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Business Associations Outline of 79

BUSINESS ASSOCIATIONS OUTLINEPROFESSOR T. MAYNARD

Choice of Business Entity

I. IntroductionA. Overview of Principal Forms of Business Organization and Relevant Statutes

1. What is a sole proprietorship?a. A business wholly owned by an individual.b. The business owner absorbs profits/losses on individual personal

income tax.c. The owner of the business is personally liable on all business

obligations because there is no legal separation between the owner and the business.

2. What is a General Partnership?a. The General Partnership is the default form for businesses that are

owned by more than one person.i. 2 or more co-owners engaged in a business for profit.

b. Uniform Partnership Act (UPA)i. UPA §6: Definition of General Partnership:

1) A partnership is an association of 2 or more persons to carry on as co-owners a business for profit.

2) But any association formed under any other statute of this state, or any statute adopted by authority, other than the authority of this state, is not a partnership under this act, unless such association would have been a partnership in this state prior to the adoption of this act; but this act shall apply to limited partnerships except in so far as the statutes relating to such partnerships are inconsistent herewith.

ii. UPA §9: Veto Power1) Each partner is a general agent for the other2) One may carry on the business of the partnership

for the other and legally bind the partnership.3) One partner’s actions may legally bind the other

partner(s) in matters relating to the business.iii. UPA §15: Nature of the Partnership

1) All partners are liable jointly and severally for the debts and obligations of the partnership, including the wrongful acts or breach of trust by other partners.

c. Revised UPA (RUPA)d. California

i. UPA §15001


ii. RUPA §16100e. Characteristics of General Partnerships

i. The definition of a partnership does NOT require a formal writing.

1) Default standard so handshake = inadvertent partnership.

2) Default standard for handshake deals that do not discuss the specific terms of the partnership.

3) The intent of the parties does not matter.ii. If the partnership agreement is silent on a certain issue,

the UPA is the default standard.1) Example: If A and B only talk about the split of

profits and not the split of losses, the UPA §18(a) becomes the default standard and losses will be allocated in the same proportion as profits.

iii. Under common law, partnerships were considered an aggregation of the individual partners and the partnership was NOT considered a separate entity from the individual owners; however, RUPA amended this and recognizes partnerships as a separate entity.

iv. Partners have individual rights against their other partners because each partner is jointly and severally liable for the debts of the business.

f. Limited Liability Partnershipsi. General partnership in all respects except that the statute

provides that partners have no personal liability for firm obligations that exceed the assets of the general partnership.

ii. Partners in an LLP have full personal liability for claims arising from their own misconduct.

3. What is a Limited Partnership?a. To form a limited partnership there must be 1 or more general

partners and 1 or more limited partners.i. Uniform Limited Partnership Act (ULPA) §1

1) A limited partnership is a partnership formed by 2 or more persons under the provisions of §2, having as members one or more general partners and one or more limited partners. The limited partners as such shall not be bound by the obligations of the partnership.

ii. Revised ULPA §100iii. California

1) ULPA §155012) RULPA §15611

b. To form a limited partnership, the partners must sign and swear to the arrangement on a certified document.


i. Cannot have an inadvertent limited partnership.c. The limited partner cannot exercise control of the operation of

the partnership and retain the shield of limited liability.i. Once the limited partner exercises control of the

partnership, he/she ceases to be a limited partner.ii. ULPA §7

1) A limited partner shall not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business.

iii. RULPA §3031) Changed the ULPA §7 rule by adding: “if the

limited partner participates in the control of the business, he [or she] is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.”

iv. CA RULPA §156321) “If a limited partner participates in the control of

the business without being named as a general partner, that partner may be held liable as a general partner only to persons who transact business with the limited partnership with actual knowledge of that partner’s participation in control and with a reasonable belief, based upon the limited partner’s conduct, that the partner is a general partner at the time of the transaction.”

4. What is a Limited Liability Company (LLC)?a. Uniform Limited Liability Company Act (ULLCA)b. California

i. LLC §17000c. Hybrid of partnerships and corporations.

i. Newly created in the 1990s.5. Corporations

a. Revised Model Business Corporation Act (RMBCA or MBCA)b. California Corporations Codec. There are formalities if you want to form a corporation

i. Must file Articles of Incorporation with the Secretary of State.

d. Hierarchy in Corporationsi. Shareholders

1) The shareholders elect the Board of Directorsii. Board of Directors

1) The directors appoint the Officers


2) The directors manage the “big picture” decisions of the business, not the day-to-day functions.

iii. Officers1) The officers manage the day-to-day business

affairs of the corporation.6. Federal Securities Laws – Administered by the SEC

a. Securities Act of 1933i. SEC Rules under the 1933 Act

b. Securities act of 1934i. SEC Rules under the 1934 Act

7. State Securities Laws – Blue Sky Statutesa. Uniform Securities Actb. California – Corporate Securities Law of 1968 §25000

i. Administered by the Department of Corporations (DOC)ii. Rules promulgated by the DOC

B. Overview of Basic Agency Principles1. Klein and Coffee “Business Organization and Finance” (Handout)

a. Agency Relationship: Agent and Principali. Fiduciary Relationship that arises from the manifestation

of mutual consent between the principal and the agent that the agent shall act on principal’s behalf and subject to principal’s control.

ii. Fiduciary Relationship: default rule If no agreement to the contrary, there is a fiduciary relationship between principal and agent. Principal owes Agent a duty to pay and Agent owes Principal a duty of loyalty.

iii. Agency Relationship includes implied terms1) Duty of care2) Duty of loyalty3) Fiduciary responsibility

iv. 2 elements to a principal agent relationship1) Hierarchal: Principal has the right to control the

Agent2) Consensual: Agent and Principal must both agree

to the relationship. Principal can only control the Agent who consents to the control.

v. No writing is required, mere consent by conduct is sufficient.

vi. Example: AB Furniture Store (a partnership) hires C to deliver furniture and drive truck.

1) AB Furniture Store = Employer = Principal2) C = Employee = Agent3) C is an employee of the furniture store and is

under the control of the business and under the supervision of AB Furniture Store.


vii. Example: What happens if C is hired to be night manager? C is hired o B can go home at nights. Is there a difference between hiring C to drive a truck vs. hiring C to manage?

1) Still principal-agent relationship.2) C now has more decisions more directly

impacting the profitability of the business.3) C needs to be given enough incentives to act in A

and B’s best interest.4) C has to be more trustworthy.

b. Scope of Agent’s Authority: Actual Authority and Apparent Authority

i. General Rule: An agent can bind the Principal if the Agent has Actual or Apparent Authority to Transact.

ii. Actual Authority: Defined boundaries in the scope of the duty

1) Look to the writing(a) Partnership agreements, or (b) Executive Committees(c) Board of Directors Resolution(d) Bylaws

2) Implied Authority is authority inherent in the position.

iii. Apparent Authority: Exists if it is reasonable for the third party to conclude that A has the authority to bind the entity.

1) Factual Inquiry asking how Principal holds Agent Out.

2) Cannot contract this away. 3) This is based on the perception of the 3rd party.4) UPA §16 Partnership by Estoppel

iv. Example: What if C, the night manager, who has been explicitly told NOT to make any purchases on behalf of the Furniture Store is working one night when a vendor of Cuckoo Clocks comes to solicit business. Despite the lack of actual authority, C enters into an agreement with the vendor to purchase 10 cuckoo clocks. Is the store bound to the agreement?

1) C has no actual authority2) Does C have apparent authority?

(a) Factual Inquiry: did the vendor have a reasonable belief that C could bind the store?

(b) What was C wearing?(c) Did C look like the manager?(d) Did the vendor believe that C had the

authority?


(e) Was the vendor on notice that C had no such authority?

c. Doctrine of Respondeat Superiori. Example: What happens if while C is driving a truck C hits

a pedestrian, V?1) Respondeat Superior: AB Furniture Store may be

liable to V based on the principle that the accident occurred while C was in the course and scope of employment.

2) If V wants to sue, he can sue C, AB Furniture Store, and A and B individually if the partnership does not have enough assets.

3) If AB Furniture Store is incorporated, the corporation is the only entity that can be sued as long as the Corporate Veil of limited liability is in place.

d. Risks and Control: Incentives and Monitoringi. The amount of discretion given to an agent can be lowered

by increasing the level of specificity.1) However, there is a cost to increasing the level of

specificity. Transaction Costs(a) Can increase specificity by making

an employment manual.(b) Apparent Authority can be

eliminated by putting 3rd parties on notice of the agent’s actual authority.

ii. The Principal may seek to create an incentive to the Agent to align their interests.

1) May create profit incentives for the Agent.2) Ownership interest short of partnership.3) The problem with this is that by giving the Agent

these interests in the store, A and B’s business interests will be diluted.

iii. However, the Separation of Ownership from Control gives rise to agency costs.

1) The principal must retain a right to information to monitor investment from being squandered.

2) However, the principal must then also retain the Right to intervene/Veto Power.

(a) What good is the right to information if there is no right to intervene.

e. Importance of Fiduciary Duty Lawi. Fiduciary Duty arises in every agency relationship.

ii. The scope of the fiduciary duty depends on the legal relationship.

iii. Look at the expectations of the parties.


1) If less than a breach of fiduciary duty, then business ethics issue.

iv. Klein and Coffee specialization of economic functions maximize the organization of a company by separating ownership and management although agency costs arise as a result of unanticipated contingencies when ownership is separated from control.

v. Trust is part of every agency relationship and fiduciary duty law creates implicit duties and is used as a gap filler for the responsibilities each person/entity in the relationship owes to the other.

II. Choice of Business EntityA. The General Partnership

1. Formation and the Need for a Written Agreementa. The formation of a partnership does not require a written

instrument.b. However, an agreement in writing provides the parties with a

substantial number of benefits.2. Sharing of Profits and Losses

a. A partnership agreement can provide for any method of sharing profits and losses.

i. Where the agreement fails to provide for a particular division of profits and losses, the UPA Controls.

1) UPA §18(a)“A partner is to share in profits equally and in

losses according to his share in the profits.”b. Partners are jointly and severally liable for the debts of the

partnership.3. Inadvertent Partnerships

a. A partnership may be implied from the conduct of the parties.i. Martin v. Peyton (154): lenders investing in a near-

bankrupt partnership were granted profit sharing and some management rights until they were repaid. When the partnership defaulted on debts, a creditor sued the lenders, contending their rights made them partners and personally liable for partnership debts.

1) Just receiving profits is prima facie evidence of a partnership unless it is a loan [UPA §7(4)(d)].

(a) In this case the profits were to be paid with a cap and floor and do not continue indefinitely.

(b) There is a limited interest in the total business.

(c) No open-endedness


(d) Length of the relationship is limited to the date from which the loan must be paid.

2) There is an option to purchase and interest in the partnership suggesting that the creditors are not partners.

(a) Preserves the intent of the agreement which specifically states that this is NOT a partnership.

(b) ***Suggests that intent is no irrelevant, but the courts will look beyond it***

b. Negative Rights of Control v. Affirmative Rights of Control ????Does one type make the partnership more likely????

i. Negative Rights1) Protecting your interest? Less likely that it will

be a partnership.ii. Affirmative Rights

4. Management of Partnership Business – UPA §9, 15, 18a. UPA §18 states that each partner has the right in management and

the conduct of the business and if the partners cannot agree with each other, the business will do nothing because both parties have the right to exercise control and exercise his/her veto power.

5. Duties of Partners to Each Othera. Fiduciary Duty is an implied term of agency.

i. 2 elements of Fiduciary Duty1) Duty of Care: to promote the interest of the

employer2) Duty of Loyalty: to put the company’s interest

above the individual’s interest and not enrich him/herself at the cost of the company.

b. Meinhard v. Salmon (80): Salmon and Meinhard are joint venturers. They enter into a 20 year lease. 4 months before the lease is over Salmon is offered a profitable lease which he accepts under his wholly owned subsidiary, Salmon Corp.

i. Meinhard sues Salmon for breach of fiduciary duty.1) Duty of loyalty case.

ii. Salmon had a duty of full and adequate disclosure of all the facts to Meinhard.

1) Salmon can enter into an agreement with Gerry but he must inform Meinhard of the opportunity.

iii. The breach of duty in this case came from the failure to disclose.

iv. Cardozo’s point is that Salmon does not have to share the opportunity Meinhard, but Salmon is obligated to notify Meinhard of the opportunity.


v. Meinhard gets the benefit of hindsight because if Salmon had made a loss, Salmon would not be able to go after Meinhard to share in the losses.

1) Cardozo is creating incentives for partners to disclose.

vi. Dissenting Opinion1) The dissent says that fiduciary duty law is a gap

filler when the agreement is silent, but the gap is filled at the time of the agreement.

2) The contract is the end all and be all.vii. Cardozo does not ignore the agreement, but looks to the

duty of loyalty which he states was breached by Salmon when he failed to disclose that he had entered into an agreement with Gerry.

viii. Salmon could have terminated the partnership and entered into the agreement, but Salmon did so when the partnership was still in effect and when it was continuing.

6. Dissolution of General Partnership – UPA §29, 31a. UPA §29 Dissolution Defined

i. The dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.

b. UPA §30 Partnership Not Terminated by Dissolutioni. On dissolution the partnership is not terminated, but

continues until the winding up of partnership affairs is completed.

c. UPA §31 Causes of Dissolutioni. Dissolution is caused:

1) Without violation of the agreement between the partners,

(a) By the termination of the definite term or particular undertaking specified in the agreement,

(b) By the express will of any partner when no definite term or particular undertaking is specified,

(c) By the express will of all the partners who have not assigned their interests or suffered them to be charged for their separate debts, either before or after the the termination of any specified term or particular undertaking,

(d) By the expulsion of any partner from the business bona fide in accordance


with such power conferred by the agreement between the partners;

2) In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time;

3) By any event which makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership

4) By the death of any partner5) By the bankruptcy of any partner or the

partnership6) By decree of the court under section 32.

7. Law Firm Partnerships8. Limited Liability Partnerships (LLPs)

B. Fundamental Considerations in Choice of Entity Decisions1. Limited Liability

a. One of 2 dominant considerations in choosing form of organizationb. Incorporation offers the corporate shield of liability.c. There are other ways to protect individual investors from

individual liability aside from incorporationi. An investor can contract to shift the loss

ii. An investor could be a limited partner in a limited partnership

iii. An investor could buy insurance2. Informality, Flexibility and Cost of Operation and Formation

a. Flexibility and Cost of Operationi. When there are gaps in the agreement, for partnerships, the

statute is the gap filler.ii. To become a member of a partnership, all the members

have to assent to the new member.iii. To obtain a partnership interest, the partner does not need

to make a capital investment.1) Can obtain an interest by contributing money or

labor, etc.iv. Partnership rules are completely open-ended, which is not

true of corporations.1) Partnership agreements may alter the default rule

and allow for greater flexibility within the partnership, especially if it is a large firm.

2) Example: Gibson, Dunn and Crutcher probably does not require the unanimous consent of the partners to make a business decision.

v. The partnership may be organized hierarchically allowing for specialization by the partners.


b. Formationi. A corporation is harder to form than a general partnership

ii. Cannot inadvertently form a corporation while a general partnership may be inadvertently created.

iii. The formalities of forming a corporation are expensive and time consuming.

iv. A partnership does not need to qualify if it wants to form another partnership in another state.

3. Continuity of Lifea. 2 Issues in Continuity

i. Legal Continuityii. Business Continuity

b. Partnershipi. The death of a partner terminates and dissolves the

partnership unless the agreement provides otherwise.ii. The business may continue, but the death of the partner has

terminated the partnership and the partnership may liquidate the business, form a new partnership between the dead partner’s heirs and the live partner, or the live partner can buy out the dead partner’s heirs’ interest in the business.

iii. Survivorship Clause: the default rule for partnerships is that they terminate/dissolve with the death of a partner. The default may be contracted away with a survivorship clause stating the entity survives the death of the partners.

c. Corporationi. The death of a shareholder has no legal effect on the legal

continuity of the corporation.1) The corporation is a legally separate entity and

survives the death of its shareholders.2) The dead shareholder’s stock goes to his estate

because they are transferable and the corporation continues to exist and there is no dissolution.

4. Centralization of Managementa. Partnership

i. Not all partners have equal rights of managementii. People in the committees get appointed by the partners and

the partnership agreement may set up a hierarchy.iii. The hierarchical structure is not the default rule in

partnerships; rather, it must be agreed upon.iv. The larger and more complex the economic enterprise the

more difficult it will be to establish.b. Corporations

i. There is a basic corporate structure.1) Shareholders

Elect the Board of Directors


2) Board of DirectorsAppoint the Officers

3) OfficersEngage in the day-to-day business affairs to

further the larger business objectives of the Board of Directors.

ii. Each level of management is not mutually exclusive.1) A shareholder may be a board member (and often

is), etc.5. Free Transferability of Interests

a. Partnershipi. Partnerships require unanimity under the UPA to add a

partner to the entity or to substitute somebody into the partnership as a new partner.

ii. One of the partners can choose to get out of the partnership and dissolve the partnership or get another partner to buy out his interest.

