asked to enter new lease for 80 year renewal period.

found out about it and demanded it be held in trust as asset of their joint venture.

2. Issue: Does the new lease come within s fiduciary duty to his joint venture partner as a joint

venture opportunity?

3. Held: Yes. was entitled to ½ interest in the new lease and must assume responsibility for ½ of

obligations.

4. Reasoning: Joint venture partners have highest obligation of loyalty to partners including and

obligation not to usurp opportunities that are incidents of the joint ventures

a. Close Nexus: there was a close nexus between joint venture and opportunity that was brought to manager of JV as it was essentially extension of subject matter

b. controlled gets 51% and should get 49%

5. Punctilio Paragraph: Not honestly alone, but the punctilio of an honor the most sensitive, is

then the standard of behavior.

a. If a court cites this case, the will lose, if the court uses the term punctilio, the will

lose big.

6. Correct Decision:

a. Yes Salmon is greedy and secretive, this is just a renewal when they had the

expectation of sharing.

b. No Would parties have negotiated to the holding ex ante probably not, this is a huge

change in operations and 50/50 split with a passive investor doesnt make sense;

Meinhard had right of first refusal in financing better approximation

7. Rebuttal and Penalty Default: Rules force the party with the information about future

opportunity (Salmon) to disclose that information to the other party (Meinhard) to avoid an

undesirable result. It is not the rule that the parties would have contracted for ex ante.

a. Problem: af ter Salmon disclosure, they do not agree and M sues, who wins?



32

Partners Fiduciary Duties: Defaults1. RUPA § 404: Only (without RUPA § 403) on old Duty of Candor (information) lef t out

a. Duty of Care: Business Judgment Rule (gross negligence rate of agreement, grossly

means that 9 of 10 people would agree)

b. Duty of Loyalty: account, conf lict of interest, non-compete (may be waived in § 103)c. Duty of Good Faith and Fair Dealing: added to RUPA

2. RUPA § 103: Agreement May NOT

a. Unreasonably restrict § 403(b) information

b. Elimination duty of loyalty except for (1) categories of acts if not manifestly

unreasonable or (2) cleansing vote

c. Unreasonably reduce duty of care

d. Eliminate Duty of Good Faith/Fair Dealing but may prescribe standards if not manifestly

unreasonable

Duties after Dissolution of a Law Firm1. Duty of Care: Bane v. Ferguson terminates on end of partnership ex-partners as creditors

BJN introduced - RUPA § 404(c)

2. Duty of Loyalty: Meehan v. Shaughnessy procedure for soliciting firm clients

a. Held: breach on the facts no candor; client notice and other communications not

proper

b. Duty to Account for Fees from partnership clients serviced by Ex-Partnerships (later in

Chapt.)

Lawyer Leaving Firm: What Actions to Take

1. What should do: sit down with the firm and tell them you are leaving jointly negotiate a letter signed by both firm and you; then cut a deal on how the clients will get approached

a. Clients have the choice on who to go to cannot just say that will not give them the file

2. Reality - Firm will kick you out in reality write your letter af ter you already are packed and give

it to them

Perretta v. Prometheus: Opting out of Fiduciary Duties

1. Facts: Prometheus PIP and PDC were partnership to manage two apartment complexes PDC is

100% owned by DNS. Peretta was limited partner in partnership between POP and PDC, PD

notified limited partners that it would merge into PIP Partners-General, which was owned by

DNS and daughter of DNS. Proxy statement sent to LPs with terms and asking to approve it said PIP would vote neutrally. Peretta alleges merger was self-dealing transaction in violation of

PDCs duty of loyalty by setting an unf airly low price

2. Issue: Can we count votes?

3. Held: The partnership agreement controls. Partners werent harmed at expense of partnership;

ratified it properly, so not in breach.



34

a. was fired to improve our lawyer to partner ratio and f acts showed that was less

productive when an alcoholic and initially concealed problem

b. There was no real issue the firm acted in good f aith to kick him out

Partnership Property1. What is it: Issue is whether property is partnership property of the individual property of a

partner; all property originally brought into the partnership or subsequently acquired, by

purchase or otherwise, for the partnership is partnership property UPA § 81(1)

a. RUPA § 203: partnership holds property as an entity separate from partners

2. Intent: Where there is no clear intention expressed courts consider all f acts related to the

acquisition and ownership of asset

a. Factors: (1) How title is held; (2) partnership funds used in purchase; (3) used to

improve; (4) central to partnerships purpose; (5) frequent and extensive is partnerships

use; (6) accounted for in financial records of partnership

3. Partners Property Rights in RUPA § 501: a. (1) Right to use specific partnership property RUPA § 401(g) tenancy in partnership

b. (2) Owns a partnership interest RUPA § 501, personal property

c. (3) Right to participate in management

Putnam v. Shoaf: Conveyance of Partnership Interest

1. Facts: FJ Gin Co. originally operated as equal partnership between EC, LC, LP, and CP in

agreement, CP succeeded her husband LP af ter death. CP decided to sever relationship and

relief from debt liability owed by gin to Bank. Shoaf s agree to take over position and assume

personal liability for all debts if CP and Cs each paid $21,000. FJ Gin has negative $90K

agreement. All Gin assets and land held in partnerships name and CP conveyed her interest toShoaf by quitclaim deed. In 1977 bookkeeper leaves and find out he embezzled money banks

pay $68,000 into court. ½ sum paid to C and other to dispute to S and CP

2. Issue: When a partner conveys her partnership interest to another, can she later claim an

interest in a recovery resulting from a chose in action unknown to the parties at the time of

conveyance of the interest?

3. Held: No, partner can only convey interest, legal claim of the partnership asset. There was no

existing interest by the exiting partner.

4. Mistake: Right result but wrong reasoning

a. Court treats agreement as partnership assignment under UPA § 27 but assignment

doesnt dissolve partnership itself ; need court decree under UPA § 32(2) and interest can be conveyed, pledged, subject to execution

b. Interest portion of profit and surplus minus cash f low

c. Agreements were in f act a voluntary dissolution under UPA § 31(1)(c) because Putnam

held ½ assets as tenant in common and conveyed all title to S secured release from

ma jor credit and assumption from S; still secondary liable on some debts if creditor

without knowledge of dissolution



35

Problems: Capital Contributions and Free Riders

1. Major Problem: when firm needs more money but some partners dont want to give it or have

enough to give (no requirement to give cash in def ault rules game of chicken)

2. Start Up Capital Equity S1m; Loan $9m

3. New Capital Default Rule: No obligation to contribute, no new partners without unanimous

consent; ma jority of partners can agree to borrow or accept new capital contributions from

existing partners

a. Free Riders: let other take risk of putting in new money and sit on initial capital

contribution

4. Agreements: Pro Rata Agreements: pro rata equity call, penalty dilution, pro rata loans, sale of

shares to new partners, promoter must make loan (def ault rules dont allow without unanimous

vote of all the existing partners)

a. Private Equity Funds: equity calls with caps, refuse, penalties (option in manager to sell

interest or dilute interest)

5. Free Rider Problem: Partners Choice $25K cash paid

a. If make loan to partnership of $12.5K, $37K now at risk

b. If no loan and keep $12.5 cash; $25K at risk and same return if someone else loans an

extra $12.5

c. Answer: Collective action, we all make loan or no one does; game of chicken and who

can bluff better

Partners Management Rights: Defaults1. Equal Rights: in management RUPA § 401(f)

2. Disagreements: ma jority on ordinary matters; unanimity with veto on ma jor changes to

partnership in UPA § 401(j)

3. Effects on Agency Powers RUPA § 301:

a. Power to Bind Partnership in the ordinary course: of the partnership business unless no

actual or apparent authority

b. Power to Bind in Extraordinary Matter: only if authorized by all partners

4. Stalemate Problem: Two partners disagree on deal, can one partner bind the partnership to the

deal?

a. If ordinary: YES, RUPA § 301 controls as def ault; no partnership decision to change

def ault rule is effective

National Biscuit v. Stroud: Cannot Escape Responsibility 1. Facts: and F enter partnership to sell groceries under Strouds name. No restrictions on

management functions of either. told s that he would not be responsible for additional

bread delivered. F still orders $171 more bread from . and F then dissolve partnership and

was responsible for the winding up; refuses to pay.



36

2. Issue: Without restrictions in the PA as to authority, can an equal partner escape responsibility

for obligations by notif ying a creditor that he will not be responsible for partnership debts

incurred with that creditor?

3. Held: No, third party knowledge of disagreement does not affect actual authority to sign bread

delivery contract.

a. Acts of partner within the scope of partnership business bind all partners.

b. A ma jority of partners can make a decision to inform creditors and then will not be

bound but acts of minority in contravention but there is no ma jority here.

4. Dissolution: Had dissolved the partnership and given notification prior to order by F,

would not have been personally liable for the partnership debt to .

5. Why not allow Stroud to opt out by notification? RUPA allows it, but it protects partnership

from hold-up power of minority partners.

6. How can Stroud protect himself?

a. Ex ante partnership agreement

b. Ex post dissolve partnership and notif y 3rd

parties that he is not liable; Fs agency

survives in the winding up period, however

Summer v. Dooley:M ajority Resolutions

1. Facts: and entered into partnership, operating trash business. Both worked, each providing

and paying for sub when couldnt. asked to hire a 3rd

person and refused, hired one

anyway and paid him with own funds. When found out, he objected. sues for

reimbursement.

2. Issue: In a two-person partnership, can one partner, over the objection of the other partner,

take action that will bind the partnership?

3. Held: No, no actually authority to hire employee. Either not ordinary or not reimbursable

between partners under UPA § 18(b) distinguish third-party cases. a. When one of two partners refuse to consent to hiring a third person and objects upon

finding out hiring there is no sitting idly by and acquiescence in the actions and it

would be unjust to allow to recover

Partnership Tort Liability1. Rule: partnership liable for partners wrongful act in ordinary course of business or with

authority of co-partners RUPA § 305

2. Indemnification: There is no indemnification against partner causing injury (def ault)

M oren ex Rel v. JAX: Indemnification1. Facts: M, partner in JAX, one day M brings in son, , to restaurant while she worked; sat and

rolled dough while pressed hand in roller.

2. Issue: Does have indemnity right against Nicole Moren?

3. Held: No, there is no right to indemnification against partners.



37

a. Distinguished from Agency: partnerships are distinct entities from their partners and

must indemnif y a partner for injuries occurring in the ordinary course of the partnership

business

b. No corresponding right for indemnity for the partnership against the partner

4. Conduct Serving Interests of Partnership: Conduct was in ordinary course of business

a. Liability for Ms negligence rests with the partnership, even if her conduct partly served

her personal interests, she was acting for the benefit of the partnership at the time of

the injury even though she was also acting in her role as mother

Day v. Sidley Austin: Law Firm M anagement

1. Facts: Day was partner at SA with long history in DC office entitled to % of firms profits.

Wants sole control of DC office, sued firm for breach and fraud.

2. Issue: Was s resignation precipitated by any illegality?

3. Held: Firm wins, no.

4. Keys: Rare to get a public glimpse of large firm PAs, practice of ten deviated from agreement

a. New partners dont see agreement b. No votes of partners

c. Power of the Executive Committee: Limited ratification by ma jority of voting

percentages; voting percentages depend on participation units (older and more senior

have more); and members of Exec. Comm. Are technically selected by ma jority vote but

just f açade (heaviest draw rights are EC)

5. Need for continuing amendment contract right adding new or dropping old partners dissolves

the partnerships without one

a. RUPA allows for you to add new partner or drop partner with vote without dissolving

and reforming the partnership

Partnership Termination: Procedure1. Major Changes from RUPA to UPA: RUPA allows for non-dissolution

2. Any change in identity of partners is:

a. UPA: defined as a dissolution

b. RUPA: may be dissolution but isnt necessarily one in § 601

3. Problems:

a. (1) Technically very tough, doctrinally tough

b. (2) All in case book are still under the UPA close but not same as RUPA and we should

look to RUPA now

UPA Partnership Dissolution1. Basic Form: Dissolution any change in identity of partners § 29

a. Winding Up: Turning assets into cash § 30, 33, 35, 37

b. Liquidation: distribution of cash § 38 and 40

c. Termination



38

2. Alternative Form: Dissolution, Buy-Out; Termination; New Partnership Formed among

continuing partners

a. Requires Agreement: Ex ante buy out provision in Day or Ex post with consent of exiting

partner § 41(3) gap filling rules

b. OR Wrongful Withdrawal § 38(2)

3. TriggersWithdrawal Per Agreement

a. Ex ante buy/sell agreement

b. Ex post settlement af ter disagreement with full or partial consent of withdrawing

partner; partial let the court decide price; full price agreed

4. Triggers Unilateral Actions: Withdrawal

a. Involuntary: Death or Bankruptcy

§ 31(4) and (5);

b. Voluntary: at will § 31(1)(b) or

Breach § 31(2)

Rightful Withdrawal Under UPA1. Rights of Any Partner if No Buy-Out

Agreement

2. Demand Liquidation: Yes, but SPLIT -

compare Dreifuerst in Wisconsin to Distoll

v. Stiltner in Arkansas

a. If so winding up: partner can

keep business going by selling to

former partners in the liquidation might need unanimity?

b. Safe harbor: judicial supervision of sale and winding up § 37 (Prentiss)

c. If final then distribution Kovacik v. Reed: 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 partners share of the profits;

d. RUPA § 401(b) expressly cites and rejects Kovacik and states that losses are shared

even when one or more partners do not contribute any capital

3. Withdrawing Partner Consents to Continuation of Business:

a. No full settlement: value determined by court § 42 and RUPA § 701

b. Full settlement: agreement determines buyout price

Breach or Expulsion under UPA1. Breach: Wrongful withdrawal withdraw in violation of partnership agreement for a term or

task (Owen can breach implied term)

2. Procedure: Remaining partners can choose between winding-up (liquidation) or continuing

business § 37 and 38(2)

a. Liquidation: exiting partner pays damages

b. If business continued: exiting partner receives value of interest minus damages and

excluding good will

UPA D ol t o Tr gg r Co ¶t

Unilateral Action: Expulsion

� Proper: Per Procedure in Agreement. UPA § 31(1)(d)

Application for Judicial Dissolution. UPA § 32

(lunatic, incapable, guilty of wrongful

conduct, breach of agreement, not

reasonably practicable to carry on business)

� Wrongful: Freeze-Out, Page

Business Failure: UPA § 32



39

c. RUPA: does not exclude good will

RUPA: Dissociation1. Dissociation: change in partners identity or legal status § 601

2. Numerous types: (1) Withdrawal; (2) death or incapacity; (6) insolvency; (3)(4)(5) Expulsion,

(4)(8)(9)(10) Partner is legal entity other than individual and entity is terminated

a. Some type require (2)(3) agreement (3) unanimous vote of other partners and (5)

court order

3. Critical Issue Schism in Agreements:

a. Some enable leaving partner to force winding up and liquidation: partnership dissolves

b. Others only require a buyout and partnership continues on without dissociating partner

4. Wrongful?

a. If YES, dissociating partner pays damages (netted with buy-out or liquidation

distribution)

b. If YES, cannot force liquidation

c. Most happen in partnerships for a term or task: can delay paying you until term or task

is over and when you walk out before term if over or task is done screwed hard

5. Buy-Outs: Partnership buys dissociated partners interest at share of firm value on dissociation

a. Equal to: higher of sales assets in liquidation or sale as ongoing business (without

dissociated partner) MINUS damages AND

b. Must tender cash within 120 days if no agreement dissociating partner can accept or

sue in 120 days

c. Prices Capital account, plus 3 years of average annual profit; other methods

appraiser, multiplier (cash f low times multiplier); game theory; lawyers error is of ten to

use book value

6. Winding Up on Dissolution: partnership continues only to wind up

a. Wind-Up: sell assets of partnership, pay creditors, distribute surplus to partners

b. Af ter distribution of all payments terminated and liquidated

7. Dissociating Partner Returns to Court: Asks court to (1) Determine buyout price § 701(i) OR (2)

Supervise wind-up on application for cause § 803

a. Holds an auction for entire business and approves private sale to old partners (distress

price?)

b. Parties now bargain over true price in shadow of court decision

RUPA: Examples of Dissociations1. Partner: Im leaving. Sell everything and pay me my share.

a. Voluntary exist from at will partnership; no express agreement can force liquidation if

exit not wrongful (can force close of business as long as not wrongful)

2. Spouse: Partners dead. Pay me her share.

a. No express agreement: can force buyout not a liquidation (can force the buyout of your

share cash from partnership)

3. Other Partners: You idiot, get out.



41

3. Assignment: Not an automatic dissolution, nor is the levy of a creditors charging order against a

persons interest but an assignee or the credit can get a decree to dissolve on the expiration of

the partnership term or at any time in a partnership at will

4. Withdrawal or admission of a partner: Most Pas provide that losing a partner or getting one will

not result in dissolution

a. New Partners: may become parties to preexisting PA by signing it at the time of

admission to the partnership § 13(7)

b. Old Leaving: usually provisions for continuing partnership and buying out the partner

who is leaving

5. Dissolution by Court Decree: A court may use discretion in certain situation to dissolve a

partnership

a. Examples insanity of partner, incapacity, improper conduct, inevitable loss and or

whatever is equitable § 32

Consequences of Dissolution and the UPA

1. Distribution of Assets: Partnership[ debts must first be paida. Capital Account: Amount are applied to pay the partners their capital account (capital

contributions plus accumulated earnings MINUS accumulated losses)

b. Current Earnings: If there is anything lef tover, receive their agreed share of current

partnership earnings § 40

c. Distributions in Kind: Where there are no debts, or where debts can be handled from

cash account, assets may not be sold but they may be distributed in kind to the partners

d. Losses: where liabilities exceed assets, partners must contribute their agreed shares to

make up the difference § 18(a)

2. Rights of Partners: Violation v. No Violation

a. No Violation of PA: assets are distributed as set forth above and no partner has any

cause of action against another

b. Violation of PA: innocent partners have a right in addition to those listed

i. Right to damages: innocent partners have right to lost profits due to

dissolution, etc. against the offender § 38(2)

ii. Right to continue business: right to not sell off and distribute assets, etc. by

buying the offenders interest in the partnership § 38(2)(b) posting bond and

begin court proceedings Alternatively, innocents may simply dissolve and wind

up, paying the offender her share, MINUS damages

3. Effects of Dissolution: Parties are liable until debts are discharged

a. New partnership remains liable for old debts when there has been death, withdrawal

or admission or new partner and business is continued, new partnership remains liable

for old debts incurred by old partnership (§ 41)

b. Retiring partners liability for debts incurred by partners continuing the business ends

power of a partner to bind the partnership except to the extent necessary to wind up his

aff airs § 33; if 3rd

parties do not know of the dissolution, contracts entered into with

partner bind the partnership thus, retiring partner must make sure that prescribed



42

procedures are following to terminate any chance of liability for partnership obligations

UPA provides notice of withdrawal or dissolution may be in newspaper or generally

circulated

Judicial Help in Dissolution: Decrees of Breachy Significant disagreements

y Incompetence

y Implied terms

Owen v. Chen: Significant Disagreements

1. Facts: and had oral agreement to become partners in bowling alley didnt state duration.

advances $7K to partnership to buy equipment knowing he was taking out loan repaid out of

profits of partnership. Disputes cause negative profits.

2. Issue: Was a decree of dissolution warranted? Proper for s loan to be paid from proceeds of

the sale of assets when the PA provided the loan would be repaid through profits?

3. Held: Yes to both, in CA the Court may order dissolution if disagreements between partners make it so they cannot act in confidence and harmony, or if one partner, by his misdeeds,

materially hinders carrying on the business.

a. Although a party to a contract may limit his right to receive payments to a specific

sources - Where the other partys conduct rendered it impossible for the partners to

carry on the business from which the payments would be made, it would be inequitable

to enforce that part of the agreement

Collins v. Lewis: Breach of Agreement

1. Facts: and have PA where puts up money to build and equip big café and would

supervise and manage it. Lease. would be paid back from net income and then they wouldprofit share. Estimate $300K and eventually costs $600K with delays. Agreement provided that

would repay $30K of s investment 1st year and $60K each year af ter. indicated that there

were costs that were being paid out of the operating revenue rather than by as promised.

2. Issue: Does have the right to dissolve the partnership?

3. Held: No, the money partner f ailed to contribute the final $60K.

a. had the right to dissolve the partnership but not the right to do so without damages

since his conduct is the course of the partnership problems and amounts to a breach of

the PA

b. can either continue to the partnership and perform on the agreement OR dissolve and

subject himself to possible damages for breaching agreement 4. Collins Declares Dissolution: Breach Agreement and becomes Wrongful Withdrawer

a. Victim (Lewis) has Options: Can continue business for term by paying Collins (value

excluding good will minus damages or posting bond to pay at end of term § 38(2) OR

can liquidate (cannot afford bond); Collins pays substantial damages (f ailure of business)

out of his share and continues to put in funds per agreement



43

b. RUPA does not deduct good will and no payout or bond until end of term unless

undue hardship

Page v. Page: At W ill Partnership

1. Facts: and partners in linen supply. supplies essentials and PTS owes him $47K

also was managing partner each

contributed $43K in capital; no written

agreement; 8 year losing money then starts

to make profit sues to dissolve for

implied term partnership saying would end

when money was paid back.

