Corporations Study Guide

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Fall 2013

MBCA.................................................................................................................................3
CHAPTER 1: BUSINESS AND RISK.............................................................................6
INTRODUCTION.................................................................................................................6
CATEGORIES OF RISK.......................................................................................................6
RISK PREFERENCE............................................................................................................7
ALLOCATING RISK............................................................................................................7
CHAPTER 2: INTRODUCTION TO CORPORATION LAW....................................8
INTRODUCTION.................................................................................................................8
WHY DO CORPORATIONS EXIST?.....................................................................................8
SOME BASIC TERMS AND CONCEPTS...............................................................................9
FIDUCIARY DUTIES.........................................................................................................10
EQUITABLE LIMITATIONS ON CORPORATE ACTIONS......................................................12
REGULATING THE MODERN CORPORATION: THE SEARCH FOR ACCOUNTABILITY........14
CHAPTER 3: THE CORPORATION AND THE CONSTITUTION........................14
THE RIGHTS OF CORPORATIONS UNDER THE CONSTITUTION IN GENERAL................14
THE RIGHTS OF CORPORATIONS UNDER THE FIRST AMENDMENT.................................14
Ways of challenging corporate action:.....................................................................17
How does one corporation acquire another?............................................................19
CHAPTER 4: CORPORATION LAW IN A FEDERAL SYSTEM............................20
THE INTRODUCTION TO FEDERALISM AND CORPORATE LAW........................................20
THE INTERNAL AFFAIRS DOCTRINE...............................................................................21
THE INTERNAL AFFAIRS DOCTRINE AS A CONSTITUTIONAL PRINCIPLE........................21
CHOICE OF STATE OF INCORPORATION...........................................................................23
CHAPTER 5: THE CORPORATION AND SOCIETY .............................................24
FRAMING THE ISSUES.....................................................................................................24
THE ROLE OF THE LAWYER...........................................................................................25
CORPORATE CHARITABLE CONTRIBUTIONS...................................................................25
CHAPTER 6: THE CHOICE OF ORGANIZATIONAL FORM...............................26
INTRODUCTION & CHART..............................................................................................26
DEFAULT RULES.............................................................................................................28
THE LIMITED LIABILITY COMPANY...............................................................................31
PLANNING CONSIDERATIONS.........................................................................................31
CHAPTER 7: FORMING THE CORPORATION......................................................33
THE PROCESS OF INCORPORATION.................................................................................33
LAWYERS PROCESSIONAL RESPONSIBILITIES: WHO IS THE CLIENT?...........................34
PROBLEMS DURING INCORPORATION.............................................................................35

CHAPTER 8: AN INTRODUCTION TO FINANCIAL ACCOUNTING AND

VALUATION....................................................................................................................36
FINANCIAL ACCOUNTING DEMYSTIFIED........................................................................36
The Balance Sheet.....................................................................................................37
Analyzing the Balance Sheet:....................................................................................39
The Income Statement...............................................................................................40
Statement of Cash Flows:..........................................................................................41
VALUING THE ENTERPRISE............................................................................................41
CHAPTER 9: FINANCIAL STRUCTURE OF THE CORPORATION...................42
CORPORATE SECURITIES................................................................................................43
Equity Securities .......................................................................................................43
Common Stock...........................................................................................................44
Preferred Stock..........................................................................................................45
Debt Securities .........................................................................................................46
Options......................................................................................................................47
CORPORATE CAPITAL STRUCTURE DECISIONS, DECISIONS.........................................47
Tax Considerations....................................................................................................48
Leverage and the Allocation of Risk.........................................................................48
REGULATION OF LEGAL CAPITAL..................................................................................49
CORPORATE DIVIDEND POLICY: LEGAL AND ECONOMICS ISSUES................................51
DISTRIBUTIONS OF STOCK.............................................................................................52
CHAPTER 11: PIERCING THE CORPORATE VEIL..............................................52
INTRODUCTION TO VEIL PIERCING.................................................................................53
TORT CREDITORS...........................................................................................................55
CONTRACT CREDITORS..................................................................................................56
PARENT-SUBSIDIARY CORPORATIONS............................................................................58
VEIL-PIERCING IN LIMITED LIABILITY COMPANIES.......................................................59
ALTERNATIVES TO LIMITED LIABILITY..........................................................................59
CHAPTER 12: ACTIONS BINDING ON THE CORPORATION............................60
AGENCY.........................................................................................................................60
FORMALITIES OF BOARD ACTION..................................................................................63
Board Action at a Meeting........................................................................................64
Notice and Quorum ..................................................................................................64
Committees of the Board...........................................................................................64
CHAPTER 13: PLANNING IN THE CLOSE CORPORATION..............................65
INTRODUCTION...............................................................................................................66
REALIGNMENT OF SHAREHOLDER CONTROL.................................................................66
Cumulative Voting.....................................................................................................67
Class Voting...............................................................................................................68
Shareholder Voting Arrangements............................................................................68
RESTRICTIONS ON BOARD DISCRETION.........................................................................69
CONTRACTUAL TRANSFER PROVISIONS.........................................................................71
Purposes and Legality of Transfer Provisions..........................................................72
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Types of Transfer Provisions.....................................................................................72