1) Interests are not freely transferable at the whim of the partner.

b. Corporationi. For a shareholder to leave the corporation, he has to be able

to find someone to buy his shares.ii. When dealing with a large publicly held corporation, this is

not a problem and there is probably a free transferability of interests; the problem is for closely held corporations.

C. The Corporation vs. The Partnerships: Reflecting on Certain Basic Federal Income Tax Considerations

1. Income Tax vs. Capital Gains Tax2. Entity Level Taxation vs. Conduit (or “flow through”) Taxation

a. Proprietorshipi. Not a separate taxable legal entity.

ii. Owners of sole proprietorships must pay the Self Employment Contributions Act (SECA) of 1954 tax.

b. Unincorporated Business Forms (Partnerships)i. An unincorporated business entity that has a single owner

generally will be disregarded as an entity separate from its owner for federal income tax purposes unless the entity elects to be classified for federal income tax purposes as a corporation (i.e. “check the box”). ????LLCs Only?????

ii. A partnership does not pay any tax.1) The income or loss reported by a partnership is

“passed through” to the partners.2) There is no entity level taxation.3) However, individually, a general partner must pay

the SECA tax whereas the limited partner may not


unless the payments constitute “guaranteed” payments.

iii. SECA tax is applicable to earnings of individual members of the LLC to the extent attributable to a trade or business.

c. C Corporationsi. C corporations have their own special tax schedule.

ii. The corporate tax rate is in addition to the tax that the shareholder must ultimately pay Therefore, there is a Double Taxation Burden.

d. S Corporationsi. Subchapter S of the Internal Revenue Code was to provide

relief from the double taxation treatment of C Corporations. ii. Becoming an S corporation is an affirmative election by the

corporation and is not available to all closely held corporations.

iii. The election is a tax election and not a corporate law election; the corporation possesses all of the normal attributes of a corporation under state law, but is taxed in a different way than C corporations.

iv. Requirements1) No more than 75 individual shareholders2) May not have a shareholder who is a nonresident

alien or a certain artificial entity; and3) May not have issued more than one class of stock

(except for classes of common stock that differ only in voting rights).

v. With a few exceptions, S Corporations have the basic flow through treatment that partnerships and sole proprietorships have.

3. Strategies to Minimize Incidence of “Double-Taxation” Burdena. Accumulation Bail Out Strategy Pre-1986 Tax Strategy

i. Took advantage of the combined effect of the favorable income tax rate on corporations plus the equally favorable tax rate applicable to capital gains.

ii. The shareholder keeps the money in the business and pays the lower tax on the income Shifts the income from the high tax payer to the person in the lower tax bracket.

iii. Example: A sells stock to C.1) A = 100,000 basis (investment the seller of the

property has in the property).2) A C in stock for $1 million cash.3) When A disposes his stocks he is going to gain $1

million (amount realized) - $100,000 (basis) = $900,000 (Gain Realized).

The gain realized is NOT the same as ordinary income.


The gain realized or the capital gain was taxed at a lower rate than individual.

4) Rather than receiving the distribution of $900,000 over the life of the investment period and pay high individual taxes, A accumulated the amount in the corporation, which paid less taxes, and then sold the stock to receive the money as a capital gain.

iv. The IRS and government applied an accumulation penalty tax to deal with this strategy Unreasonable accumulations catch the eye of the government and subject the corporation to this tax.

b. Zeroing Out Strategyi. This strategy allows the corporation to avoid the corporate

tax.ii. This strategy relies on the fact that while distributions in

the form of dividends are not deductible by corporations, payments to shareholders in the form of salaries, rent and interest are deductible by the corporation so long as they are reasonable in amount.

iii. LIMITATION: may be subject to audit if zeroing out every year. Must show that the reason for the zeroing out is reasonable.

D. Combination of Forms of Business Organization: Evolution of the Modern Limited Partnerships with Corporate General Partner

1. Delaney v. Fidelity Lease Ltd. (Handout): Delaney is the landlord plaintiff. Tenant is Fidelity (limited partnership). The general partner is Interlease Corporation. There are 22 limited partners (19 doctors and Crombie, Kahn, and Sanders). Crombie, Kahn and Sanders are officers for Interlease Corp. Fidelity was going to operate a fast food restaurant, but defaults. Delaney sues for breach of contract.

a. Delaney first sues Fidelity, but Fidelity is insolvent.b. Delaney next sues Interlease, the general partnership, but Interlease

is also insolve.c. Delaney sues the 3 officers of the corporation in their capacity as

limited partners.d. Delaney points to evidence of control that makes the limited

partners liable.i. The 3 officers exercised control by making management

determinations.1) The officers say that they were just acting as

officers of the corporation. They were acting as agents of the corporation and the lease was signed with the explicit point that the officers were signing in their capacity as officers.

There is no fraud.


2) The theory in this case was not to hold the officers liable as shareholders by piercing the corporate veil, but rather they are being sued as limited partners who violated ULPA §7 or RULPA §303 by exercising control.

e. The court finds that Delaney took a risk that the corporation would not make a profit by leasing to a corporation with no assets.

f. Delaney is a stakeholder because he has bargained for a lower rent in the beginning to escalate with the profitability of the business.

i. He is taking a risk that Fidelity may not make a profit.g. Dissenting Opinion

i. The corporation cannot be a general partner.ii. The statute says that a partnership can be dissolved by

retirement, death or insanity of a partner and so the partner has to be a person.

iii. This is judicial activism because the statute does not mention corporations. It is the job of the legislature to change this law.

iv. Breach of Fiduciary Duty Argument1) The corporation cannot be the general partner

because Crombie, Kahn and Sanders are the sole shareholders of Interlease (the general partner) and they are also limited partners.

2) General partners have a duty to the Limited Partner and the Officers of a Corporation owe a duty to the corporation.

3) There is a conflict of interest because as officers of a corporation and part of the limited partnership, these 3 have divided loyalty.

Crombie, Kahn, and Sanders have a duty to the corporation and to the limited partnership.

The dissent wants to establish a prophylactic rule to eliminate the possibility of divided loyalties.

4) However, the courts favor freedom of contract and have allowed for situations that may give way to potential conflicts of interest and have then “filled in the gaps” with fiduciary duty law.

h. The court in this case looked at fundamental fairness and tried to avoid giving Delaney a windfall because he bargained for this risk.

i. Under RULPA §303 the limited partner is only liable to persons who transact business with the limited partnership and reasonably believe that the limited partner is a general partner.


i. In this case, Delaney knew for a fact that he was not dealing with a corporation through Crombie, Kahn and Sanders.

ii. RULPA §303(b) is a safe harbor provision that states that you are not participating in the control of the business by being a contractor for or an agent or employee f the limited partnership or of a general partner or being an officer, director or shareholder of a corporation that is a general partner in a limited partnership.

j. When this case reached the Supreme Court, it agreed with the dissent that a corporation could not serve as a general partner.

2. Mt. Vernon Savings and Loan v. Partridge Assoc. (Handout): Partridge Associates is a limited partnership. American Housing is the General Partner and MIW is 50% limited partner. Partridge enters into a contract from a loan with Mount Vernon Savings and Loan. FSLIC is the federal agency that insured the deposits of Mount Vernon Savings and Loan and became the successor in interest after the Savings and Loan Scandal. Partridge defaults on its loan and the General Partner, American Housing, is insolvent.

a. FSLIC sues MIW under the theory that MIW has exercised sufficient control to be liable as a general partner.

b. MIW defense is that it did not exercise sufficient control to make them a general partner.

i. ULPA §7: a limited partner shall not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business.

c. The court applies a 2 pronged testi. Did Mount Vernon have actual knowledge when dealing

with Partridge that MIW was acting as more than a limited partner?

1) MIW is going to point to the fact that prior to the time when American Housing stopped making loan payments, MIW’s president was not present at the meetings.

2) Only after the default of payments did MIW’s president go to the meetings. At this point, MIW has lost trust and confident in American Housing Corp. as the general partner.

3) There is no evidence that MIW actually exercised control at these meetings.

4) There is no evidence to suggest that Mount Vernon relied on MIW as a general partner or was in any way misled by MIW.


ii. Was MIW’s participation in the control of Partridge Associations substantially the same as the exercise of the powers of a general partner?

1) As a practical matter, MIW went to the meetings as a gesture to American Housing Corp.

2) MIW went to the meetings to exert influence and pressure on the actual decision maker—American Housing Corp.

d. The court in this case found that a limited partner will become liable as a general partner if he transacts business with third parties who have actual knowledge that the limited partner is exercising control.

i. There is no evidence of this in this case.e. The limited partner could also be liable if the exercise of control by

the limited partner was substantially the same as that of the general partner.

i. There is no evidence of this.ii. The public policy behind this is to preserve the integrity of

the statute. 1) The shield of limited liability is granted by the

state and it requires that a limited partner cannot take part in the control of the partnership.

2) Therefore, if a limited partner wants the limited liability shield, he/she/it cannot usurp the state’s authority by receiving the limited liability shield even though acting as a general partner.

f. What would the majority in Delaney think of this case?i. Majority would not have imposed liability because the

majority would only impose liability if Mount Vernon had relied on MIW’s actions/control as a general partner.

ii. No liability without 3rd party reliance.1) ULPA §7 had no 3rd party reliance

requirement, but Delaney required it to prevent Delaney from getting a windfall.

2) Under RULPA §303 the law holds limited partners liable when there is reliance by the 3rd

party that the limited partner is a general partner.

As a matter of public policy the limited partner is treated as a general partner only when the 3rd party transacts business with the limited partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.

3) California §15632 is the equivalent of RULPA §303.


California has additional language “based upon the limited partner’s conduct” and unsure as to whether that increases or decreases the burden.

The burden is now on the P to prove conduct of limited partner and the P has to show that the LP’s conduct was reasonably interpreted as GP’s conduct.

iii. So long as the P is entering into the transaction with full disclosure, the P is also assuming the risk.

1) The law is moving away from the notion that the general partner is the “deep pocket”

2) And rather than the “integrity of the statute” argument, the law has moved towards 3rd party reliance.

3. Limited Liability Partnershipsa. Part of the General Partnership Statutes.

i. California LLP provision begins at §16306.ii. Allows for limited liability for the malpractice of your

partners, but not your own malpractice or your team’s malpractice if you are the supervising attorney.

iii. Scope of LLP is unclear.b. To be a LLP, must register with the Secretary of State and usually

put up some sort of bond.4. Scope of Fiduciary Duty in Modern Limited Partnership

a. In Re USA Cafes, L. P. Litigation 5. The IRS “Check the Box” Regulations

III. History of the Corporation: Development of Corporation Law in the United StatesA. Race of the Lax: Competition for State Incorporation Business

1. The corporation was originally created to allow for an entity that could last forever separate and apart from the lives of the owners.

2. The industrial revolution created the need for limited liability.a. This goal was established through special charters granted by the

Crown and State Legislatures.3. The race of the lax refers to the competition between states to recruit

incorporation business.4. States compete with one another in designing their laws.

B. Implications of the Separation of Ownership from Control1. What is the cost of A leaving B in control of the furniture store and

traveling the world.2. In a corporation, there is separation of ownership of the business from

managerial control. What are the costs of monitoring and aligning the incentives of the management with ownership?

C. Influence of Delaware Law1. The Modern Corporation Code as Enabling vs. Regulatory


a. Enabling: facilitates incorporation.b. Regulatory: regulates incorporation and requires knowledge of the

rules.2. Goals of the RMBCA

D. Internal Affairs Doctrine and California Corporations Code §21151. According to California Corporations Code §2115 there are 2 types of

corporations.a. Foreign

i. Corporations incorporated in another state/country.ii. If a foreign corporation, must register/apply to do business

in CA.iii. Quasi-Foreign Corporations

1) Internal Affairs Doctrine states that the company’s internal affairs are governed by the rules of the state in which the company is incorporated.

2) In CA, this is true unless the corporation meets the triple 50% test, then it is a quasi-foreign corporation and the internal affairs of the company are governed by CA statute.

- more than 50% of payroll- more than 50% of property, AND- more than 50% of sales

3) The reason for this rule in CA is to protect CA corporations and CA believes that the listed sections of the CA code are superior than other states’ laws.

4) The theory is similar to minimum contacts. So much of the foreign corp.’s business is in CA so that CA state slaw should be applied.

b. Domestici. Incorporated in CA.

E. Theories of Corporateness1. Separate Entity Theory

a. Corporations are separate legal entities.b. The separate entity status gives the entity all the rights of a natural

person.2. Realist Theory

a. The entity is really the identity of its individual investorsi. This may be true for AB Furniture Store and closely held

corporations, but is it true for Disney and other publicly held corporations?

3. Contract Theorya. The corporations code is an “off the rack” set of rules.

i. You opt into these set of rules by picking the state you incorporate in and if you don’t like some things, you can


for the most part make alterations in your articles of incorporation.

b. There is some manifestation of the idea that the corporations are opting into the set of rules in the state.

c. Economists have a nexus of contract theory that all employees have an input in the company and the company is nothing more than a nexus of all the inputs into the corporation.

i. The corporation comprises of contracts between different groups, e.g. employees, shareholders, directors, officers, etc.

F. What is the Future?

Forming a New Corporation

I. The Incorporation Process and Its PitfallsA. Articles of Incorporation of Royal Plumbing Service, Inc. Hypothetical

1. Namea. Choosing a Name

i. RMBCA §4.01(c)(2)1) As long as the name of the company is not the

same as another company’s it will be accepted.Gives less discretion to the Secretary of State.More predictability.Movement towards the Model Act to encourage

incorporation in the state over other states.ii. CA §201

1) The secretary of state may require the company to change its name if it is too similar to another company’s name because it may be deceptive or misleading.

Secretary of State has less discretion.b. Reserving the Name Reserve name to prevent another person

from incorporating under the same name, but it is valid for a limited time to allow people from indefinitely reserving a name and forming the business.

i. RMCBA §4.02ii. CA §201(c)

c. Registering a Name Required for foreign companies to register their name in the state of business every year.

i. RMBCA §4.03ii. CA §201

1) CA §110 Filing of Instruments, Date, Endorsement, Requested Future Date, Return for Failure to Conform to law, Resubmission, Delayed Effective Date, Revocation

2. Duration


a. Unless the duration is limited by the Articles of Incorporation, the life of the corporation continues indefinitely.

i. MBCA §3.02ii. CA §200(c)

b. If the corporation originally has a limited duration, the corporation can amend the Articles under CA Chapter 9 if it wants to continue the life of the corporation beyond that which it was limited to.

i. Can amend, but need the approval of the shareholders.ii. Also, the Secretary of State must be notified of the

amendment.iii. Sometimes, if the corporation is limited and the corporation

continues without amendment, the law may recognize that the corporation has continued, but someone could use the life clause to argue that the corporation has been terminated.

3. Purposesa. General Purpose Clause unless you want to limit the purpose of the

business.b. If limited purposes, the ultra vires rules may apply.

4. Powersa. In California, a corporation has all the powers of a natural person

unless the language in the Articles limits the powers of the corporation.

5. Capitalizationa. Mandatory Provision

i. RMBCA §2.02 There is no minimum capitalization requirement because the RMBCA is an enabling statute.

ii. CA §202(d) and (e)6. **Intentionally Omitted**7. Directors

a. RMBCA §8.03i. Need 1 or more directors to form a corporation

b. CA Code §212i. Need just 1 director before the shares are issued to the

investors and need 3 directors after the shares are issued.1) Blackstone: Need 3 directors to have a

corporation.2) CA EXCEPTION: if there is only 1 shareholder

or there are 2 shareholders, the code permits having only 2 directors.

ii. CA §212 states if there are only 2 investors, need 3 directors to have a corporation. However, rather than recruit a third body, the fight will be who gets to select the 3rd director.

1) Consequently, as a practical matter, when there are 2 investors, there will be 4 directors.


c. Directors must be natural persons, but an incorporator may be anybody, including a corporation, partnership or any entity.

i. Definition of a Person1) RMBCA §1.402) CA §200(a)

8. Limitation on Director Liability9. Indemnification10. Interested Officers and Directors11. Signatures of the Parties12. Verification and Acknowledgement

B. By-Laws are internal operating procedures for the company.1. Not public record like the Articles of Incorporation.

C. Mandatory Provisions of the Articles of Incorporation1. RMBCA §2.02(a)2. CA §202

D. Option Provisions of the Articles of Incorporation1. RMBCA §2.02(b)2. CA §204

E. Incorporation Procedures: Formation of a Corporation1. Where to Incorporate

a. Race of the Laxb. For large publicly owned corporations, Delaware will probably be

the best choice, but for small, closely held corporations, should incorporate in the principal state of business.

2. Preparation and Filing of the Articles of Incorporationa. File with the Secretary of State’s Office

3. Post-Filing ProceduresF. Corporation’s Purposes and Powers: The Decline of the Ultra Vires Doctrine

1. The Articles of Incorporation must state the purpose of the business.2. The Articles of Incorporation used to require narrow and specific

purposes that stated the specificity of the business.a. When the purposes and powers of the Corporation were narrowly

construed, the Ultra Vires Doctrine was a doctrine through which one could assert that the Corporation had gone beyond their purpose or powers.

i. Ultra Vires Doctrine: “Beyond the Power.” An ultra vires act or contract is one that is beyond the powers expressly or impliedly conferred upon a corporation. Applies to acts of a fully organized corporation.