2. Issue: Was the partnership for a term

rather than at will?

3. Held: No term, but fiduciary duty to not appropriate new prosperity

a. said there were no

understandings about continuation

for a term or until money was paid back some cases do hold that PTS shall continue for

necessary term to repay debut but only if there is evidence showing this intention

b. No evidence of intention here instead it reveals at will partnership; had power to

dissolve the partnership upon express notice to

c. If dissolves in bad f aith he may be violating fiduciary duty as partner and would have

to pay damages in a separate action but a partner is not bound at will to remain in a

partnership just because it is profitable

Prentiss v. Sheffel: W inding-Up Problem of Bidding for Assets

1. Facts: s and s were three partners to buy Center s filed suit to dissolve saying was

derelict in duties and f ailed to pay balance of his share of operating losses. Seek permission to

continue business and request value be placed on s interest. counterclaims seeking winding

up as well as appointment of receiver and said he was wrongfully excluded from PTS in violation

of rights. Court appointed a receiver to protect the partnership property until it could be sold, a

partition made and assets distributed. At auction, s buy assets from court.

2. Issue: Should two ma jority partners in 3-man PTS, who have excluded the 3rd

from management

and aff airs, be allowed to buy the PTS assets at a judicially supervised dissolution sale?3. Held: Yes, his exclusion was not done for the wrongful purpose of buying the PTS asset in bad

f aith but rather was result of f ailure to relate in harmony for benefit of

Pav-Saver v. Vasso: W ind-Up Problems and PA

1. Facts: owned PST and patents. Ma jority SH, Dale, invests SLP. M owner and sole SH of .

Dale and formed PSMC for sale of PSM. Sale agreed to contribute his service to venture

patents and trademarks are contributed and M agrees to financing. Draf ts PA approved by s

Page v. Page

Can plaint i

d i¡ ¡ ¢

lv£

partnership?

Held: Yes, at will; could be liable for breach of f iduciary duhowever. Effect? ³Implied´ term, long enough time torecover capital investment; or ³Generous´

¤ uy Out Price

Plaintiff Defendant

Leven Supply Ptn.

$43,000

$47,000Credit

$43,000

1948-1957: Lost $62,0001958-1959: Made $6,000



44

president. Dissolved and replaced with identical one between and eliminating individual

partners.

2. Issue: What is the effect of the wrongful dissolution?

3. Held: The business can survive, the innocent may keep his patents and receive the agree upon

penalty in the PA that was poorly draf ted.

Kovacik v. Reed: Sharing of Losses in the UPA

1. Facts: asks to be his superintendent and estimator for kitchen job in SF. said would invest

$50k and share profits on 50-50 if would do it. Never talked about loss obtained jobs and

was super with giving all financing. told venture lost $ and that had to pay portion.

refused sought account and recovery.

2. Issue: Is a party who has contributed only his services and not capital to a joint venture liable

for a portion of the ventures losses?

3. Held: No, generally it is presumed that partners and joint venturers intended to share equally

in profits and losses BUT

a. Capital v. Work: Exception is that when one partner contributes the capital when theother contributes skill and labor neither is liable to the other for losses

b. Rationale: where one party gives money and other services, in event of loss each party

loses the value of his own capital or contribution

Distribution Problems: Default Rules (RUPA)1. Marshall Cash: pay cash in order, UPA § 807 to (1) creditors; (2) partners and loans and (3)

partners for capital contributions

2. RUPA § 401(b): Partners equally split for profits; expressly rejects Kovacik and states that losses

are shared even when one or more partners do not contribute any capital 3. Deficiency in 1, 2 or 3? UPA § 401, 807 (c) and (d) each partner pays suffers losses in same

proportion as split of profits (def ault equal payments)

4. Surprises: Capital Contribution Gross Up

a. Capital contribution proportion not ref lected in def ault split rule (50/50)

b. E.g. A gives $1,000 and B gives $5,000 split on profits and losses 50-50; absent an

agreement otherwise

c. E.g. MB contributes $1,000 in capital; worker contributes labor; 50-50 on profits; If

business insolvent must worker give MB $500; NO in Kovacik and YES in others.

Law Firm Dissolutions1. What is the effect on fees collected after dissolution from old clients?

2. UPA § 21 Default: New fees, net of expenses, allocated under old agreement as partner assets.

a. Duty to Account

b. Deduction for reasonable overhead expenses

c. No partner salaries



45

3. WrongfulWithdrawal: New fees received by leaving partners subject to off set for damages in

breach of duty case

a. If clients would have lef t with proper conduct pay f air charge

b. Pay fees net of overhead and f air charged (double charge)

c. Note that breaching partners lost claim on new fees obtained by continuing firm from

old clients who stayed with the firm

Jewel v. Boxer: Law Partnership Dissolutions without Agreement

1. Facts: s and s dissolved law firm 2 and 2 split. No written agreement as to fees from active

cases allocate. Former went to new firms and hired 3 associated who had been employed by

older firm. s had many cases and s handled most of rest. Sent letter to each af ter

dissolution. Clients executed and return the forms and new firms represented the clients under

fee agreements of old firm. filed complaint for accounting of fees.

2. Issue: Upon dissolution of a law partnership, are attorneys fees received on open cases upon

dissolution to be shared according to the former partners rights under the former partnership

agreement regardless of which former partner provides the legal services?3. Held: Yes. UPA says dissolved partnership continued until unfinished PTS business is wound up.

Without agreement to contract, those are def ault

a. Unfinished business is allocated among partners according to their respected interests

in the former PTS.

b. Unless partner is the surviving partner, UPA expressly stops receipt of extra

compensation and no partner can get more than value of interest regardless of level of

participation in winding up.

M eehan v. Shaugnessy: Enforcement of Agreement

1. Facts: Same f acts as above. 2. Issue: Do a partnership agreements provisions regarding dissolution supersede the applicable

UPA provisions?

3. Held: Yes. s partnership agreement provided specific means for handling dissolution of firm

when partners lef t and they overrule UPA def aults.

a. Burden of proof on s to show that the clients who lef t would have consented to leave

even if there had not been a breach of fiduciary duty; if cannot reach burden must

account to the firm for any profits received from these cases plus must pay firm the f air

charge called for by agreement

b. Damages allowed are only those CAUSED by s actions share of current income and

return of their capital contributions



46

Limited Partnerships1. Modern Limited Partnership: Entities created by modern statutes to protect from liability

a. Used: Private equity funds like hedge funds, venture capital funds

2. Purpose: developed to f acilitate commercial investments by those who want a financial interest

in a business but not all the responsibility and liabilities of partners a. May carry on any business that a partnership could carry on (ULPA § 3)

3. Limited Partnerships before 1976: most states had adopted the ULPA and in 1976 was revised

to make it applicable to large PTSs and to ref lect new business practices; most states now have

adopted the RULPA in 1985

a. New revision of ULPA was draf ted in 2001 and adopted by a few states

4. Liability: LP has no personal liability for PTS debts and max loss is amount of her investment in

the LP; ULPA § 1

a. EXCEPT: when a LP takes part of the management and control of the business, she

becomes liable as a GP RUPA § 303(b)

5. New Act: RULPA (ULPA 2001) overlays RUPA (UPA 1997) and sometimes explicit in the statute,otherwise by duplicative language on duties;

a. RUPA applies unless a RULPA provisions changes the rule

Limited Partnerships: Generally1. Defined: an LP is partnership formed by two or more people and have as its members or more

general partners and one or more limited partners

2. General Partner: the GP assumes management responsibilities and full liability for the debts of

the PTShip

3. Limited Partner: makes contribution of cash, property or services rendered to the PTFship and

gets an interest in the PTS in return, but is not active in management and has limited liability for

PTS debts RUPA § 303(b)

a. Rights of LPs: substantially same as those of a partner in ordinary PTS, except no

substantive right with regard to management; rights to access books of PTS, to an

accounting as to business and to dissolution and winding up by decree ULPA § 10; may

also lend money to, or do business with, the PTS (ULPA § 13)

b. Assignment Interest: unless provided otherwise vests in the assignee all rights to

income and distribution of assets of the PTS but unless and until cert. of LP is amended

with consent of ALL other parties, assignee is not entitled to inspect books, accounting,

etc (RULPA § 702)

4. Person as Both: possible, in such a case the partner has, with respect to her contribution as a

LP, all the rights she would have if she were not also a GP

Forming Limited Partnerships1. Formation: Formalities are generally not required; certain things must be met



47

a. (1) must execute a certificate setting forth the name of the PTS, character of business,

location of principal office, name and address of each partner and their capital

contributions, GP or LP designation, and rights and priorities of any partners

b. (2) Copy must be in country of principal place of business ULPA § 2 but may be

amended or canceled by following similar formalities ULPA § 25

2. Certificates: Three issues

a. False Statements: If included, anyone who suffers a loss by reliance upon them can hold

all of the partners liable, both GP and LP (ULPA § 6)

b. Purpose: to give all potential creditors notice of the Limited Liability of the LPs

c. Substantial compliance of good f aith: required, if there has been no substantial

compliance, the purported LP may be held liable as a GP; the purported LP can escape

GP liability if when seeing the mistake promptly renounces her interest in the profits of

the business or other compensation by way of income

Holzman v. de Escamilla: Limited or General Partner?

1. Facts: HF, Ltd. was a business created as LPh with deEscamilla as the GP and R and A as LPs; Later it went

bankrupt and H was trustee appointed. sued

saying R and A were liable as GPs to creditors

because they had taken control of the business.

2. Issue: Are purported LPs who controlled the

finances o the PTS business and controlled the

actions of the GP liable as GPs?

3. Held: Yes, LPs can be recast as GPs if they take part

in the control of the business of the firm. Change

from ULPA § 303 to RULPA § 303

Limit d Part r hips

Gener ¥ l ¦

§

rtner ( C ̈

r© .?) Limited

¦

§

rtner

Li ited ¥ rtner i

C§

/Sli

e ̈

f ¦

M§

nagement/ ee

Sli

e ̈

f ¦ r

̈

fit



49

Policy Question: Why Have a Double Tax?

Pre-Bush Evil Bush Obama

Corporate Tax 39% Income 35% Rich only tax-cut

repeal then because

only help rich:

Personal Tax: Dividends 39% Income 15% - do not have to

sell the share; still

Personal Tax: Capital Gains 25% Gains 15%

1. Old tax is good tax (corporate income taxes pre-date Personal Income Taxes

2. Corporations are Wealthy: Not f air for janitor to pay income tax and Microsof t escape it

3. Corporate Investors are Wealthy: Just a hidden progressive tax4. Lawyers and Accountants need money: huge amounts spent on tax planning

BUT?

5. Why do most all of the rest of the developed countries of the world (including those with a more

socialized system) reject the double tax?

6. Why are LLCs not morally offensive?

7. Do we need a tax penalty based solely on business legal structure (and not income type)? Not

based on anything else (e.g. taxing the rich high, etc.)

Small Business Rule of Thumb1. Small business (> 35 investors) presumption in f avor of an LLC (with operating agreement

written); if business grows, convert to a C corporation.

o Rebutted by industry specific common practice (VCs as LPs)

o Rebutted if net profits are zero (use a C Corp.)

2. Medium to large businesses (likely to be publicly held): C Corporation

Source of Law on LLCs1. State Statutes: Old and New

a. Old: Designed to satisf y a tax regulations see Konstant b. New: Very open textured (DE); parties can create what they want; minimum of

mandatory rule; def ault rules based on what most parties to an LLC want and expect

and easily modifiable (OH amendments coming because it is a mess)

c. Elect: Local OH Gen. Corp. L. ch 1701; Other DE Gen. Corp. L. tit. 8 (Supp.)

d. Model: ABAs MBCA (Supp.) constant revisions; 30 or so states have various versions

OH is not an MBCA state



50

e. Federal Securities Law: SOX

2. Model Acts: Uniform Limited Liability Act (ULLCA, 1996) and the DE LLC Act

a. Q uestion use contract or general fiduciary duty doctrines of reasonableness

b. DE uses general fiduciary duty doctrines; OH uses contract doctrines DE better

The Corporate Form1. Legal Person: or entity

2. Indefinite life: since shares cann be transferred

3. Limited Liability: of investors

4. Free Transferability: of ownerships (equity, stock

or shares) interests

5. Centralized: specialized management

6. Oversight Board: elected by equity investors

7. Powers: can sue, be sued, contract and own

property like legal entity 8. Limited Liability: belong to corp. itself and

normally incurs debts and obligations in own

name that are not responsibility of the SHs (owners); same time not responsible for debts and

obligations of owners (SHs)

9. Exceptions and Piercing the Veil:

a. (1) Fraud or injustice where maintenance of the corp. results in fraud/injustice to

outside parties;

b. (2) Disregard of corporate requirements where SHs do not maintain the corp. as a

separate entity but use it for personal purposes (records not maintain, meetings

required not held, money commingled between individuals and corp., etc.) then can

pierce

c. (3) Undercapitalization: prime piercing exists where the corp. is undercapitalized given

the liabilities, debts and risk it reasonably could be expected to incur

d. (4) Fairness: may pierce is any other situation where it is only f air that the corporate

form be disregarded

Limited Liability of Investors: Policy

1. Owners (SHs and Passive Investors): have no personal liability for debts or obligations of the

corporations; their risk of loss is limited to excess of the amount they invest

a. Risk on their capital contributions

b. Original owners risk only their capital contributions

c. Subsequent purchases of the stock risk the purchase price on the secondary market

2. Benefits

a. Ease of valuation cannot have secondary market without it and with unlimited liability,

youd ignore law probably during disasters and financial status of co-owners

b. Enables secondary trading markets check on managers from market



51

c. Specializations: firms can tailor risk to segment investor market, investors can diversif y,

high tech firms get funding

d. Increase incentive of debtors (banks) to monitor firm actions

3. Efficiencies and Controversies of the Corporate Form:

a. Operational: Free standing legal entity with power to act; centralized and specialized;

Too powerful - Should not have Constitutional rights, are unaccountable, anti-social

b. Attractive to investors: limited liability and free transferability (liquidity premium);

Opposition enabled avoidance of responsibility for tortuous conduct, share market

gambling, cons and greed

4. Allow Private Arrangement for - economies of scale and technology advances require mass

scale

a. Diffuse ownership: need large pools of investor capital

Creation of a Corporation

1. Articles or Certificate of Incorporation: Incorporator files Articles for (RMBCA; OH) or Certificate(DE)

2. Records: Sec. of State records the filing and it will be effective on filing date (unless specifically

delayed)

3. OrganizationalMeeting: new Corp. holds one to adopts BYLAWS (regulations in OH) that

empower agents

a. DE Meeting: If Board of Directors isnt listed in articles, Incorporators meet, accept stock

subscriptions, issue stock, adopt bylaws, elect initial directors who appoint officers and

then filing (one page application, no one knows who the owners, directors and

promoters are unless publicly owned)

b. New SHs meet, elect next board of directors and of ten ratif y acts of prior board andpromoters

c. Ohio Common Practice: Incorporators meet and elect directors (no initial Board); initial

Board meets and accepts stock subscriptions, issues stock, appoints officers and adopts

regulations (if meeting within 90 days of formation)

d. Ohio Rare Practice: Incorporators accept stock subs and issue stock no initial Board

listed; new SHs meet, elect Board and adopt bylaws; SH elected Board meets and

appoints officers

4. Analogy: Cert. and Bylaws (constitutional documents), board regulation (legislation) and

executive decisions (Presidential or agency order)

Corporate Charter: Articles/Certificate1. Mandatory Provisions:

a. Name

b. Registered Agent

c. Purpose

d. Authorized Amount of common (voting) stock



52

e. DE and OH par value: archaic practice specif y how many shares will issue and the par

value of the share or check no par value (complex)

2. Discretionary Provisions: Customized and Optional

a. Complex capital structure: preferred stock, two-tier voting stock

b. Complex governance provisions: board terms of up to 3 years; staggered; class voting;

bylaw amendments by board or lower ma jority

Promoters1. Defined: Someone who says they will form a business or corporation but not unless they can get

people to throw money in; wants firm commitments (Agency Law Controls Rest.Ag. § 320 and

326)

2. General Rule: If promoter contracts in the name of and solely on behalf of, the corporation, he

cannot be held liable if the corporation is never formed. If contracts in his own name, then may

be held liable.

a. Intent of parties and other f actors will enter into the determination of the letter

b. YES Liable: Contract, unilateral offer to corporation. Q uasi-contractual if corp.

repudiates contract, still liable for value of anything that it makes use of ; adoption by

implication rule is that ratification is retroactive and adoption is not.

c. NOT Liable: Contract with promoter; for good f aith efforts to get corporation adoption;

until corporation affirms then the promoter is released; survives corporation affirmation

promoter bound and has secondary liability

d. BUT Novation: new K with corporation replaces old deal promoter usually released

but novation language in everything

3. Can unincorporated (or defectively incorporated) firm sue on contract:

a. YES De f acto corporation: has complied strictly with all mandatory provisions for

incorporation cannot be attacked by any party (even state) mandatory and directory is

matter of judicial construction of state

b. YES Corporation by Estoppel: when a corporation is not given de jure or de f acto status,

its existence as a corp. may be attacked by any third party BUT there are situations

where courts will hold that the attacking party is estopped to treat the entity as other

than a corp.

Southern-Gulf M arine v. Camcraft: Conduct of Parties

1. Facts: Pursuant to Letter of Agreement, , company not formed yet became obligated to buy

boat from for $1.3M; given authority to begin buying components to buy boat. Later parties

executed boat building contract and was listed in a preamble as a corp. organized under TX

law with B as Pres. One condition said was US citizen within meaning SA of 1916. B tells BM,

s Pres. That had finally be incorporated a year later but in the Caymans. BM accepts and

agrees. def aults on building boat and sues for breach.

2. Issue: Should a party to a contract be permitted to escape performance by raising an issue as to

the character of the organization to which it is obligated if its substantial rights are not affected?



53

3. Held: No. If party contracts with entity it acknowledges to be and treats as a corp., and incurs

obligations in its f avor, and later sued it is generally estopped from arguing lack of corp.

existence as defense.

a. was De Facto Corporation: Both parties relied on the K; financed and began no

evidence that s substantial rights were affected by the s de f acto status

Fiduciary Duty of Promoters

Y Must: disgorge profits on land resale

unless Y disclosed to X personal profit

and X ratifies it

Y forms C Corp.: takes C stock in

exchange for land, immediately sells

personally-held C stock to X at a profit,

no disclosure? Potential violationDistinction: Y is in same position ex post

in both transactions but procedure

matters sale to X before or sale of land

Corporate Bylaws or in Ohio, Regulations1. Operating Rule for the Corp.: Empowers board to open bank account, buy and sell land, ect.

2. Amendments: Compare with Charter Amendment - Board must recommend and SH must ratif y

them (2/3 in OH); Exceptions: No SHs; OH no prejudice to SHs and name change § 71, etc.

a. Shareholders: ratif y absolute ma jority (2/3 if by written consent)

b. DE Board Alone: if certificate gives Board power to amend OH must be SH except

emergency exceptions e.g. § .11(C)

c. Limits on SH Bylaw Amendments: Current debate no takeover defenses?

V ocabulary and Equity: Corporate Finance and Shares1. Corporate Finance: Rights, duties, terms for people who give money to a corporation

2. Types: preferred/common, classes, controvertible

a. Three types of Corporate Distributions: (1) Dividends; (2) Liquidating Dividends and (3)redemption

b. Class A and B: common for a few selected areas of industry

3. Authorized/Issued/Outstanding: Like treasury shares

4. Primary Secondary market sales

Fi i r t f

Pr t r Y Form

Corp C,

CEO

! C Corp.

" ll

C

tock

to X, # $ t ! " # Y imm " $ iat " ly t ! " r " af t " r " ll p " r o # ally ! " l$ land to C, acc " pting a CEO, atp " r onal profit. Y m% t di gorg " profit on land r " al "

% nl " Y di clo " d to X p" r onal profit (and Xr atifie ??).Y Form

C Corp, take

C tock in exc

! ange f or land,immediately ell per onally- ! eld C tock to X at a profit. No di clo % r e of per onal profit. Violation? (Split: US no; Ma . ye ) Di

&

tinction?? Y i&

in &

ame po&

i tion ex po&

t in bot ' tr an

&

action&

? ( )

t procedur e matter &

. Sale to X bef or e/af ter &

ale of land.



56

2. Distinguish Agency Problems of Executives:

a. Executives as agents bind firm on contracts; agents are not personally parties (or

personally liable) unless agreed upon

b. Liable for PERSONAL wrongful acts not liable for wrongful acts of other agents (absent

some form of participation)

Shareholder Personal Exposure and Piercing the V eil1. Equitable Subordination: If SH is an (1) officer and (2) a creditor of firm and misbehaves debts

subordinated to those of all other creditors

a. Disregard the registered legal entity becomes a General Partnership or Sole

Proprietorship

2. Disregard the Entity: SH (1) Dominates firm and (2) Acts unjustly towards creditors

a. Evidence of Domination: commingling of corporate and personal funds, lack of

observance of necessary entity formalities (board and SH meetings) note that OH lack

of meetings is not f actors

b. Courts Vary what is unf air or unjust?