Valuation of Restricted Shares..................................................................................73
CH. 14 OPPRESSION IN THE CLOSE CORPORATION........................................75
DISSENSION AND OPPRESSION IN THE CLOSE CORPORATION........................................75
JUDICIAL PROTECTION OF MINORITY OWNERS.............................................................75
The Fiduciary Approach...........................................................................................75
Contractual and Tort Approaches.............................................................................76
STATUTORY REMEDIES FOR OPPRESSION.......................................................................76
Dissolution as a Remedy...........................................................................................77
Oppression of Shareholder-Employees.....................................................................78
Non-Dissolution Remedies in Oppression Cases......................................................78
Valuation of Minority Shares.....................................................................................78
CHAPTER 15: SHAREHOLDER VOTING................................................................78
FEDERAL REGULATION ..............................................................................................80
SOLICITATION.................................................................................................................81
CHAPTER 16: DISCLOSURE DUTIES TO SHAREHOLDERS.............................82
ELEMENTS OF A FEDERAL ACTION FOR PROXY FRAUD:...............................................83
CHAPTER 17: SHAREHOLDER RIGHTS OF INSPECTION................................85
SHAREHOLDER INFORMATION & DERIVATIVE SUITS.....................................................87
CHAPTER 18: MECHANICS OF CORPORATE COMBINATIONS:....................88
TERMINOLOGY:..............................................................................................................88
THEORY/POLICY:............................................................................................................89
General rules.............................................................................................................90
Statutory merger........................................................................................................90
Triangular Merger.....................................................................................................91
Asset Acquisition.......................................................................................................92
CHAPTER 19: CORPORATE GOVERNANCE & MODELS..................................92
CHAPTER 21: ROLE OF THE SHAREHOLDER IN GOVERNANCE..................95
DYNAMICS OF SHAREHOLDER VOTING AND THE COLLECTIVE ACTION PROBLEM.....96
SHAREHOLDER PROPOSALS............................................................................................97
FIDUCIARY DUTIES (USE EMANUELS AS SKELETON)...................................100
OVERVIEW....................................................................................................................101
DUTY OF CARE.............................................................................................................102
The Duty of Care Standard......................................................................................102
BJR stuff...............................................................................................................103
Shlensky v. Wrigley..................................................................................................103
Duty of Oversight....................................................................................................104
Francis....................................................................................................................104
Reliance (MBCA 8.30(d) - (f))..............................................................................104
Van Gorkom.............................................................................................................105
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Graham...................................................................................................................107
Caremark.................................................................................................................107
Citigroup.................................................................................................................107
SUM OF IT ALL:.....................................................................................................108
DUTY OF LOYALTY....................................................................................................108
DIRECTOR CONFLICT OF INTEREST TRANSACTIONS....................................................109
Fundamental point: ................................................................................................109
Former 8.31 and DGCL 144...................................................................................110
Subchapter f - applies to Directors conflicting interest transactions (DCITs). 110
Case law...................................................................................................................111
In re InfoUSA: Vinod Gupta case............................................................................112
Oracle......................................................................................................................113
DIRECTOR LIABILITY IN CASH-OUT TRANSACTION.....................................................114

MBCA
2.01 Incorporators
o One or more persons may act as the incorporator or incorporators of a corporation
by delivering articles of incorporation to the secretary of state for filing
2.02 Articles of Incorporation
o Dictates what must be set forth corporate name, number of shares the corp is
authorized to issue, street address of initial office; name & address of each
incorporator
o States what may be set forth, such as defining, limiting, and regulating the
powers of the corporation, its board of directors, and shareholders.
o Also a provision eliminating or limiting the liability of a director to the
corporation or its shareholder for money damages for any action taken, or
any failure to take any action, as a director, except liability for (A) the
amount of a financial benefit received by a director to which the director is
not entitled; (b) an intentional infliction of harm on the corp or the
shareholders; (C) a violation of section 8.33; or (D) an intentional
violation of criminal law
2.03 Incorporation
o Unless a delayed effective date is specified, the corporation existence begins
when the articles of incorporation are filed
o The Secretary of States filing of the articles of incorporation is conclusive proof
that the incorporators satisfied all conditions precedent.
2.04 Liability for Pre-incorporation Transactions

All persons purporting to act as or on behalf of a corporation, knowing there was

no corporation under this Act, are jointly and severally liable for all liabilities
while so acting
o Comments:
o Recent case law indicates, however, that even where a version of this
section is present in the State statute, courts have continued to rely on
common law concepts of de facto corporations, de jure corporations, and
corporations by estoppel that provide uncertain protection against liability
for pre-incorporation transactions
o See reading notes for more, but basically:
What seems to be most important is knowing that no corporation
exists but acting anyway
2.05 Organization of Corporation
o (a) After incorporation:
o (1) If initial directors are named in the articles of incorporation, they shall
hold an organizational meeting, at the call of a majority of the directors, to
complete the organization of the corporation by appointing officers,
adopting bylaws, and carrying on any other business brought before the
meeting
o (2) If original directors arent named in the article, the incorporator(s)
shall hold an organizational meeting at the call of a majority of the
incorporators:
(i) to elect directors and complete the organization or corp.; or
(ii) to elect a BoD who shall complete the org or corp
2.06 Bylaws
o The bylaws of a corporation may contain any provision that is not inconsistent
with law or the articles of incorporation
o Section 2.06(d) allows directors to ensure that such bylaws adequately provide for
a reasonable, practicable, and orderly process, but is not intended to allow the
board of directors to frustrate the purpose of a shareholder-adopted proxy access
or expense reimbursement provision
4.01 Corporation Name (pg 11 of PDF, ~ 35 reading notes)
o (a) A corporate name:
o (1) Must contain the word corporation, incorporated, company, or
limited, or an abbreviated form of one of them.
o (2) May not contain language stating or implying that the corp is
organized for a purpose other than that permitted by section 3.01 and its
articles of incorporation
o (b) Except as authorized by subsections (c) and (d), a corporate name must be
distinguishable upon the records of the sec of state from [other corps]:

5.01 Registered Office and Registered Agent

o Each corp must continuously maintain in this state:
o (1) a registered office that may be the same as any of its places of
business; and
o (2) a registered agent who may be:
(i) pg 13 of PDF
5.02 Change of Registered Office or Registered Agent
o A corp may change its registered office or agent by delivering to the sec of state a
filing statement that sets forth item listed (1 6)
5.03 Resignation of Registered Agent
5.04 Service on Corporation
o (a) A corporations registered agent is the corps agent for service of process,
notice, or demand required or permitted by law to be served on the corporation
o (b) If a corp has no registered agent or the agent cannot with reasonable diligence
be served, the corp may be served by registered or certified mail addressed to the
sec of the corporation at its principal office
o Subsections 1 3 define the date upon which service is effectuated
o (c) this section does not prescribe the only means, or necessarily the required
means of serving a corporation
6.01 Authorized Shares
o (a) The articles of incorporation must set forth any classes of shares and series of
shares within a class, and the number of shares of each class and series, that the
corporation is authorized to issue. The articles of incorporation must prescribe a
distinguishing designation for different classes or series and must describe, prior
to the issuance of shares of a class or series, the terms, including the preferences,
rights and limitations, of that class or series.
o (b) The articles of incorporation must authorize:
o (1) one or more classes or series of shares that together have unlimited
voting rights; and
o (2) one or more classes or series of shares that together are entitled to
receive the net assets of the corporation upon dissolution
o (c) the articles of incorporation may authorize one or more classes or series of
shares that:
o etc etc.. (pg 15 of pdf)