3. 711 Kings Highway Corp. v. FIM’s Marine Repair Services, Inc. (277): 711 leased premises to FIM to operate a movie theater. FIM’s articles state that their purpose is to conduct marine services. Landlord 711 sues FIM to prevent them from operating the movie theater and to invalidate the lease.

a. The general rule today is that any business can do what they want to today and engage in any lawful business activity.


b. To bring an ultra vires claim, must conform to RMBCA §3.04.i. There is a proceeding by the Attorney General under

§14.30.1) Rarely Happens

ii. There is a proceeding by a shareholder against the corporation to enjoin the act

1) Ultra vires may be brought by a shareholder to preserve the shareholder’s idea of what the corporation should be engaged in.

2) Equitable Relief RMBCA §3.04(c)3) The landlord has constructive notice because the

Articles of Incorporation were publicly filed/recorded. If the shareholders want to bring a motion to enjoin, the Landlord must be a party to it as well because “all affected persons” must be parties to the proceedings.

iii. There is a proceeding by the corporation, directly, derivatively or through a receiver, trustee or other legal representative, against an incumbent or former director, officer, employee, or agent of the corporation.

4. Theodora Holding Corporation v. Henderson (280): Corporation Alex Dawson, Inc. made a charitable donation to Charity Alex Dawson Foundation. Minority Shareholder Theodora Holding Corp. sues derivatively as well as on its own behalf for losses allegedly sustained by the corporate Defendant as a result of the charitable gift.

a. The court found that a corporation may make reasonable charitable contributions.

i. Reasonableness is defined by the IRS codes/deductions.G. Premature Commencement of Business: Liability on Pre-Incorporation

Agreements1. Promoter’s Liability on Pre-Incorporation Contracts

a. Stanley J. How & Associates, Inc. v. Boss (288): Boss (Promoter) entered into an agreement with How on behalf of a yet to be formed corporation. Boss is going to start a corporation to form a chain of hotels and How is going to design them as the architect. When the contract is entered into by How and Boss, Boss signs as “Edwin A. Boss, agent for a Minnesota corporation to be formed who will be the obligor.” Boss does not sign as Boss Hotel, Inc. because the corporation has not yet been formed.

i. There is a breach of contract and Boss argues that the corporation is liable, not him.

ii. The corporation is insolvent and How cannot collect against the corporation.

iii. The manner in which Boss signed the contract is ambiguous and the intent is unclear.


iv. The court states that there are 4 different interpretations of this ambiguity.

1) One party is making a revocable offer to the nonexistent corporation which will result in a contract if the corporation is formed and accepts the offer prior to the withdrawal.

The offer comes from the architect and the architect started performance on the contract and so the court does not accept the revocable offer theory.

2) A party is making an irrevocable offer for a limited time.

Consideration to support the promise to keep the offer open can be found in an express or limited promise by the promoter to organize the corporation and use his best efforts to cause it to accept the offer.

The contract will be formed only upon the formation of the corporation and the corporation’s acceptance of How’s offer.

Architect started performance on the contract almost immediately and did not wait for the formation of the corporation suggesting the contract was between How and Boss (not the corporation).

3) The parties agree to a present contract by which the promoter is bound, but with an agreement that his liability terminates if the corporation is formed and manifests its willingness to become a party. There can be no ratification by the newly formed corporation since it was not in existence when the agreement was made.

When the corporation is formed and agrees to enter into the contract, the promoter is released from liability.

4) They agree to a present contract on which, even though the corporation becomes a party, the promoter remains liable either primarily or as surety for the performance of the corporation’s obligations.

Boss is not released from liability.If the company does not pay, the corporation

and Boss can be sued. Boss can sue the corporation for equitable indemnification.


v. The court favors interpretations 3 and 4 in this case because How had already begun performance on the contract.

vi. Rule of Personal Liability: The promoter is personally liable unless the parties manifestly contract that Boss will NOT be liable and that the corporation yet to be formed will be liable.

1) The default rule is personal liability for the promoter.

b. Quaker Hill, Inc. v. Parr (293 and Handout): Parr is the promoter of a yet to be formed corporation, Denver Memorial Inc. Parr signs an agreement with Quaker Hill, Inc. on behalf of the corporation.

i. Quaker Hill sued Denver Memorial, but since it never came into existence, sued the promoter, Parr.

ii. Default Rule: Rule of Personal Liability1) Parr hast eh burden of proving that he is not

personally liable.2) For Parr to not be liable, he has to show that there

was an agreement that Quaker Hill would only look to the corporation for payment.

iii. The court in this case found that there was no promoter liability because the Quaker Hill knew that the corporation was not formed and Quaker Hill’s salesman, Barker, nonetheless, urged signing the agreement.

c. In the above 2 cases, the court seems to be saying “He who could have prevented the harm must be liable for it.”

i. In Boss, the promoter could have avoided the liability by waiting to sign the contract until the corporation was formed. So, between How and Boss, Boss was the one who could have prevented the harm and must bear the responsibility for the resulting injury.

ii. In Quaker Hill, the vendor could have avoided the harm by waiting for the corporation to form before signing the agreement.

d. Releasing Promoters from Liabilityi. Goldman v. Darden (294, Note 6)

1) “We do not believe the agreement to release a promoter from liability must say in so many words, ‘I agree to release.’ Where the promoter cannot show an express agreement, existence of the agreement to release him from liability may be shown by circumstances. Of course, where circumstantial evidence is relied on, the circumstances must be such as to make it reasonably certain that the parties intended to and did enter into the agreement.”


2. Corporation’s Liability on Pre-Incorporation Contractsa. MacArthur v. Times Printing Co. (Handout): Nimocks is the

promoter for Times Printing and enters into an employment contract with MacArthur. MacArthur is to be the Advertising solicitor for the newspaperfor one year, but is fired and sues for breach of contract.

i. The corporation argues that the agreement was entered into before the corporation was formed and so the promoter is personally liable.

ii. When the newspaper is formed, it does not become automatically liable unless the corporation adopts the agreement (most often expressly).

1) However, the promoters liability is not automatically released by the corporation’s agreement.

2) The promoter should get a release by the corporation and by the other party in the contract to assure that he/she has been released from liability.

iii. Although the contract is signed by Nimocks, there is evidence that all of the stockholders, directors and officers of the corporation knew of the contract at the time of its organization or were informed of it soon afterwards and none of them objected or repudiated it, but retained P in the employment of the company without any other or new contract.

1) Therefore, the court finds that although the contract between Nimocks and MacArthur did not bind the corporation, the corporation acquiesced to the contract through their subsequent actions. It adopted the contract and accepted liability.

iv. MacArthur could have probably sued the promoter but wanted to sue the corporation because the corporation has money.

H. Defective Incorporation1. De Jure Corporations

a. Official Corporation recognized by the State and Certificate of Incorporation.

b. That which exists by reason of full compliance by incorporators with requirements of an existing law permitting organization of such corporation.

c. Properly formed corporations.d. Can be a de jure corporation without by-laws because by-laws are

NOT required to form a corporation.2. De Facto Corporations


a. An association claiming to be a legally incorporated company, and exercising the power and functions of a corporation, but without actual lawful authority to do so.

b. De Facto Corporation Requirementsi. A valid law under which such a corporation can be lawfully

organizedii. An attempt to organize thereunder

iii. Actual use of the corporate franchiseiv. Good faith in claiming to be and in doing business as a

corporation is often added as a further condition.3. Corporations by Estoppel

a. A corporation which comes about when parties, by their agreements or conduct, estop themselves from denying the existence of the corporation.

4. Robertson v. Levy (297): Robertson and Levy entered into an agreement. Levy was to form corporation Penn Ave. Record Shack, Inc., which was going to purchase Robertson’s business. Levy submitted the Articles of Incorporation to the Secretary of State, but a Certificate was not issued and the Articles were rejected on Jan. 2, 1962. On Jan. 8, Robertson executed a bill of sale to Penn Ave. Record Shack, Inc. the Certificate of Incorporation was issued on Jan. 17, 1962. In July, the corporation stopped paying lease.

a. It was up to Levy to form the corporation and the corporation was going to use a note providing for installments payments to pay for the purchase of Penn Ave. Record Shack, Inc.

b. Robertson did not know that the corporation was not in existence when he entered into the contract with Levy.

c. The court found that Levy was liable for the breach of contract to Robertson because he had no authority to act but did so.

d. Model Act §50: De Facto Corporationsi. RMBCA §2.03 Eliminates de facto corporations.

e. Model Act §139: Corporation by Estoppeli. RMBCA §2.04 “All person purporting to act as or on

behalf of a corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.

f. The trial court had found that Levy had no liability under the estoppel theory.

i. Robertson bargained on the risk.ii. Robertson was looking to the corporation for payment on

the note.iii. Robertson, by not obtaining a personal guarantee from

Levy assumed the risk.5. Cantor v. Sunshine Greenery, Inc. (handout): Cantor (P) sued Brunetti,

officer/promoter of Sunshine Greenery, Inc. for a lease agreement. Brunetti had signed a certificate of incorporation on Dec. 3 and mailed


it to the Secretary of State on the same date with a check for the filing fee, but for some reason the filing was not immediate and there was no de jure corporation until Dec. 18, 2 days after the execution of the lease.

a. The court found that there is no personal liability under the De Facto Corporation Doctrine.

b. The P cannot attack the promoter because there was a good faith delay, and D honestly believed there was a corporation in place.

i. The shield is placed to protect D from P.ii. If de facto corporation, the state can sue the

corporation, but nobody else can.1) The state can sue because it is the one who grants

the right of a business entity to be a corporation.c. Many states are trying to eliminate the de facto doctrine.

6. Cranson v. International Business Machines Corp. (handout): Cranson goes to the attorney to form a corporation, signs the articles of incorporation and then enter into a contract to buy computers from IBM. The lawyer does not file the articles of incorporation.

a. There was no effort made to organize the entity as a corporation.b. The court allocates the consequences of the mistake.c. Cranson argues that there is a shield of limited liability because of

the corporation, but IBM responds that there is no shield because there is no de jure corporation.

d. Cranson, then argues that his corporation is a de facto corporation.

i. Cranson has difficulty arguing that he has the shield of limited liability as a de facto corporation

1) There is no good faith effort to incorporate under the existing law.

e. Cranson will then argue Corporation by Estoppel.i. Equitable Doctrine.

ii. Cranson was holding himself out as a de jure corporation, IBM was relying on the representation and now IBM is estopped from denying the corporation’s existence.

1) The party making the representation is not the one that is estopped from talking about the truth of the representation.

iii. Cranson did not have knowledge that the Articles of Incorporation were defective or not issued, whereas Levy knew of the defective incorporation.

f. In CA, where there is no de facto corporation doctrine, the state still holds onto an estoppel doctrine because there may be equitable considerations.

i. If a corporation by estoppel, the shield is not against everyone, but just the person who reasonably relied.

ii. If a de facto corporation, the state can take action against the corporation whereas the rest of the community cannot.


iii. If a de jure corporation, then P would have to pierce the corporate veil.

1) However, if like Cranson, since he was in the best position to make sure that there was correct incorporation, against a 3rd party, the corporate veil would probably be pierced and Cranson would probably be liable.

7. Frontier Refining Company v. Kunkel’s, Inc. (310): Kunkel wants to start a gas station and is financed by Fairfield and Beach. Kunkel enters into a contract with Frontier Refining Co. The contract is signed by “Clifford D. Kunkel dba Kunkel’s, Inc.” Frontier Refining Co. contemplated getting paid on a COD (Cash on Delivery) basis but the delivery man did not collect the money. Kunkel, Inc. started doing poorly and Frontier sues Kunkel, Beach and Fairfield.

a. There was no actual incorporation and so Frontier claims that Kunkel, Fairfield and Beach were general partners.

b. The court found that Beach and Fairfield were not liable.i. The court found that Beach and Fairfield were inactive

investors and because they did not know that they were not incorporated, there is no intent and they did not hold themselves as a corporation. They did not purport to act, Kunkel did.

c. A decisive element in this case is the intent of Frontier and Kunkel, Inc. because Frontier would have gotten a windfall.

i. Frontier did not get paid because they made a mistake and did not collect upon delivery.

ii. Frontier’s mistake and failure to internally control the payments led to the error.

iii. Frontier only became aware of Beach and Fairfield sometime after they had cut off credit to Kunkel and wanted money.

d. Beach and Fairfield are not liable as promoters because Frontier never relied on them and to hold Beach and Fairfield liable, Frontier would have the burden of showing that they relied on Beach and Fairfield for payment should the corporation default.

e. Estoppel does not apply because Kunkel, Inc. was involved in the dealings and Fairfield and Beach were not involved.

f. There is an argument that Beach and Fairfield should have followed up if they really had wanted the shield of limited liability and should have checked to make sure that Kunkel incorporated.

I. Promoter’s Fiduciary Duties1. Frick v. Howard (Handout): Preston bought land with the intent of

opening a hotel on the land. He enters into a contract to purchase for $240,000. On April 1, 1958, he formed a corporation, Pan American Motel, Inc. After he formed the corporation, he took title to the property and Pan American bought the property from Preston for $350,000 with


a $110,000 note. The directors who approved this transaction were Preston, his wife and his attorney. Later on, no payments were made on the note and the company took back the $110,000 note and substituted a $145,000 note which is sold to Frick. Preston collects $72,500 from Frick in December and in January Pan American goes bankrupt. Frick sues Pan American, Inc. because Frick is a secured creditor. Howard is the Receiver and is suing to stop the foreclosure of the property because he doesn’t want Frick to take over the property.

a. Howard tried to prevent the sale of the property by invalidating the transaction between Preston and the Corporation.

b. The court says that if Preston wants to engage in this transaction, he must disclose all the material facts to creditors and future investors.

i. Like Meinhard v. Salmon.ii. Full and adequate disclosure is required.

II. Piercing the Corporate Veil: Risks of Corporateness Being DisregardedA. These cases begin on the premise that the corporation is a de jure corporation.B. The Common Law Doctrine

1. Contract Creditor Casesa. Bartle v. Home Owners Corp. (315): Westerlea, Inc. was

established by Home Owners Corp. to build homes for war veterans. Westerlea, Inc. went bankrupt and P (bankruptcy trustee) seeks to pierce the corporate veil and hold Home Owners Corp. liable for Westerlea’s debts because the homes built by Westerlea were to be sold to Home’s shareholders for a fixed amount so that Westerlea would never make a profit.

i. Basic Standard for Piercing: Must show fraud and fundamental unfairness to pierce the corporate veil.

ii. The court found that there was no fraud because WEsterlea never misled, confused, etc. the contractors

iii. The court found that there was no illegality.iv. Dissent

1) When doing business with a company, there is an assumption that the company is established to make profits and so there is fraud.

2) The corporate veil should be pierced.b. Dewitt Truck Brothers v. W. Ray Flemming Fruit Co. (317):

Flemming is an agent between the fruit growers and the markets. Flemming hires truckers to transport the fruit. One of the truckers hired is Dewitt. Ray contemplates paying Dewitt through a corporation, Flemming Truck Co. and by paying Dewitt from part of his profits from picking up the fruit. Flemming takes commission. Money from vendors is to be distributed to Dewitt, Flemming for commissions, and the fruit growers. Ray Flemmings Co. becomes insolvent and goes bankrupt.


i. Ray Flemmings Co. is a one man operation.1) The company is not retaining profits because its

revenues are being zeroed out by paying a salary to Flemming.

ii. Dewitt did not get paid and Flemming gave a personal assurance that he would pay Dewitt if the corporation did not.

iii. Dewitt sues Flemming personally to recover the balance due from Flemming’s corporation.

iv. The court finds Flemming to be personally liable because of fundamental unfairness. The corporation was an artificial shield for Flemming’s actions.

1) Alter-Ego2) Commingling of Funds3) Instrumentality Theory4) Failure to observe corporate formalities

Dewitt was harmed as a result of Flemming failing to observe corporate formalities.

5) A marginally capitalized corporation can be used to allocate risk and so by itself is not fraudulent.

The fact that there is no money in the corporation is irrelevant.

Marginally financed corporations are used to allocate the risk which generates the revenue stream.

As long as Flemming is honest and discloses the business model, the corporate veil will not be pierced for inadequate capitalization.

v. Flemming becomes fraudulent by taking out money from his proceeds and cheating his creditors.

1) He takes out money and distributes it to himself instead of paying his creditors.

2) Flemming gave Dewitt a personal guarantee.When the corporate veil is pierced, Flemming is

being held liable through the corporation’s actions.

The corporation acted as an alter-ego of Flemming.