Exceptions to Limited Liability1. Compare by Contract: execute a personal guarantee with

2. Compare by Law: Disregard the entity or pierce the veil forms

a. Vertical SHs liable on firm obligations

b. Horizontal - sister corporations liable on firm obligation (enterprise liability)

c. Reverse piercing corp. liable to personal creditors of SH

3. Contract v. Tort: Ma jor difference between tort and contract cases is that in contract cases, the

had chance in advance to investigate the financial resources of the corporation and had then

chosen to do business with it. THUS, in contract cases, the intention of the parties and

knowledge of the risks assumed in entering into a contract are f actors to be assessed in making

a determination as to whether the corporate veil should be pierced.

W alkovszky v. Carlton: Liability Insurance as Evidence

1. Facts: was hurt in taxi and sues driver, corp. owning

cab and who owned corp. and 9 others, each with

minimum of $10K of liability insurance coverage

required. Complaint said corporations operated as single

entity and constituted on fraud on public.

2. Issue: Does complaint state a cause of action becausethe companies were underinsured and undercapitalized?

3. Held: No. Dismissed. Courts will pierce the veil when

necessary to stop fraud or achieve equity.

a. Nothing wrong with one corp. being part of

larger enterprise (like subsidiary);

Wal vszky v arlt

Marchese

Employee

Seon Cab: 2 cabs(min. required insurance)

Carlton

O0 ner

Walkovszky

9 other Cab

Companies

Tort

Shares

Shares

Jud1 ment?

Jud1 ment

Can Walkovszky br in1 suit a1 ainst Carlton? A1 ainst the nine

other cab companies? Held: Motion to Dismiss Granted



57

4. Question: issue is if business is really carried on in a corp.

form but by and for another entity or person with a

disregard of the corporate formalities?

5. Undercapitalization: state has set minimum insurance

people driving cabs have taken out minimum; insurance is

OK unless state has legislated higher bar.

Parent and Subsidiary1. Is SH control OR domination enough for disregard of

entity/piercing?

a. No, US v. Bestfoods.

2. Distinguish: Disregard of Entity Other Theories of SH

Liability

a. Direct Liability: Direct intervention or participation In re Silicon

b. Indirect Liability: Corporation is agent of SH (respondeat superior)

Sea-Land Services v. Pepper Source: Cannot Differentiate Between Corp. and Individual

1. Facts: was ocean carrier who ships peppers on PS behalf . PS refused to pay freight bill and

sues. couldnt obtain recovery because PS dissolved and then sues PS sole SH and the

other corporations owned.

2. Issue: May the corporate veil be pierced when the court can no longer different between the

corporate and the person and it would be unjust to protect the person?

3. Held: Yes. A corporate veil may be pierced if two requirements are met (1) must be such unity

of interest and ownership that the separate personalities no longer exist and (2) circumstances

show that adherence to the fiction of separate corp. existence would sanction fraud or promote

injusticea. Four Factors: (1) Failure to comply with formalities; (2) commingling of corp. assets; (3)

undercapitalization and (4) one corporations treatment of another corporations assets

as its own

b. Here used same office, phone, expense account to run ma jority of corps. None of

them ever held a meeting. Borrowed funds for personal expenses and corporations

borrowed from each other. Did not even have a personal bank account.

c. Promote Injustice: f ailure to pierce would result in some wrong that lies beyond the f act

that a creditor may not be able to recover e.g. that a party would be unjustly enriched

( has burden to show the wrong)

Roman Catholic Archbishop of San Francisco v. Sheffield: Liability between Subsidiaries

1. Facts: When in SUI, visits church of RC contracts with PC to buy dog for $175 payable. Dog

shipped to LA made two installments but didnt get the dog. told wouldnt be shipped until

all paid and additional fees for trip to deliver dog. told he couldnt refund. sues RC, Pope,

Canons and FC.



58

2. Issue: When a parent corporation controls several subsidiaries, is each subsidiary liable for the

actions of all other subsidiaries?

3. Held: No, not domination, no injustice. No alter ego theory.

4. Rule: must show that not only is inf luenced and governed by the other entity but also that

there is such a unity of interest and ownership that the individuality or separateness of each has

ceased and the f acts are such that an adherence to fiction of separation would promote

injustice and allow fraud.

a. No respondent superior between subagents. Even though RC is an alter ego of the

Church doesnt show that the RC is an alter ego of ; had no dealings with the church.

In re Silicone Gel Breasts: Liability of Parent to Subsidiary

1. Facts: is sole SH of breast implant MEC, had 3 directors

on board. Two were s execs and MEC president

evidence revealed MEC prepped reports for and had

MEC submit 5 year plan MEC submits budgets, kept

monitoring of . MEC was highly involved in personnel,

auditing, review, name and logo were with sale and

communications. s exec VP suspended MEC sales and

MEC stopped ops later that year selling with s

approval and turning proceeds over to . s bring

products liability.

2. Issue: Is the parent corporation liable for product torts of a subsidiary?

3. Held: Yes. They had control, the subsidiary was underfunded and undercapitalized.

a. Control: A parent corp. is expected to exert SOME control over its subsidiary BUT

when a corp. is controlled to such an extent that it is merely the ALTER EGO orINSTRUMENTALITY of its SH, the corporate veil should be pierced in interest of justice

b. DE can pierce without finding fraud or misconduct if a subsidiary is found to be an

alter ego or mere instrumentality; many states that do require fraud do only in contract

cases not torts

c. Vouched: since MEC funds may be insufficient to pay for damages, and may have

induced people to think was vouching through actions in support allow finding

Frigidaire Sales v. Union Properties: No Improper Actions

1. Facts: contracts with CI, an LP. s were LPs of CI, as well

as officers, directors and SHs of CIs only partner, Union. s

controlled U and through control had day-to-day

management and control of CI. CI breaches and sues.

2. Issue: Do LPs incur general liability for the limited

partnerships obligations because they are directors,

officers, or SHs of the corporations general partner?

3. Held: No, LPs are not personally liable as GPs.

4. Rule: In WA, parties may form an LPship with one corp. as

In r e Silicone Gel r ea tImplant

Held: No S.J. for Bristol. Distinguish Bristols situation fromDow Chemicals.

Publ ic S 2 a r ehol de r 3

ME C

4 r i

3

to l

P lain tiff 3

5

iable?

Product Liability

100%

ne Per on: Many ³Hat ´

Commercial Investors, LP

Limited Partne

M 6 7 7 8 7 & 9 6 xt @ General Partner :

U 7 i 8 7 Pr 8 p@ rti @ s, I 7 c.

A B

C

rD B

E

lF D

rs/OfficD rs

/G irD ct E

rs: MC

H H

E

H &

I

C

xt D r

MC

H H

E

H &

I

C

xt D r Li

C

blD

C

sP D H D

rC

l pC

rt H D

rs??Q D

lF :

R

E

.



59

its only GP if that GP is inadequately capitalized, a creditor is protected under the corporation

law doctrine of piercing the corporate veil.

a. Mere undercapitalization is not a reason to open liability to LPs who control the GP

b. was never misled into thinking s were acting outside their corporate capacity kept

the corp. aff airs away from personal aff airs and did not defraud or create injustice upon

parties in dealings separate entity should be respected;

c. No evidence thought they were GPs, knew they were LPs

Likelihood of Courts Piercing the V eil (Best Chance to Worst)1. By Structure

a. Individual/Wholly Owned Close Corporation (Controlling SH/Close Corp.) less likely

with more SH

b. Parent/Wholly Owned Subsidiary less likely with more minority SHs

c. Public Corp. very rare

d. Sister/Brother Corps. very rare

2. By Claim: Contract > Tort

3. By Reason: Unf airness Commingling of funds (confusions of accounts) undercapitalization

and lack of formalities

4. Highly Unlikely to Disregard the Entity Situations:

a. (1) Public Corps.

b. (2) Against Passive SHs

(3) Against Minority SHs

c. (4) All Corporate Formalities are Observed, business is real and not a sham

Lawyer: Observing Formalities

1. Client Doesnt Observe Formalities: e.g. not held director of SH meetings, has not even issued

shares

2. Do NOT back date: a set of formal documents it is MALPRACTICE

3. Forgeries: backdated documents are forgeries and it is not an excuse that they represent what

was true or CLOSE to true according to the memory of an old person

Policy: LLCs and Tort Claims against SHs

1. Advantages of LLCs: investor incentives pro-investment; holding companies specialized

investment; most contract claimants assumed the risk

2. Disadvantages (Involuntary claimants; Tort victims): Incentive to inf lict injuries without

internalizing costs e.g. run a borderline solvent gold mine on the top of a mountain in CO; Yale

no LL for torts, force or require corporations to carry adequate insurance

3. Torts against SHs:

a. Victims cannot rely on the creditworthiness of the firm when acting

b. Victims cannot negotiate with the firm for contractual protections from

undercapitalization may be unaware of firm itself

c. BUT victims can protect themselves with personal insurance



60

4. Can stock trading market survive the Yale position? No.

a. Difficulties of administration stock must be indistinguishable; equities distinguish

pass/active SHs

b. Worth caring? There are alternatives personal protection and governmental

protection

Shareholder Lawsuits1. Distinguish: Derivative Actions/Direct Actions (class

actions) to whom is duty owed?

a. Classic breach of fiduciary duty by board

derivative (Cohen personal enrichment)

b. Direct: Classic violation of Federal Securities

Laws; State law voting rights violation

(Eisenberg problem for s, no cash)

2. Effect: Procedural hurdles FRCP Rule 23/23.1

a. Who collects damages?

3. Direct and Derivative Suits: a SH may sue to enforce

managements duties

a. Derivative: If claim is that managements breach reduced the residual value of the

business (shirking, self-dealing), file in name of corp.

b. Direct: if claim is that breach deprived the SH of some other right (other than her

contingent right to that residual value) e.g. right to inspect SH list, file in own name (may

be brought as class actions)

4. Threat of Derivative Strike Suits: a person with a small stake in the residual value of a business

may be tempted to bring a derivative suit for the primary purpose of bring bought off

a. Reduce temptation by requiring s to make payment to corp. for the complaining SH

b. Attorney is generally real interest obtain fee from the corporation and legitimately

demand some payment in connection with a settlement

5. Limits to Derivative Action: Pretty much all corporations limit the SH who may bring these suits

many states have laws requiring the -SH in a derivative suit to post a bond or other security

to indemnif y the corp. against certain of its litigation expenses in the event the loses the suit

a. When security must be posted: great variety some says if owns less than % of stock;

some discretionary by court and demanded only when reasonable possibility the action

could benefit the corp. b. Entitled to Security: most state only the corp. may demand security and only for

expenses to pay some states allow officers and directors to demand it

c. Covered expenses: usually all expenses, including attorneys fees, are covered maybe

expenses the corp. must pay the directors and officers because it has indemnified them

(may indemnif y them for actions in good f aith and business judgment but not for fraud)

Shareholder Suits

ShareholdersS

ompany &/or T U

Shareholders:on behal

V

oV

company

Third W arty:

T U ecutives or X

th

S

ompany

Y irect;as a class

Y erivative

cash

cash



61

Cohen v. Beneficial Industrial Loan Corp.: Application in Federal Diversity Cases

1. Facts: Cohens decedent, , brings SHs deriviative action in Federal Ct. in NH against and

managers and directors. Alleged that since 1929 s had conspiracy to enrich themselves at

corp. expense. owned about .0125% of the shares. Af ter began, NJ made law requiring 5%

ownership unless those shares have a value over $50,000 to be reasonable for expenses and

attorneys fees of the defense if the suit f ails. Has to post bond of $125,000.

2. Issue: Must a federal court sitting in diversity apply a state of the forum state providing for the

posting of security for the corporation?

3. Held: Yes. A SH who brings derivative action assumes a position of fiduciary nature sues as a

rep of a class that did not elect him as rep as they elected the corp. director/manager state

has power to regulate and promote accountability, responsibility and liability

a. Reasonable Expenses: law that requires liability and security for only reasonable

expenses doesnt violate Due Process or Equal Protection by classification basis on

financial interest only serves to insure some good f aith

b. Federal Courts in Diversity: must apply substantive law of forum state while following

federal rules of procedure

Eisenberg v. Flying T iger: Statute Applicability

1. Facts: , DE corp., organized subsidiary in DE called FTC organized subsidiary, FTL, month

later. Three DE corps then created plan to reorganization, subject to SH approval, where

would merge into FTL approved by 2/3 vote. Merger,

stops operating and FTL takes over ops. s shares

convert into equal FTC shares then FTL changes name

to FTLI, resulting in all business operations being

confined to a wholly owned subsidiary of a holding

company whose SHs are the former SHs. sues to

enjoin the reorganization and merger stating purpose

to dilute his voting rights. removes to NY motion

for order that comply with § 627 of the NYBCL saying

in derivative suit against corp. must post security for

the corp. costs.

2. Issue: Is an action asserting that SHs have been

deprived of any voice in the aff airs of the company derivative for the purposes of the statute?

3. Held: No. Even if DE law, which has no security requirement, control the merits of the case, this

court must look to the NY law regarding the issue of security.

a. § 627 Applies only to derivative actions claims he and his fellow SHs have been

deprived any voice in the operation of their company; not challenging the management

of the company on behalf of the corp.

b. THUS s action is personal and not derivative within the meaning of § 627

Security for Expenses Statutes in Derivative Actions1. NY and NJ: Deposit bond unless 5% SH or shares > $50K (Cohen) Two way expense shif ting

Eisenber ̀ v Flyin ̀ Ti ̀ er a

ine

b

lainti c c ; Shareholder

Flyin d Tid er

Flyind Tid er e

orp

f

ir Frei d hte

orp

mer d e

b

laintic c

g bjects to

h

er d er i

ondp

q

eld:r

o

sub

sub

stock

es chand e



62

2. MBCA: omitted in 1982 shif t expenses to if court finds proceedings without reasonable

cause or for an improper cause

3. OH: No law one way shif ting (firm to on success)

4. Incentive to Sue: SH collective action problem

a. Gain to any one small SH of success not worth cost of prosecuting suit

b. Solution: firm pays s attorneys fees on success (settlement or judgment) 20% or

30%

c. Problems: agency costs - attorneys and s are both agents of SH and can misbehave

d. Applies to both class/derivative actions

5. American Bounty Hunter System: Expense shif ting is an exception to the American Rule each

side bears its own litigation costs

a. E.g. derivative suit against top 3 execs of CA; settlement return $500m in stock to

firm; attorney collected $50m; attorneys out of pocket expenses - $250K

Shareholder Suits in Practice

1. Collusive Settlement Problem:

a. Corrupt managers collude with s lawyers (double agency) to make cosmetic changes

and buy off lawyers

i. Error managers should pay and do not

b. Tamer managers collude to settle nuisance litigation and buy off lawyers

i. Error managers should pay and dont

2. Value of Settlement: determined by surviving summary judgment motions

3. Problem of Supervision by Court:

a. Judge wants settlements no parties in court opposing settlement; love fest.

4. Incentive to Sue: depends on size of recovery size depends on D & O Insurance Coverage

a. Best Rule: induce some suits that decrease firm value and f ail to induce suits that may

increase value

b. Lodestar Formula: hourly fee with multiplier

c. Auction: among attorneys low ball, settle

5. Other Incentive Problems:

a. Interrelated: obvious solution, control fees

b. Procedural fine-tuning: early decisions (1) pleading particularity (Grimes and PSLRA of

1995); (2) named control who is real party interest and intervention by large SHs; (3)

higher burden of proof (clear and convincing)

c. Substantive Law: higher hurdle for s on legal standards distinguish best practice from

legally required

Real Party In Interest: Standing in Derivative Actions1. Federal Rule of Civil Procedure 23.1

2. must have been SH at time of wrong

3. must be SH for duration of action

4. must f airly and adequately represent the other SHs



63

Derivative Action Burden: The Demand Requirement 1. Demand on Board Requirement

2. If Board disinterested must make demand (boards decision control) actual demand waives

claim of excuse (Grimes)

3. If Board interested (conf licted) demand excused because futile

a. Delaware: reasonable doubt would have to allege particularized f acts that would

create a reasonable doubt about the independence or disinterestedness of the board or

whether the challenged transaction

is otherwise the product of a valid

exercise of business judgment

b. NY (three part test) Grimes

compared to Marx: (1) not sufficient

to merely name a ma jority of the

directors as parties with conclusory

allegations of wrongdoing or control

by wrongdoers -

c. Universal Demand in MBCA 15

states around a notice rule, make

demand, if board doesnt sue, SHs

sue

4. Effect: prefer securities class actions over

derivatives

5. Other Options: (1) SH must hold more than 2% or $500,000 Rule 14a- 1% or $1,000; (2) PSLRA

of 1995: for class actions only largest disinterested SH willing to intervene takes over

a. State courts may use the rule who f airly and adequately represents 6. Legal Standards

a. When is demand excused: Aronson (DE), Grimes, Barr (NY), Marx

b. If not excused, board refuses, sue board for refusing; BJR Grimes case (DE), Spiegel

(actual demand waives claim of excuse)

c. If excused, special litigation committee files a motion to dismiss; SCL decision evaluated

under BJR Shaw (NC), rule of deference, Auerbach (NY) or compelling corporate

interest, Zapata (DE)

Grimes v. Donald: Abdication

1. Facts: is SH in DSC claims board f ailed to use due care, commits waste, approved excessive

compensation and unlawfully delegated by entering to agreement with CEO unreasonably

interfered with s management of the company was agreement. Seeks declaration that the

provision of delegation was invalid.

2. Issue: May a SH proceed directly on an abdication claim when he seeks only a declaration that

an agreement between a board and its CEO is invalid?

The Demand Requirement

Sharehol t ers Must Make a Demand on the Board to Sue (Major ity of Board ³Disinterested´)

± Board¶s Choices: It Agrees to Sue, Ref uses to Sue, or Def ers to Shareholder Suit.

± If Ref uses: Shareholder Sui t Dismissed; Sue Board,Wr ongf ul Ref usal? Grimes: BJR unless conf lict or lack of due care

Demand on Board ³Excused´

± Board Creates a Special Litigation Subcommi ttee (SLC):SLC Def ers or Files a Motion to Dismiss

± On Motion to Dismiss, Court Review on NY or Del test(BJR/´compelling interest´)



64

3. Held: Yes, whether a claim may proceed as a direct or derivative suit depends on the nature of

the wrong alleged and the relief sought. Claims seeking injunctive or prospective relief, such as

s, are more likely to qualif y as direct

a. Focus on nature of relief sought consistent with the idea that the function of the SH

derivative claim mechanism is to avoid the problems of f ashioning compensatory relief

that would plague a class action claim

M arx v. Akers: Futility Exception

1. Facts: Without making demand on IBM board, s, Marx files SH derivative suit alleging that

the board wasted assets by awarding excessive compensation to execs and to outside directors.

Complaint alleged that during a 5 year period, s increased compensation rates from $20K plus

$500 per to $55,000 plus 100 share of IMB.

2. Issues: Excessive compensation? Outside directors? Relation?

3. Held: Having a ma jority of a board of outside director, does not excuse from making a demand

in connection with claims of excessive compensation to execs.

a. With ma jority outside directors on board, futility excuse excuses from making a demand in connection with claims of excessive compensation to outsiders.

b. Demand Requirement: (1) Creates a form of alternative dispute resolution to allow corp.

directors with chance to correct abuses; (2) helps insulate directors from harassment by

litigation on matters within discretion; (3) discourages strike suits began by SHs for

personal gain not benefit of corp.

c. Exception: permits SHs to bring claims on behalf of the corp. when it is evident that the

directors will wrongfully refuse to bring the claims

d. Q ualif y for Exception: (1) ma jority of board are interested by self-interest or control by

self-interest director; (2) board didnt fully inform themselves about deal to the extent

reasonably appropriate under the circumstances; OR (3) deal was so bad on its f acecouldnt have been product of sound business judgment of board

Auerbach v. Bennett: Special Litigation Committees

1. Facts: GTE management looks into chance that co. or subsidiaries made improper payments

board determines that $11m had been bribed and that 4 of 15 s had been personally involved.

SH brings derivative suit on behalf of corp. against bribes. Board creates SLC of 3 disinterested

directors who had joined the board af ter bad deal happened. SLC found that it was not in the

best interest of the corp. for the action to proceed.

2. Issue: Does BJR stop inquiry into the disinterested impendence of SLC? Is SLC allowed to

determine whether suit may go on?3. Held: Courts may inquire into the disinterested independence of the members of the board

who are chosen to pass on whether the derivative suit should be dismissed or not. To require

the people outside the board to investigation would require that board abdicate its fiduciary to

the corp. to manage aff airs. Good f aith inquiry.

a. Decision of SLC: substantive decision may not be looked into by court; only the

composition of the Committee (Substantive is within BJR)



66

b. Statutory: MI ongoing business relationship may disqualif y OH § 1701.59 clear and

convincing evidence needed that director salary concerns defeat good f aith

c. NYSE: listing requirements similar to MI

d. DE: common law test evolving

In re Oracle Corp. Derivative Litigation:Burden on SLC 1. Facts: SHs of Oracle bring derivative on insider trading by 4 of board Ellison, H, L and B; Forms

SLC to look into and determine best course 2 board Ms G and G were named to SLC joined

af ter events and both were Stanford prof s. Hourly wage paid but agreed to waive compensation

if a court deemed it necessary to maintain impartiality.