Chapter 1: Business and Risk

Introduction

Shirking: Occurs when somebody works less hard than they would if they owned
the business for which they are working themselves.
o Can be offset by monitoring, but this requires monitoring costs
Monitoring costs + shirking = agency costs

Categories of Risk

Controllable risks those that the parties have some ability to influence
Non-controllable risks. Cannot be completely eliminated
Important difference between risk, which can be quantified, and uncertainty,
which cannot
An expected return is defined as the weighted average return based on the
probabilities of events. Depends on being able to quantify the risks associated
with a particular decision
o To calculate: multiply the probability of each event happening by the
return associated with that event and add up the results

Risk Preference

Some people are risk seekers, other risk averse, other risk neutral

Allocating Risk

Non-controllable risks can be managed by:

o Insurance
o The financial markets people can, for instance, bet against themselves
through futures contracts (e.g. invest money on the chance of their
being a drought if a drought occurring would be detrimental to you; then
either way youre covered)
o Diversification
o Allocate the risk to the person best able to bear it
Controllable Risks
o Shirking can be mitigated by monitoring and disciplining devices that
align the agents incentives with the interests of the principal
However, if they have greater incentives that the business will do
well, theyll often want more control
o Sometimes, those best able to control risks are the best to bear them (e.g.
the person who waters the plants best bears the risk of them not getting
watered)
Allocating Risk to the Owner
o Theyre typically less risk averse than, say, their employees
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Can monitor through direct supervision or setting benchmarks or doing

post-work evaluation, or contract for sanctions for failure to perform
certain duties
But these can all be expensive and dont always account for
unforeseeable/unpredictable things
Allocating Risks to the Employees
o One example: Ernests annual salary is $x. But if the annual income of our
venture is less than $y, then his salary shall be reduced by z%
o However, might run into problems of employee thinking in short term
interest, owner thinking more long term
Middle ground solution:
o Can divide profits between owner/employee in mutually agreeable
proportion, but then employee might want more control and it could be
hard to do with no pre-established relationship

Chapter 2: Introduction to Corporation Law

Introduction
o

Corporations have the following characteristics, subject to modification:

o Separate entity: every corporation is a legal entity, separate from its
investors or mangers
o Perpetual existence: can be of unlimited life, as opposed to those that
work for or invest in them.
o Limited liability: a shareholders liability is limited to the amount of
money she paid for her shares. The corporation, not the shareholders,
owns the assets of the business and is liable for its debts
o Centralized management: directors have a duty to act in the best interest
of the corporation rather than in their own best interest
o Transferability of ownership interests: shareholders are free to transfer
their shares without obtaining the consent of other shareholders

Why Do Corporations Exist?

o

A firm is a legal entity used to assemble, organize, and manage resources to carry
on some economic activity
o Individuals can expand the scope of their economic activities by entering
into contracts with other individuals
Theories:
o Firms come into existence because their hierarchical relationships can
minimize the transaction and agency costs inherent in the principal-agent
relationship.

A firm acts as the centralized contractual agent in a team productive

process is in a position to monitor the productivity of each member of
the team and allocate rewards to each in accordance with their
contribution
o * All of the theories agree that one of the principal reasons that firms exist
is that they reduce the information, transaction, and agency costs that
would exist in a theoretical free market in which individuals cooperate
only by contracting among themselves*
o Why the Corporate Firm?
o The corporate form is particularly useful in addressing the problem of
raising capital
Other major advantage: Limited liability
Other advantages: well-understood structure; relatively clear legal
rules; well-understood and convenient means of dividing up and
allocating risks and rewards
o Fiduciary obligation: a vague constraint applied to employment
relationships between those who undertake to accomplish some object for
another person and that individual.

Some Basic Terms and Concepts

o Public vs close or private
o In close corporations, there is typically no market for the corporations
securities and there is a substantial overlap of ownership and management
o In public corporations, the governance structure separates ownership from
control and shareholders generally do not play an active role in the
management of the business
o Corporate Statutes: (there is no one; we focus on the Model Business
Corporation Act (MBCA) and Delaware General Corporation Law (DGCL)
o Although state corporate statutes have some mandatory provisions, to a
substantial extent they consist of a set of default rules that set forth the
relationship among corporate actors unless they agree otherwise
o Organic Documents
o Articles of incorporation represents the constitution of the
corporation
o Bylaws usually set for the details of the corporations internal
governance arrangements
o Corporate Actors:
o Stockholders or shareholders
o Stockholders elect a board of directors, which is responsible for
managing or supervising the corporations business.
Are required to act in the best interest of the corporation
For public corps, the board consists of inside and outside directors

Officers are elected by the BoD --- include president, VP, secretary,
treasurer --- duties are typically described in the bylaws; they take care of
day-to-day operations
o GENERAL STRUCTURE: stockholders elect BoD elects officers
o Other corporate actors stakeholders are those who dont fit the legal
categories above. Include creditors, employees, customers, the public
Theyre not protected by the fiduciary duty, but are often protected
under common law, statutes regulating the environment or
workplace, etc.
Corporate Securities
o Corporations raise money by issuing securities to their investors. There
are two kinds of securities: debt and equity.
Equity securities consist of common stock and preferred stock.
Debt securities generally are the least risky and have the lowest
expected return. The holder typically expects to receive only fixed
payments of interest over time and the return of the principal on
the maturity date of the debt.
Debt securities can be secured or unsecured and are called
bonds, debentures, or notes
Common stock assumes the greatest risk of the success or failure
of the corporation and has the greatest expected return.
Common stockholders can receive payment through
dividends cash payments that the corporation may make
at the discretion of the board of directors.
Preferred stock sits between common stock and debt (i.e. between
them risk-wise and return-wise)
Judge-Made Corporate Law
o State corporation statutes are not all-encompassing and court decisions fill
many interpretive and theoretical gaps. In fact, a central aspect of
corporate law, fiduciary duties, is largely judge-made
Corporate Choice of Law
o The law of the state of incorporation, with rare exceptions, governs the
internal affairs of the corporation --- this affords a high degree of
certainty to corporate managers when planning transactions or other
courses of action