2. Tort Creditor Casesa. Baatz v. Arrow Bar (326): a married couple is in a car accident.

The person who hit the couple had been at Arrow Bar and was intoxicated. The bar and its owners, Ed and Lavella, are being sued along with the tortfeasor. The theory is that the employee of the bar was negligent in serving alcohol to an already intoxicated customer and the employer is personally liable through respondeat superior.


i. The tortfeasor has no money and no/not enough insurance and the corporation does not have enough and so Ed and Lavella are sued to pierce the corporate veil.

ii. Ed and Lavella personally guaranteed a $145,000 loan from the bank and contributed $5000 into the corporation.

iii. Factors for Piercing the Corporate Veil (328)1) Fraudulent representation by corporation

directors2) Undercapitalization

Alone Insufficient to pierce the corporate veil.

3) Failure to observe corporate formalities4) Absence of corporate records5) Payment by the corporation of individual

obligations6) Use of the corporation to promote fraud,

injustice or illegalities.iv. The court rules against eh P and incentivizes the honest

business entrepreneur.1) But to know if Ed and Lavella are honest business

entrepreneurs, don’t we need to know the price of dram shop insurance and whether or not they made a reasonable business decision.

v. Fraud and Fundamental Unfairness are required to pierce the corporate veil.

1) The factors that tend to show fraud and fundamental unfairness are the same in contract and tort creditor cases.

vi. Role of the Lawyer1) Inform the clients of not getting dram shop

insurance2) As the business gets more profitable, encourage

the clients to buy insurance at that point3) Inadequate capitalization

When do you measure it?What do you measure it on?Where does the law come from?

b. Radaszewski v. Telecom Corp. (334): Contrux is engaged in interstate commerce and a driver of Contrux gets into an accident.

i. Contrux is liable under the theory of respondeat superior.ii. The problem in going against Contrux is that Contrux’s

insurance carrier went insolvent.iii. Contrux went beyond what was required to protect their

business, but because the insurance company was bankrupt, they did not have enough to cover the accident and the P wants to sue Telecom by piercing the corporate veil.


iv. The court found that the P could not pierce the corporate veil.

v. P argues that there is fundamental unfairness because Contrux was undercapitalized.

1) The court found that this did not matter and Contrux was not inadequately capitalized because the company purchased insurance to take care of situations such as this.

vi. The court protects the reasonable expectations of the parent company.

c. Walkovsky v. Carlton (338, Note 4): Carlton owns cab companies. Required insurance with $10,000 coverage. A person injured by one of the cabs sues.

i. P’s medical costs exceed the $10,000 insurance coverage.ii. P tried to show that all the cab companies were one

business and that Carlton was the parent company.iii. In order for the P to pierce the corporate veil, he has to

show that there was fundamental unfairness.1) There was commingling of funds2) Failure to observe corporate formalities3) Etc.

iv. The court found that the complaint failed to state any sufficiently particularized statements that the D, Carlton, and his associates were actual doing business in their individual capacities shutting their personal funds in and out of the corporations without regard to the formality and to suit their immediate convenience.

3. Parent-Subsidiary Casesa. Fletcher v. Atex, Inc. (341): Ps sued Atex and parent company,

Kodak, for injuries caused by use of their keyboards. Atex was the wholly owned subsidiary of Kodak. P sought to hold Kodak liable for Atex under the alter ego theory.

i. P alleged that Kodak and Atex operated as a single economic entity.

ii. P could not prove that Kodak and Atex operated as a single economic unit, and even if they were a single economic entity, there is no evidence that shows fundamental unfairness.

1) Fundamental unfairness is the confusion in the creditor’s mind as a result of the failure to disclose that these entities are separate.

iii. Delaware Law requires1) Parent and Subsidiary “operated as a single

economic entity” AND2) An overall element of “injustice or unfairness”

iv. Cash Management System


1) Every night the subsidiary corporation hands over their revenues to the parent corporation and the parent is able to invest more money and make more money.

2) By collectivizing their investments the consumer is hoping that the company will have lower costs and pass the lower costs to consumer.

3) Tool by parent company to get a better return on investment.

C. Cases that Masquerade as Piercing the Corporate Veil Cases1. Stark v. Fleming (366): appellant placed her assets into a newly

organized corporation and began to draw $400 per month as salary and built up her social security account.

a. The government, via Secretary of Health, Education, and Welfare is suing the widow because she used this newly organized corporation to build up her social security.

b. The court found that a widow is an intended beneficiary of Social Security Statute.

c. The court did find that the secretary could make an objective reappraisal of the widow’s salary to determine if it was reasonable for the services she performed.

2. Reccograndi v. Unemployment Compensation Board (366): appellants are all members of a family who are involved in the wrecking business together. Each member is an officer of the corporation. During periods of insufficient work, the board meets and lays off 2 of the 3 family members who then in turn claim unemployment compensation.

a. The court found that unemployment is for employees, not employers and the owners of capital.

i. The unemployment statutes were not intended to benefit the owners of capital, but rather laborers and employees.

D. Equitable Subordination Doctrine1. Pepper v. Litton (372): Dixie Split Coal Co. is fully owned by Litton

who also acts as the President of the company. The company is successful, at first, but starts to decline. Litton stops paying himself and his salary accrues. Litton has a royalty contract with Pepper and Pepper sues Dixie Co. for Breach of Contract. When Litton finds out that Pepper filed a law suit, he files one against Dixie Co. for his back salary.

a. In the claim by Litton against Dixie Co., the company confesses judgment to the back salary.

b. Once executed and judgment is enforced, Dixie Co. files for bankruptcy and the trustee sues on behalf of the creditors.

c. Pepper sues Litton under the “Deep Rock” Doctrine.i. “Deep Rock” Doctrine: bankruptcy court has the

power to subordinate inequitable claims of dominant and controlling shareholders.


d. This is not a piercing case, but looks like it because equitable subordination requires a showing of fundamental unfairness.

e. The court does not allow Pepper to pierce and go after Litton because then Pepper will get a windfall because he did not bargain for a personal guarantee from Litton.

f. Pepper wants to undo the execution of the judgment from Litton v. Dixie Splint and restore the assets to the company and make it available for him and the other creditors.

g. The court does not find that it was inherently fraudulent for Litton to do what he did.

h. This is like Frick v. Howard wherein there is no independent person agreeing on the note.

i. In this case there is no independent person to judge the unpaid wages and confess judgment of back salary.

Planning the Capital Structure of the Closely Held Corporation

I. The Financial Structure of the Closely Held CorporationA. Planning the Capital Structure for the Closely Held CorporationB. Types of Securities: The Fundamental Distinction between Debt and Equity and

the Concept of Hybrid Securities1. Debt

a. Debt is a contract and it alludes to the rights of the creditors.b. Generally speaking the money is borrowed and the transaction

establishes a maturity date (when the loan is due) and this transaction is not free (interest) and the interest is tax deductible to the business.

2. Equitya. Money invested as shares gives a return in form of dividend and is

taxable and gives rise to double taxation.i. There are ways to avoid double taxation.

b. Every corporation has an Articles of Incorporation that define the types of stocks that they have.

i. There are 2 types of stocks1) Preferred2) Common

C. Different Types of Equity Securities1. Attributes of Common Stock

a. Rights are established in Articles of Incorporation.b. Stock generally has 2 basic attributes

i. Financial Rights1) Right to receive payments and distributions from

the company2) Distributions are payments to the shareholders.

ii. Control Rights1) What kind of voting rights


c. Must have common stock for their to be preferred stock.2. Shareholder Distributions (including Dividends)

a. There are 2 types of Distributionsi. Dividends

1) Distributions from current/retained earningsii. Liquidation

1) Distributions from the liquidation fo the business2) When the stocks are sold to get out fo the

investment3) Liquidity is the ability to get in and out of the

investment.4) Includes redemptions and repurchases

b. Nobody has the right to a dividend until the board declares a right to a dividend.

i. The board has to declare a dividend before somebody has a legally enforceable right to a dividend.

3. Preferred Stock: Use of Multiple Classes of Stocka. Preferred stock is senior to the common, but gets paid its

preference AFTER the creditors.i. Only senior to the common stock, but not senior to the

creditors.b. There are 3 types of shares

i. Authorized = Maximum number of shares a company can sell

ii. Issued = Shares that are actually soldiii. Outstanding = shares that are sold, but not reacquired.

c. The statement of authorized capital must be set forth in the Articles of Incorporation

i. RMBCA §2.02 and §6.01-6.03ii. CA §202(d)-(e)

d. If there is no distinction of stocks set forth in the articles, all the stocks are treated as common stocks.

i. CA §2034. Different Types of Preferences

a. Cumulative Dividendi. Dividend Overhang

ii. Give the holder a priority to receive any prior unpaid dividends from a previous year before any dividends are paid on common stock.

b. Non-Cumulative Dividendi. Rights of Preferred shareholder do not accumulate and

carry over unpaid dividends from previous years.ii. If the company does not pay dividends one year, it

disappears for that year.c. Partially Cumulative Dividend


i. If the company could have paid the dividends, but chose not to pay, the unpaid dividends will accumulate.

d. Participating Preferred Stocksi. The shareholder receives their preference before

distribution to the common shareholder, but also gets distributions that common shareholders are entitled to.

ii. Participating preferred stocks get paid twice – once for the preference and again with the common shareholders.

e. Dividend preferences can be changedi. CA §902-903 allows changes in rights, preferences and

privileges of a class of outstanding preferred stockii. The company’s Articles of Incorporation must show the

capital structure of the corporation, so there must be an amendment which is approved by the shareholders if a change is to be made.

iii. A corporation can change the articles by board action and approval by the shareholders.

1) But the amendment has to be approved by the outstanding shareholders entitled to vote and the preferred stock holders if the proposed amendment would affect their rights.

CA §903(a)(4)iv. Classes and Series of Stock

1) Preferred stock is a class and that class carried a dividend preference, but the market changes and the dividend preference in the market changes.

To change the dividend preference, must take a vote and amend, but that is cumbersome and so rather than do that, the corporations have moved to “series” and Blank Check preferred stock (leaves the preferences blank and the blanks are filled in by the board of directors.

(a) RMBCA §6.02(b) CA §202(e) and §401

f. Voting or Non-Voting Preferred Stocki. Usually preferred stock has no voting rights in general.

ii. However, can be triggered by consecutive defaults on dividend rights of preferred stock.

iii. Voting rights must be specified in articles of incorporation, which represents preferred shareholder’s contract with corporation.

iv. Gives shareholders some right to monitor/control.g. Liquidation (or dissolution) Preference

i. When a corporation is dissolved and all creditors claims have been paid—both secured and unsecured, then


preferred shareholders have priority over common shares to extent of their preference in any further distribution of any remaining assets.

ii. After payment of any liquidation preference, distribute any remaining funds to common stock (residual claimants).

h. Use Participating or Non-Participating Preferred Stocki. Participating preferred stock is a hybrid security – having

some features of common stock (i.e. the right to participate in further dividend distributions made by the company) as well as having some preference over common stock (which makes it look more like a senior security).

i. Making Changes to Terms of Outstanding Preferred Stocki. Changes to rights, preferences and privileges of a class of

outstanding preferred stock are governed by the codes.1) RMBCA §10.03-10.042) CA §902-903

ii. The board cannot unilaterally amend terms of its outstanding preferred stock.

iii. The terms of an outstanding class of preferred stock cannot be amended without first obtaining the preferred stockholders’ consent to such changes (usually by a majority vote of such class) – even if such shares are otherwise non-voting.

j. Authorize Different Classes (or series) of Preferred Stocki. To avoid the cumbersome process of changing the

preferred stock preferences, corporations have moved to “series” of preferred stock.

1) i.e. $2 dividend series, $4 dividend series, etc.k. Authorize Blank Shares?

i. Blank Check Preferred Stock1) Allows the Board flexibility to establish financial

terms of a particular class or series of shares at time of issuance.

2) The market and the fiduciary duty of the Board will dictate how the Board fills in the blank.

3) The board issues a Certificate of Determination once it decides to issue preferred stock.

ii. Allows board to take into account current economic conditions in specifying the terms of the preferred stock it plans to sell.

5. Redeemable Preferred Stocka. Preferred Stock “Redeemable” at Option of Corporation –

“Callable” Preferred Stocki. Stock that is callable at the option of the Board.


ii. Usually callable at a fixed price in the Articles (redemption price) and subject to any other terms or restrictions on the Board’s right to redeem out these preferred shares.

1) Any discretion that the shareholder is going to have is going to be in the Articles of Incorporation.

iii. CA §402b. Preferred Stock “Redeemable” at Option of Shareholder – a form

of demand indebtedness?i. Preferred stock may be made redeemable at the option of

holder – akin to a “demand note.”ii. The preferred shareholder can demand that the company

pay him/her.iii. The difference between a demand note and preferred stock

is the tax treatment.1) Dividends on preferred stock are taxed twice.2) Demand note is a debt and the company has to

pay interest, which is a fixed obligation.Preferred stock does not result in a fixed debt

until the board declares a dividend.iv. Security interestv. For the preferred shareholder that is worried about not

being paid, insist on a “sinking fund” which is established to set aside money to pay preferred shareholders.

6. Convertible Preferred Stocka. Convertible at Option of Holder

i. Generally convertible into some other class of stock.1) Example: convertible preferred stock that is

convertible into company’s common stock.ii. Usually subject to limitations

1) How many shares if the shareholder converts?2) What is the price of conversion?3) Are there black out periods for exercising

conversion?iii. Preferred shareholders will want to convert if the

company is making a lot of money because the preferred shareholder is limited in equity sharing.

iv. CA §403b. Forced Conversion

i. Preferred stock redeemable at the board’s call.ii. When the call for redemption is made, the preferred

stockholder gets the redemption price set out in the articles.iii. Once the call is made, no longer preferred shareholders;

only entitled to the amount of the money set forth in articles.


iv. The preferred shares are no longer considered outstanding The company has reacquired them.

1) Preferred shares may be converted to common stock and there is an exchange ration of 1 on 1.

v. In a forced conversion, the corporation eliminates the preferences and the class of preferred stock from the capital structure.

vi. The board assumes that preferred stockholder will convert if trading price of common stock exceeds redemption price of preferred stock at time Board makes the call for redemption of preferred stock.

7. Redeemable Common Stocka. In CA, redeemable common stock is absolutely prohibited (as was

the law under common law).i. Danger to the corporation because of cash flow problems

and fraud on the creditors. ???Why a fraud to creditors???

1) ???Depleting your account by buying back common stock???

2) Purchasing stock with capital that was assumed to be for the creditors.

3) Made assumption that the call would be when the company is doing poorly.

ii. CA §402(c)b. Model Act allows for redeemable common stock.

i. Broad Freedom of Contract.1) Creditors take the risk when they decide to loan

money to the corporation.2) It is up to the creditors to take the necessary

precautions.ii. RMBCA §6.01

c. At the Option of the Holderd. At the Option of Corporation (Callable Common Stock)

8. Convertible Common Stocka. Convertible into another class of stock

i. Downstream Conversion1) Allows conversion from preferred to common

stock.2) Allows bondholders/debt holders to convert into

stock if the company performs well. - Convertible Debenture.

ii. Upstream Conversion1) Upstream Conversion is the right to convert

common shares into preferred shares, or to convert either common or preferred shares into debt securities or interest.


2) Although preferred stock may be convertible into common stock, most state statutes prohibit shares with an “upstream conversion” right.

3) Both the Model Act and CA permit conversion from common shares into preferred stock.

4) What about converting from being a shareholder to a bondholder?

- Problem because the creditors have relied on the common shareholders.

- CA views upstream conversion as inherently fraudulent and prohibits it.

- Model Act allows upstream conversion and can bargain for the protections you want. Everybody is on notice. Default Rule.

b. Convertible into debt9. The RMBCA’s “Freedom of Contract” Approach

D. Issuance of Shares1. Problem 1, Page 415-4162. Subscription Agreements

a. Post-Incorporation Subscription Agreementi. Contract usually made after the company is in place that

obligates the investor to buy shares and obligates the company to issue the shares on the terms set out in the subscription agreement.

b. Pre-Incorporation Subscription Agreementi. Contract between A and B wherein B will insist on a

subscription agreement because B has no cash and A has all the cash and B wants to insure that A will invest his cash.

3. Number of Authorized Shares: Herein of “Dilution”a. Disparate contributions of founding shareholders

i. A is contributing all the money into AB furniture store and so if the corporation issues its shares equally to A and B, should something happen to the corporation and its assets be liquidated, A and B will receive half of the corporation’s assets.

1) A will be mad because he financed the capital.2) B argues that he is putting in consideration as well

Non-cash consideration. Labor Capital.b. Valuation of non-cash consideration

i. Must value B’s contribution to the corporation, but is hard to do.

ii. In CA, a promise to render future services is NOT considered consideration because it is uncertain as to whether or not the services will be rendered.

1) The CA rule protects creditors who are contributing tangible assets to the corporation.


iii. Under the Model Act, future services may be consideration.1) As long as there is some benefit to the company,

anything may be consideration.c. Concept of “Earn-Outs”

i. A is putting in the money and since B is not going to contribute capital, he is going to sign an employment agreement at which he is going to receive his shares on a “sliding scale” according to the services rendered to the company.

ii. Example: A is going to contribute $100,000 in cash and buys 100 shares and B contributes $100 in cash and buys 100 shares. What happens if there is an electrical storm and the company has $100,100 and the company is insolvent?