2. Issue: Has the SLC met its burden of persuasion and shown there is no material issue of f act

calling into doubt its independence?

3. Held: No. Did not disclose Boskin was also Stanford professor that L had made donations to

Stanford and that one donations was used by G for personal research. Failed to disclose that B

taught G when PHD, two are good friends in Stanford Committees. L is well known Stanford

alum. Third E was Stanford contributor and wanted to make it best. a. Social Inf luences: may also inf luence and be motivating f actors can use them to show

SLC did not meet burden to show absence of material f actual question about

independence

Questions: s Suits against Corporations1. DE Supreme Court: views in Martha Stewart

a. Burden: directors in Oracle had the burden of demonstrating their independence for

purposes of their motion to dismiss the derivative action. In contrast,

b. In Beam ex rel Martha Stewart Living Omnimedia, Inc v Stewart, which was also a

shareholder derivative action, the PTF had the burden of alleging sufficient f acts to raisereasonable doubts about the independence of directors.

2. Distinguish: should we look at structural bias v. social circle bias personally beholden

3. Oracle: personal and f amilial, collegial as well as economic interests count

4. Standard: too substantial and guided by a general sense of human nature

a. Higher than standard for demand excuse: Martha Stewart (implied)

Plaintiff·s Lawyer: Derivative Strike Suits

1. File and Plead with Particularity:

a. First choice: A class (direct) action securities law; vote or dividend related

b. Second Choice: Derivative Action, plead that demand is excused first choice: breach of duty of loyalty, second choice bready of duty of care (hopeless)

2. Under both actions, expect and defeat

a. Motion based on the named s f ailure to adequately represent SHs

b. Motion on f ailure to plead with particularity

3. IF Class Action, Expect and Defeat Summary Motions: Motions to dismiss and a motion for

summary judgment on the merits; if lose, settle for peanuts; if win, settle for millions



67

4. IF Derivative Actions:

a. Expect and beat motion based on f ailure to make a demand; if lose, make demand and

start second suit for wrongful dismissal (hopeless?)

b. Expect and beat a second summary motion filed by an SLC

c. Expect and beat a third summary motion on the merits defense just a duty of care

case then BJR applies

d. If lose, file appeal and settle for peanuts or take risk of appeal

Settle for Millions: take 20-30% of the cash and collude with lawyers and sell the settlement to the

judge; who must approve. If successful buy naming rights to a law school.

Demand Excused: Aronson v. Lewis (DEL) and Barr v. W ackman (N Y )

1. Aronson v. Lewis: Test

a. Specifically plead one of two claims: reasonable doubt or belief that directors are (1)

ma jority interested or dominated by interested party OR (2) otherwise unable to

exercise independent judgment in evaluating SH demand (procedural/substantive tests of due care)

2. Barr v.Wackman (NY): Marx in NY

a. Ma jority of board interested pecuniary interest or controlled by someone who has

pecuniary interest

b. Directors not informed OR

c. Decision egregious on its f act; directors didnt exercise sound business judgment

PrimaryDuties: Board of Directors (and AppointedOfficers)

1. Duty to Whom: To the firm collectively, to maintain firm health not to individual SHs or

individual constituencies

2. Measuring FirmHealth Legally:

a. SH Value maximize residual profits long/short term; stock market price inaccuracies

b. Total firm capital value SHs returns PLUS bondholder returns

c. Total firm value return to investors plus income value to workers

d. Total social value firm is better off in the long run if society is healthy??

3. Corporate Powers: Express Powers

a. Generally: Most states have provisions to allow corporations to sue, be sued, own

property, make gif ts to charity, borrow money, get stock and redeem or purchase stockb. Limitations: most have limits e.g. transfer of substantially all of corporations assets

normally require approval of ma jority of voting power of the SHs

4. Corporate Powers: Implied Powers

a. Reasonably Necessary: most corporations have power to reasonably do what it is

necessary for the purpose of promoting their purposes (firm health) and help express

powers unless they are expressly prohibited by common or statutory law.



68

b. Broad Power: Trend is to construe broadly what is reasonably necessary

When can a Board Favor Non-SH Constituencies:1. Facts Patterns:

a. (1) Gif ts to Charities AP Smith;

b. (2) Distributions of extra cash, higher wages or dividends Dodge;

c. (3) Community, culture and tradition over profits Shlensky v. Wrigley

2. Potential Answers:

a. Never tie all decisions to shareholder welf are do not do it at all (Friedman);

controversial but it has been the legal rule for almost 150 years

b. Y es, a bit but only if amount is small and promotes the Good and Ethical (ALI)

c. Y es, Full Board Discretion to Act Board may discretionary choose to act in a socially

responsible manner [Ohio Statutory Rule § 1701.59(E)) Board of Directors of OH

Company has no duty to follow Shareholder Primacy Rule (unlike DE)

3. Objective of Corporation: What extent may a corporation may act in a way that is not intended

to maximize profits?

a. Social Responsibility: Early days broad power to contribute; now more of a debate

b. Arguments key objective to get best possible returns and not other legal standard is

enforceable; others says they have social responsibility and must balance with SHs

interests and public at large

AP Smith v. Barlow: Social Responsibility and Charitable Donations (1953)

1. Facts: Corp. formed in 1896 gave $1,500 to Princeton and SH challenged. President testified

that it was sound investment and created f avorable environment for the company public had

reasonable expectation of such socially oriented contributions by corps.

2. Issue: Is such a gif t to a university by a corporation a violation of the duty of loyalty?3. Held: No, judges are Princeton grads.

4. Rule: Probably not an impartial judgment

Questions for Non-Profit Motivated Gifts

1. Does the CEO get any personal benefits from such a gift? Elephant Bumping.

2. Would a majority of SHs ratif y the deal?

3. Does the type of gift matter? Tressel bonus v. Green party presidential campaign

4. Should SHs decide on them?

a. Individually give them cash dividends and they can give to charities themselves

b. Collectively Proportional allocation like Warren Buffet system of requests 5. Are executive decisions based on personal whim? Creates Conflict?

a. Gif ts to outside directors of f avorites ties them to managers form of quid pro quo like

in Seton Hall

b. To bind outside directors just give their school money in their name, easiest form of

bribery and elephant bumping



70

Shlensky v. W rigley:M isconduct not found

1. Facts: minority SH in corp. that owns Cubs brings derivative suit for refusal to light Wrigley

Field and increase revenues. Directors motivation was result of views of Mr. Wrigley and

ma jority SH who wanted to preserve neighborhood surrounding and who thought baseball

was day sport.

2. Issue: May a SH bring a derivative suit for mismanagement where there are no allegations of

fraud, illegality or conf lict of interest for not installing lights?

3. Held: No, the court will not disturb the business judgment of ma jority of directors without

above reasons. No evidence that installing lights and scheduling will increase benefits to and

there appear other valid reasons for refusal to install e.g. detrimental effect on surrounding

neighborhood (which Corp. Property is located in and has interest in).

a. Not obligated to follow direction taken by other, similar corps. Even if these MAY be

better not guaranteed.

Shareholder Primacy Rule1. Board Members Behold only to SHs if ONLY SHs vote: SH will vote for board that maximizes SH

welf are

a. SH welf are without clear SH direction to contrary a DUTY to maximize SH wealth

2. Duty to Others Constituencies: Ideas

a. Others may vote: Germany

b. Room for duty because SH vote is a joke and board is self-perpetuating

c. YES but only with a clear link of other constituencies welf are to SH welf are our system

3. Distinguish Idea: That Corp. should follow green ideals because it will do better over time

(maximize profits in a long-term plan) FROM

a. Following them because the expense of profits over time because society is better off

(it is moral, ethical or right)

b. Substitute for green sin-free like no booze, etc..

Defense of Shareholder Primacy Rule

1. Goal of Corporate Law: Serve interests of society as a whole

2. Achieved: Does this by advancing aggregate wealth good!

3. Surrogate measure of firm health best interest of SHs? SH Primacy Principle

a. 95% of the time if SHs are happy everyone else is happy (litmus test even for

employees); They are served last so all before them get hooked up

b. Auction of board vote SHs pay the price of what they think the stock would be worse

v. what they think it would be worth if they had control or if the directors had control

i. If SHs control the vote then we are happy they control the interest they

are the ones with the RISK and who have something to lose.

4. Who should prevail when SHs and other constituencies are in conflict? E.g. company is on edge

of insolvency

a. Pro-shareholder - reduce wages or dissolve because if not, I am gone



71

b. Pro-labor run company until broke and until all the cash is gone (like NYTIMES, GM

and CHRYSLER)

5. Opponents of Rule: CEOs in OH have duty to all accountable to none; insulated board from

Court Review

a. Asset redistribution social engineers want say over others assets and money for

greater good of society

b. Opportunistic renegotiation contracts agree to terms (labor money) and ask court to

change it because of circumstances (big profits, no profits)

c. Promoters of idea that consensual, inclusive decision making dialogue is a universal

good and will lead to peace and

happiness

6. Bottom Line on Principle: one of the most

significant structural assets

a. Combination: Economic f lexibility and

accountability of those who control

pools of investor money

b. Constant attack from politicians,

academics, journalists, clergy, etc. and

survives because competition among

nations, states and companies; core

respect for individual initiative and

common sense

What st rl i t ay

Republican � r�

paganda: �

�

(I�

ish), t he Republic�

E�

s do not like

y views eit her. They do not wanbe held account able in shareholder law suits; t hey li

dividend ret ention and t he power t o

ake charit ablegifts (and political contributions t o � ixon).

Profits�

ver Environment : � o, t he met hod of prot ecting t he environment is t o pass general legislawit h prohibitions; do not give t he board a fiduciary dt o be green.

Do � ot Invest in (or buy Products from) only Et hical�

ompanies:� o, recognize and accept t he cost. Res

t he limits of legislating et hics.



73

W ater, W aste and Land v. Lanham: Gap Filling and Constructive Notice

1. Facts: , manager and member of PII, . was LLC under CO LLC Act and contacted WWL, ,

about doing work. During discussions gave business card with PII and address of other

member and president of PII, L, who had same address listed as principle office and place of

business in Sec. State filing. Oral K with and asked to send written work proposal to sign and

return. Never sent but authorized to begin work; when work done sent $9k bill.

2. Issue: Is a member-manager of an LLC personally liable on a K entered into by another member-

manager and a 3rd

party if the 3rd

party lacks knowledge of the business entity and thinks the

member-manager with who dealing with was acting as an agent for the other member-

manager?

3. Held: Yes, even though L was agent of PII, LLC, he f ailed to fully disclose his principal to a 3rd

party with whom his agent dealt and under agency law, f ailure made him liable on the K with

the 3rd

party.

4. Rule: Even though statute calls for filing with the Sec. of State, the member is liable when not

disclosing principal is LLC. (OH has reverse § .07(c))

a. To interpret the notice section of the LLC Act as making filing constructive notice even if

they lack knowledge of the LLC existence would invite fraud and sharp practices;

allowing agent of an LCC to mislead a 3rd

party to think that the agent would make good

on K.

b. Constructive Notice - Better Interpretation: notice of an LLCs name puts a 3rd

party who

deals with someone that he knows is a member of an LLC on constructive notice f the

LLCs limited liability status and that managers and members bear no liability because of

status.

c. Interpret Statutes in derogation of common law narrowly, particularly when broad

interpretation would depart greatly from settled agency rules and create uncertainty

about known rules when L got proposed K from showing thought L was principal

he could have easily corrected s to avoid this.

Elf Atochem v. Jaffari: Operating Agreements and Arbitration

1. Facts: Elf and J agreed to joint venture to market J product and form M, LCC a DE LLC.

says he gave 30% capital in exchange for 30% interest and J gave rights to product for 70%

interest. OA said arbitration clause would govern all disputes coming from OA and forum would

be in CA. files in DE claiming duty of loyalty. Because OA says forum is CA, DE Court

dismissed claim.

2. Issue: May the members of an LLC, through the use of a forum selection clause in their OA, vest

jurisdiction in a particular forum?

3. Held: Yes. DE LLC Act allows broad discretion in draf ting LLC OA and gives def aults only when

OA members agreement is silent.

a. Maximum effect to freedom to contract and to freedom of enforceability of LLC OAs.

Only when inconsistent with mandatory statutory provisions will the Members

agreement be invalid.

b. Omitted in OH



74

Kaycee v. Flahive: Piercing the LCC Veil

1. Facts: KC, , and FOG contracted to use s real property and Roger, , is managing member of

FOG says that during use, FOG fucked up property. FOG has no assets and seeks to pierce

LCC and hold ROGER individually liable for the fucking up.

2. Issue: Without fraud, may a court pierce the LLC veil in the same manner as the court would

pierce a corporate veil?

3. Held: Yes. Every state that has enacted LCC piercing laws hasnt developed a different LLC

standard but has chosen to follow corp. law standards; no reason to treaty LLCs differently than

corps

a. Some f actors justif ying corp. piercing like f ailure of formalities obviously will not apply

b. OH §.48 says no language on formalities

M cConnel v. Hunt Sports: M ember-M anaged LLC with OA

1. Facts: CHL in 1996 was formed; Member managed LLC with an OA; LLC OA allowed members to

compete with LLC; restricted liability of members of willful misconduct; required ma jority to file

suit. Member of LLC formed new LP to take sports franchise in competition with LLC2. Issue: Can an OA of an LLC limit of define the scope of fiduciary duties imposed on its members?

3. Held: Yes, § 3.3 of the OA said that members may compete and shall not in any way be stopped

from engaging or owning any competing interest. Language is clear and unambiguous

o By very clear terms OA allowed competition and voided duty of loyalty for the LLC

members involved; no duty not to compete

o OA obligations only apply to conduct in carrying out their duties of the OA: Breach of LLC

OA was by member for filing an unauthorized suit against LP

4. Waiver of fiduciary duties: in partnerships harder to do this because of common law duty; cannot

be engaging in any other business in joint venture industry (so preserve the right to pursue other

businesses)

o Members may waive: all duty of care claims other than willful acts and some types of

duty of loyalty claims (duty not to compete)

o Court Refusals to Respect Waiver: basic contract theory strict construction of language

mistake, fraud, contract of adhesion, non-waivable fiduciary rights?

o Homer Opinion: in this case, OA doesnt specifically say that cannot TAKE THIS BUSINESS

only says cannot take others (ridiculous)

5. Cannot waive in RUPA § 103: generally any unless manifestly unreasonable

Formalities of LLCs1. Many Without Formalities: Operate with one-page Articles of Associations

a. Many oral implied agreements custom, course of practice evidence

b. Usually member-managed but can be manager-managed in mutual unwritten

understanding that only B runs business, not A.

2. Effect on Integrity of Entity: Court interprets implied agreement and other applies def ault rules



75

Ohio: Summary of ch. 17051. Keys: No constructive notice on filing; no freedom of contract language

2. Default Rules:

a. Create LLC capital contributions create division of profits

b. No automatic capital calls

c. New members on unanimous vote

d. Lock-in: members may not withdraw but may assign interest in membership to others

for consideration (ceases to be a member on death or insolvency); partnerships

withdraw at your own will

e. Withdrawal: § 1705.16 (go from no lock-in in A and B from absolute lock-in in C)

f . Authority depends on member- or manager-managed distinction

g. Duties of managers comes from Corp. Model

3. Lock-In: Member of LLC with no OA and want to unilaterally leave

a. Cannot withdraw

b.

Can sell; purchaser not a new member

c. Sue to dissolve not practicable to carry on business in harmony, etc.

d. Die estate has powers of members, can assign, not membership

e. Lesson: Use an OA and DO NOT use the def ault rules.

Transaction Lawyers: Operating Agreements

1. Why is lock-in important? Automatic lock-in with LLC def aults, which is why they are so popular

2. Why not law firms? Because of the vanity of the word partnership

a. Inherent lock-in, too

3. Minimal info in articles because updating

4. Money

into bu

sine

ssno

tper

son

al

5. Critical membership issues allow what? Deny what?

6. Review to see if change procedures if so, amend

7. Know about tax issues

8. Oesterle:

a. (1) PutMinimal Information In Articles: Updating Obligations Are Easy to Forget and

Remember Annual Fees; also Check Name (Make Sure No-one Else Has It)

b. (2) Take Extra Care on Instructing Client on Proper Use of Business Name: LLC in Title

and on Signs and Instruct Client, in Writing, on How to Sign Documents

c. (3) Take Extra Care on Instructing Client to Keep Separate Business/Personal Accounts

d. (4) Always, Always Use aW

ritten OA (Start with a Good Form; Modif y It)i. Include Critical Client Understandings on: Membership Issues (Admission;

Withdrawal and Expulsion; Assignments) Division of Profits; Capital Calls;

Management Structure (Decision Making and Voting Procedures) and always

Prefer Simplicity

ii. Handy Road Map: Client Can Read and Follow the Directions - Include Tailored

Rules and Def ault Rules into a Single Package of Instructions



76

iii. Review the OA Periodically to Make Sure that Client Has Not Changed

Procedures. If so, Amend OA or Amend Client Procedures. Do not let it go.

a. (5) Know a Few Essential Details About Partnership Tax and A Good, Reliable Tax

Expert for Clients and Yourself .

FiduciaryDuties on the Corporate Side1. Control of judges: in corporate context much more refined

2. Duty of Loyalty of Good Faith: Bound by rules of f airness, loyalty, honesty and good f aith in

their relationships, dealings and managements

3. Duty of Reasonable Care: Exercise reasonable care, prudence and diligence in the management

of the corp.

4. Duty of Candor: growing in corporate context and reduced in partnership and LLC context (duty

to reveal or disclose info)

Duty of Care and Common Factual Issues5. Takeovers: Board sold for too little or refused to make a good offer (Van Gorkom and Cede)

a. Buyer just pays too much, buy a company that isnt worth that much; OR target

company sells for too little by not holding out for more cash

6. SH Dividend Cases: Board should NOT have paid a dividend (AmEx case)

a. Board decides or doesnt decide to pay an extraordinary dividend (dumping cash on

shareholders) should we do this?

7. Duty of Monitor: (1) Inattention (Francis and Allis-Chalmers) and (2) lack of legal compliance

programs (Caremark)

a. New stuff board is just not paying any attention, stuff is happening with the company

and they are just not informed and dont care enough to create legal complianceprograms to structure information sharing

8. Illegal Act Cases: AT&T Case

a. bribe foreign officials, statute act to stop wholesale bribery of foreign officials; campaign

contribution violations

The Business Judgment Rule1. Along with Care and Loyalty, Third Standard: Confusion as to what the standard actually is

thresholds? If good f aith, gross negligence? Affirmative defense? Good f aith as a defense to

negligence?

2. Purpose: Courts are reluctant to hold directors truly responsible for the management of thecorporation and truly liable for its financial errors

3. Defined: When a matter of business judgment is involved, the directors meet their

responsibilities of care if they use honest, good f aith, unbiased judgment.

4. GrossNegligence: When standard is applied only a director acting in good f aith could be held

liable if his actions were grossly negligent or worse

5. Thresholds:



77

a. (1) Financially disinterested (no conflicts of interest)

b. (2) Reasonably Informed

c. (3) Acting in Good Faith in the firms interests

6. True Standard: Regardless of standard of negligence courts say they use,

a. Generally just look at all the f acts and determine whether the total situation is one in

which the directors or officers SHOULD be held liable

b. BECAUSE they knew or should have known of the situation AND they could have done

anything about it.

c. Applied to each individually

Kamin v. American Express: Informed Business Judgment

1. Facts: Minority SH s sue AmEx on derivative and request declaration that certain dividend in

kind that is to be paid is a waste of assets. s that in 1972 bought 2M shares of DLJ at $29M

and current is about $4M. 1975 board has special dividend to which DLJ were given to SHs in

kind. If sell thinks would sustain capital loss of $25 and would be off set against capital gains

of about $8M to . Rejected. 2. Issue: Minus of a showing of bad f aith, fraud, oppression, arbitrary action, or breach of trust,

are the business judgment decisions of corporate directors judicially rescindable for alleged

imprudence or mistaken judgment?

3. Held: No. Once the plaintiff s had conceded that the American Express board considered the tax

advantages of selling the DLJ stock before deciding to distribute that stock as a dividend,NO

questioning of the board's demonstrably foolish decision would be entertained

a. Neutral of tax reduction economists cannot make decision and neither can AmEx but

they say that boards will spin-off and earnings number will be higher

b. Key it was good f aith, they acted without any impropriety.

What to do if buy business for millions and worth millions less now?