Fiduciary Duties

Also known as duty of care and duty of loyalty

o Concept: The fiduciary must subordinate his individual and private
interests to his duty to the corporation whenever the two conflict
Requires a director to act in the corporations best interests and to exercise
reasonable care in overseeing the corporations affairs and in making business
decisions
In order to encourage directors to take risks on behalf of the corporation without
fear of personal liability for any losses which may ensue, courts have developed a

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rule of abstention, known as the business judgment rule (BJR) under which
courts will defer to the judgment of the board of directors absent highly unusual
circumstances, such as conflict of interest or gross inattention
o The BJR creates a presumption that in making a business decision, the
directors of a corporation acted on an informed basis, in good faith and in
the honest belief that the action taken was in the bests interests of the
company
o To rebut, P must show that a decision: (1) was not informed; (2) was not
made in good faith; (3) did not have a rational purpose; (4) was made by a
director(s) with a personal interest in the decision; or (5) was made by a
director(s) who otherwise were not independent.
o The derivative suit was designed to enable shareholders to hold corporate
managers liable for a breach of fiduciary duty. It is an action in equity
brought by a shareholder on behalf of the corporation. Any recovery
belongs to the corporation for whose benefit the suit has been brought.
Bayer v. Beran (1944)
Facts: Defendants are the directors of Celanese
Corporation of America. For advertising, Dr. Camille
Dreyfus, who owned a majority share in the corporation,
suggested a $1 million radio campaign built around a radio
musical program. One of the stars of the program is also his
wife. The Board approved the campaign, and it has
subsequently been renewed.
Synopsis of Rule of Law. A director has a fiduciary duty
to support the corporations interest over his or her own
conflicting interests, and any competing interests renders
the business judgment rule inapplicable (judged under a
greater level of scrutiny, looking at it for duty of loyalty)
1st the claim involving the corporations decision to
advertise by way of an opera program
o This raises a duty of care question
Their conduct passes muster, even if a
different advertisement plan might have
reached a wider audience, because of the
BJR: the court wont put its own opinions of
what would have been best above that of the
corporation
2nd claim director chose his wife to be the singer in the ad
person close to the decision stood to make money from
this, so we cant presume the decision was made in the best
interest of the corporation
o Raises a duty of loyalty claim
Burden of proof was on the directors:
required to prove total fairness of transaction
to the corporation

11

o Conclusion: no violation of the duty of loyalty

shows that cases for breach of fiduciary duty arent
easy to win.
* Fiduciary rules are less strict in corporate law than
elsewhere
Break fiduciary duty into 2 different duties:
Duty of care
Has to do with competence: has director acted with the
requisite care?
Business judgment rule: courts bend over backwards not
to simply second guess the decisions of executives. The
BJR says that if the director properly informed him/herself,
the court wont substitute its own judgment even if the
decision turns out to be wrong.--- strong presumption that
director acted properly so long as they can show they were
informed. Threefold reasoning:
o Judicial competence: courts arent as competent as
the business in the matter before them
o Courts come at the problem ex post the conduct
already took place and whatever went wrong went
wrong and its difficult not to think about this when
judging initial conduct
o Relationship between business and risk we dont
want businessmen afraid of what is going to happen
to them personally because they take a risk that
could be profitable but might end up being wrong
Duty of loyalty
An agent cannot serve 2 masters
If there is a duty of loyalty problem, the business judgment
rule does not apply.
o The duty of loyalty trumps the presumption we
made because their own best interests are involved
Initial burden is on the director to show the total fairness of
the transaction to the corporation

Equitable Limitations on Corporate Actions

Schnell v. Chris-Craft Industries, Inc. (1971)

o Issue: Can the directors, in complying with state law, move a meeting
solely to obstruct shareholders efforts to gain control of the corporation?
o Holding: no, it would be inequitable to go along with this scheme even
though the directors did strictly comply with state law.
o Catch line: Inequitable action does not become permissible simply
because it is legally possible
12

Bove v. Community Hotel Corp. of Newport, R.I. (1969)

o FACTS: Attempt by common shareholders to eliminate preferred
shareholders.
Why? they wanted to sell more common stock/expand the
corporation but to do that they had to pay off their liability to
preferred shareholders
Rule to get rid of preferred stock: needed unanimous
consent of preferred shareholders
What did management do to get around the problem?
Created another corporation and had the new board of
directors get together with initial B of D and merge. The
new company has only common stock; the original has
common and preferred stockholders. But in order to merge,
all you need is a 2/3 vote of each class of stock, and the
directors could get that.
o So used a merger device to get rid of need to get
unanimous consent of preferred shareholders. (got
around the problem)
o Court allows them to get around the rule in this way
Why? Because nothing in the statute forbids a merger between
parent and subsidiary corp. also, the preferred shareholders have a
way of keeping the value of their preferred stock they can go to
some sort of court thing.
Doctrine of independent legal significance

So whats the difference (Schnell v. Bove)?

How do we go about advising a client?
** Independent legal significance
o In Bove, there may have been another reason why they wanted to do a
merger
o Schnell shows that at some point, courts will step in as a matter of equity
no matter what the rules say
Theres an outer limit on corporate conduct. But where to draw the
line?

Regulating the Modern Corporation: The Search for

Accountability

Stockholders can exit if theyre unhappy

What is the purpose of the corporation:
o Is it just property of the stockholder-owners and the function of the
directors is to faithfully advance the financial interests of owners?
o Or Is it private property of stockholders AND also a social institution?