1) If the company decides to liquidate then the dividends will be distributed 50-50. A will argue that B hadn’t vested and didn’t earn the full amount.

- Problem of Equity Dilution on Premature Liquidation.

2) When there is premature liquidation, B gets a windfall and A suffers.

3) B has a tax problem, if he gets his shares today, B gets a bargain purchase because he got something for $100 what someone else paid $100,000 for. The government will impute the income and tax B for the full $100,000.

4) CA §4095) RMBCA §6.21

- Old Model Act §194. Concept of “Par Value”

a. Par value is largely obsolete, but Delaware still retains this concept.

i. Created in a period when the government wanted to encourage industry.

ii. Par value is an arbitrary dollar value assigned to shares of stock which represents the minimum amount for which each share may be sold.

iii. When somebody pays for stock greater than the stated par value, the par value amount goes into the stated capital account under Shareholder’s equity. The addition amount goes into the Capital (or Paid-In) Surplus account under Shareholder’s equity.

b. Balance Sheet Accountsi. Stated Capital

ii. Capital Surplus


iii. Retained Earningsc. Watered Stock Liability

i. Watered stock liability arises when the stock is sold for less than the par value.

ii. Hospes v. Northwestern Manufacturing and Car Company (393): the Board issued common stock for less than the par value of the stock when it was issued.

iii. Hanewald v. Bryan’s Inc. (397): de jure corporation. Hanewald sold Bryan’s Inc. his dry goods store. Bryan’s has another dry goods store in another state. Hanewald has agreed to sell the store to the corporation that Keith and Joan are going to form. They pay $60,000 ($55,000 in cash and $5000 in promissory note). Keith and Joan also agreed to a 5 year lease for $600 per month. After 4 months Bryan’s Inc. shuts down. Hanewald sues Keith and Joan because he didn’t get paid his note or his rent for the 5 years. The company had 100 shares total, which were issued and divided 50-50 between Keith and Joan. Keith and Joan contributed $10,000 for which they got stock and a $10,000 note. The company owes Keith and Joan $10,000. Keith and Joan also guaranteed a loan from the bank for the corporation. Keith and Joan enter into the transaction completely transparent. The par value of the shares was $1000.

1) The articles stated a very high par value and so look at the Legal Capital Rules §18.

2) Keith and Joan had paid off themselves, the bank and other trade creditors by collecting on the par value of their shares, but didn’t pay Hanewald.

3) Hanewald had entered into the contract with the corporation, but because the corporation is insolvent Hanewald is attempting to pierce the corporate veil.

4) There are 3 theories regarding watered stock based on par value.

- Trust Fund: the par value is treated like a reserve/fund for the creditors. This theory has been rejected because this theory implies a separation of legal and equitable interest which is not true and because the company is supposed to spend money in the best interest of the company (not the trustees – or creditors in this case)

- Implied Contract: based on the theory that there was an implied contract between Hanewald and investors. Implied contract


that one will pay at least par value for the stock. In this case, Keith and Joan did not pay the full value for the stock or any value.

- Fraud/Holding Out: no fraud because Hanewald did not rely on a fraudulent balance sheet.

5) The trial court found that because Keith and Joan did not act in bad faith, the corporate veil would not be pierced.

- Although Bryan’s Inc. is liable on the note and lease, Keith and Joan are not.

6) The appellate court reversed the decision of the trial court.

- The court found that the risk had been allocated to Keith and Joan to inform their creditors. The judge ignored the clear language of Model Act §18.

7) The trial court had found for Keith and Joan because Hanewald was not looking to Keith and Joan to get paid, but the corporation.

8) The maximum liability exposure based on watered stock liability was $38,000.

9) When the corporate veil is pierced the Ds are liable for the total debt but under the Watered Stock liability there is a cap on par value and how much Ds received.

5. What type of Consideration can be used to Acquire Stock?a. Traditional Distinction between Permitted (Eligible) Forms of

Consideration and Prohibited (Ineligible) Formsb. RMBCA c. CA

6. Par Value in Modern Practicea. Modern Use of “No Par” shares

i. Today to avoid watered stock liability corporations will issue no par value shares.

b. Legally available source of funds for shareholder “distributions”i. Retained earnings

1) Can pay out of this account as long as it does not result in insolvency.

- Prior to GAAP, Insolvency = cannot pay debts when due

- Balance Sheet Testii. Capital surplus

1) If you distribute from capital surplus, must disclose to the shareholders that you are distributing from this account.


iii. CANNOT distribute from stated capital.7. Legal Restrictions on Dividends and Other Shareholder Distributions

II. Use of Debt FinancingA. Different Types of Debt Securities

1. Bond2. Debenture3. Revisiting the Concept of “Hybrid Securities”

B. Concept of Leverage1. Loans made by 3rd Parties (“Outside” Debt)2. Loans made by Shareholders (“Inside” Debt)

C. Tax Advantages of Debt1. Debt-Equity Ratio

a. The courts have found that the proper debt-equity ratio is 3:1.2. “Thin” Capitalization

a. When there is a high debt-equity ratio.D. Debt as a Planning Device: Obre v. Alban Tractor Co. (413): Obre and Nelson

form a new corporation to engage in moving dirt and building roads. Obre agreed to contribute to the corporation equipment and cash worth $65,548.10 while Nelson agreed to contribute $10,000 in cash and equipment. The value of the equipment is negotiated by Obre and Nelson.

1. The Board values the consideration and once it does the value is binding.a. CA §409

2. The company in this case became insolvent.3. The company had been financed as follows

a. Obrei. Non-Voting Preferred Shares 20,000

ii. Voting common stocks 10,000iii. Note (5 years/5% interest) 35,500iv. Total 65,500

b. Nelsoni. Voting common stocks 10,000

ii. Total 10,000c. This is within the zone of acceptability because there is a 1:1 debt-

equity ratio.4. The creditors sue when the company becomes insolvent

a. The creditors argue that Obre’s 35,500 note was really equity and not a loan.

i. Equitable Subordination: Deep Rock Doctrine (Pepper v. Litton)

5. The court found that there was no showing of undercapitalization, fraud, misrepresentation or estoppel.

6. Not a piercing claim because the creditors were not trying to hold Obre personally liable.

7. There was no fraud in this case Obre and Nelson were disclosing to their creditors the $35,500 note to Obre and so the creditors assumed a risk.


E. Use of Debt in Planning Capital Structure of AB Furniture Store, Inc.

III. Use of Limited Liability Company as an Alternative to IncorporationA. What is a Limited Liability Company?

1. LLCs are relatively new entities that were first created in Wyoming to address the problem in Delaney in which the general partner in the limited partnership was a corporation.

a. In the Delaney case the limited partnership was established because it wanted flow-through tax treatment.

2. LLCs provide for complete freedom of contract3. Benefits

a. The entity lasts foreverb. Taxed like a corporationc. Limited liability

4. Drawbacksa. Relatively newb. Uncertainty in a lot of areas

i. Will the courts pierce the shield of limited liability?ii. Can the parties contract to eliminate fiduciary duty?

c. Expensive to create the Operating Agreement because of complete freedom of contract.

d. LLC statutes vary widely in their terms i. Question as whether other states will recognize other state’s

LLC statutes if the LLC becomes interstate.5. To form an LLC must file with the Secretary of State6. CA LLC Statute §17000, et. al. seq.

B. Taxation of LLCs1. Check the Box Tax Treatment

C. AB Furniture Store and Choice of Entity Decision1. Page 421 Chart

IV. Professional ResponsibilityA. If you have a client who wants to help you form a LLC or corporation or LLP, as

a threshold issue the lawyer must clarify who the client is.B. There is a potential for conflict of interest.

V. Public OfferingsA. Securities Act of 1933B. Blue Sky Laws

1. California Corporations Codes §25000C. IPO’s – Initial Public OfferingsD. Additional Rounds of Debt or Equity Financing by Publicly Traded Companies

VI. Doctrine of Preemptive RightsA. Traditional Common Law Approach


1. Stokes v. Continental Trust, Co. (443): bank had outstanding shares of 221 to the Ps. Blair and Company was offering to buy 5000 shares at $450 per share. The par value was $100. P is complaining that his proportionate interest has been cut in half and although his equity interest has not been diluted, his voting rights have.

a. P wanted to exercise his pre-emptive rights and purchase the 221 shares at par value of $100.

b. The majority found that the pre-emptive right was not waived but rather he should have been able to exercise them.

i. Property rights form the basis for pre-emptive rights.c. The dissent states that P waived his pre-emptive rights when he

refused to pay the $450.2. Model Act §6.30: Pre-Emptive Rights exist on an opt-in approach.

a. A shareholder has pre-emptive rights when the Articles of incorporation provide for them.

b. The right is only provided when it is in the articles.3. CA §406: Pre-Emptive Rights are Opt-In.4. In an opt-out provision, the statute would state that the pre-emptive

rights are the default rule unless the Articles eliminate them.a. Articles of publicly traded companies show that I many states the

statutes are opt-out provisions and that most companies eliminate the pre-emptive rights because they are cumbersome.

B. Modern Doctrine of Quasi-Preemptive Rights1. Katzowitz v. Sidler (448): closely held corporation in which 3 people

each hold 5 shares. The 3 shareholders had a falling out and entered into a stipulation rather than go to trial. The stipulation provided that the P, Katzowitz, would withdraw from the active participation of the day to day operations of the business but would be remain on the board and Katzowitz is to receive the same benefits and compensation that the other 2 board members receive.

a. There are 1000 authorized shares, but only 15 are outstanding.b. The corporation ends up owing $2500 to each of the 3 shareholders

and the company is going to be $7500 poorer and so rather than pay the money to the directors, the corporation wants to issue more stock.

i. The board of directors decides when the shares will be issued and the price of the shares.

ii. Sidler and Lasker decide to issue 75 more shares at $100 per share and offers 25 shares to each of the 3 board members with the consider being $2500 that the company owed each director.

1) Adequate Compensation?- Legal Capital Rules §18 and §19- CA §409

(a) Elaborates on §19 of the Legal Capital Rules


(b) States this is permissible consideration.

(c) Debt-cancellation.iii. Sidler and Lasker buy the shares, but Katzowitz wants his

money.c. After this, there is an accident and the company decides to dissolve

and liquidate.d. The corporation is liquidating and it pays its creditors and then the

shareholders.i. Katzowitz only has 5 shares whereas Sidler and Lasker

have 30.ii. Katzowitz receives $3147.59 upon liquidation and Sidler

and Lasker each receives $18,885.52 upon liquidation.e. Katzowitz got his pre-emptive rights, but chose to waive them and

is not in the same situation that Stokes was in.f. Katzowitz’s harm is that Sidler and Lasker bought the extra 25

shares at a “bargain price” and Katzowitz suffered equity dilution.i. The shares were sold above par value because there was no

par value so Katzowitz claims that they were sold below book value.

g. Book value is the worth of the stocks [(Assets – Liabilities)/number of shares]\

i. May or may not be the true value.h. Sidler and Lasker have a duty to act in the best interest of the

corporation. Sidler and Lasker violated their fiduciary duty.i. The quasi-pre-emptive rights duty is one grounded in

fiduciary duty and not property rights.ii. Katzowitz has standing to complain of fiduciary duty.

i. The board of directors owes a fiduciary duty to the corporation.

i. The duty is not to the controlling shareholdersC. Introduce the Concept of “Freeze-Out” Transaction (452-453)

Management and Control of Closely Held Corporations

I. The Respective Roles of Shareholders and DirectorsA. Shareholder Agreements and the Rule of McQuade

1. McQuade v. Stoneham (499): D was the majority shareholder of the corporation and P was a minority shareholder. As part of the transaction, P paid D money for the stock he purchased and they entered into an agreement wherein P would become the treasure. P was fired and sues for breach of contract. The board argues that firing McQuade was best for the corporation.

a. The court found that the contract between McQuade and Stoneham was unenforceable because it violated the public policy by requiring directors to vote in a certain way.


b. The directors have a duty to the corporation and the contract is limiting their discretion by violating the strong public policy that the Board makes decisions in the best interest of the corporation.

c. The “Corporate Norm” Rulei. RMBCA §8.01(a)

ii. CA §300(a)d. The agreement between the shareholders cannot be enforced

because it impinges on the discretion of the board members.e. Stoneham got a financial windfall by getting paid more by

McQuade for not only the stocks but the agreement for guaranteed employment as an officer.

f. Shareholder agreements that impinge on the director’s discretion and business affairs violate public policy. Job of the Board of Directors.

2. The board manages the business affairs of the corporation.a. The job of the shareholders is to vote for the Board.b. An agreement that voids the “corporate norm” is generally

invalidated.B. Exceptions to the Rule of McQuade

1. Clark v. Dodge (503): Agreements that run afoul of the corporate norm are unenforceable unless

a. ????All the shareholders sign the agreement????b. The impingement on the Board’s discretion is slight.

C. The Modern Judicial View of Shareholder Agreements in the Context of Closely Held Corporations

1. Galler v. Galler (505): Brothers Isadore and Benjamin form a corporation and split the stock 50-50. They enter into an agreement so that if one of the brothers dies the shares of the company will be transferred to their wives.

a. Statutesi. RMBCA §10.20 and §2.06(b)

ii. CA §211 and §212(b)b. The brothers want to amend the by-laws to require a minimum of 3

for quorum. i. This does not violate McQuade because this is something

that should be properly decided by shareholders. c. There is an agreement to pool their votes together and elect

themselves to the Board. i. Does not violate McQuade because the shareholders are

binding themselves and not directors. ii. RMBCA §8.10

iii. CA §305d. The agreement provided for a balance of power on the board.

They also have a provision to pay a certain amount of annual dividends so long as a certain amount of capital surplus is retained by the corporation.


i. The court found that this was a slight impingement and did not violate public policy.

e. The brothers also agree to a restrictive legend on the stock certificate.

i. So long as the restriction is “reasonable” under RMBCA §6.27 or CA §418 and CA §204(b) this does not violate McQuade.

f. The brothers also agree to continue salary contributions to the widow.

i. The board decides the salary of the employees so doesn’t this violate the rule in McQuade?

ii. The court found that this does not impinge.g. The court usually will not uphold agreements that continue

indefinitely.i. Worried about the “Dead Hand” Problem of somebody

trying to run the corporation from the grave.ii. The court got around this by saying that the duration of the

agreement was until the death of the wife.h. The reason the court probably upheld this agreement was because

this is a closely held corporation without a lot of liquidity.i. This case is like Katzowitz because the wife is being squeezed out.j. Today, to eliminate the uncertainty, the corporation can elect to be

a closed corporationi. If a closed corporation, the company will be governed

under CA §158.ii. CA §158 requires that there be no more than 35

shareholders and the articles must make the election to be a closed corporation.

iii. CA §300(b) states that if the corporation makes the election to be a closed corporation, although the board still manages the business affairs, shareholder agreements that relate to any phase of the business affairs are permissible and they will not be invalidated based on the premise that it is impinging on the functions of the board.

D. The Modern Legislative Approach to Shareholder Agreements1. Zion v. Kurtz (516): Zion and Kurtz form Group, Inc. with the sole

purpose of financing Lombard-Wall, Inc. as stated in the agreement. Kurtz assured Zion that the Articles of Incorporation would be amended to make the corporation closed, but did not.

a. The court in this case enforced the agreement and found for Zion even though the articles did not have the language stating that this was a closed corporation.

i. Kurtz started the business and told Zion that he would change/reform the articles and did not.


ii. Kurtz is estopped to deny that the corporation is closed and the court balances the rights between Zion and Kurtz.

iii. Between Kurtz and Zion, Zion is the innocent party.b. Dissenting Opinion

i. Public policy of giving notice to the public/creditors.ii. The state gives this status and so the corporation’s articles

must be amended.c. This court was a NY court applying DE law under the internal

affairs doctrine.i. In Nixon v. Blackwell (522) the DE Supreme Court

followed the dissent and stated that unless the Articles conformed with the state’s requirements, no closed corporation existed.