1. Could do one-time write down of -$80M; big write-down will come right out of the net profit

line P/E Ratio would go down price to earnings ratio earnings per share (stock price goes

down, etc. not good for shareholders)

2. Sell shares and get the cash, still have $20M in cash now (true ref lection of value of the firm)

but wont write-down as much

a. Advantages tax deductions for capital losses

3. Which AMEX took declare a special stock dividend (not just cash): give out more cash (in-

kind/in-specie dividend); take shares of the sub (SH Apparent Sub) the Apparent then gives

the SHs stock in the sub for freea. Tax status pay more

b. Net profits looks greater but we are paying more taxes to the government in this

situation EVEN THOUGH our Price/Earnings Ratio (SO therefore paying tax to the

government is good for the company) SHs say NO, take the deduction and cash

because this is retarded

c. AMEX won no fraud, no conf lict of interest, no bad f aith, just plain DUMB



79

e. Investment banker admits he was paid $1M; had to pay 2nd

or 3rd

investment banker to

make deals like this (free money)

4. Effect on legal advice to board?

a. Fairness opinions from investment bankers and scripted recorded board decision-

making procedures (all a show) no short board meetings

b. Makes money for lawyers for associates

c. Must take at least two weeks to have board meetings on sales to sell it

d. Procedure at meetings must be heavily legalized/official

LiabilityWaivers: Delaware1. SHs must sue on behalf of firm:

a. (1) demand requirement in duty of care cases are hard to get excused

b. (2) BJR of the defense motion to dismiss; hard to overcome

2. Waiver Does not Apply:

a. To injunctions only to claims for damages

b. To allegations of bad f aith or personal benefit

3. DOES apply to:

a. Damage claims against disinterested directors

b. UNLESS the Entire Fairness Test applies controlling SH transactions (Emerald Partners)

4. Duty of Care in DCL § 141(a) Statutory Cases: Business and aff airs of this corporation shall be

managed by the board of directors, except otherwise provided in this chapter or cert. of

incorporation

a. Exception § 102(b)(7) amending the cert. of incorporation limiting or eliminating

the personal liability of the director (not the firm or an officer) for monetary damages

(can always for injunctive relief) sue as a director provided that (1) cannot eliminate

duty of loyalty; (2) intentional or knowing violation of the law; (3) improper personal

benefit problem

b. Problem what do we do for recklessness? Can we exempt or not?

c. § 102(a)(7) can put in a provision (voted on) to eliminate the personal liability of the

director in a duty of care case unless there is a reckless or intentional conduct

Ohio: Duty to Care § 1701.59 and 1701.601. § 1701.59 duty of care;§ 1701.60 also has an impact

2. Tries to rip Smith v. Van Gorkom apart general statement is in § 1701.59 BUT then may

adopt BYLAWS in order to change

3. Bylaws in OH like rules of order use in a context where no one else would understand

(regulation are the actual bylaws of a corporation in OH)

4. Codify the Exceptions to the BJR: straight negligence standard (ordinarily prudent person who

would have done in the situation)

a. (b)Negligence Test:

b. (c) Changes everything (c) is usually most important director SHALL not be found to

have violated (b) duties unless proved by clear and convincing evidence (standard of



80

proof like common law fraud in torts or equitable concepts); cannot sue under a duty

care unless they have clear and convincing evidence

i. No good f aith if unwarranted

c. (d) Injunctive relief to damage action

d. (e) for purposes of duty of care director best interests of the corporation shall

consider the SHs interests (touchstone is best interests of corporation) may consider

economy, community and societal considerations, employees, debtors and creditors,

continuing independence (dont sell)

5. Default rule not amended into the cert. of incorp. but must amend out of it

a. Very pro-director with lots of exceptions

b. Lots of protection from the duty of care impossible to win even if get to a jury (duty to

nobody)

6. (e) constituency statute: directors can be beholden to a lot of constituencies

a. Duty of care has been shat on OH is laughingstock for good corporate lawyers

everywhere

7. § 1701.60(c) Redefine Duty of Loyalty

a. Changes (a) conf lict of interest definitions and duty of loyalty

b. A director is not an interest director SOLELY because the subject of the K, action or

transaction MAY involve or affect a change in control of the corp. or his continuation in

office as a director of that corp.

c. Damages § 102(b)(7) reckless disregard; § in D that excludes negligence and gross

negligence for monetary damages must be intentional disregard for corp.

d. Must opt-out if dont like (d)

e. (e) compensation provision

8. Irrespective of any financial or personal interests of any of them shall have the authority to

establish reasonable compensation

a. With conf lict of interest? Goes to duty of care

9. Duty of Care: all compensation decisions irrespective of financial interests and includes all

takeover decisions as well

10. 1701.59(a): general duty of care;

a. (c) negligence definition of duty of care and also reaches out to takeovers no duty of

loyalty problem

b. Adds clear and convincing test in (c) standard of proof in all actions

c. (d) monetary damages: more restrictions outside (c) get 102(b)(7) situation standard

to get cash from a director is intent or recklessness (not gross negligence or negligence)

recklessness is not express in the DE provision

d. Default in OH: (c) and (d) is an opt-out limitation on director liability in OH if you dont

like it, you can opt out (name the provision) with a waiver specific to this section very

specific (can go back to gross negligence)

e. Opt-in in DE: must have an opt-in amendment voted on by SHs



81

OHIO DELAWARE

Def ault Rule: Opt out not opt in

Opt In but as def aults: Will not apply to injunctions

only to claims for damage and To allegations of

bad f aith or personal benefit

DOES apply to: Damage claims against

disinterested directors UNLESS the Entire Fairness

Test applies controlling SH transactions (Emerald

Partners)

Tighter: Clear and convincing standard of proof ;

best interests of Corp. included other

constituencies; no improper personal benefit

exclusion; no Unocal rule; reckless disregard

Culpability doesnt include reckless disregard for

best interests of corporation; only gross negligence

Cons: SHs are duped. Pros of Waivers: why ratif y? They know what they

are doing.

Brehm v. Eisner: Informed Compensation and Severance

1. Facts: Disney hires O as Pres. In 1995 approved 5 year compensation pack of $1 with bonuses

and stocks with generous compensation package. O lef t without f ault before 5 year term. O

sucked at work and 1996 Eisner allows to terminate. Vote to approve non-f ault termination.

Give package over $140M.

2. Issue: Was there a breach of fiduciary duty of board by f ailing to assess employment agreement

properly or approval of termination for no f ault?3. Held: No. Had expert assess contract didnt look to package doesnt infer that board f ailed to

look at cost of firing him.

a. Standard: doesnt require that boards decision be informed on every f act only

reasonably informed (even without exact cost fully informed about manner in which

such payment would be calculated because of expert)

b. Negotiations for severance was BJR value of contract against value of employee; court

will not apply 20/20 hindsight to 2nd

guess boards opinion UNLESS rare cases when a

deal is so bad on its f ace that the boards approval cannot meet the BJ test.

c. Terms of Agreement limit to gross negligence or malfeasance for at f ault termination

he may not have been here, so boards f ailure wasnt problem. 4. Duty of Care: Directors decisions respected as presumption unless

a. (1) Interested

b. (2) Lack independence relative to the decision

c. (3) do not act in good f aith

d. (4) act without a rational (not reasonable) business purpose



82

e. (5) Use grossly negligent process (includes f ailure to consider all material f acts

reasonably available)

Business Judgment Rule: Implications1. Design: to end cases at Summary Motion pleading matters and should use SH inspection

rights at first

2. Second Guessing: Courts will not 2nd

guess business judgment if they are rational or reasonable;

defer to disinterested and independent directors and rely on experts (this will make judgment

reasonable or rational)

3. Best Practice Standards are not liability standards: Standards evolve; process and procedure

matters (keep good records, no check box drills; objective reasonable test on procedures of

gross negligence)

4. BUT NewWrinkle of Good Faith: different from duties of care and loyalty?

a. Violated by willfulness or recklessness (intentional misconduct or conscious disregard

for duties

b. Even though no recklessness in the record

Eisner v. Disney: Implications of New W rinkle

1. Facts: Board Compensation Committee Rarely Met. Some Members (Sidney Poitier) Attended by

Phone from His Yacht and Did Not Have the Foggiest Idea What Was Going On. They Relied on

Eisners Recommendations

a. Changes in Severance Provisions (For Tax Purposes) At the Last Minute Were Not

Understood Nor Discussed by the Board of its Committees. [The Compensation

Consultant was also surprised.]

b. Eisners Severance Provisions Were Similarly Bad.

2. Issue: Breach of fiduciary duties?3. Because of 102(b)(7) Waiver: Court must hold

a. (1) Board was reckless

b. (2) Board violated good f aith by deliberate disregard

c. (3) Wasted corporate assets

4. LoyaltyNot Available because O not on board and O not f amily or friend of dominant SH or CEO

5. NewWrinkle Effect of BJR Rebuttal of Presumption?

a. DE: shif ts burden of proof to directors standard of entire f airness

b. Others (Allen): s must prove(1) lack of due care (negligence), (2) proximate cause and

(3) damages

c. Difference: Rescission available as damages? Eliminated by Allen ruling that NO

Transaction Lawyers: Waivers

1. ALWAYS: include a 102(b)(7) waiver

2. WithWaiver: board members personally liable, only for (1) willful misconduct, (2) recklessness

or (3) personal pecuniary gain



83

3. ALWAYS: include corporate promise to employment agreement (backed with provisions in

Articles) to maximize indemnification and insurance coverage

4. NOW have new rules to deal with: organizational sentencing guidelines lower fines for firms

a. with compliance problems

b. that turn into bad actors because scapegoats

c. SOX of 2002 for publicly traded firms; they MUST have internal compliance info and

disclosure programs that are audited; federal and criminal/civil penalties; CEO and CFO

certifications

The Duty to Monitor: Corporations1. Argument: directors were ignorant and things happen that should not have because they were

not paying necessary attention

2. Distinguish: a breach by commission FROM one by omission (unwitting express ratification of

fraud; willful blindness?)

3. Distinguish: Excusable ignorance FROM breach 4. Director must:

a. (1) understand business;

b. (2) stay informed in operations;

c. (3) be f amiliar with financial status and

d. (4) inquire on any red f lags

5. Standards: Distinguish between objective and more subjective sophistication of director

6. Statutory Defense: reasonable reliance on experts

7. Key Question: did the board of directors establish an adequate procedural disclosure system to

inform them of problems and keep them up to date on key company issues?

Francis v. United Jersey Bank: Familiarity

1. Facts: Bank was run by idiot sons who embezzled money af ter son died; their mother didnt care

nor pay attention even though was also director.

2. Issue: Was Mother, as director, individually

liable because negligent, and if so, was

negligence proximate cause of losses by s?

3. Held: Yes. Causation was provable because

banks are special and easier to prove causation.

4. Director must: know and understand basic and

required to generally monitor aff airs andpolicies; if illegal conduct, had duty to object and

maybe take reasonable means to prevent such

conduct or resign.

5. Nonfeasance: causation issue requires

determining what reasonable steps a director

could have taken and whether those steps

Ba ne v. And ew ( .D.N.Y. 1924)

Liable f or f ailur e to stay inf ormed?

Held: No, unless evidence that neglect caused losses.

Liberty Starter s(Insolven t)

Receiver

Andr ews (Dir ector and lar gest shar eho lde



84

would have prevented the loss. The f ailure to act must be a substantial f actor in producing the

harm. Here inaction encouraged it and could infer she should have acted to object or seek

counsel.

a. Causation case by case analysis.

In re Caremark Intl.: Duty to Oversee Employees1. Facts: Settling a lawsuit where Caremark employees were engaging in Medicaid fraud

2. Issue: were the directors liable for these employees who were breaking the law and losing lots

of money?

a. Settled the case af ter suit by SHs

b. In the settlement (non-reviewable) directors have a duty to install internal controls

(info and reporting systems)

3. Settlement Creates Law new law could be

installed in settlements, so they try to change

it; now they have internal controls, could have

found as a judge that we established doctrinebased on internal control (judge)

a. If a board doesnt have a procedure to

stop illegal procedure and care for it,

then it is a duty of care breach (by

dicta)

Legal Compliance Programs: General Duty to Investigate?

1. Old Rule: No, unless there was a red f lag. 2. New Rule Caremark: Must have internal legal compliance program because there is a general

duty to establish it.

3. Why? 1991 Sentencing Guidelines on how to sentence Corporations 2002 SOX Requirements

says they will go lenient on corporations with Legal Compliance Programs will not get

sentenced harshly if illegal stuff is going on

a. Sarbanes-Oxley adds to this type of thinking

b. Only if you are publically traded S-O requires legal compliance and audits

4. What is a legal compliance program? Audited? Costs?

a. Legal compliance program must be audited (required by Sarbanes-Oxley)

b. Must hire one of the 4 big accounting firms to audit your firm Congress makes this rule5. Problems: If the accounting firms makes a mistake?

a. (1) they get delicensed SO they are hypercritical to save their own asses because of the

fines and potential loss of business this happened to Arthur Anderson in Enron (out of

business)

b. (2) this is not their specialty they are accountants, not legal compliance officers or

lawyers who should know this type of stuff (no lawyer expertise)

Stone v Ritter (Del. 6)

� The f inal br ick in the wall against an independent good f aith standard. Just a

recklessness standard in disguise.

� Also Aff irms the Caremark duty, a duty to put in internal contr ols. Did the company have money-launder ing contr ols in place?Yes. Case Dismissed.



85

c. (3) Use checklists for CYA; use among all the officers so no problems

6. Sum total incredible added expense to our auditing of companies (antithesis of what we

wanted to do in Sarbanes-Oxley to attack auditors)

Duty to Object 1. Once a director identifies a problem must the director: Object?

a. Form: in a meeting? On the Record?

2. Once outvoted:

a. Resign

b. Attempt to prevent? Francis (unusual)

c. Blow the whistle? Notif y

i. Government the state, the SEC (of Resignation or Of Specific Info), prosecutors

ii. Shareholders (media)

d. Sue offenders? Standing as a director to sue on behalf of the firm may sue the other

directors 3. Compel to whistle blow? Sarbanes-Oxley whistle blow for public financials

a. Rule Now: Want to protect from litigation, all you are obligated to do is resign publicly

and object in the public forum (unless you have done something yourself, in the

conspiracy, then resignation will not be enough)

4. Question: Should we go one step further? Problems?

a. Sarbanes-Oxley: attempts to protect voluntary whistle blower you are owed lots of

cash in litigation (protections voluntary whistleblowers)

b. Creates incentive for voluntary whistle blowing

c. Duty to Rat: creates incentive not to inform others, creates incentive to not rat, not

share information or at least too much (cliques)

Illegal Acts: Exception to the Business Judgment Rule1. Miller v. ATT&T: Allegation of illegal campaign contribution

2. Standard: good f aith? In best interests of the corporation?

3. Duty to Act Lawfully: Officers and directors have a duty to act within law; if they KNOWINGLY

cause their corporations to violate the law, they are in violation. Also have duty to ensure that

the corporation has effective internal controls to prevent employees from engaging in illegal

acts.

The Entire Fairness Test 1. Duty of Loyalty/Conflict of Interest: These are the cases you can win, have settlement value

and are cases that judges actually do understand cannot judge real business decisions

a. Judges are outside capacity in duty of care; here this is traditional stuff serving two

masters, conf licting goals, lying to people (human condition stuff)

b. E.g. Director/Officer on one firm inks a deal with a second firm that is owed by

director/officer (Bayer listen to wife who is an idiot); Lewis (board members own more



86

than lessor); BOT v. Benihanna (board member bought convertible preferred stock); has

independently paid (bribed) the director/officer or CS (Agency)

2. Standard of Review: Entire Fairness Test is current version

a. Test: It makes little difference whether the board is disinterested or not, the issue is

whether the transaction is f air.

b. Requirements: Directors interest must be fully disclosed if the board is not

disinterested, the contract will be given very close scrutiny; many states have this.

c. Burden: On the conf licted board with careful scrutiny met in Bayer and BOT

3. Two Types of Duty of Loyalty

a. (1) Sweetheart deal: CEO who owns both

corporation, one corp. is 2% and other is 100%

- has them deal with each other with 2% share

and sell goods for too little money to the 100%

(Singapore asset stripping); CEOs Mom buys

$100 hat for $10 puts asset value out

b. (2) Bribery: CEO approaches CEO and wants

deal says will bribe CEO for decision-making

in company, outside the deal (a lot of problems

here e.g. takeover artist with one CEO

blocking it pays that guy bribe and he stops

blocking it)

Bayer v. Beran: Relatives

1. Facts: Wife choose advertising campaign even though

she is singer. She chose herself to sing in ads and paid

normal price. SHs sue who was ma jority owner. 2. Breach? No. Burden to show good f aith of deal and

inherent unf airness. No disloyalty. Just because the

participation of wife may have helped her singing

career is not a sole ground for subjected s to liability

for breach because there wasnt excessive pay to her

and directors free to chose campaign.

Lewis v. SL: Fairness Burdens

1. Facts: SR owns SLE and LGT and real property used by LGT owned by SLE. Transfers stock to 6

children in LGT but not SLE, who leases from LGT. Sell stock to LGT at low price and refused tosell saying rental was greater than what lease was for and so was book value.

2. Burden: Overcome by s, made no effort to determine f air rental value at any time. Must show

the deal was f air and reasonable.

Safe Harbor State Statutes1. Sources: DGCL § 144; RMBCA § 8.60-63; OH GCL § 1701.60

Sweet Heart Deal

R m

n o f

o Pm

m

I

.A

o

S

m

n n o I

S z

{

|

}

~

|

{

. A

}

~

~

| z

50%

. A

100

CEO C z

{

z

. A

D| z

~

S o

� �

A

o

f

� m

�

o

�

�

� y �

o

f

� �

BOT v Benihanna

AokiB

r ust

Benihanna, US

50.9

Common 75%Seats2% Class A Common 25% Seats

BF C$20M Conv. Pr ef err ed

oting Stock

1 dedicat ed seat;

oted as × 28% of CommonFor 75% seats

( Abdo,

0%

wner )

( Abdo, Dir ector-Exec.

Comm .)



87

2. Transaction not voidable if:

a. Details fully disclosed AND

b. Ratified by disinterested directors OR disinterested SHs

c. AND Fair

3. § 144 Issues: Ratification and Fairness Tests Same tests (ma jority)?

a. If no, does ratification effect f airness; if no, use weaker test

b. If yes, does ratification end inquiry? No, BJR on ratification decision

c. Full disclosure required by f airness test? Ma jority, Yes.

d. Fair procedure and pair price? Ma jority, yes. (Hayes Oyster, Wash.)

4. § 144 Issue: Relate to suits against directors for damages or unjust enrichment like BOT? Agency

law controls. BOT defines duty:

a. (1) Section 144 of Delaware General Corporation Law provides a safe harbor for

interested transactions if the material f acts as to the directors relationship or interested

and as to the contract or transaction are disclosed or are known to the Board and the

Board, in food f aith, authorizes the contract or transaction by the affirmative votes of a

ma jority of the disinterested directors

b. (2) Corporate action may not be taken for the sole and primary purpose of

entrenchment

5. Distinguish: director deals FROM controlling SH (parent/partially controlled subsidiary) deals

§ 144 Issues with Ratification

1. Are Shareholder Ratification and Fairness Alternative Tests?? (Is or conjunctive or

dis junctive?)

2. Majority With Delaware Style Statute: No. See Fliegler v Lawrence (Del. 76)?? [But in Fliegler

there was not a disinterested ma jority of shareholders.]

a. If no, does valid ratification affect strength of f airness test?

i. No, unless disinterested votes in ma jority. Delaware Court effectively amended

the statute to look more like Ohios.

ii. If disinterested ma jority vote, use weaker test: BJR.

iii. In parent- controlled sub deal, then shif t burden of proof on ma jority of

minority vote but use entire f airness test. In Re Wheelabrator

6. Minority: Yes (Ohio: Statute Requires a Disinterested Shareholder Vote).

a. If yes, does ratification end inquiry?

b. Effectively, yes (hard to second guess informed, disinterested shareholder decision

when protecting disinterested shareholders).

7. Is Full Disclosure Required by the Fairness Test (as well as the Ratification Test)?? Fair

Procedure and Fair Price?? Majority: Yes (H ayes Oyster )

Shareholder Ratification1. Maybe Stronger than Board Ratification

2. BJR Applies: SH Ratification of director/officer related party transactions

a. BUT if wasted assets, unanimity required (Lewis)



88

3. Fairness Test Applies: Transactions between corporation and controlling SH with burden shif ted

(Wheelabrator)

Transaction Lawyer: Special Committee of Independent Directors

1. Composition: independent directors

2. Authority: full powers to decide, delegated by resolution of full board3. Charge: negotiate best price

4. Powers: may hire outside lawyers, banks and accountants

5. Effect on Standard of Review: Only shif ts burden to to show unf airness in controlled SH

transactions

The Duty of Loyalty1. Distinguish from Duty of Care:

a. (1) Sloth, inattention or stupidity

b. (2) Disloyalty, betrayal, personal benefit at firm expense selfishness c. (3) Care: s lose; Loyalty: s win.

2. Alternative Terms: Bad f aith, self-interested, self-dealing, conf licted, interested or related party

transactions; conf licts of interest

Corporate Opportunities1. Prevents: Corporate officers and directors from taking opportunities for themselves that should

belong to the corporation

a. Example of Property: May not use corp. property to develop own personal business

2. Distinguish: FROM related party transactions like In re Ebay (bribes not Cos)

3. Standard: interest or expectancy test; stronger line of business test (Guth)4. Expectancies: May not assume for herself property or interests in which the corp. is interested

or which the corp. could be said to have a tangible expectancy or which are important to corp.

business purposes

a. Corp. leases land cannot buy the land for self

b. If reasonably foreseeable corp. would be interested in property necessary expectancy

and if opportunities relate very closely to the business of the corp. necessary

expectancy

5. Defenses: Must be in good f aith

a. (1) Individual Capacity: s may claim opportunities were presented to them as

individuals and not through role in corp. b. (2) Corp. Unable to Take Advantage: if disclosed to corp. first, and cannot use, then

officer and director may use. Need heavy justification to show no finances.

c. (3) Corp. refuses: May take advantage of

6. Remedies: (1) Damages or (2) constructive trust

7. Competition with Corporation: May not use assets, property, materials, secrets to form

competition BUT



89

a. A fiduciary may leave corporation and form a business in competition occasionally the

conduct of the fiduciary while still with the corp. prior to leaving may be examined

Broz v. Cellular Info Systems: Financially Unable

1. Facts: hears of chance to buy company; wants to sell and tells in personal capacity because

Corp. was not seen as viable to purchase. 2. Issue: did usurp corporate opportunity?