13

Chapter 3: The Corporation and the Constitution

The Rights of Corporations under the Constitution In General
o
o
o
o

Corporations are given life by a states corporate statute

The law treats corporations as having the attributes of a legal person for many
purposes --- can own property, enter into contracts, and sue/be sued in its own
name. Can be held liable for its debts while the people who created it are not
Currently, all states reserve the power to amend the corporate charters they issue
(this emanates from states having added reserved powers clauses to their
constitutions, general corporation laws, or both)
Santa Clara County v. Southern Pacific Railroad Co. (1886): Court examined the
extent to which a corporation is entitled to the rights and privileges that the
Constitution provides to natural persons.
o Held that a corporation is entitled to equal protection of the law under the
Fourteenth Amendment.
o Minneapolis & St. Louis Railway Co. v. Beckwith (1888) extended the
holding of Santa Clara and ruled that a corporation also is entitled to due
process of law.
o Hale v. Henkel (1906) established that a corporation is protected against
unreasonable searches and seizures by the Fourth Amendment BUT, the
Fifth Amendments protection against self-incrimination is not available to
a corporation.

The Rights of Corporations under the First Amendment

o

In 1907, Congress enacted the Tillman Act, which prohibits corporations from
contributing $ to federal political campaigns because:
o Fear that corporate managers were exercising control over $ in ways that
unduly influenced political decisions; OR
o Seen as giving away other peoples money (shareholders) without any
restraints.
First National Bank of Boston v. Bellotti (1978): Court held unconstitutional a
Massachusetts statute that prohibited certain expenditures by banks and business
corporations for the purpose of influencing the vote on referendum proposals
other than those that materially affected the property, business or assets of the
corp.
o Synopsis of Rule of Law. The government may not restrict the topics of
speech for corporations. A corporation should not be treated differently
than private persons. The corporation may freely discuss government
affairs
o Dissent:
what some have considered to be the principal function of the
First Amendment, the use of communication as a means of self14

expression, self-realization, and self-fulfillment, is not at all

furthered by corporate speech --- they do not represent a
manifestation of individual freedom or choice
Shareholders may share a common interest in making money, but
their ideological hegemony breaks down aside from this
Under the majoritys holding, shareholders must choose between
supporting the propagation of views with which they disagree or
passing up investment opportunities.
Austin v. Michigan Chamber of Commerce (1990): Clearly inconsistent with
Bellotti. Court upheld the Constitutionality of a Michigan statute that prohibited
corporations from using corporate funds for contributions or independent
expenditures in support of or in opposition to any candidate in elections for state
office. Basically said that any such funding had to come from a PAC.
o Michigans regulation aims at a different type of corruption in the
political arena: the corrosive and distorting effects of immense
aggregations of wealth that are accumulated with the help of the corporate
form and that have little or not correlation to the publics support for the
corporations political ideas.
o The unique state-conferred corporate structure that facilitates the
amassing of large treasuries warrants the limit on independent
expenditures
o On dangers of corporations (Marshall): corporations as dangerous
corrosive and distorting effects of immense aggregations of wealth that
are accumulated with the help of the corporate form and that have little or
no correlation to the publics support for the corporations political ideas
(pg 58)
o Dissent: (Scalia)
Government cannot be trusted to assure, through censorship, the
fairness of political debate
Citizens United v. Federal Election Commission (2010): Court expressly
overruled Austin by striking down a federal prohibition of the use of corporate
funds for electioneering communication
o Holding: We return to the principle established in Bellotti: the
Government may not suppress political speech on the basis of the
speakers corporate identity. No sufficient governmental interest justifies
limits on the political speech of nonprofit or for-profit corporations.
The concept that govt may restrict the speech of some elements of
our society in order to enhance the relative voice of others is
wholly foreign to the First Amendment
Moreover, most US corporations dont have massive wealth
o Dissent: Corporate speech is derivative speech speech by proxy.
Denying it does not prevent anyone from speaking his or her own voice.
o From class, holding: There can be no limit on corporate political speech

Class discussion dangers of corporations:

15

o
o
o
o

Is the danger of restraining speech more dangerous than the danger of restraining
corporations? --- what is more dangerous, corporations or the government?
Power of money
o Some candidates might have great ideas and want to run for office but
dont have the corporate backing to compete with other candidates who do
Whose money is being spent when a corporation spends on advertising?
What can people do if they disagree with the way a corp spends its money?
o Exit: sell shares
But if we want capital markets to run effectively, we only want
people exiting because of inefficiencies, not moral rationales
o Derivative suit: claiming that people running the org arent doing their job
properly
o Proxy vote: get people behind him to get new director

Four models that come out of our discussion: (different ways of viewing
corporations)
Corporation is an entity (entity theory)
o Treat corporation as a single person
Economic entity
o Is an entity that is only there for profit maximization (legal person with
one value)
o Does this take morality out of the picture?
Concession theory
o The corporation is what the state says it is
Contractarian theory
o The corporation can be viewed as nothing more than an association of
people (nexus of contracts)
o This is the view of the majority in Citizens United
*Be aware when youre going back and forth between views; make sure youre being
consistent with the theories when using them to argue for one or another side

Ways of challenging corporate action:

PROXY FIGHTS
Directors elected by the shareholders. Federal law deals with proxies a document that
gives people the right to vote for them. People sometimes use proxies to enable
shareholders to vote for directors.
All shareholders get proxy forms (that are sent out by the board of directors), they
send them in, and then people read them and the individual with the most proxies
wins.
One way to take control of a corporation is to wage a proxy fight

16

o
o

Proxy fight: somebody comes in as an outsider and comes up with a slate

of directors. They then send information to all of the shareholders asking
them to vote for their directors rather than the directors suggested by the
board of directors.
Board of directors doesnt have to pay for the other side to wage a proxy
fight.
Proxy fights are very expensive. It is possible but not mandatory that if
you win a proxy fight you get paid back for your expenses. Proxy fights
are not easy to win.