2. The Close Corporation Electiona. Once the corporation elects to be closed, it does not need to rely on

the ambiguity of “slight impingement” because the courts are more likely to enforce shareholder agreements.

b. In CA, not only does the election to be a closed corporation have to be in the Articles of Incorporation, but the corporation must disclose this information to the creditors.

i. Adequate Capitalization: make sure that the client is not undercapitalized for involuntary creditors.

c. RMBCA §7.32d. CA §158, §186, §300

E. Shareholder Monitoring of Directors and Business Affairs of the Corporation1. Auer v. Dressel (522): This is not a squeeze out case. The Class A

stockholders want Auer, but Auer has been ousted by the Board who have a statutory responsibility to fire him for the benefit of the company.

a. The Board is the one who decides who the officers of the company will be.

b. In this case, the shareholders want to call a special meeting to reinstate the president.

c. Special Meeting v. Annual Meetingi. RMBCA §7.01 and 7.02

ii. CA §600(d)1) Special meetings may be called by the board, the

chairman of the board or over 10% of the shareholders.

d. Proper Practice Clausei. When management is faced with a demand, the

management will argue that the purpose for the special meeting is not proper.

e. The question in this case is whether the shareholders can call a special meeting to remove the current president.

i. The court finds that the shareholders cannot because that is the job of the Board.


ii. However, the majority finds that the shareholders can call a special meeting to make a recommendation to the Board

1) This allows the shareholders a voice2) This may be a useful signal to the directors that

the shareholders are opposed to the Board’s decisions.

f. The shareholders can call a special meeting to remove Board Members because their job is to elect the board.

i. Under Modern statutes the shareholders can remove a director with or without cause.

ii. The old statutes required good cause.1) Cause = fraud, misrepresentation, breach of

fiduciary duty, egregious misconduct. Need Due Process before removing for cause.

g. Under the modern view, if the director is removed by shareholders, the shareholders may fill the vacancy; however, if there is a natural occurrence or a director resigns, the Board can fill the vacancy.

II. Shareholder Voting and Shareholder Pooling AgreementsA. Election Inspectors and Other Mechanics of Shareholder Election of Directors

1. Mechanics of Shareholder Meetingsa. Notice

i. RMBCA §7.05-7.06ii. CA §601

iii. Must provide notice of shareholders meetings1) Time2) Place of meeting

iv. Must provide notice of annual and special meetings1) When2) Where

v. For special meetings must provide notice of the purpose of the meeting

1) A proper purpose of a meeting is something that does not impinge on the role of the directors

2) Cannot go beyond the purpose stated in the notice of the special meeting.

vi. Waiver of Notice1) Expressly: must be in writing and can be made

either before or after the meeting2) Implied: if the shareholder attends the meeting

and there is no objection of notice, there is an implied waiver.

b. Quorumi. RMBCA §7.25

ii. CA §602(a)


iii. Unless otherwise stated, a majority of the voting shares constitutes a quorum

c. Votingi. RMBCA §7.07

ii. CA §701iii. Record Owner v. Beneficial Owner

1) Record Owner = the person who owns the shares in name/certificate.

2) Beneficial Owner = the person with the interest in the company.

3) In the Ling case (575), the court found that stocks may be transferred by signing a certificate but the endorsed stock certificate does not make the person with the endorsed stock certificate the record owner, but rather the person has to go to the corporation and get the corporation to reissue new stocks in that person’s name and cancel the old stocks in the seller’s name to make the buyer the record owner.

iv. Record Date: The date set by the Board on which the people with shares on that date will be able to vote at the meeting.

1) Must be set within 60 days of the meeting.2) Hypothetical: C corp. sets the annual meeting

date for July 7 and sets June 6 as the record date. On June 25, S sells her C Corp. shares to B. Who votes the shares at the annual meeting? S gets to vote because S owned the shares on the record date.

v. Proxy Voting1) RMBCA §7.222) CA §7053) Can vote by proxy.4) Hypothetical: same as above. What should

the B do? The buyer should bargain with the seller to obtain the proxy from the seller and hold the proxy. Proxy voter = S. Proxy Holder = B. a proxy is revocable unless it is coupled with an interest by the proxy holder.

vi. Monitoring Elections1) CA §707 and §7092) The election inspector monitors the annual and

special meetings.2. Salgo v. Matthews (529): annual meeting of General Electrodynamics.

There are 2 factions, one headed by Salgo and the other by Matthews. Matthews got the proxy from Pioneer, inc. a company that is in


receivership because it has filed for bankruptcy. The election inspector refused to accept the proxy.

a. The authority to act for Pioneer is obtained by going to the bankruptcy court.

b. For Matthews to validly assert the proxy, he has to show up at the annual meeting with

i. Certificates showing that Pioneer owns the stockii. Proxy document giving him the right to vote from Pioneer

signed by the Receiver1) Court paper giving the receiver the power to act

on behalf of Pioneer.c. The court found that the election inspector has the discretion to

decide who gets to vote and who doesn’t and only after the election is over and the votes are tabulated and the results announced can the other side sue for injunction and/or preliminary injunction for the uncounted votes and question the discretion of the election inspector.

d. The election inspector’s decisions are reviewable but only after the final results of the vote are announced.

e. RMBCA §7.24(b)(3): The election inspector has the discretion to determine if the “…evidence is acceptable to the corporation…”

i. The statute limits the discretion of the corporation and it does not have unfettered discretion, but the discretion is reviewed only after the final count of the vote.

f. This case is before Street Ownership.B. Cumulative Voting vs. Straight Voting

1. Shareholder Voting Rulesa. Who gets to vote?

i. Rule of Record Date Ownership.b. There are 3 different standards for when an action has been

passed by shareholdersi. Old Model Act

1) Majority of the shares present at the meetingii. RMBCA §7.25

1) Majority of the shares actually votingiii. CA §602(a) Public policy behind the 2nd prong is to

prevent situations in which a small number of shareholders are deciding the actions of the company (extreme example: 1 yes, 0 no, 599 abstaining which would pass under the RMBCA).

1) Majority of the shares present and voting AND2) Majority of the required quorum.

c. For the election of directors, the rules require a plurality to elect a director.

d. There are 2 types of voting for the Election of Directorsi. Straight Voting


ii. Cumulative Voting1) This gives the minority shareholder(s) a chance to

get an opportunity to get somebody on the board because under straight voting there is no chance for the minority shareholder(s) any say in the election of the board.

2. Cumulative Voting Hypotheticala. Facts

i. A = 74 sharesii. B = 26 shares

iii. [s/(d+1)] + 11) [shares/(number of directors + 1)] + 1 = the

number of shares a shareholder needs to have in order to win 1 director’s seat.

2) S = total number of shares voting, NOT outstanding.

b. A is the controlling majority.c. This is a 3 person board.d. If Straight Voting:

i. A1, A2, A3 Nominated by Aii. B1, B2, B3 Nominated by B

iii. All of A’s nominees are going to be appointed because each is going to get 74 votes vs. B’s 26 votes.

e. If Cumulative Voting:i. A gets 74 x 3 votes = 222 total votes

ii. B gets 26 x 3 votes = 78 total votesiii. In this company, in order for the minority shareholder to

elect a director, the minority shareholder needs 26 shares1) [100/(3+1)] + 1 = 25 + 1 = 26

iv. If you want to vote cumulatively, need to give notice (usually 24 or 48 hours before the meeting).

1) The purpose of the notice requirement is to allow for the voter to “vote smart.”

3. RMBCA §7.28a. Cumulative Voting is present when the company opts-in and the

articles provide for cumulative voting.4. CA §708(b) and §301.5

a. Cumulative voting is mandatory unless you have opted out.b. The only corporations that may opt out are those that are publicly

traded on the NYSE.i. The CA code also allows for staggered voting for publicly

traded corporations.c. Under CA §301, cumulative voting is mandatory unless publicly

traded.


i. If not publicly traded, must have cumulative voting and cannot have staggered voting (must elect directors at the same time and for the same terms).

5. Removal Rulesa. CA §303(a)(1): “(a) Any or all of the directors may be removed

without cause if the removal is approved by the outstanding shares (§152), subject to the following: (1) Except for a corporation to which paragraph (3) is applicable, no director may be removed (unless the entire board is removed) when the votes cast against removal, or not consenting in writing to the removal, would be sufficient to elect the director if voted cumulatively at an election at which the same total number of votes were cast (or, if the action is taken by written consent, all shares entitled to vote were voted) and the entire number of directors authorized at the time of the director’s most recent election were then being elected).”

6. Humphreys v. Winous Co. (526): 3 person board and each stands for election every year allowing the minority shareholder to get in at least one board member. The majority shareholder gets mad and classifies one of the directors, staggering the election of directors. Each director is given a 3 year term.

a. The P (minority shareholder) argues that the statute grants cumulative voting to guarantee a seat on the board, but by staggering the terms, the D (majority shareholder) has nullified cumulative voting and rendered it straight voting.

b. The court rules in favor of D and finds that the statute guarantees cumulative voting, but not a seat on the Board.

c. In CA, this problem will never come up for a small closely held corporation. This rule only applies to large publicly traded corporations.

i. CA §301.5 Implemented as a result of the race of the lax.

C. Shareholder Pooling Agreements and the Use of Irrevocable Proxies1. Ringling Bros.-Barnum and Bailey v. Ringling (543): Cumulative

voting case. This is a small closely held firm with 3 shareholders. Edith and Aubrey each have 315 shares and North has 370 shares. Edith and Aubrey decide to get together and pool their votes to become the controlling shareholders.

a. This pooling agreement does not violate public policy because the shareholders are agreeing to fulfill their shareholder function and are not taking away discretion from the board.

b. Edith and Aubrey have a falling out and there is a provision in the agreement that stated if the 2 reached an impasse, Loos (an attorney) would be the “tie-breaker” and each would vote as directed by Loos.

c. Aubrey does not vote the way that Loos instructs.


d. If the point of the agreement between Aubrey and Edith was to control the board, there is still a majority, but Edith is made because the people that Aubrey vote for are now going to vote with North.

i. Edith wants to bind the directors to vote with her.1) This violates McQuade because it impinges on the

discretion of the directors.ii. Edith alternatively wants the vote as the arbitrator (Loos)

specified.1) She wants specific performance.2) The courts are reluctant to award specific

performance.3) The trial court said that to get around the problem

of specific performance Edith would get to vote Aubrey’s shares as an implied agent possessing the irrevocable proxy.

4) The problem with the trial courts decision was that the proxy was “implied” and continued litigation would ensue.

e. This court does not invalidate the election, but invalidates Aubrey’s votes.

i. As a practical matter this means Aubrey’s votes will only count if she honors the agreement.

ii. However, under this remedy, the control of the circus will be under North so that intent of the pooling agreement is no longer effectuated by this agreement.

iii. Ultimately, Edith does not get what she wants.1) Edith wanted an irrevocable proxy, but the

general rule is that a proxy is freely revocable unless it is coupled with an interest by the person given the proxy (i.e. seller is the record date owner but subsequently sold shares to buyer).

D. Use of Committees of the Board1. RMBCA §8.252. CA §311

E. Action by Written Consent1. RMBCA §7.04

a. Unanimous approval is required.b. All the share entitled to vote must approve an action without a

meeting2. CA §603

a. Absolute majority vote rulei. 51% of the outstanding shares required to give written

consent to get shareholder action without a meeting.F. Use of Voting Trusts


1. When legal title is surrendered to a 3rd party (the voting trustee) who votes for the parties.

2. Brown v. McLanahan G. Use of Classified Stock to Elect Directors

1. RMCA §6.01(c)2. CA §400(a)3. Lehrman v. Cohen (565): there are 4 directors initially. One of the 2

original shareholders dies and conflicts begin to arise between Cohen and Lehrman’s son. To resolve the conflicts, Cohen and Lehrman decide to have a 5th director on the board to be elected by Danzansky who holds AD stock and solely elects the 5th tie-breaking director.

a. There are 3 classes of stock.i. AC

ii. AD iii. AL

b. There is no difference between AC and AL stocks identical number and same rights of control and financial rights.

c. AD stock only has voting rights and no financial rights.d. For 15 years the tie breaking director is unnecessary. Then in 1964

a tie breaker is necessary. i. Danzansky and Cohen decide that Danzansky should be the

president of the corporation and he is appointed over the objection of lehrman.

ii. When Danzansky becomes president he resigns as board member and appoints Millard F. West, Jr. as the 5th director.

e. Lehrman sues saying that the creation of the AD stock created an illegal voting trust by not complying with the Voting Trust Statute.

i. The court found that this did not create a voting trust because there was no separation of voting rights from the other attributes of ownership.

ii. The court found that although there was dilution there was no divesture of voting rights and so there was no voting trust.

f. Lehrman’s Public Policy Argumenti. Should not have a director being the arbitrator of the

disputeii. Danzansky has no financial rights and so may not care

about the best interest of the company.iii. Proxies are only irrevocable if coupled with an interest in

the company. This may create a harm to people with a financial interest in the company.

g. The court finds that because the shareholders followed the proper procedures, the public policy arguments are not compelling.

H. Use of Stock Transfer Restrictions1. RMBCA §6.27


a. The articles of incorporation, the bylaws, an agreement between shareholders or an agreement between the shareholders and the corporation may impose restrictions on the free transfer of shares from the corporation. The restriction must be noted conspicuously on the front or back of the certificate or in the information statement required by §6.26(b). If the person has no knowledge of the restriction, it is not enforceable.

2. CA §204(b) and §418(a)a. Reasonable restrictions upon the right to transfer are binding.b. The certificate must have written statements that state the shares

are subject to restrictions upon transfer.3. Ling & Co. v. Trinity Savings and Loan Association (573): Bowman

took out a loan with Trinity Savings and Loan Associations pledging stock in Ling and Company, Inc. as security for the loan. D did not pay back the loan and Trinity sued Bowman for the balance of the loan to try and foreclose on the certificate for the shares of stock.

a. The company’s articles of incorporation required that D would have to obtain the written approval of NYSE if the corporation was a member of the exchange and that before selling to an outsider the corporation and then the other holders of the same class of stock must have the opportunity to purchase the stock.

b. When the borrower defaulted the bank wanted to foreclose on the certificate for the shares of stock, but the corporation objects because the corporation’s stocks are not freely transferable.

c. The court found that the restrictions were not valid because the stock certificate did not give conspicuous notice of the restrictions.

d. Reference was made on the face of the certificate to the restrictions described on the back of the stock certificate, but the state requires that the restriction be conspicuous and there is nothing conspicuous about the notice on the certificate. The statute also requires that the restrictions be reasonable and in this case the court found that the restrictons were not unreasonable.

I. Use of Buy-Sell Agreements1. If there is a buy-sell agreement, upon the triggering event, a mandatory

obligation to carry out the agreement occurs.2. These agreements are different from “rights of first refusal” because

rights of first refusals are options that may or may not be exercised.3.

III. The Problems of Dissension and DeadlockA. Gearing v. Kelly (584): there is a 4 person board. The bylaws state that a

majority of the 4 directors was necessary to constitute quorum. One of the directors resigns and the others want to elect her successor. One of the directors intentionally does not show up to prevent quorum, but the other 2 directors conducted the meeting and appointed a director giving these 3 control of the Board.


1. The court found that a director who intentionally is absent from a board meeting for the purpose of preventing a quorum cannot later complain that the board transacted business in the absence of a quorum absent some other wrong-doing.

2. Dissenta. Gearing effectively and unfairly becomes a minority shareholder.b. Gearing will be unable to fix this inequity.

B. In Re Radom & Neidorff, Inc. (587): Neidorff and Radom were brothers in law for 30 years and they formed a corporation to engage in the business of lithographing or printing musical compositions. Each held 80 shares of the company’s stock. Upon his death, Neidorff left his shares to his wife, Radom’s Sister, Anna. Anna and Radom did not get along. Radom acted as the president and Anna who was supposed to write his salary checks has refused to do so. Radom has offered to buy-out Anna, but she has refused. Radom petitioned the court to dissolve the corporation 5 months after Henry Neidorff’s death, but because of a will contest to determine the ownership of Henry’s stock, the petition was not answered for 3 years.

1. Although David Radom had the legal right to request a dissolution to the court, the statute does not guarantee that it will be granted.

2. The court found that there is no stalemate or impasse as to the management of corporate affairs and the corporation is thriving.

3. Dissolution is not necessary for the corporation or the stockholders.4. Radom’s failure to receive a salary may be remedied by other court

actions.5. The court found that the main question in deciding dissolution is

whether judicially imposed death will be beneficial to the stockholders or members and not injurious to the public.

C. Dissolution1. RMBCA §14.40

IV. The Modern Remedies for Oppression, Dissension and DeadlockA. The Evolving Standard of “Oppression” and the Emerging Remedy of a Court

Ordered Buy-Out1. Davis v. Sheerin

B. Use of Provisional Directors1. Abreu v. Unica Industrial Sales, Inc.

C. Today, the court could order a buy-out which was not a remedy at the time of Radom v. Neidorff.

V. Action by Directors and Authority of OfficersA. The Meeting Requirement for Board Action

1. In order to have valid board action there must be a meeting.B. Board Action by Written Consent

1. To have valid action without a board meeting, there must be written consent by the ENTIRE board on that action.


2. The statutes require unanimity because there is no useful purpose to be served to require everyone to be present for a meeting when everybody agrees. Alternatively, if no unanimity, the theory is that the corporation will benefit from the exchange of ideas.