3. Held: No, they were financially incapable of exploiting the chance to buy the land and was; not

clear that had a cognizable interest or expectancy in the license because their business plan

didnt involve any new acquisitions.

a. Emphasis that did not formally present the matter to the board of directors but

these are not required under circumstances where there is no interest, expectancy or

financial ability to pursue the opportunity

b. Came to Broz in capacity as individual not CIS director and CIS had no expectancy or

financial capacity

c. Same line of business; CIS CEO says that expectancy not there f ailure to act oninformal disclosure would be impeaching evidence

In re E B AY : Delaware

1. Facts: 1995 O and S found Ebay as sole proprietorship and in 1998 retained underwriters for

IPO, GS was lead and GS recommends to rewarded clients including directors of Ebay by

allocating 1000s of IPO shares at IPO price for HUGE profits.

2. Issue: Were allocations a corporate opportunity?

3. Held: Yes. Ebay was financially able to exploit the opportunity; was in the business of investing

in securities and had been their cash management strategy

a. Unique, Below Market Price: offered as a direct reward for their dealings with Goldmanb. Agent is under a duty to account for profits obtained personally in connection with

transactions related to the company; reasonable to infer that s accepted a commission

or gratuity from GS that rightfully belonged to eBay

Controlling or Dominant Shareholder Transactions 1. Situations: (1) Parent-Subsidiary and (2) Dominant individual SH founder, raider

2. Can SH favor interested while running firm: Yes, but must be done within NARROW bounds

a. Cannot be unf air to the minority

b. Cannot be due to bribe

3. Example: if a dominant SH deals with the corp. (contract) the deal will be closely scrutinized tosee that minority SHs are treaty f airly

a. Corp. loans a ma jority SH money scrutinize

b. Deals where ma jority had effect to make deal check to see good f aith and NOT to

the specific detriment of minority SHs



90

Sinclair Oil v. Levien: T he Standard

1. Facts: owns 97% of subsidiary stock in Sinven, involved in SA Oil; appoints all board and

officers and drains dividends from Sin to meet cash needs. All met limits by state law but

exceeded current earnings. charged for inability to grow.

2. Issues: (1) Fails to sue on breach; (2) paid excessive dividends and(3) didnt buy fields purchased

by other subsidiaries

3. Tests: Fairness to f ailure to sue, BJR for 2 and 3. Distinguish SELF-DEALING and f ailure to sue

from others even though - All decisions f avored controlling parent.

a. Fairness applies to ma jority SH issue with self-dealing to show that the deal with the sub

was objectively f air; f ailure to sue on contract from payment of healthy dividends and

from allocations of business opportunities

b. With dividend there was no self-dealing since parent didnt get something from the sub

to the exclusion or detriment of the minority they shared pro rata in the dividend

distributions

c. Expansion issue didnt usurp opportunities that would normally have gone to the

sub

Z ahn v. T ransamerica: Liquidation

1. Facts: owned class A stock two other classes B and preferred liquidation and preferred

gets sset and then A gets $2:1 ratio to B class. bought both A and B then converted A into B

and owned almost all of the B stock (A was controvertible). Book value of $6M and worth $20M

FMV. Unknown to SHs and called A shares then liquidated assets and paid itself remained.

claimed that had he been included in liquidation would have got $240 and not $80.

2. Issue: Can MSH use control over board to gain at the expense of the minority SH in a deal

where each step is performed in accordance with state law?

3. Held: Ma jority SH has a fiduciary duty to the corp. and minority the same as directors and

actions must meet good f aith and f airness tests.

a. Disinterested directors could have called the class A stock but here the directors were

controlled by the MSH

b. Directors owe fiduciary duty for the best interests of ALL of the SHs and only acted in

interests of MSH.

Mutual Funds1. Legal Structure of Mutual Funds: trustees fund is a statutory trust, not common law created in

the equity court

2. Trustees: elected by the owners no def ault rule by elections, they can actually appoint

themselves (like in NPOs)

o Investors Give Cash: want return on investment

o How to get cash + return: trustee hires an advisor who tells trustee what to do with the

cash and sends returns back

o Sponsors are also advisors and trustees hire them to give them advice they get money

from fees by advisor groups (Fidelity and Vanguard)



91

3. Index Funds: mimic the movements of the ma jor industries tell us where the markets are and

we decide where they are going

4. Closed-end funds v. open-end funds no redemption value

Jones v. Harris: Advisor Fees for M utual Funds

1. Advisor Fees In Mutual Fees: especially not in index funds the fees can get crazy big andridiculous; consumer advocates say investors get cheated by the fees

2. Investment Company Act of 1940: one of five acts passed to regulate securities af ter the Great

Depression (fees regulated in companies act)

a. Hedge Funds: not under the act because the number of investors is small less than 30

and go to very rich guys in small groups and are not considered investment companies

b. Mutual Funds: public investment funds

c. Structural Protections: 40% of trustees must be independent of the sponsors, that

group must be only group acting on setting fees

3. Advisors Regulated qualified, licensed, conf lict free

4. Supreme Court rules against Trustees by vacating and remandinga. Vacating is odd because District Court at first did exactly what should have been and

could have reinstituted that original opinion without remand

5. Gartenberg Standard: balancing test and just shill for judicial discretion

a. Look to process and amount if process progress

b. Less rigorous look at amount and vice versa

6. Circuit Court SHOULD have considered but threw out one of the KEY f actors the f actor that

the advisor and sponsor were affiliated with other funds and charged different fees for those

other funds they worked together with

a. Other fees were much lower than the ones they charged the s who brought suit

b. Evidence of fees in and out brings suit 7. Easterbrook-Posner argument based on bargaining power, if they didnt like them they could

have gone to another fund because they have to disclose all the fees to the investors and they

are not hidden

a. Easterbrook they can leave, can drive down themselves since there is full disclosure

shouldnt be allowed to sue

b. Posner I used to be market-guy, market now sucks because investors are not

protected; shocking to law-economics community; market is imperfect and these

investors must be protected from these affiliated and non-affiliated fees

8. Supreme Court consider all f actors, dont go down to the nitty gritty of Easterbrook dispute,

dispute from Posner-Easterbrook is one for Congress to decide

a. Punted on central issue to declare an imperfect or perfect market

b. Protection in the market is up to Congress

c. Preserve small procedural area for judicial review still look at a bit but defer to

trustees, almost like BJR (gross negligence standard?); maybe put BJR in but didnt

decide case officially



92

Securities1. Statutory Definition: 33 Act § 2(1); 34 Act § 3(10) Ohio § 1707.01 (title interests)

2. 1993 Act: Defines security very broadly as most passive instruments; if you sell the security to

the public, must go through a full registration process at a federal level involving the SECa. If didnt sell them to public find exemption to federal registration system and had

procedural and merit based exemption issues

b. Criminal and civil penalties criminal if sell a security which is not registered properly,

you can go to jail (if selling big security, not small listen for broadness and schemes to

get around it)

3. Once in broad net: (1) Register or (2) find exemption

4. Look to state laws on top of federal laws

5. Technical side of the side deal securities

Securities:Defined1. 1933 and 1934 Acts: do not agree; a technical difference

2. Ohio title interest only state that adds to federal definition, and doesnt just take it in

whole; title interests, which is real estate titles are added (split up real estate title among small

amount of people may have a security)

a. In Rem Property Interest: generally, outside of OH, is never a security

3. Specific Instruments: stock, notes, bonds

4. Catchalls: Evidence of indebtedness, investment contracts and any instrument commonly

known as a security

a. Trying to catch: passive investors (want peoples manage, who are not going to manage

the company who get investment back and return)

b. Partnerships active investors not securities

c. Surprises: worm f arming, condos, strips of orange grove, oil drilling rights, pyramid sales

schemes and scams

Sources of Corporate Capital1. Retained earnings how much capital of obtained in growth

a. By f ar the biggest way to capitalize a company

b. Tax incentives to retain earnings double tax phenomenon very strong tax incentive

to grow by retained earnings

2. BorrowMoney: cash for promises to repay plus interest

a. Bonds real estate, secured, earnings

b. Debentures unsecured, middle length

c. Notes unsecured, shortest term (security itself is only helpful if there is a def ault you

dont want it, youd rather the IOU)

d. Lines of credit and commercial paper house and business;



93

e. Commercial paper is alternative to line of credit but cheaper (legal notion execute a

document and the document itself has value document itself is transferrable and has

real value like a check)

i. Rules for the endorsement; fraud, etc.; legal rules that stand behind problems

with enforceable commercial paper

3. Stocks and Bonds Transferrability: § 8

a. Difference with check bearer paper (check) but stock and bond has books and

registration with endorsements (corp. is a player); issue bearer bonds then not a

player

b. Problems with Bearer Bonds/Stocks (illegal in US): money laundering since equivalent of

cash

4. Commercial Paper Special IOU issued by a blue-chip, highly rated companies (highly secure)

a. To issue must be qualified; AAA, very secure never been a def ault except for 1 (Penn

Central)

b. Reason so secure very short term (60-90 days must roll, pay original issuer and then

get another), very secure companies issue them

c. Roll: every 60 days interest rates i.e. treasury is higher, then buy a lot, then goes

down, worth much less; treasury notes very secure, no money made, no interest shock

d. Just as good as cash very liquid, very secure, little shock, sell for a lot; issuers of

commercial paper can use it as cash

e. Money market fund: no risk for individual only invests in commercial paper; no risk at

all and make very little compensate for inf lation and interest rates (BUY INDEX FUNDS

diversified)

f . CombineMoney Market Fund/Mutual Funds with Index Funds invest cheaply, go for

growth more in index fund and go for retirement more in index funds

5. 2008 Stock Market Crash: Lehman Brothers declared bankruptcy and had issued commercial

paper

a. Only One Money Market Fund Says: may have to bust the buck and lose money as

money market fund shocking

b. Busting The Buck: created the calamity because money markets were supposed to be

so secure and this wouldnt happen

c. Suggestion prop up money market funds; government does exactly the opposite with

bailouts and stimulus

Hybrid of Capitals1. Convertible option to change so if stock goes way up in value you dont just sit there with

none of gains

2. Convertible preferred can convert to common

a. Both for high tech companies

3. Stock options (warrants) put and call options are 3rd

party bets (original derivative); company

can get in the business as writer warrants with one exception if writing for CEO they are

compensatory options (bonus plans)



94

4. Redeemable bonds/stock options to repurchase

Debt Covenants1. When issue debt and IOUs to protect repayment there are many options

2. Self-help: collateral

3. Financial/Operational Commitments: limits on dividends, senior debt, veto on decisions

a. Can be in indenture that is not even in the IOU itself

4. Repayment terms: periodic payments

5. Guarantees: secondary liability (homes, cars, etc.)

6. Def ault Conditions: broad definition, acceleration of repayment obligation

a. Dont make an interest payment clearly def ault

b. Many others: business goals, def ault on someone elses interest payment (then def ault

on mine too)

c. When def ault get principle back right now, this moment; acceleration clauses hit

insolvency immediately

d. When def ault any one of debtors can put you in bankruptcy but they dont they

want to work out of a deal; bargain over Chapter 11 because no one wants it

Stock 1. Problem of dilution control: effect on existing shareholders

a. Dilute percentage of ownership af ter youve paid the money and you understand that is

the price

b. How do you protect against dilution: pre-emptive rights (whenever they issue new

shares you get a piece of new shares equal to the percentage Issued of what you

hold); Can put in contract rules that prohibit watered stock, stock issued for less than

FMV

2. Private/Public

a. Private: private offerings venture capital, etc.

i. Hardly any regulations

ii. Hedge funds

b. Public: public offerings

i. Meet § 12 of Securities Act - > 300 OR IPO > belong to ma jor market

ii. Heaviest hit by regulations on securities

iii. Mutual Funds

Importance of Defining Securities1. Registration requirements: the definition indicates whether the registration requirement of the

Sec. Acts apply to the transaction

2. s: generally have easier time bringing suit under federal securities laws than under state

common law fraud rules because elements of federal securities are easier to prove

3. 1933 Application: offer or sale of a property interest must constitute the offer or sale of a

security to apply



95

4. Three Categories:

a. (1) Any interest of instrument commonly known as security: stocks, bonds debentures,

warrants, etc.

b. (2) Types mentioned specifically in the Act: preorganization subscriptions and fractional

interests of oil, gas or minerals

c. (3) Investment contracts and certificates of participation: broad and catchall (Howey

Test)

Four Part Howey Test 1. Critical Test: everywhere except in OH (where we have our own test from HI)

2. Facts: orange grove, didnt want to sell securities, so sold strips of the grove and could buy the

strips; problem oranges on those trees were not yours, the profits came from selling juice to

the public; had option to get into the processing deal, which would take slice of the profits

based on % of strips of land owned

3. Held: this is a security you dont have a % of ownership in property, you have a security 4. Ask: An investment contract is any K or scheme whereby a person invests his money in a

common enterprise and expects to make a profit solely on the efforts of the promoter or a third

party responsible for management.

a. (1) is it a profit-making venture?

b. (2) is the investor passive in management?

5. Howey Test:

a. (1) Investment of value to get money back

b. (2) In a common enterprise selling orange juice together, pooling requirement

c. (3) With an expectative of profits - return

d. (4) Solely (not largely) from the efforts of others picking, selling, marketing andprofiting from the efforts of the f arm

6. Glynn: is he a passive or active investor?

a. Application (1) Member-managed or manager-managed?

b. Member: Presumption to Member is not a security;

c. Manager: Presumption to Manager it is a security and must overcome on the f acts

d. Glynn: overcomes presumption even though it was manager-managed; it was not a

security

7. Trend Towards Expansion in Decisions: Expansion of the word security now covers situations

where investors do participate in management and the form of benefit derived by the investor

may be something other than cash profits

a. Mentioned: (1) Is the property interest one that is specifically mentioned in the Act?

b. Commonly Thought: (2) Is the type of interest commonly thought to be a security?

c. Profit-Making: (3) Is it an investment contract or a participation in a profit-making

venture? Benefit of substance to investor? Third party management?

d. Need: (4) Is there a need for the protection of the Act? Is there an investment so that

investors need the protection of full disclosure?



96

8. ExamplesHeld as Securities:

a. Interests in Land

b. Pyramid sales plans

Bypass the Howey Test

1. Initially required: purchasers must perform some minor management duties like filing reports but investors dont assume the ma jor duties normally required of a person buying a franchise

2. BUT Substantial Control: even these plans have been held to involve securities and now the test

no longer requires total management passivity but only substantial control

3. Not Only Cash Benefit: may be any economic benefit as property interest

Registration1. Registration: prior to IPO must file.

2. Purpose: to disclose all info possible to decide if sound investment

3. Prospectus: most important info is in shorter document given to a purchaser prior to buyingor at some time delivered

4. MaterialRequired:

a. SEC exercises broad discretion over what is put in the statement

b. Financial info about issuer is a very big part and must be disclosed

Private Placement Exemption to Registration1. 1933 Act Allows: certain exemptions from registration in § 5 (e.g. issues by banks or guaranteed

by the US); certain deals are also exempt (e.g. deals without an IPO private offerings are

exempted from registration under § 4(2)

2. Private offerings under § 4(2) 3. Fact Q uestion: to decide if private or public offering

a. (1) need for protection;

b. (2) Access to investment info sophistication of offerees

i. for private must show that offerees were given or had access to the same kind

of info that would have been contained in a registration statement

ii. Must be allied with or have CLOSE RELATIONSHIP with issuer and management

c. (3) Distribution of Material info: implied that the mere access to material info is not

enough may have to actually distribute to the offerees the same type of material in

registration and may even have to give additional info if requested by private firm

d. (4) Number of offerees: fewer in number generally not ma jor f actor but RULE OFTHUMB is > 25 = IPO but now it is more like > People = > Chance of Public;

e. (5) Dollar amount of offering

f . (6) Marketability of securities smaller denominations greater public

g. (7) Diverse group rule more unrelated to each other, the more chance of public

h. (8) Manner of offering manner in which the offering is made (advertising?)

4. New Regulations: (1) Integration; (2) Info Requirements; (3) Manner; (4) Resale limits



97

Doran v. Petro M anagement: Public or Private?

1. Facts: PMC was LP with oil; Advised by securities broker of chance to become special

participant in drilling and puts in put in $25K of $125K rest down under note by MCS and

sends info periodically; overproduced in violation of allowances. Seal property. Def aults and

loses money.

2. Issue: Private or public?

3. Held: No registration was filed in connection with the offering. Look to f actors. Size was only 8.

BUT relationship between issuer and offerees

a. Information available to the offerees by virtue of special relationship clearly

establishes that and were both sophisticated but had special knowledge it did not

disclose to

b. If the investors do not possess the info required for a registration, they cannot bring

their sophisticated knowledge into play to determine if to invest

c. Availably of info means either disclosure or access to the relevant info relationship

may be most important

The Successful High-Tech Start-Up

1. Resales are NOT Exempt except for 504s and need second exemption to resell Rule 144

(trickle out)

2. Birth: founders, 100% equity personal savings, credit cards (but new bankruptcy laws)

3. Private Placements of Equity (1933 Act Exempt)

a. Seed Money: friends, f amily and angels (founder 70%, equity worth $300,000, firm

value $500,000)

b. Venture Capital: 3 to 5 rounds of financing from VC funds (private equity markets)

founder 40% equity worth $4M, firm value $10M (invest in 20 companies with hopes of

1 making it big means they must take a lot of equity in all of the companies, so when

that one hits it will pay off the losses)

4. Goal: to get out of the equity market and into the debt market by establishing income stream

5. Go Public (IPO): sell 20% or more of the equity to public in a Register PO under 33 Act

a. Dont go public unless worth more than $100M jackpot this market $500M

b. Founders problem: how to retain management control? Turn stock to cash? Trickle out.

Regulation D: Safe Harbors Exemption1. Defined: Ma jor initiative was to help small business grow with 501-506 and new definitions only

apply to issue, the control persons may not use them

2. Purpose: to simply and clarif y existing exemptions, expand availability of exemptions and

uniformity between state and federal exemptions

3. Four Conditions to be Met:

a. (1) Integration: All sales that take place at least 6 months before start of or six months

af ter the end of the Reg. D offering as long as there are no offers and sales of same

securities (aside from pensions) within either 6-month period



98

b. (2) Info Requirements: 505 or 506 then specific disclosure to ALL purchasers is required;

Type of info depends on nature and size of offering. Must also give investors the chance

to ask questions and get any info the issuer can get without unreasonable effort Only

under 504 or sells under credited investor then Reg. D doesnt mandate specific

disclosure.

c. (3) Manner of Offering: Use of general ads or solicitation in connection with Reg. D is

prohibited unless in certain 504 cases see 502(c)

d. (4) Limitations on Resale: With exceptions of certain 504 offerings, have status of

securities acquired in a transaction under 4(2) of the 1933 Act 502(c) issuers must

use reasonable care to assure that buyers of these securities are not UWs and to make

reasonable inquiry as to an investors investment purpose; legend restricting transfer

must be placed on the share

certificates.

4. Form D: Uniform notice of sales

form for use in 4(6) and Reg. D

offerings give info on Form D with

checklist within 15 days af ter first

sale in Reg. D; then every 6 months

af ter first sale and 30 days af ter last

sale.