DERIVATIVE SUITS
Commonly, a shareholder will file a claim against a director saying that s/he has
violated their duty to the corp and therefore owes the corporation $
A derivative suit can be filed by one or more shareholders. It raises a claim in the
name of the corporation. Youre basically suing the corporation to force the
corporation to collect a debt.
o If there is a recovery in a derivative case, it almost always goes to the
corporation
The pressure is not really from the shareholders, its from the Bar and attorneys
can gain a lot of money from them, so its lucrative enough to bring these suits
o Its a form of private enforcement.
How they work and problems/solutions:
o Theres a problem with derivative suits: the board of directors manages the
corp; if there is a claim, who decides to sue on the claim?; what if the
claim is against all of the directors then theres a conflict of interests.
o Other problem: strike suits suits that are brought not with the intention
of collecting money for the corporation, or not with the intent of getting
corp to do something. The only purpose is to get attorneys fees.
Basically a way of settling that gets money out of the corporation
Same if directors want, for their own motives, to get rid of a case
o Law gets rid of these problems by putting numerous procedural hurdles in
the way of derivative suits
E.g.: must own stock in the company, often for a certain amount of
time, sometimes need to own a particular amount of stock
There are also rules governing settlements: cant settle without
approval of the court
Most important: Demand
Board of directors manages the corp.
Demand means that the P in the derivative suit goes to the
corporation and says will you, the corp, go forward with
this claim?
Delaware and MBCA have different procedures but come
out the same in the end
o In Delaware, prior to filing suit, you must make
demand on the board of directors unless its a
demand excused situation

17

If BoD decides it will take control of the

case, then the Ps role is gone. Corporation,
not P, files the suit. Corporation can also
take control of the suit and dismiss it corp
can do this as long as directors arent
themselves conflicted
A demand is excused if you can show that
half the BoD is disqualified either because
theyre interested or not independent
If the shareholder doesnt plead demand
excused (with particularity) or demand the
BoD, then the claim is dropped for failure to
follow procedure.
o Under MBCA, you must make demand in every
case. And then the corp will move to dismiss and
youll end up litigating the same things you would
have litigated in Delaware (conflict, etc)
Directors are typically divided into inside directors (are
related to company employee, CEO, etc) and outside
directors (only relation to company is being on the board)
o Outside directors are seen as being more
independent
o Stock ownership itself is not enough to make you an
inside director
Special Litigation Committee is comprised of outside directors
who make a determination of whether a suit should be continued if
there is a conflict of interest among other directors
can also come up in a demand excused situation if case is
filed, BoD can set up a SLC made up of outside directors
if everybody on the BoD is conflicted, BoD can put 2 new
outside directors on BoD and turn them into SLC and then
they handle the question of whether the derivative suit
should be allowed to go on
o but these are interested people appointing
supposedly independent directors
To deal with this: In demand situations, Ps
must come forward with reasonable proof
that directors are conflicted or not
independent. But if its a SLC, the burden is
on the company to prove that the SLC is
independent or disinterested

THIRD TYPE OF CHALLENGE

Suppose theres a claim by a shareholder that the corporation has harmed the
shareholder or a class of shareholders. --- claim belongs to the mistreated

18

individuals, not the corporation. --- can try and make it a class action;
representing all of the shareholders
This is not a derivative suit, however its not a claim of the corporation and
recovery doesnt go to the corporation.

How does one corporation acquire another?

Friendly merger:
o Board of A goes to board of corp B and says they want to merge. Corp B
says fine.
May or may not require shareholder (or even board) approval
If the merger is approved by shareholders, then B is merged into A
and B goes out of existence. Payment is made directly to the
former stockholders of B could be given cash or shares in A. A
steps into Bs legal shoes its not as if theres a transfer of
property for instance, A doesnt have to rerecord land deeds in
As name, just has to step in for B.
BUT, mergers arent usually done this way
Usually, A creates a subsidiary
o A becomes the sole shareholder of the sub and appoints the board of
directors. Then B get merged into SubA --- triangular merger
There are times when A wants to merge with B and B doesnt want to.
o One way to handle this is for A to buy a majority share of stock in B and
start a proxy fight and change the board
o Another way: a tender offer -- A makes an offer directly to Bs shareholders asking them to sell A
their stock in B.
Tender offers are always above the market price. Are also done in a
specific way that protects the tender offerer in case the offer isnt
accepted.
Once A has control of B, A wants to merge B into A
Are expensive and usually involve taking on a lot of debt (to buy
tons of stock) might take the form of Bs assets.
Williams Act
o A federal statute that regulates tender offers
o After this Act, there was still dissatisfaction because a lot of companies
feel in danger when other companies make tender offers --- the possibility
of a tender offer is claimed to be detrimental to many companies
o So states started to pass statutes to make tender offers more difficult to
pass off
There were 3 cycles the first was declared unconstitutional
The second was upheld (CTS)

19

** These made it much more difficult to complete tender

offers

Chapter 4: Corporation Law in a Federal System

The Introduction to Federalism and Corporate Law
With few exceptions, corporations are creatures of state law. The federal government still
regulates corporations in many ways, however. For example: under antitrust laws,
banking regulation, civil rights laws, environmental law, labor law, and product safety
laws. Particularly, public companies are regulated by federal law.
o CTS and Amanda introduce the topic of the relationship between state corporate
law and federal law, as well as choice of law issues.

The Internal Affairs Doctrine

o
o

o
o

A business can choose to incorporate under the laws of whatever state best suits
its needs. It can also relatively easily reincorporate elsewhere.
The law of the state of incorporation governs the internal affairs of the corp.
This means that the relationship between shareholders and managers (directors
and officers) will be governed by the corporate statutes and case law of the state
where the corporation is incorporated.
o The law of the state of incorporation also determines the procedures by
which the board of directors will act, the right and extent to which officers
and directors may be indemnified by the corp, and the corps right to issue
stock and merge with other companies.
The external affairs of a corporation are generally governed by the law of the
place where the activities occur and by federal and state regulatory statutes (e.g.
state labor laws, tax laws)
Some activities are governed by both internal and external rules. E.g. mergers

The Internal Affairs Doctrine as a Constitutional Principle

o

Courts have said that the internal affairs doctrine presents questions of US
constitutional law:
o Violates the federal dormant commerce clause if a state statute treats
domestic and foreign corps differently or if it generates multiple and
conflicting standards that would burden interstate commerce.
o Another argument: may violate federal due process clause. States cant apply
their laws to corps incorporated in other states if they lack sufficient contacts
with the corporation and its conduct.
o Antitakeover Statutes: CTS and its Progeny