3. RMBCA §8.21a. Requires unanimity.

4. CA §307(b)a. Requires unanimity.

C. Mechanics of Board of Director meetings1. RMBCA §8.20-8.24

a. Board Meetings: board of directors may permit any or all directors to participate in a regular or special meeting unless the articles of incorporation or bylaws provide otherwise.a director participating in a meeting by this means is deemed to be present in person at the meeting. The board of directors may hold regular or special meetings in or out of the state.

b. Action without meeting: each director must sign a consent describing the action to be taken and deliver it to the corporation.

c. Notice of meeting: Unless the articles of incorporation or bylaws provide otherwise, regular meetings of the board of directors may be held without notice of the date, time, place, or purpose of the meeting. (?????ONLY IF FIXED as in CA?????)

i. Unless the articles of incorporation or bylaws provide for a longer or shorter period, special meetings of the board of directors must be preceded by AT LEAST 2 days notice of the date, time, and place of the meeting. The notice need not describe the purpose of the special meeting unless required by the articles of incorporation or bylaw

ii. (????Why the different rule for directors v. shareholders wherein the purpose has to be stated and cannot be exceeded at the meeting?????)

d. Waiver of Notice: a director may waive any notice required by this Act, the articles of incorporation, or bylaws before or after the date and time stated in the notice. Except as provided by subsection (b), the waiver must be in writing, signed by the director entitled to the notice, and filed with the minutes or corporate records. A directors attendance at or participation in a meeting waives any required notice unless the director at the beginning of the meeting objects to holding the meeting or transacting business at the meeting and does not thereafter vote for or assent to action taken at the meeting.

e. Quorum: majority of the fixed number of directors if the corporation has a fixed board size; or a majority of the number of directors prescribed or if no number is prescribed the number in office immediately before the meeting begins, if the corporation has a variable range size board. The articles or bylaws may


authorize a quorum of a board of directors to consist of NO FEWER than 1/3 of the fixed or prescribed number of directors.

f. Voting: if a quorum is present when a vote is taken, the affirmative vote of a majority of directors present is the act of the board of directors unless the articles of incorporation or bylaws require the vote of a greater number of directors.

2. CA §307a. Board Meetings: Meetings of the board may be called by the

chair of the board or the president or any vice president or the secretary or any 2 directors.

b. Notice: regular meetings of the board may be held without notice if the time and place of the meetings are fixed by the bylaws or the board. Special meetings shall be held upon 4 days notice by mail or 48 hours’ notice delivered personally or by telephone, including a voice messaging system or other system or technology designed to record and communicate messages, telegraph, facsimile, electronic mail or other electronic means. The articles or bylaws MAY NOT dispense with notice of a special meeting. A notice, or waiver of notice, need not specify the purpose of any regular or special meeting of the board.

i. Notice of meeting need not be given to a director who signs a waiver of notice or a consent to holding the meeting or an approval of the minutes thereof, whether before or after the meeting, or who attends the meeting without protesting, prior thereto or at its commencement, the lack of notice to that director.

c. Adjournment: a majority of the directors present, whether or not a quorum is present may adjourn any meeting to another time and place. If the meeting is adjourned for more than 24 hours, notice of an adjournment to another time or place shall be given prior to the time of the adjourned meeting to the directors who were not present at the time of the adjournment.

d. Participation: members of the board may participate in a meeting through use of conference telephone, electronic video screen communication or other communications equipment…

e. Quorum: a majority of the authorized number of directors constitutes a quorum of the board for the transaction of business. The articles or bylaws MAY NOT provide that a quorum shall be less than 1/3 of the authorized number of directors or less than 2, whichever is larger, unless the authorized number of directors is one, in which case one director constitutes a quorum.

f. Board Action: an act or decision done or made by a majority of the directors present at a meeting duly held at which a quorum is present is the act of the board, subject to the provisions of §310 and subdivision (e) of §317. The articles or bylaws MAY NOT provide that a lesser vote than a majority of the directors present at


a meeting is an act of the board. A meeting at which a quorum is initially present may continue to transact business notwithstanding the withdrawal of directors, if any action taken is approved by at least a majority of the required quorum for that meeting.

3. Hypotheticala. Facts

i. 7 person boardii. 4 directors required for quorum

iii. 2 directors vote yesiv. 1 director votes nov. 1 director abstains

b. Under the RMBCA and CA, the vote does not pass because the majority of the directors PRESENT is considered approval.

D. Authority of Officers: Revisiting Agency Law Principles of Authority1. Scope of Officers’ Actual Authority

a. RMBCA §4.4 (H&M 614)2. Scope of Officers’ Apparent Authority

a. Black v. Harrison Home Co. (610): were the actions of the president within the ordinary or extraordinary course of business?

i. The court will look at the reasonable belief of the 3rd party.1) Ordinary and extra-ordinary are a matter of

industry practice/standard.3. Importance of Certified Board Resolutions

a. RMBCA §8.40(c)b. CA §314c. In RE Matter of Drive-In Development Corporation (608):

Officers of Drive In induced National Blvd. Bank to make a loan to Tastee Freez by executing documents whereby D guaranteed the loan. Bank requested a copy of the resolution authorizing the guarantee. A document purporting to be a copy of the resolution was certified by D’s secretary and delivered to the P. P relied on the resolution and the guarantee and loaned money to Tastee Freez.

i. The court found that the secretary of the corporation had the authority to bind the corporation because it is generally the duty of the secretary to keep the corporate records and make proper entries of the actions and resolutions of the directors.

ii. Statements made by an officer or agent in the course of a transaction in which the corporation is engaged and which are within the scope of his/her authority are binding upon the corporation.

iii. If the bank was on notice that the secretary’s certification is not accurate, the state estops the bank from denying that they were on notice.


iv. In the absence of a Board Approved Resolution, the courts will fall back on the relationship between the officer and the 3rd party.

Corporate Governance in the Publicly Traded Corporation

I. What are (Should Be) the Goals of a Publicly Held Company?A. Traditional View: Primacy of Shareholder Interests

1. The role of the corporation is to maximize the profits for the benefit of the shareholders.

2. Principles of Corporate Governance §201: can take ethical considerations when making decisions.

B. The Scope of Corporation’s Social Responsibility1. Even though companies exist as extractions, because it consists of

human beings, human interests are going to be taken into account.2. The company has a character and persona and has a social responsibility.

C. Publicly Held Companies and the Agency Costs of Separation of Ownership from Control: To Whom is Management Accountable?

1. The management is held accountable by the shareholders.2. The “Reputation Market” for Corporate Managers

a. The reputation market acts as a disciplining mechanism for corporate officers.

b. Apart from stock ownership incentives, officers in large publicly held corporations have an incentive to increase the profitability of the corporation and manage the corporation successfully because of their reputations.

3. Use of Incentive Stock Options to Align Managers’ and Shareholders’ Interests

a. Provide officers an ownership interest in the corporation to better align the interests of the managers and the shareholders.

4. Promulgation of “Other Constituency Statutes”

II. The Role of ShareholdersA. Exercise of the “Wall Street Vote”: Shareholder vs. Stakeholder

1. In a large publicly held corporation, if the shareholder is unhappy with the management the shareholder will share his/her stock in the corporation.

a. The shareholder will “vote with his/her feet” and exercise his/her “Wall Street” vote.

B. “Street Name” Ownership: The Use of Nominees1. The sheer volume of stocks that are traded would make it cumbersome

to require all sellers to sign their stock certificates and physically transfer the stock certificates to the buyers.

2. The system has moved to “certificate-less” trading which is done purely with book-keeping without physical stock certificate exchange.


3. Large depository institutions, such as Cede and Co., hold the certificates and act as the record owner.

C. Concept of “Control”1. Majority or Voting Control

a. When a shareholder has a majority of the shares and therefore has control of the corporation.

b. In most largely held corporations, such as Disney, no discrete group controls the majority of the shares.

2. Minority or Working Controla. A discrete and identifiable minority owns the stock.b. Example: 30% of a company’s stock is owned by an identifiable

management group and no one else owns more than 2% of the shares. The 30% group probably has effective working control.

3. Management Controla. The management controls the actions of the corporation.

D. Publicly Held Companies and the Efficient Market Theory1. There is a cost to overseeing management.2. In a large publicly held corporation, nobody has a big enough interest to

expend his/her resources to hold corporate management accountable.3. There is a disincentive to take on the costs of holding management

responsible because the shareholder will bear the entire cost, but the other shareholders and the corporation will benefit.

4. This means that rather than hold management accountable, people are going to sell their stocks and so all the remaining shareholders will be those who are satisfied with the management or don’t care.

E. The “Market for Corporate Control”1. Proxy Contests

a. Like a referendum.b. Either a contest with another management team or a showing of

dissatisfaction by withholding votes.2. Negotiated Acquisitions (Board Approval and Shareholder Approval)

a. The efficient market says that all the publicly available information about the company is impounded into the pricing of the stock, but the market price does not tell you the inherent value of the stock.

b. The value of the company is not the price of the stock times the number of outstanding stock.

i. Market capitalization = outstanding shares x trading price.c. The premium for one company taking over another is negotiated

and approved by the board and the shareholders.3. Tender Offers (Direct Offer to Shareholders)

F. Institutional Stock Ownership1. Who are these “Institutional” Shareholders?

a. Institutional shareholders are plans/funds established so that normal everyday people can invest in the market with a fund manager monitoring the corporations.


b. Way to diversify an investor’s portfolio when the investor does not have enough money to do it him/herself.

2. The Role of Institutional Shareholders: What are their Options?a. Because institutional investors represent a group of people and

because they have long term interests in the investment, they have incentives to hold management accountable.

3. Institutional Shareholders as “Investor Activists”a. Institutional investors should be the active shareholders that bear

the cost of holding management accountable.b. The institutional investor bears the cost, but because of the long

term interest, the cost will not be so onerous as it would be to an individual investor.

III. The Respective Roles of Officers and Directors in Public CompaniesA. Who Manages the Business Affairs of the Modern Publicly Held Corporation?

1. The Board of Directors manages the business affairs of the corporation.2. However, the Corporate Officers manage the day-to-day operations of

the corporation.B. What is the Function of the Modern Board of Directors

1. Bayless Manning Article (692)a. The decisions of the Board are fluid.the board’s function is to

oversee and monitor the officers and the operations of the corporation.

2. The modern board of directors serves an oversight function and the day to day management of the corporation is done by the Corporate officers.

C. The Role of Outside Directors1. Management vs. Non-Management Directors – also known as “Inside”

or “Outside” Directors2. OR Who qualifies as a truly “independent” director?

IV. The Reforms Adopted AS part of the Sarbanes-Oxley Act (SOX)A. The Increasing Use of Board Committees Consisting (Entirely?) of Independent

Directors1. The Audit Committee

a. Must be entirely outside directors.b. A financial expert must head the audit committee.

2. The Compensation Committee3. The Nominating Committee

B. The Gatekeeper Function: The Role of Lawyers and Auditors of Public Companies

V. Federal Proxy RegulationsA. Scope of Federal Regulation of the Solicitation of Proxies: Definition of

“Reporting Company”1. A reporting company is a §12 company and comes in 2 types


a. Any company whose stock is listed in a stock exchange (NYSE); OR

b. Any company who has at least $10 million in assets and 500 or more shareholders (NASDAQ).

2. A reporting company has to file period reportsa. Annual report: Form 10-Kb. Quarterly report: Form 10-Q

3. The federal proxy rules require an annual report by the corporation to the shareholders.

a. Like the Form 10-K but more accessible to the everyday investor.b. Along with the annual report must be a notice of the meeting and

the proxy statement (information about what you are being asked to vote on).

4. SEC Rule 14(a)(8): Proxy StatementsB. Proxy Solicitation materials: Proxy Forms, Proxy Statements and Annual Reports

1. State law permits voting by proxy, but the Federal Rules regulate the process of proxy voting.

2. The federal government requires that for proxy voting to be adequately conducted,

C. False and Misleading Proxy Solicitation Material: Rule 14(a)-91. Implied Civil Liability for Violations of Rule 14(a)-9

a. The private remedy for a violation of this rule is to invalidate the vote and require the corporation to reissue the proxy statement and have a properly administered election.

b. The courts order a revised proxy statement and a new election to be consistent with congressional intent.

c. The SEC gives a private remedy for an administrative regulation to reserve the resources of the SEC and to give more effect and power to the regulation.

2. Rule 14(a)-9 Liability for “materially” Misleading Proxy Statementsa. TSC Industries, Inc. v. Northway, Inc. b. Standard for Materiality

D. Rule 14(a)-8: Shareholder Proposal Rule

Management’s Fiduciary Duties

I. The Duty of Care and the Business Judgment RuleA. The Traditional Statement of the Business Judgment Rule

1. Shlensky v. Wrigley (807): P is a minority shareholder of the Cubs and is suing the Wrigley family because of the Board’s decision not to install lights and play day games.

a. The court found that it is not the job of the shareholder or court to determine whether or not the board has made the “right” decision.

b. Business Judgment Rule


i. Absent fraud, illegality or conflicts of interest by the Board, the court will not review business decisions made by the Board.

ii. The court defers to the judgment of the board.c. The court would have to find no business justification for the

decision for the court to intervene.d. The Board has a fiduciary duty to the corporation, not the

shareholder.2. Negligence Cause of Action for Breach of Fiduciary Duty

a. Duty of Care.b. Duty may be breached in 2 ways

i. Misfeasance Affirmative action taken by the board that was taken with honesty or good faith.

1) The outcome of the decision is NOT determinative of whether the duty of care was breached or fulfilled.

ii. Nonfeasance Failure to actc. Fundamental Tension

i. The board’s job is to act as a reasonable Board would in the same situation.

ii. The board is also expected to act in the best interest of the company, even if that means taking risks to make money.

1) The board has to take risks, but they have to be reasonable?

3. RMBCA §8.30 exists to eliminate the “chilling” effect this rule may have on the Board by not imposing tort liability.

4. CA §309: Director Duty Statutesa. CA permits the imposition of tort liability on the Board and

implements a standard of due care and negligence.b. Does this statute discourage the Board from taking risks?

B. The Modern Statement of BJR1. Smith v. Van Gorkum (818): Trans Union Board got sued for decision

regarding a cash out merger of New T. Co. and Trans Union. Marmon funds New T. Co. Pritsker decides whether or not to allow for the completion of the merger. The Priskers are the sole shareholders of Marmon and the parties in interest. Van Gorkum, the CEO of Trans Union, met with Pritsker and formed a business deal for the transaction.

a. Van Gorkum did not inform the CFO, but went to the controller to run the numbers at 2 given prices

i. Van Gorkum did this without consulting with the senior executives and without going to the Board.

ii. Van Gorkum and Pritsker had decided on a $55 selling price.

b. This is a different situation than Wrigley because this is a one shot chance to get a premium.

i. Once the premium is paid, the interest disappears.


c. Smith, a shareholder, filed a class action to rescind the merger or to recover damages alleging

i. The directors breached their duty of care by selling the company without proper valuation; and

ii. The shareholder vote was invalid because shareholders were misinformed.

d. The court focuses on the decision making process by the Board.i. The court finds that Van Gorkum should have shared and

disclosed the information to the Board.ii. The Board should have conducted an independent

valuation.e. Dissenting Opinion

i. The board members of this corporation had a lot of cumulative experience and are best situated to know the worth of the company.

ii. An independent valuation would have been a waste of time and money.

f. This is NOT a conflict of interest case.g. The court in this case applied a standard of gross negligence even

though that is not the standard in the statutes.C. Statutory Limitations on Director and Officer Liability: a backlash?

1. Delaware §102(b)(7) Safe Harbor Provisiona. In addition to the matters required to be set forth in the Certificate

of Incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters: (7) a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director (i) for any breach of the director’s duty of loyalty to the corporation of its stockholders, (ii) for act or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under section 174 of this Title, or (iv) for any transaction from which the director derived an improper personal benefit. No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective.

b. Must amend the articles.c. Can eliminate personal liability for some obligations but not for the

4 stated above.2. This is an opt-in provision in the Articles.

D. Is there a fiduciary duty of disclosure?1. In Re Caremark Intern., Inc. Derivative Litigation (836): Derivative suit

for nonfeasance. The Ps allege that D breached its duty of care for failing to detect “kick backs” to physicians in violation of Federal statutes.


a. The shareholders want to be able to recover the money that Caremark has to pay from the directors because the directors failed to detect the illegal acts of the corporation’s employees.

b. The court did not hold the directors personally liable to the shareholders and the corporation.

c. Chancellor Allen’s Opinion applies a standard of gross negligence and tries to address the inherent tension between what a director wants to do vs. what a director should do.

i. He did not impose personal liability because that would discourage people from becoming directors.

II. The Duty of Loyalty and Conflicts of InterestA. Self Dealing Transactions

1. The Common law Rule of “Automatic Voidability”a. Conflict of interest or self-dealing, corporation could void.b. The common law rule was viewed as too harsh because sometimes

investors dealt with the corporation to the benefit of the corporation and the common law rule discouraged inside investors to transact with the company.