Exemptions on Lower Priced

Sales1. Rule 504 Sales Less than $1M:

Section 3(b) of 19

33 allows sales >$1M during any 12-month period

(SA 504); not available to investment companies or to 1934 Act reporting companies

commissions or similar remuneration MAY be paid to those selling the offering in a rule 504

offering

a. Rule 504: Does not mandate specific disclosure BUT issuer is subject to antifraud and

civil liability provisions of the fed. Sec. laws and MUST comply with any applicable STATE

requirements

b. If whole offering is in states with registration requirement: and the offering is in

compliance then the general rule of 502(c) (manner) and (d) (restrictions) do not apply

2. Rule 505 Sales Less than $5M: Under 3(b) of 1933 Act allows any number of ACCREDITED investors and to no more than 34 NONACCREDITED investors for sale of $5M or less available

to any issuer that is not an investment company

V enture Capital1. Goal: get income f low to begin selling debt; must have some type of equity to begin selling debt

and stop selling equity then final goal to sell equity into the public market



99

2. Controversial: the 20% that comes out to manager thats where the traders make the money

3. Convertible Preferred Stock: takes first cut and then residual cut from the equity pool

convertible into common and also loads; unusual preferred stock usually preferred stock is not

convertible, just get first cut

4. Downside Protection: voting rights, veto rights, dilution protection if sell equity to someone

else, redeemable in 5 years (get out or death knell so can kill the company if dont work with

them)

5. Upside Protection: Liquidation rights, registration force a portfolio company to go public if

they dont want to sometimes (manager taking 20% - taxed as capital gains now; Obama tax will

tax normal at 39%)

a. Government would be taking cash away from the managers at the margin, make VC

funding more expensive and less prevalent

6. Venture Capital in Ohio: state government in Columbus because most VC are on both coasts

created VC through citizens vote Third Frontier (add to it)

7. Alternative Investment Pools: VC, Hedge funds, etc.

a. Hedge fund: only difference is duration; hedge fund

wants to make money in 2-5 years, while VCs want to

make money in 60 days

Private Placement Exemption1. Graph above 2 private placements: (1) Investors investing in VC fund

and (2) VC fund investing in the company

2. PP Exemption: Dont have to go through the full exemption process with

the SEC, wait, etc. (very important for small business)

3. Statutory 4(2) Exemption: Ralston Purina Test

4. Reg. D: Rules 504, 505 and 506 safe harbors

a. 504 - > $1M

b. 505 - > S5M (35 + accredited investors), no ads

c. 506: 35 sophisticated plus accredited investors, no ads

5. Disadvantage: resales are not exempt (but some 504s) need a 2nd

exemption to resell rule

144 (trickle out rule)

a. If Private Placement: everyone who invests and gives money, the investment contract

cannot be sold unless the reseller itself has another private exemption (such as Rule 144

but only trickle it out as constrained by the rule)

b. Hardest on the founders because equity they got is subject to this rule and until they

do the IPO there is no market and if resell it have to take note to have another

exemption

6. General Practice: Combine 4(2) and Reg. D

a. Private offering memo: record recipients of memo; prefer accredited investors

b. Investor meeting: info with scripting meeting; sign statements by investors

c. Legends on stock certificates



101

2. File registration statement with SEC: waiting period of limited offers and no sales felony if do it

o Go on the road (road shows)

3. SEC: effective distribution period (offers and sales with delivery of prospectus)

o Declaration declared to be effective

o Everyone who buy stock during primary distribution period must have this prospectus

o When distribution period is over start the secondary trading on the NYSE, etc.

4. Key to process: protect the exclusivity of the prospectus during and until the distribution period

cannot buy and sell without a prospectus

5. Goals to Regulation:

o All buyers in distribution receive prospectus on sale or confirmation of sale

o Distribution over: secondary market trading like NYSE without prospectus delivery

requirement

6. Liability of Participants Offering Firm, UWs and Individuals

o Defective Public Offers § 12, 33 Act no registration, not exempt (invalid private

placement) and

defective offering

process

o Fraud (material

misrepresentatio

ns or omissions):

§ 11, 12 and 17 of

33 Act and Rule

10b-5 of the 34

Act

Securities:Liability

1. Common Law: a

defrauded purchaser

had to prove same thing

to recover for any other

good; now can recover for material misstatements and omissions in an effective prospectus

unless the s can show they had reasonable grounds to believe and actually did believe that the

statements were accurate

2. Materiality: must prove that it was actually material f act

3. Persons Subject to Liability: § 11 says that

a. (1) anyone who signs the registration statement (including people who MUST issuer,

CEOs, CFO, accounting officer and ma jority of board of issuer);

b. (2) Director of the issuer;

c. (3) Named with his consent as about to become director;

& choi pritchard securities regulatio

Section 12(a)(2) MisstatementsC/L \ 10(b) \ 11 \ 12(a)(1) \ 12(a)

Materiality

State of

Mind

Reliance

Causation

Damages

yes

yes

scienter

yes

yes

unlimited

yes

yes

scienter

transactioncausation

loss causation

unlimited

yes

yes

strictliability

tracingr equir ement

(losscausation)

off eringprice

no

no

strictliability

no

no

r escission

yes

yes

(negligen

no

(losscausati

r esciss

Misstat. or

Omission



102

d. (4) Any expert who gives certification that part of the registration statement was

prepped by him (accountants, etc.);

e. (5) Every UW involved

f . (6) Controlled persons people who control any other person listed above SA § 15

4. Key Practical Issue: Law firm should be very interested in what partners are doing because the

law firm itself and board of directors may be liable for it; can get malpractice insurance but

there are of ten rider for securities to not insure you for it

a. Why dont insure it? Cant assess the premium, cannot assess the liability so of ten

exclude environmental and securities liability because cannot predict what judges will

do

Private Securities Litigation

Reform Act 1. 1994 Contract of America Legislation put

in to reign in Clinton2. Key: to try to reign in strike suits

3. How: if you are on the private side and bring 10(b)5 lawsuit,

you must plead scienter (particularity) with particularity, must show

in the pleadings why there was scienter so that means that you can

throw a lot of these out for Rule 12(b)(6)

4. Key Provisions apply to Section 11 but not Rule 10(b)5 on slide

Elements in Section 11 Action

1. Privity of Contract not Required: Anyone buying a security that was subject of a defectiveregistration may sue under § 11 but there is a tracing requirement so that the must be able

to trace the securities bought back to the defective registration statement

2. Reliance: need not prove relied on misstatement or omission in order to recover BUT if the

issuer sends out an earnings statement covering period of 1 year af ter the effective date of the

registration statement then a person buying it af ter that must prove reliance to recover

Section 11: Defenses1. Issue Defenses:

a. (1) Show were true

b. (2) Show immateriality c. (3) Show knew of them and bought the securities anyway

2. Distinctions: Non-issuers can get due diligence excuse but issuers cannot

Non-experts in Section 11

1. Standard of Diligence: Must meet test and (1) actually believe statements were true and that

belief must be reasonable



103

a. With reasonable investigation; look at each based on position, skill, background,

responsibilities, training and access to info to determine if a reasonable investigation

was made

b. Goes Beyond just trusting: and respecting the responses and opinions of the issuers

officers as to material f acts

c. Includes: original written records,

verif ying f acts and statements in the

statement and would probably

examine f acility, ops, material

contracts, minutes and other

documents and items material to

financial status

3. Portions of Registration: Attorneys

a. Nonexperts For attorney-director of

issuer who draf ted registration

statement for the issuer to be

nonexpert as to registration

statement

b. Expert: May be conceivable that

attorney may be requested to examine, certif y, as an expert, some portion of the

registration statement in that case, he would be held to due diligence test of expert

c. Inside Directors and Principal Executive Officers: Must meet standard of due diligence

required by nonexperts

4. Reviewing Statements of Experts: lower standard of care and non-experts are entitled to rely

to a greater extent on the ste statemens made by experts (outsider director relying on

accountants financial statements, e.g.)

a. Nonexpert MUST: (1) did not think they were untrue and had no reasonable ground to

think they were f alse no need for investigation

b. (2) s usually meet burden: BarChris

General Civil Liability under the Act § 121. Fraud: Prohibits fraud generally if sale or offer and anyone who offers or sells a security by

the use of any means of interstate commerce and makes an untrue statement of material f act or

omissions in connection with and who cannot sustain the burden of proof that he didnt know

and in the exercise of reasonable care could not have known of such untruth is liable to the

buyer.

2. Privity Requirement: Must be arms length may only sue the seller from whom she purchased

the security

3. Persons Liable: Only people offering or selling security can be liable

a. Issuers, dealers and maybe control people can be liable but others in registration

process like directors, accountants would not be)



104

4. Liability Standard: is held for intentional of negligent violations has burden to prove non-

negligence

a. (1) Privity with

b. (2) has violated one of the privisions of Section 5 and she can recover

c. (3)No need for reliance, causation and scienter

5. Damages: Consideration paid with interest MINUS the amount of any income received on the

securities OR for damages if the purchaser no longer owns the security

Experts and Section 11

1. Statement Test:

a. (1) Must ACTUALLY believe that they were true

b. (2) Belief must be reasonable

c. (3) Reasonable belief comes from investigations perform at least standards of his

professor (accountants in certifiying that financial statements of the issuer are prepared

according to generally accepted principles of accounting, e.g.)

Rule 10b-b Fraud1. Rule: Unlawful in connection with the purchase or sale of any security for any person, directly or

indirectly by the use of any means to:

a. (1) employ any scheme or device to defraud

b. (2) make any untrue statement of material f act OR to omit a material f act necessary in

order to make the statements made (circumstantially) not misleading

c. (3) engage in any act, practice, or course of business conduct which operates or would

operate as fraud or deceit upon any person

2. Transactions Covered:

a. (1) Purchases and Sales can be either buy or sell

b. (2) Remedies: security must be involved

c. (3) Securities: a security must be involved in some way broad application

d. (4) Jurisdiction: interstate commerce must be involved or MEANS

e. (5) Statute of limitations: not applicable

f . (6) Liable parties: broad to application ANY person CONNECTED WITH a securities

transaction so accountants and lawyers and others involved in some way with a

securities deal may be liable

Elements of 10b-5 Fraud

1. (1) Fraud, Deception, Misrepresentation, etc.: Must be fraudulent act that has ACTUALLYoccurred

a. Insider Concept: Two elements to an insider (1) must have a relationship that grants

them access to info intended to only be for a business purpose and not for personal

benefit of anyone and (2) must be inherently unf air where party takes advantage of

such information knowing it is unavailable to those he is dealing with

2. (2)Materiality: Material f act



105

a. Reasonable person standard: whether a reasonable person would attach importance

to the misrepresented f act in determining his choice of action in the deal in question

b. Probability balanced against magnitude: high probability likely will occur or high

magnitude of occurrence will be clearly material

c. Totality of Facts: under whatever test use all f acts to see if info might reasonably

inf luence conduct

d. Examples: intention of a company management to pay a dividend or a significant drop

in the profit level of the company

3. (3) Reliance: relied on f act to make decision; actual with effect on market; act different if know

f acts; Trend towards abolishment

a. Two Cases: (1) Actually relied OR (2) Effect on market may allege that s statements

affects the market price at which the sold his stock; would need not argue reliance

4. (4) Causation: s action must have caused the s injury. E.g. misrepresentation caused the

drop in the price of the stock; necessity is also trending to disappear

5. (5) Scienter: A material misstatement or material omission of a f act necessary to make revealed

f acts not misleading runs afoul of 10b-5 if defendant intended to defraud, knew he was

defrauding, or was reckless with regard to the possibility that he could be defrauding

a. Mental state embracing the intent to deceive, manipulate or defraud BUT

b. Other courts have held recklessness to apply

c. Supreme Court must be shown in injunctive actions brought by the SEC

d. Private damage and SEC injunctions reckless couduct may also qualif y under 10b-5

e. IF SEC is there is no Scienter

6. Remedies:

a. (1) Rescission: take deal back and restart in place came from

b. (2) Damages provide restitution e.g.

restore what lost (reasonable period

of time?)

c. (3) Unlimited Liability unsettled if

can be held for unlimited amount

d. (4) Punitive none



106

Escott v. Barchris Construction

1. Garden variety financial fraud like Enron

in small case

2. Facts: Barchris sells bowling alleys to

athletes, then take back a note under

Art. 9 if real estate note, its a

mortgage (goods v. real estate); then

Barchris has cash problems and sells the

IOUs from the bowling alleys to Talcott

(f actor) and he gave back cash

3. Misrepresentations:

a. (1) Amount of sales backlog

b. (2) Contingent liability to Factor guarantee to repay

c. (3) Loans repaid

d. (4) Use of proceeds lied about what they would use for bailing out bowling alleys

theyd already sold stuff too

4. Problem: bowling alleys start to def ault on the loans then Barchris needs money from

debenture investors to pay of the notes

a. Def aults owe to people then take over and register sales to self (which you cannot

do) so revenue statement looked acceptable

5. Fraud: selling debentures to the public and were making a public offering of debentures (f airly

unsecured debt instruments on short-term)

6. Young Lawyer: hit by red f lag test and lost reasonable investigation test even though he was a

non-expert in a non-expertise situation; two key problems:

a. (1) two contracts should have been read the f actor contract more closely at the

guarantee that if money was lost had to pay guarantee (cannot pay off guarantees

because he does not take the full risk definition of ownership off-balancing

financing) hiding debt with independent guarantees to f actors

b. (2) Sales same types of guarantees to sell a bunch of stuff ; have trouble paying, we will

pick up payments and buy the bowling alleys from them off-balance sheet financing

their our sales

Securities and Fraud1. Factor someone you sell obligations to

2. Channel stuffing inventory channeled down to buyers you control and setup to look like sales to

outside buyers on balance sheet even though they arent getting money back from it

o Dealing with self and lying about it OR dealing with 3rd

party and lying about risk

Fraud in the Markets1. Common Law (State Law): Shareholder to Shareholder traditional fraud

o Reason why works complexity and misunderstanding; superseded by federal now



108

o Duty to inform at annual meeting? Ohio § .38 is very broad

o None unless SH vote needed (Malone)

o State Blue Sky Law exemptions

2. Federal Law: Very heavy Mandatory Disclosure Rules Publicly-traded, wherever Incorporated;

o Periodic filings of financials: quarterly earnings reports audited forms of 10-K (cannot

lie)

o Episodic filings Events: 8-K (mergers, lose accounting forms); S-1 (IPO Filing); and 14d-1

(tender offer)

3. Voluntary Disclosures (CEO Statements): Duty to be accurate

Policy Debate

1. Mandatory Disclosure

o Cons: (1) firms would disclosure voluntarily anyway and that stuff would be more tailored

to what market really wants and then (2) enforce anti-fraud rules we have

Incentive to disclosure negative information? Accurate for fraud rules?

o Pros: More info

2. Contours of Private Actions for Disclosure Violations

o Con: Strike suits legal extortion

o Pro: Private attorney-generals can supplement government where no time

Basis Elements of Fraud: Rule 10b-51. Misstatements or omissions of a:

o (1) Material f act with (TSC Industries, Basic)

o (2) Scienter (Intent to Deceive Hochfelder) plead with specificity now

o (3) In connection with the purchase or sale of securities (Blue Chip Stamps) includes stock options like Deutchman (must be

buyer or seller cut out people who would

have bought or would have sold); does it

include derivatives and swaps? Big new

question SEC says YES now. A swap is a

security completely neutral third party

bet on anything (interest rates, life of CEO,

life of company, etc.)

o (4) Upon which relies but see

presumption of reliance in Basic if firms securities publicly-traded)

o (5) Reliance was proximate cause of injury

(lost causation)

Types of Actions1. Criminal DOJ

Rule 0b-5

Face-to-Face Fraud in Secur ities �

ransactions (br other buys sidling¶s stock in a f amily cor poration)

Fraud in the Pr imar y �

rading Mar ket: ± Fir m/Shar eho lder

�

ransaction s (Pr im ar y Mar ke t Sales

(Placemen ts o r �

istr ibution s); Secur ity Repur chases

( � egotiated; Sel f -

�

ender ff e r s)

Fraud in the Secondar y �

rading Mar kets ± Mar ke t Manipu lat ion (i.e .,

o sho rt, start bad r umo r s, close

position ; o long , f alse ly tou t, close position )

± Insi de r �

rad ing/Misappr op r iat ion



109

2. SEC can prosecute can be in Fed. Ct. or in Agency Actions

3. Private Actions by Investors implied under 10b-5 and express in § 16 (34Act)

Elements of Rule 10b-5

1. When is f ailure to disclose actionable must be under a duty to speak: SEC Filings, mandatory duty to disclosure; voluntary statements, duty to be accurate; insider trading

o (1)Materiality

probability X

magnitude test to

determine if material

o (2) Scienter Ernst and

Ernst

o (3) Reliance or

Causation

o (4) Standing 2. Rule 10b-5 Elements Change if SEC is

o No scienter

o No standing problems

o Enhanced remedies

Materiality1. Puffery: vague statements of optimism by company officials are immaterial

2. Bespeaks Caution: read in context

3. Zero Price Change: price of security doesnt drop when truth revealed

4. Trivial: only effect small % of total firm sales/revenues (exceptions for lies of the CEO presumedto effect and not be trivial)

5. Truth in the market: if market already knows truth, then new lie isnt material

Materiality Problems

1. Internal Forecasts: Do I have to tell everyone internal ideas of what business will be like?

2. Sensitive Business Info: like merger dont want to tell the world you are negotiating, what to do.

Scienter1. E rnst & E rnst : intention to deceive

a. Only Private Actions b. Inference from Recklessness??

2. Pleading: Private Securities Litigation Reform Act of 1995. State with particularity f acts giving

rise to a strong inference of scienter.

a. Is pleading motive and opportunity enough??

3. Possession (Trading while in possession of) Versus Use (Trading on the Basis of) See Rule 10b5-1

(possession test with exceptions)



111

b. Example- Widow SH asks director before a board if company would pay dividend and he

showed her financials and said didnt know; he then bought her stock for $1.25 and

declared $1 per share dividend three days later director was liable

4. Special Circumstances Rule: Number of courts took position that a duty of disclosure is owed

only if there are special f acts or circumstances making nondisclosure unf air

a. Example Strong v. Repide director and pres. And 75% SH use strawman to buy

minority interest knowing that government would buy company property had duty

of disclosure

5. State Law No Duty to Disclose unless special f acts in Goodwin v. Agassiz

SEC v. T exas Gulf: M ateriality and Probability

1. Facts: TGS conducted exploratory activities in eastern Canada. These operations resulted in the

detection of a significant amount of commercially mineable ore. Rumors of the ore strike began

circulating throughout Canada. TGS issued a press release denying having struck ore and stating

that the rumors were only speculation. Between the time of the press release (April 12) and the

dissemination of the TGS official announcement (April 16), two of the defendants purchasedTGS stock as the mining industry journal article was published, statement to Ont. Min of Mines

and US Finance Media released. . April 13 press release drilling inconclusive but stock goes to

30 because info was seeping out that they pulled some good stuff out

a. April 16 Release to media they found largest copper mine in all of North America

timeframe from 9:40-10:54 am.

2. Questions:

a. Coates: lef t TGS Presser and buys shares at 10:20 liable? Yes, because market must

have time to disseminate info which was done at 10:54 am when ran on ticket

b. Call Options: if client buys call options who usually doesnt buy them at all, he is doing

insider trading use them for leverage because for $1 in stock but if option on 10,000shares is $1 because for each share I buy I can get leverage on stock price

3. Held: Basic test of materiality is whether a reasonable person would attach importance to the

information in making decisions about the deal.

a. Need not be conservative one in sense of f acts solely by measuring effect knowledge

would have upon prudent and conservative investors (may be risky)

b. Test encompasses any f act that in reasonable and objective contemplation may affect

the value of the securities

Insider Trading: Duty to Disclosure and Questions to Ask

1. What was the injury to the people who sold their shares:

2. Who are the insiders? directors, Sr. employees and in some cases (like man who pulled out

sample of copper) can be an insider ONLY if there was a confidentiality agreement with employer

and anyone these people tells

3. Information is material? Must be was discovery of hole material YES.

4. Trades? Purchased stock and calls on stock.

5. Latent Issue: is possession alone enough or must it motivate the trade possession is enough.



112

Critical Question in TX Gulf Sulphur

1. Assume that af ter find copper TGS had to buy land for mine what do they have to tell the

f armer who owns the land? NOTHING, just cannot misrepresent, however:

2. Why is what TGS has to tell f armer different from what insiders must tell SHs when insiders

purchase shares? He owns the land, could have found it himself .

o Fruits of his labor not the f armers; but why not fraud by omission?

o Essence of capitalist system: the incentive to discover something, do something for

yourself so you can benefit for yourself

o Law: no need to tell f armer but cannot tell f armer there is nothing on your land, dont

worry; if f armer asks why are you buying borderline?

o Difference between SHs and telling f armer? Fiduciary duty to you, if there is not a

fiduciary duty (like f armer) then it is ok

Dirks v. SEC: T ippers and T ippees

1. Facts: was officer in firm to give investments to insurance company securities to investors

info on EF due to fraud were grossly overstated and investigated many regulatory f ail to act

and EF says he is right. No one published the articles, etc. talked with clients about it and

they sold shares. EF plummeted as fraud shows up and is investigated.

2. Issue: Is a tippee always under an obligation to disclose inside info before trading or to refrain

from trading?

3. Held: No, tippees inherent the insiders duty to SHs to disclose material, nonpublic info before

trading to not trade ONLY when the info has been IMPROPERLY disclosed to them by the insider.

a. Cannot impose duty just because someone knows something

b. Test: will the insider receive a direct or indirect personal benefit from the disclosure, if

the insider doesnt stand to personally gain he has not breached his duty to the SH and

there can be no derivative breach by the tippee

Insider Trading: Potential s1. Insiders: Senior Executives, Directors, Controlling SHs

2. Quasi-Insiders: Temporary Insiders Professionals (UWs, Investment bankers), accountants,

lawyers, consultants who get info with an obligation of confidentiality

3. Tippees of Insiders or Quasi-Insiders: or other tippees

Tipper/Tippee Liability (Dirks)

1. Why was Dirks not liable as a Tippee of Secrist (insider officer of equity funding)?

o Dirks liability is derivative of Secrists liability problem with tippor and tippee becausehe gave him information without any motivation for PERSONAL GAIN

o In tippee and tippor relationship must know that Secrist is breaching (1) fiduciary duty

AND (2) doing it for personal gain directly or indirectly with a (3) personal gain

2. Personal Benefit:

o Secrist was just a whistleblower not doing it for personal gain doing it out of good

f aith and that was difference



113

o Must usually be: Pecuniary gain, reputation benefit that will generate future earnings, gif t

to fried or relative

3. From 1934-1967 insider trading was illegal in US Japanese are forced to adopt but does so

without tippor/tippee liability: not universally illegal except with US pressures countries to do it

Aftermath of Chiarella/Dirks1. Chiarella: Employee of printer handling corporate takeover bids who deduced target companies'

identities and dealt in their stock without disclosing knowledge of impending takeovers, held

not to have violated 10(b) of 1934 Securities Act (15

USCS 78j(b)) and SEC Rule 10b-5.