20

o
o
o

During the takeover wave of the 1970s and 1980s, a number of states adopted
laws designed to protect corporations conducting local business from
uninvited takeover bids that were opposed by the target companys
management. (~ 76)
CTS Corp. v. Dynamics Corp. of America (1987)
Synopsis of Rule of Law. States, as the creators of corporate entities,
have the ability to define the protections afforded to shareholders
providing that it is possible to comply with the state law and federal
law.
Issues: (1) whether the Williams Act preempts the Indiana Act. (2)
whether the Indiana Act violates the Commerce Clause due to unequal
treatment between in-state and out-of-state entities.
Holding: The Indiana Act is not preempted by the federal law because
entities can comply with both federal and state law without frustrating
the federal law. The state law furthers the federal laws goal of
protecting shareholders from tender offer abuses but does not tip the
balance between management and acquirers. The Indian Act does not
violate the Commerce Clause because corporations by definition are
entities created by state law, and therefore it is only logical that states
would define the rights and characteristics of corporations.
Because nothing in the Indiana Act imposes a greater burden
on out-of-state offerors than it does on similarly situated
Indiana offerors, we reject the contention that the Act
discriminates against interstate commerce. No discrimination
The state is only regulating the voting rights of the corporations
it has created, so each corporation is only subject to the law of
one state. There is no risk of inconsistent regulation by
different states. No risk of conflicting standards
Why was there no conflict with (/preemption by) the Williams Act?
For instance, Williams Act says you have 20 days to do
something but the CTS state law says you have 50 days to do
it.
Corporations are creatures of state law. And SCOTUS is very
sensitive about anything it considers as a federalization of this
state prerogative. They want to protect states ability to govern
these corporations
Importance of CTS: SCOTUS/the law defers greatly to states ability to
regulate/create corps. Where federal government does intrude, its typically in
a non-substantive way
Aftermath of CTS: led to a third generation of statutes that seek to protect
an acquirer from entering into a range of transactions with the acquired corp
for the period of time specified in the statute
Amanda Acquisition Corp. v. Universal Foods Corp. (1989)
A third generation takeover statute was at issue. Issue was whether the
statute was consistent with the Williams Act and Commerce Clauses?

21

Important considerations: No interstate transaction is regulated or

forbidden and the Act doesnt leave open the possibility of inconsistent
regulation, therefore its constitutional. It might be protectionist, but
the protected people are the exiting body of managers, suppliers, etc,
which bears no necessary relation to state boundaries.
Internal Affairs Doctrine: when a matter deals with the internal affairs of a
corporation e.g. relationship between corp and shareholders or directors;
about what powers the corp has or what stock may be issued; things coming
out of the corporate statute, bylaws, articles of incorp - then the law that
applies is the law of the state of incorporation
When were talking about external affairs i.e. corps relationship to
outside world, like labor and tax laws - then the regular conflict rules
apply and the law that usually applies is the law of the place where the
action occurs.
The internal affairs doctrine provides certainty.
Look for: hypo with many corporations. Itll deal with various
relationships between and among corps. LOOK AT what is the
state of incorporation of each corporation. If its an internal
affair, whose internal affair is it? Careful because with respect
to mergers, there might be voting rules that differ between then
and the rules applied to each are eachs state of incorp.

Choice of State of Incorporation

State corporation laws are essentially enabling statutes that establish a relatively
flexible organizational framework that allows considerable room for selfordering and involves minimal regulatory intervention.
Louis K. Liggett Co. v. Lee (1933)
o States didnt use to give the benefit of incorporation so freely; the removal
by the leading industrial states of the limitations upon the size and powers
of business corporations seems to have been due to the conviction that it
was futile to insist upon them because local restriction would be
circumvented by foreign incorporation.
So there was a race of laxity
Cary v. Winter debate
o Carys theory: management chooses the state, not the shareholders, in
order to get corps to incorporate in their state. So state legislatures will
keep making their rules more attractive to management (more power to
management, less to shareholders) and there will be a race to the bottom.
Cary says we need the state to make positive law so that this
doesnt happen
Problems with this view: if there ever was a race to the bottom, its
over. No state can unseat Delaware
o Winters approach: we have to look at what effect this race to the bottom
will have on the corporations ability to survive/make money. Rules will

22

affect their share price and ability to raise capital. If its more difficult to
raise capital, their costs will go up and they wont survive. So states are
looking to create the most efficient rules to govern corporate conduct.
Winters says the most efficient organizations come organically; we
dont need positive law to regulate the market.
Problems with this view: might lead to wealth disparities. While
government can regulate to correct this, that regulation might
distort the market. Additionally, theres the problem of Citizens
United: what if corps are exercising power over the govt?
o Another view (discussed in class): these are all problems of federalism
(the race to the bottom). So what we could do is just come up with Federal
Rules; however, this would run into the problem of the laws preference
for corporate law being the States domain
The Preeminence of Delaware
o Many corporations reincorporate in Delaware because they feel confident
that Delaware will respond promptly to the concerns of corporate
managers in the future, because it has done so in the past.
Three factors bolster this belief:
D relies heavily on corporate franchise taxes and would
have much to lose by failing to provide firms with
advantages offered elsewhere
The D state constitution requires a two-thirds vote of both
houses of the legislature to change its corporate code. This
makes it particularly difficult for the legislature to deprive
corporations of benefits they currently enjoy
Delaware has tremendous assets in terms of legal capital,
including case law, judicial expertise, and an admin body
that is geared to process corporate filings expeditiously
Delaware and Federal Law (pg 92)
o Delawares primary competition comes not from the other states but from
the federal government. It is the fear of federal incursion that keeps
Delaware from going too far in one direction or the other
Think about: what is the purpose of a corporate statue?
o Is it, as Judge Winter believes, to supply standard terms which reduce
transaction costs? Another possible purpose is to consider the interests of
shareholders, managers and other constituencies and have the statute strike
a balance among them
o Delawares doesnt strike a balance, however. Its pro-management.