2. The Modern Approacha. Marciano v. Nakash (908): Gasoline Inc. is owned 50% by the

Marciano family and 50% by the Nakash family. The company is being dissolved and liquidated and there is a question as to whether a loan that the Nakash family gave to Gasoline in the amount of $2.5 million was valid.

i. The shareholders are fighting as to whether or not the Nakash’s should be paid the $2.5 million as creditors before the distribution to the shareholders.

ii. This is a self-dealing case because the Nakash’s are on both sides of the transaction.

b. Modern Cleansing Statutes ONLY covers SELF-DEALING cases

i. California Code §310(a)(1): Shareholder Approval1) Full Disclosure of ALL material facts2) Shareholder Vote in Good Faith3) By a Majority of Disinterested Shares (Exclude

shares of interested directors)4) No requirement that transaction is fair to the

corporation.ii. California Code §310(a)(2): Board Approval

1) Full Disclosure of ALL material facts2) Good Faith Approval by Disinterested Directors3) By a vote sufficient without counting vote of

interested Director4) Transaction is fair to the corporation at time it is

made


iii. California Code §310(a)(3): Fairness Standard1) Who decides fairness of the transaction?2) Who has burden of proof on fairness?

iv. DE §1441) Gets rid of the rule of automatic voidability.

c. The Fairness Standard and a Shifting Burden of Proofi. If the transaction is cleansed by the board the burden of

proof is on the P to show that the transaction is unfair notwithstanding the cleansed approval.

ii. If the transaction is cleansed by the shareholders, the court will not question the fairness of the transaction.

1) Shareholder approval is presumed fair because no judge is going to substitute his thought process and decisions as to the fairness of the transaction when the owners have decided that the transaction is fair to the corporation.

iii. If the transaction is not cleansed, then the burden of proof is on the D to show that the transaction is fair.

1) Under §310(a)(3) it is the burden of the interested party to show that the transaction is fair and the court is going to decide the fairness.

d. Self-Dealing Hypo’se. RMBCA Subchapter F

B. Executive Compensation1. The Judicial Standard for “Excessive” Compensation

a. Heller v. Boylan (918): Derivative Action. P is suing to recover bonus payments paid out to officers. The by-laws of the company set up a lavish bonus compensation plan. Only 7 out of over 60,000 shareholders joined this action.

i. The incentive compensation plans are designed to align the interests of management and owners. Klein and Coffee.

ii. The shareholders had accepted the incentive compensation system.

iii. The court found that when evaluating executive compensation packages, it will apply a standard of waste.

1) The P must be able to show that the resulting compensation is so large that it amounts to waste of the company’s a property.

2) Different than the business judgment rule or the intrinsic fairness rule.

b. Brehm v. Eisner (923): Disney hires Ovitz as president and in his employment contract there is a no fault termination provision. Within 14 months of the appointment Ovitz leaves the company and receives $140 million upon his termination. His option vested the day that he left the company.


i. The shareholders allege that the Board breached its duty of care by providing Ovitz with the termination package.

ii. The agreement was approved by an independent board and there is no self dealing and so §310 does not apply.

1) For a board to be independent, there board must not have a financial stake in the outcome of the matter.

iii. Waste = a decision that no rational person would make.1) So irrational that it is outside the limits of the

business judgment rule.2) Facts that no reasonable person would agree to.

iv. Fiduciary Duty is about both liability and an aspirational standard.

1) Page 925 there is a gray area between the law of corporate fiduciary duties and remedies for violation of those duties are distinct from the aspirational goals of ideal corporate governance practices.

v. Individually, the company may be liable for upwards of $140 million and under Smith v. Van Gorkum the directors may be personally liable.

1) Delaware §102(b)(7) eliminates personal liability of directors.

2. Regarding the Nature of the Recent Controversy over the “Reasonableness” or Executive Compensation (H&M 929)

C. Parent-Subsidiary Dealings1. Define “Self-Dealing” in this context

a. Sinclair Oil Corp. v. Levien (934): Sinclair Oil owns 97% of its subsidiary Sinven. The minority shareholders of Sinven sue the controlling shareholder for breach of fiduciary duty.

i. The shareholders allege that the following 3 acts resulted in a breach of fiduciary duty.

1) Declaration of Dividends2) Contract between Sinven and Sinclair

International3) Allocation of oil investment opportunities in

countries other than Venezuela.ii. There are 2 possible standards of evaluation

1) Business judgment rule2) Intrinsic fairness

iii. Dividends1) The dividends are not paid to the individual board

members, but to the shareholders. 2) By virtue of the ownership interests, 97% of the

dividends are going to go to Sinclair, Inc. and only 3% is going to go to the minority.


3) P’s assertion that the dividend is too much is only valid if it would result in the insolvency of the corporation of—under DE statute—the dividends are declared in order to satisfy Sinclair’s need for case (middle 976).

4) The court found that the dividends are not illegal under the 1st prong because they will not result in the company’s insolvency.

5) There is no self-dealing. Sinclair is not favoring itself and eliminating the minority from participation in the dividends.

6) The court therefore evaluates this decision under the Business Judgment Rule.

iv. Decision not to sue for breach of contract between Sinclair International (a wholly owned subsidiary of Sinclair, Inc.) and Sinven.

1) Sinven did not sue Sinclair International and because Sinclair, Inc. wholly owns Sinclair International it is receiving a benefit.

2) The court finds that there is self-dealing in this case.

3) Under Entire Fairness, the burden is on Sinclair, inc. to show that the transaction is fair.

4) The transaction is not automatically set aside but the board’s decision not to sue has to be fair and the burden of proof is going to be imposed on Sinclair and NOT on the board of Sinven because Sinclair got the benefit of the decision.

v. Corporate Opportunity1) The oil exploration opportunities were not

interests that belonged to Sinven.2) The parent company would only be liable if it had

usurped the oil exploration opportunity without providing Sinven’s board a chance to act on the opportunity with full and adequate disclosure.

2. Modern Standard of Judicial Review of Squeeze-Out (Freeze-Out) Transactions

a. Weinberger v. UOP, Inc. (940)i. To show instrinsic fairness must show 2 things

1) Fair Dealing2) Fair Price

ii. The burden is on the majority shareholder to show that the process was fair.

D. Corporate Opportunity Cases1. Different Tests

a. Line of Business


b. Fairnessc. Interest/Expectancy d. ALI

2. Corporate Opportunity Hypotheticals

III. Shareholder Derivative Litigation and the Business Judgment RuleA. Derivative Suits

1. Brought by the shareholder on behalf of the corporation.B. There are types of Derivative Actions

1. Shareholder/P v. 3rd Partya. When the P wants to sue the 3rd party for harm suffered by the

corporation by the 3rd party’s action.b. Example: Suing a competitor for an anti-trust violation.c. The P must make a demand on the board to file the suit on the

company’s behalf.i. The basis for the demand requirement is to make sure that

the suit is truly in the best interest of the corporation and the other shareholders.

d. RMBCA §8.01e. CA §309f. The board is in a better position to determine when a suit is in the

best interest of the corporation.g. When a demand is made and refused, the shareholder can sue the

Board for breach of fiduciary duty and the Board will apply the Business Judgment Rule when there is no duty of loyalty complaints or Intrinsic Fairness when there is self-dealing.

2. Shareholder/P v. Directors/Officersa. Breach of fiduciary duty.

C. What is the Appropriate Standard for Judicial Review of a Decision made by the Company’s Board of Directors? [Or by a Special Litigation Committee (SLC) appointed by the board?] which recommends dismissal of derivative litigation brought by the company’s shareholders?

1. The court will apply the Business Judgment Rule absent a claim of self-dealing.

D. The Traditional Business Judgment Rule Approach1. Gall v. Exxon Corp. (860): minority shareholder is suing the Board for

alleged payments from corporate funds as bribes or political payments. The shareholder wants to hold the Board of Directors personally liable for not adequately monitoring the employees who violated the rule.

a. The court did not look to whether the shareholder had made a demand or not.

b. The Board of Directors had established a special committee of uninterested/outside directors (directors appointed after all the illegal payments and facts that formed the basis for P’s claims).


c. Outside Directors: not employed by the company and do not work for the company and no financial ties to the company. No involvement with the underlying facts.

d. The court remanded the case to determine if the directors were truly independent.

e. Criticism of BJR Approach: Problems of Structural Biasi. Whenever there is a committee of directors who will have

to deal with the other directors on a continuing basis are they truly independent? May be influenced by the other non-independent board members.

f. Balancing the Competing Interests: the corporation vs. the Derivative Plaintiff-Shareholder

E. A Broader Standard of Judicial Review1. Zapata Corp. v. Maldonado (866): a shareholder filed derivative suit

against most of the corporation’s directors. The directors created a litigation committee of 2 independent directors, which claims its business judgment permits it to dismiss the suit.

a. When bringing a suit, the shareholder has to first make a demand on the board.

i. The Ps stated that they were demand excused because it would have been futile to make the demand.

b. When the motion is demand excusedi. Is the board independent and did the board exercise

informed decision making?ii. The court then decides whether it is in the company’s best

interest to dismiss the law suit.1) This is to protect the shareholder’s interest and the

ability to bring a derivative lawsuit against the Board for breach of fiduciary duty.

2) The P had a demand excused case and later on the board brought in 2 people.

3) Meritorious causes of action will disappear.F. The Demand Requirement and the Test for Demand Futility: An Unnecessary

Relic of the Past?1. Delaware’s Approach

a. Demand Requirement in Derivative Litigation is Tied to Standard of Judicial Review

b. Aronson v. Lewis (874): Demand excused. P can plead particularized facts that the Board is independent and the decision is protected by the Business Judgment Rule.

i. Demand will almost always be required unless a majority of the Board is so directly self-interested in he challenged transaction that there is serious doubt that the business judgment rule would protect that transaction.

2. ALI’s Approacha. Universal Demand Requirement


b. Cuker v. Mikalauskas

Insider Trading

I. Introduction to the Duty of Loyalty and Insider Trading: Transactions in the Company’s Shares by Directors and Officers

A. Based on a set of rules that we have already seen wherein 2 neighboring landowners enter into negotiations for the sale of land.

1. Landowner B has found oil in his plot of land and wants to buy A’s land.2. If A asks B if he is drilling for oil, B must answer truthfully.

a. What if B is not drilling for oil? He can truthfully answer “no” to A’s question.

b. Doctrine of Half-Truthsi. Cannot omit a material fact.

ii. Duty to speak in a completely truthful way.iii. Cannot give technically true answers.

B. Under Common Law fraud only applied in the case of an affirmative misstatement of a material fact.

II. The (Evolving?) Approach under State LawA. Traditional Common Law Rule

1. Goodwin v. Agassiz 2. The common law made 2 distinctions

i. Good News v. Bad News1) Good News: the stock in the company will go up. Insiders

will buy.2) Bad News: the stock is going to depreciate. Insiders will

sell.(a) Goodwin (975)(b) Diamond (976, FN 4)

ii. Open Market v. Privately Negotiated Deals1) Open Market: anonymous dealings between the seller and

the buyer.2) Privately Negotiated Deals: face to face dealings.

B. The Modern Approach and the Scope of Insider’s Duty to Shareholders1. Strong v. Repide (976): Strong, the company’s manager tries to sell his

share of the business. Manager is negotiating the sale in escrow but does not go directly to the other shareholder, but has another party 3 steps removed purchase the stock.

i. P sued for securities fraud because D hid his identity from P in the sale.

ii. The misrepresentation was in not disclosing the true identity of the buyer.

iii. Even in the absence of a misstatement, the court found there was securites fraud because special facts were known to D and not known to the shareholder.


iv. The court found that the D had a duty to disclose because he had “special facts” (material facts a reasonably investor would want to know).

2. Hotchkiss v. Fischer (977): widow wants to know if a dividend is going to be declared on her shares of stock. The board member tells her that he does not know what the board is going to do, but gives her the numbers and asks her to decide for herself whether or not a dividend will be declared.

i. She sells her shares and the board subsequently decides to declare a dividend.

ii. Case of pure fiduciary duty obligation.iii. Minority Rule/Rule of Strict Accountability: A company

insider when dealing with the company shares has a duty to disclose special facts.

3. The Modern Trend towards a rule of Strict Accountability and the common law development of the “Special Facts Doctrine”

III. The Development of an Implied Remedy under Rule 10b-5A. Rule 10b-5 included the common law problem of omission of material facts.

1. The common law only dealt with affirmative misrepresentation.B. Kardon v. National Gypsum Co. : 2 families evenly owned a company. The

Kardons contributed capital and the Slavins managed the corporation. A bidder offers to buy the corporation and before the merger, Slavins asked the kardons if they wanted to sell their shares. During the transaction the Kardons asked the Slvins if they planned to sell the stock. The Slavins answered “no.”

1. Doctrine of Half-Truths: technically the Slavins were not lying because they were not selling their shares, but their assets.

a. The Slavins omitted a material fact.2. The court found there is an implied remedy for the violation of 10b-5

and a private cause of action for the Kardons to sue the Slavins.3. Implied right of action for securities

IV. The (Shrinking?) Scope of Rule 10b-5 Remedy: Elements of an Implied Cause of Action Under Rule 10b-5

A. Jurisdiction1. Interstate Commerce

a. Use the facilities of interstate commerce such as phones, banks, etc.

b. Rarely a barrier to bringing a 10b-5 action.2. Security

a. Must be related to the purchase or sale of securitiesB. Standing to Sue for Rule 10b-5 Violations

1. Actual Buyers or Sellers2. The SEC3. US Attorney’s Office to sue for a criminal violation of the SEC rule.

C. Defendant1. Any person can be a defendant to 10b-5.


a. Natural Personsb. Business Entities

D. The Scienter Requirement1. Intent to Deceive, Manipulate or Defraud

a. Ernst & Ernst v. Hochfelder (987): securies fraud case wherein the President of the securities firm defrauded people and then committed suicide. The Ps are trying to hold the auditors liable.

i. The court found that there is no willful or intentional misconduct and that the D was negligent and made a mistake which is not enough to impose liability.

ii. The theory under which Ps went after D was aiding and abetting President’s violation of securities laws.

1) No longer does the court impose liability for aiding and abetting.

2. Will Recklessness suffice?E. Conduct that Violates Rule 10b-5

1. Securities Frauda. Misstatements of material facts that occur within the purchase and

sale of a security.2. Failure to Disclose material non-public information where there is some

independent source of duty to disclosea. Omissions or failures to disclose

3. Insider Trading – Tippee LiabilityF. Material Fact

1. Test for materiality same as TSC Industriesa. What a reasonable investor would consider important.b. Proprietary information that is not public that a reasonable investor

would consider important.G. Reliance Requirement

1. Actual Reliance2. “Fraud on the Market Theory”

a. Gives rise to a rebuttable presumption of reliance in cases ofi. Misrepresentations in open market transaction

ii. Non-disclosureH. Damages

V. Insider Trading as a Violation of Rule 10b-5A. The Nature of the ProblemB. The Genesis of the rule 10b-5 “Duty to Disclose or Abstain from Trading”

1. SEC v. Texas Gulf Sulphur Co. (1011): K55-1 problem.a. SEC 10b-5 does not create a duty to disclose.b. This is an undisclosed good news case.c. The court found that K55-1 was a material fact because a

reasonable investor would want to know.d. The court found that the Ds violated 10b-5 by not disclosing the

inside information to the investing public or abstaining from trading until the inside information was adequately disseminated.


e. Equality of Information/Parity of Accessi. Reason for the insider trading rules is to prevent insiders

from having an advantage from outside investors.C. The Modern View: The Supreme Court Scales Back the Scope of the Rule 10b-5

“Duty to Disclose or Abstain from Trading” 1. Chiarella v. US (1028): Tender offer Case. Bidder sends papers to

printer and an employee of the printer uses the information to his benefit by purchasing stock in the Target companies.

a. The court finds that to create a duty to disclose there must be a relationship of trust and confidence.

i. Mere possession of material non-public information is not enough, there must be some independent source, i.e. fiduciary relationship.

2. The Supreme Court establishes that insider trading violations of Rule 10b-5 are tied to the insider’s breach of fiduciary duty and rejects the “parity of information” theory set out in TGS and its progeny

3. The SEC responds to the Court’s ruling in Chiarella by promulgating Rule 14e-3 which applies in the context of tender offers

a. The rule states that if a person is in possession of material, non-public information he/she is prohibited from trading on the rule.

D. The Misappropriation Theory of Liability for Insider Trading Violations under Rule 10b-5

1. United States v. O’Hagan (1039): attorney comes into possession of information during legal representation of the bidding company (Grand Met).

a. The Supreme Court upheld the misappropriation Theory.i. The duty that O’Hagan has to Dorsey and Dorsey’s clients

is what gives rise to the misappropriation theory.ii. The government has standing to sue the D.

b. Unclear as to whether the shareholders of the target company have standing under this theory.

E. Tipper-Tippee Liability under Rule 10b-51. Dirks v. SEC (1054): Secrist, insider, was a whistleblower who told

Dirks, a financial analyst and investigated the story.a. The court found that the ban on tippee-tipper liability is based on

the tipper’s fiduciary obligations to the corporation.i. Need a ban on tipping to enforce the fiduciary obligation

that Secrist has to Equity Funding.b. Dirks will be liable for trading or tipping others in the information

he is receiving if Secrist (tipper) is giving the information for personal benefit (pecuniary or non-pecuniary) and he knows or should have known that it was in breach of tipper’s fiduciary duty.

c. In this case, Dirks does not inherit any 10b-5 liability because Secrist did not disclose the information for personal benefit.

d. SEC is going after Dirks because Secrist is not trading and not acting upon the information.

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