2. Misappropriation Theory: A person commits fraud in

connection with a securities transaction and violates

10(b) and 10b-5, when he misappropriates confidential

info for securities trading purposes, in breach of a duty

owed to the source of the information.

a. Liability: premised on traders deception of

those who entrusted him with access to

confidential information not fiduciary duty;

duty is owed not to other trader BUT to the

source of the information

b. Requirement: Deceptive conduct in

connection with securities transactions

MUST involve deceptive device (f ake identity while secretly getting info from

confidential source for personal gain)

i. If had disclosed to source that he planned to trade on this nonpublic info,

there would be no deceptive device and no violation

3. SEC Rule 143-4 Tender Offers: Prohibits fraud in connection with a tender offer given

authority to prescribe means reasonably designed to prevent, such acts and practices as are

fraud.

a. Rule 10b-5 covers all misappropriation cases

4. No More Selective Disclosure: open to all market professionals

5. Secondary liability: catches professionals in aiding and abetting and conspiracy

a. Answered in Central Bank of Denver (1994) no aiding and abetting in private civil

actions

6. Strike Suits: Hurdles erected in PSLRA of 1995

Duty of trust or Confidence: Rule 10b5-21. Person Agrees Explicitly to Maintain Confidence

2. Recipient Knows or Reasonably Should Know that Confidence is Expected by Tipper

3. Info from spouse, parent, child or sibling, not confidential unless knows or reasonably should

know of expectation of confidentiality



114

4. Questions from OHagan: If Burglar Breaks into Dorsey, steals information and trades, breach

of Rule 10b-5?

a. Deception required; none from burglar; Would breach Rule 14e-3, however.

5. If OHagan tells Dorsey he wants to trade and Dorsey does not object, breach of Rule 10b-5??

a. No, Breaches Rule 14e-3, however. [Odd language from the ACLU Justice.]

6. Whats left for eavesdroppers?

a. Shadow Traders: Can broker shadow trade on Warren Buffetts purchases?

b. Assume he is a client: No.

c. Assume broker is an eavesdropper: No.

d. Assume a janitor, eavesdropper: Yes, if not explicit duty to remain confidential and

information is given in trust.

SEC Safe Harbor: Rule 10b5-1 Plans

1. On the Basis: Not trading on the basis of inside info IF

a. Insider has adopted a written plan before becoming aware of information

b. Written plan should specif y mechanics for period deals

c. No subsequent inf luence

d. Good f aith and not scheme to evade liability

Congr : Enf or nt t t t (34A t § A, A & )

In ider Tr ding S n ti n Act f 1 4 SEC can impo e tr eble damage fine , plu disgor gement (4x).

Insider Tr ading And Securities Fr aud Enf r cement Act f 1

± ounty Hunter Pr visi ns (10%) ± Contempor aneous Tr ading, Private Plaintiff Class (also

covers Rule 14e 3) §20 A

± Contr olling Person Liability ($1 M or tr eble damages)(br oker age fir ms)

Private Securities Litigation Ref or m Act of 1 ± Lead Plaintiff Substitution (lar gest financial inter est)

± Specific Pleading Requir ements

± Settlement Notice & Damage Allocation



115

Shareholder Derivative Suits and Indemnification

1. Derivative Suits: State statutes govern extent to which the corp. may properly indemnif y its

officers for expenses incurred in of suits for conduct in official capacity; apply to both derivative

and direct exclusive basis for indemnification

o Demand on SHs?o Right to jury trial?

2. Court approval of settlement (or voluntary dismissal): Ellison settlement in CA derivative litigation

3. Recovery of attorneys fees: Benefit to Corporation standard

o Non-monetary awards consent decrees with injunctions against future violations and/or

structural relief

Indemnification1. Mandatory v. Options: Discretionary

o

Statutory: mostly discretionary with the board but under some statutes

the corp. must indemnif y the Ds and

Os when he is successful on the

merits in of derivatives.

o Ex Post DE: right is subject to a

judicial finding that his conduct f airly

and equitably merits such indemnity

o Ex Post (optional board of directors

hires attorney and pays advances

that is unsecured)2. Mandatory: Successful defense § 145(c)

3. Contractual Option ex ante becomes

owed in ex post

o optional ex ante firm will indemnif y to the full extent allowed ex post; § 145(f) BUT requires

board to indemnif y if able to

o Good Faith: good f aith finding required to extend

Ex Post Indemnification1. Ex post good faith (DE); as long as the D or O wins on the merits, there is usually no problem;

o DSCC § 145(c) required indemnification expenses in connection with the of any action as towhich the indemnification is successful on the merits or otherwise

o When loses: varying statutes when lose distinguish 3rd

party suits and derivative suits

o Amounts paid DGCL § 145(a) and (b);

o Advances in (e) unsecured promised to repay reasonableness requirement

2. Procedure: Decision By

o independent board (not been sued);

Indemnification and Insurance:

Terms

Indemni ication: Firm ays Jud ments and

ama es evied ainst embers o the

oard

& Insurance: Firm ays remiums to

Insurance ompany; Insurance ompany

ays Jud ments and ama es evied ainst

embers o the oard



116

o independent legal counsel (only area where lawyers may speak for firm)

o OR Shareholders

3. Ohio Distinguish Direct/Derivative Modeled on Del. § 144

o has weird one again and adds Court of Common Pleas Procedure adds Court review to

Decision by board or independent counsel

o Advance for expenses is mandatory and not optional in Ohio (opt out) unless you go to court

and they find under clear and convincing test that the CEO intended to hurt the

corporation

o MUST extend CEO cash to defend themselves with a lawyer

D & O Insurance: Practically

1. Power to insure broader than power indemnif y?

o Yes, insurance companies will limit coverage based on their ability to price and profit

2. Maximize money two clauses

o (1) agree to indemnif y to max and

o (2) insure for what additional protection they can (D & O insurance)

3. Employment Agreement:

o MAX Obligation to advance

o MAX obligation to reimburse

o MAX obligation to buy D & O

Insurance

4. In litigation: claim advance, if

derivative settle and claim

indemnification;

o Otherwise claim insurance

5. New wrinkle Thompson memo

Duty of Care: Summary1. Very hard to win: AND If lose dont

pay damages

o Exception: Francis Total

Dereliction of Duty

2. If Win: Directors Dont Pay Damages:

o Indemnification for settlement amounts

o Insurance for judgments

3. Cases, even if success very embarrassing to the s because Court

o Court moral arbiters; scolding the CEOs

Dutyof Loyalty: s Gold Mine

1. Key Hurdle: Only hurdle is effective ratification (vote of independent board or SHs)

2. Preponderance of evidence, burden on s no deference to business decisions (de novo review

entire f airness test)



117

o Can argue good f aith test cannot be met on indemnification

3. Indemnification is harder best interest of the firm? on settlement; insurance coverage offend

not available

4. Insurance Companies will not insure CEO on OWN duty of care

Basics of SH V oting Proxy1. Combination of State and Federal Law

2. State Law: defines what a proxy is because an area of agency

3. Federal law: defining disclosure obligations for publicly traded company

o Not publicly traded no federal law at all with exception of anti-fraud statute

4. Record owner writer grants proxy to proxy holder to vote shares at a physical meeting

o Guys name on record books of a corporation

o Right to vote when shows up at SH meeting then vote your shares of which you are a

record owner

o If do not go may grant an agency power to someone else (proxy) who shows up at themeeting and votes your shares

o Proxy delegation of agency to vote on your behalf

5. Proxy is an AGENCY created by state law OH § .48 and DE § 212

6. NOT a written or absentee ballot:

o distinguish written consent procedure

7. Terms: revocable at will unless coupled with an interest (e.g. sale of stock af ter record date but

before meeting)

o Coupled problem with SH meetings is that you must close the record 30 days prior to the

meeting; what if buy stock in that period record holder does not change, so there may be a

guy who sold his stock and still has right to vote as record holder; SO when you buy stockfrom a record holder, you get stock PLUS proxy (that would be coupled with an interest) ex-

record stock

o Supplemented by federal law if IPO

Federal Proxy Rules1. Defined: required that you solicit proxies from all your SHs; if have annual meeting, must send out

firm proxy solicitation to all the record SHs and then firm will nominate proxy for SHs who do not

show up and votes all the shares in whichever way the firm wants

2. Why are they needed?

3. What law controls?

o State

o Federal: 34 § 14(a)-(c) AND has rules 14a to 14a- 15 and Schedule 14A

Overview: Regulation 14A1. Mandatory Disclosure Requirements: Full disclosure all material information to the SHs



118

2. SolicitationRegulation can only solicit them in certain way, regulation form no discretionary

voting; general anti-fraud prohibition; must be true(form and process)

3. SH Resolutions (Rule 14a-8): regulates when ordinary SHs can get access to the firm held property

normally board of directors controls what is on the firm

4. Fraud Prohibition (Rule 14a-9)

Proxy V oting: Terms1. Must be publicly traded company

2. Must be a proxy someone authorized to act on someones behalf

3. Solicitation is carefully defined

o Doesnt include: efforts at persuasion as opposed to requests for proxies Rule 14a-2

o 10 Person exception Rule 14a-2(c)

o Cannot just try to convince people to vote one way or another must try to get them to give

proxy votes to you before going in

Basic Requirements1. Proxy statements form 14A, items

2. Proxy Card: format requirements

o Limited discretionary grants

o Slates of directors yes and abstain (no NO or other)

3. Filing requirements: general rule for plain vanilla proxy statement and form file with the SEC on

first use

How is a Ballot Slate Selected?4. Only one candidate per seat decided by the board of directors with ONE choice (YES or abstain)

5. Opponents do not have access to Managements Proxy 6. Voting Oddities: All you need is plurality so when there is no vote it is very hard for anyone to

win

7. Must send out NEW FORM to get someone else on the form in there is a quorum requirement

but SOME do not have it in states that dont require it (usually 25% vote abstentions count

toward it)

8. New Rage: ma jority vote buy-ups, we will not seek a director unless he or she gets a ma jority of

all those voting (which means more yeses than abstentions)

o Stricter: ma jority of outstanding shares to vote YES

o If do not get: seated because you win but you offer letter to resign but Board has decision to

take it or not if there is an empty seat and they accept, Board fills empty seat

Proxy Contest 1. Insurgents: to defeat management slate MUST

o Create own proxy statement and card with an alternate slate

o File with the SEC AND

o Pay to have firm mail the material to all SH or if firm elects, mail material themselves



119

2. Who Pays: Incumbents firm pays all expenses and no SH ratification is necessary

o Insurgents pay own way, firm pays back only on victory if ratified by SH vote and if on policy

dispute

3. If want to contest board must get own group of candidates together

o File own form

o File own statement

o Send to all SHs

4. Costs - $500,000 to $1M and chance to win is very small

o Very rare

5. Even with happen rarely win; only makes sense if you have a huge block of shares or are

coupling the proxy contest with a takeover control of board then buy the stock

6. If win firm pays all the expenses of the incumbents, no SH ratification necessary

o Insurgents firm pays ONLY on victory if ratified by SH vote and if on policy dispute

Options for Thrifty Challenge1. Ask SH to abstain on Managements proxy: Disney in 2004

o CEO running for board had 45% abstention vote stripped of Chairman title and resigned in

2006 because

2. SEC Rule Change now languishing ma jor SHs can nominate a candidate IF nominee gets 35%

abstention vote

3. SH Resolutions on Management Proxy Rule 14a-8: Bylaw Amendment that allows large SHs to

nominate candidate for board AIG case

o Cannot run a contested election through a 14a-8: problem is whether you can force a bylaw

through that allows this type of stuff

4. Who nominates candidates for the firm?

o Nominating committee creates a slate but independent nominating committee usually just

takes advice of the CEO and doesnt give much thought to anything else

Litigation Over Proxy M aterials: Supreme Court

1. J.I. Case v. Borak (1964): first private cause of action for violations of Rule 14a-9 (up to now

private lawyers couldnt bring these types of suits, could bring 16b suits, though)

o Affirmative vote on merger f alse statements in proxy statement

o Af ter this case lid was blown on 14a and 10b-5 for all securities actions to open up to

litigation in lower courts

o Began argument of what materiality is because f alse statements must be material

o Material: maybe same as reliance, show that if new would have been negative vote on

merger (changed vote of merger), if not just leave it alone

2. Mills v. Electric Auto-Lite Co (1970): Causation doesnt require proof that vote would have been

different

o Facts that s controlled 54% needed 66% to control

o Virginia Bankshares 66% control does break causation

o Awards of attorneys fees to proper



120

o Substantial benefit test does not have to be pecuniary

3. TSC Industries v. Northway: Defined materiality

o Materiality: doesnt require proof that the vote would have been different but for f alse

statement

o Defined as Reasonable Investor-TotalMix TestIf a reasonable investor would have found

it to be an important f act in the questioning of the deal

o Define causation, materiality, reliance

4. Take these doctrines and apply them to 10b because these proxy fights were big deal: open

license to sue as private litigants under 10b-5 with the diminished causation, reliance and

materiality requirements

o Borak now limited to its f acts

o Congressional Intent Test Now: if you have an open-ended prohibition in a federal statute

the presumption is NO and rebutted only if you have very strong evidence that Congress

intended to have a private cause of action available; generally not implied by the courts

would write it in

Seinfeld v. Bartz Application

1. Importance: compensation of CEOs and stock options

2. Qualified 16b-3 Plan: must have a plan distributed to your SHs

3. Facts: everyone knew all the details of dates and what not but there was no present valuation

of the options in the statement released;

o CEO would get $2m salary and then $1m in stock options but they didnt say they were

paying the CEOs the salary plus the options because firm didnt value the options correctly

and were under by $320,000

4. Held: No, not material. If you wanted to value the shares, then you do it. We have no obligation

to do it ourselves when you have enough information that was released

o Call Options: Note on p. 555 on options; compensatory call option that give CEOs, can buy

stock from company that is well in the black

o No back dating controversy

Proxy Rights and Shareholder Proposals (14a-8)1. Compare incentives for takeover and proxy fights

2. CompareMethods of Takeovers to Proxy Fights

3. Capitalism (1) private property ownership and (2) are able to aggregate, buy and sell, property

(widows and orphans owning one share of GM permissibility of aggregation creates our largest

corporations)

o Example assume only own 10% (very much) of firm with capital value of $8m (worth

$800,000) and believes that firing CEO will raise value by 20% to another $1.6m

o Question: how do you execute upon that belief when willing to take the risk

4. Option 1 Proxy Fights: win ma jority of the seats and throw him out but cost lots of money

$250,000 and you wouldnt gain enough back to gain costs (odds of f ailing are extremely high, risk

not worth rewards)



121

o Effect of Staggered Board: two 2 successful contests gain control of board elect 1/3 first

year and another 1/3 the next year double expense

o Usually not done proxies unless gains would be monstrous with low risk

5. Option 2 Takeovers: Have 10% and want to buy 40% but key is you want to buy it at the lower

rate get interest rates to cover the difference so it makes up for the losses while also getting

20% - must get another from firing CEO to repay the 20% and carry the interest payment

o Purchase 90% you dont own costs $7.2m and gain $1.6m assume premium is required;

can pay SHs up to 20% (less than $8.2) and still show gain

o Assume premium required and must borrow money can pay SHs up to 20% minus interest

(e.g. 6%) and still show gain

o States and politicians hate on these now stop it at the buying ma jority ownership in OH

Board must accept takeover (meaning there are ZERO takeovers here UNLESS there are

special consulting contracts OR confidential information agreements that are basically

bribery); OH empowers boards to take bribes so they dont have to allow the takeover

o Bad Managers Blocking Takeovers: stay in power effect OR can pay SHs up to 20% minus

interest and minus bribes to managers and still show gain (severance, golden chutes, etc.)

o Worries: companies are liquid in the past you could not raise that type of money so quickly

but now you can easily

So with the OH legislation all the shares are worth 97% less than they are in other

states without this type of legislation

Instead front-end tax incentives like property tax relief (non-contingent on anything

government planning)

New Option Three1. New Rules for Proxy Contests: AIG Case stands

o SH proposes and wins 14a-8 resolution

2. Let 10% SH nominate slates of candidates for the boards and the firm has to pay

o Option one would suddenly make sense

o If force firm to put opposing slates that are real on ballots then there is whole different

issue

o Easiest way to pick opposition slate SH amounts of largest opposition SH gets the right to

select candidate to oppose

3. Problem: more collusion CEO pays much more attention to that SH in opposition and may give

him other perks and information that may dissuade him from putting quality candidate on the

ballot

Rule 14a-8: Shareholder Proposals1. Town Meeting Rule: Q ualif ying SHs may include some kinds of proposals for a SH vote in the

companys proxy solicitation material

o Allows ordinary people to get on the SH Voting proxy list; 500 words or less

o Something for nothing

2. § 14 in SEC Act (a) delegates power to the SEC and regulating proxies



122

o 14a means it was 1934 Act rule, later Acts are larger numbers

3. Policy:

o Pros: Low cost SH access to SH vote process

No SEC filing, no cost of mailing

Even f ailed proposals make the point

o Con: Costly annoyance overwhelming number of proposals f ail; infringed on

management prerogatives

4. Procedure: Submit to request (resolution and supporting statement) to corp. within deadlines of

14a-8

o Firm requests a no-action letter from the SEC on whether firm can exclude

o SEC issues no-action letter (will you sue us? Not at this time, but may sue you later but

not today doesnt bind SEC); only if clear precedent that the SEC will not allow this to

keep out then they will try to get it out of there

o Review of staff latter by 5 SEC Commissioners

o Loser Petitioners Federal Circuit Court to overturn SEC decision or firm excludes it despite

advice and forces SEC to sue in FDC

5. Types of Proposals: 13 Most Improper

o Personal Grievance or Personal interest

o Ordinary business operations (Dole proposal, study on health care, Con Ed proposal on

retirement age)

o Election for a board seat (AIG case)

o Materiality (relevance): less than 5% of

Total assets or net earnings and gross sales

Exception for otherwise significantly related to business (Iroquois Brands proposal on

pate)

o Resubmission in 5 years: any do-gooder that gets 3% vote once, less than 6% twice this

is the definition of victory

6. Shareholder Power?

o Are these Rule 14a-8 Resolutions Binding on the board:

NO Corp. Code State that Board has power to manage because resolution must be

proper under State Corp. Codes (which gives power to the directors)

Possible exception: SH power to amend bylaws

o Solution: make resolutions precatory recommend or request the board act (see Con Ed

proposal)

Board may or may not comply boards of ten f ail to comply;

If they do not? Option is to vote them out.

7. Special Case: Bylaw Amendments

o Not Resolved

o Common Practice: To allow SHs to make bylawys by charter election in MBCA; boards

have exclusive power to amend bylaws (DE and OH) some states can take this right out

in the charter



123

o But DE § 109(b) and OH § 11(regulations): SHs have inherent right to amend bylaws can

SHs amend bylaws with a Rule 14a-8 resolution, making it binding?

o When do SHs recommend bylaw changes?

In DE issue is scope of SH management power SHs do not have power to manage

board; directors do some argue that this invalidates Poison Pill bylaws

AIG Case: Amending B ylaws

1. Proposal: Amend bylaws to allow ma jor SHs (3%) to nominate candidates for board elections; put

a bylaw amendment on AIG proxy solicitation to allow a ma jor SH to nominate candidates

o Access Bylaw can SH amend proxy machinery that is in place?

2. SEC: Deals with election, may be excluded

3. 2nd Circuit: SEC is not following text of rule AN ELECTION allows bylaws that change election

procedure (all elections)

4. SEC Could rewrite rule: DE could change SH power to amend bylaws (would not stop precatory

resolutions, however)

o SEC has new rule out to change decision of 2nd Circuit ando DE has new rule to blunt effect 2

ndCircuit decision

V oting Results1. Social Responsibility Resolutions Fail (Dole vote, 5.4% in f avor; 83.6% against, 11% abstained

unusually high) goal is to beat resubmission 3% bar; Vietnam victory for proponents (advice to

Nixon declare victory and pull out)

2. Governance resolutions may succeed: these may be ones that matter

o Example drop the staggered board because it makes it too hard

o Drop the poison pill plan

o Sponsored by the institutional investors in your company who are worried about the stopprice

o Resolutions by the big players, on economic issues to maximize the stock price

Corporate Responsibility Proposals

1. Types abortion funding, gay rights, affirmative action, environmental impact rarely succeed

2. C racker Barrel controversy (not in book):

o 1992 SEC allows company to exclude SH proposal to prohibit employment

discrimination based on sexual preference

Ordinary business matter or not material (5% rule)

o 1998 Under political pressure SEC withdraws Cracker Barrel letter says it will rely on a case by case analysis

Governance Resolutions

1. Examples: Repeal stagger boards; repeal poison pill plans; ma jority vote bylaws; SH nomination

bylaws (AIG case)

2. Success? Because institutional investors involved and public pension plans