Chapter 5: The Corporation and Society

Framing the Issues

Dodge v. Ford Motor Co. (1919)

23

Synopsis of Rule of Law. The purpose of a corporation is to make a profit

for the shareholders, but a court will not interfere with decisions that come
under the business judgment of directors.
As long as the goal of the corp is profit maximization, the directors
have virtually unfettered discretion to choose the strategies to be
employed to that end
Insert stuff on Milton Friedman and other views of corporate social responsibility
(CSR) ---- inter-relationship between long-term social gains and short/long-term
business profitability
A significant development in corporate social responsibility is the creation of a
new type of business entity, the benefit corporation. Under this model, in addition
to having a fiduciary duty to shareholders, directors also have a legal duty to other
stakeholder interests, including employees, suppliers, customers, society, and the
environment.
o Must release annual benefit reports to shareholders and post them online

The Role of the Lawyer

o
o

Some theorize that the best role for lawyers is ability and willingness to give
independent legal advice to business clients
The moral interdependence theory is premised on the assumption that actions of
lawyers and clients are not always easily distinguished. Often, lawyers and clients
accomplish objectives together, not separately.

Corporate Charitable Contributions

o

There are two principal concerns in these expenditures: how to protect the
interests of shareholders who may not agree with the choices that corporate
management has made and how to create a system of managerial accountability
with respect to such expenditures.
Theodora Holding Corp. v. Henderson (1969)
o Rule: the test to be applied in passing on the validity of a gift such as the
one here in issue is that of reasonbleness, a test in which the provisions of
the Internal Revenue Code pertaining to charitable gifts by corporations
furnish a helpful guide.
Due to the Business Judgment Rule, the Court was not going to
second guess a business decision unless it was unreasonable, and
this big corporate donation seemed reasonable (was within the 5%
of corporate revenue limit, set by the Internal Revenue Code).
Additionally, the court wanted to promote the public policy of
corporate donations
Kahn v. Sullivan (1991)
o Had to do with Occidentals donation, prompted by Hammer.
o Facts: The Trial Court found that the huge donation was not a good
business decision. However, whether or not it was a good decision was not

24

their problem. The Business Judgment Rule only requires that a business
decision to not be reckless or unconscionable.
o Appellate holding: because of the Business Judgment Rule, the only time
a court should overturn a business decision was when it amounted
to corporate waste.
Corporate waste can be defined as "an exchange of corporate
assets for consideration so small as to lie beyond the range at
which a reasonable person might be willing to trade.
o Conclusion: the Trial Courts finding that the donation didnt amount to
corporate waste was not an abuse of discretion
Perspectives on Corporate Charity
o Is there a difference between traditional advertising and advertising a
companys socially responsible behavior? both are attempts to increase
sales & profits

Chapter 6: The Choice of Organizational Form

Introduction & Chart

Corp

Limited
liability

Continuity of
life

Transferability
of interest

Management
structure

Ability to
raise capital

Tax treatment

Yes

Perpetual

Free
transferability

Centralized, but

Sell more
stock

As a separate
individual;
own losses

Partnershi No
p

Death,
Not transferable Not centralized
withdrawal, or
bankruptcy

Limited

Not a taxable
entity

General
Partner
--------Limited
Partner

No

No
Yes

Death,
Not transferable Management
withdrawal, or
bankruptcy
but only of
transferable
Not
general
management
partner

Like
partnership

LLC

Yes

Perpetual

Very flexible

Either

either

Sell limited
partnership

o Forms: Partnership, the corporation, and the limited liability company (LLC)
o Corporation:

25

Option

Is a legal entity distinct from its owners; formed by filing papers; formed
under and governed by the corporate law of the state in which it is
incorporated
o Management is centralized in a board of directors elected by shareholders
o The liability of the shareholders is limited to whatever amounts theyve
agreed to contribute to the corp and doesnt extend to any debts of or
liabilities that the corporation incurs
o In general, owners of shares in a corp can transfer them by sale, gift, or
devise as easily as they transfer ownership of any other intangible property
o Basic document: articles of incorporation; secondary document: bylaws
o Owners called shareholders or stockholders
o General Partnership:
o Is an entity in which all partners have unlimited liability, an equal voice in
management and the authority to act as agents for the partnership and
incur obligations that will bind all partners
o Generally not possible to transfer all of the rights included in a partnership
interest
o Default form when two people do business/contract together
o Limited Partnership
o Combines elements of the corp and general partnership
o Formed by filing papers with state; there are limited partnership statutes
o Must have at least one general partner in addition to limited partners. The
general partners have comparable liability to those in a general partnership
but a limited partners liability is limited to the capital she has contributed.
o A limited partner has no voice in the active management of the partnership
but can vote on major decisions
o The Limited Liability Corporation (LLC) is a hybrid form of business
organization that has proliferated since the 1990s.
o It is a legal entity distinct from its owners, who are called members and
receive the benefits of limited liability
o Set up pursuant to state statute and established by filing articles of
organization; lesser rules are found in the operating agreement, and
these generally specify management arrangements
o An LLC can elect to be taxed as either a partnership or a corporation,
making it attractive in a variety of business settings.
o State LLC statutes vary much more than do state corporate and partnership
statutes
o Are either member managed or manager managed (by outside
manager who comes in to run the LLC)

Default Rules
o

Formation
o Corporation: file articles of incorporation with state

26

Must include: corporate name, number of shares of stock that the

corporation is authorized to issue, and the name and address of
each incorporator
May include: provisions regulating the management and affairs or
limiting the powers of the corp and its shareholders, officers, or
directors
o General Partnership: Most are formed consensually when 2+ people
enter into a contract, governing for instance - such matters as managerial
rights, distribution of rights, interests in profits and losses, and rights upon
dissolution of the enterprise.
o Limited Partnership: file w/ state certificate of partnership setting forth
rights and duties of partners and IDing general partners. If new general
partners are added, amended filings are required
o LLC: requires filing articles of organization with the appropriate state
agency; articles must include the name of the LLC and address of its
registered agent
Members also enter into an operating agreement that sets forth the
members rights and duties
Limited Liability
o Corporations: this is one of their key features. Means that a creditor of
the corporation ahs the right to satisfy the debt out of any assets owned by
the corp but once those assets are exhausted, the creditor of the org doesnt
have a right to go after the personal assets of the shareholders of the
organization
However, three major exceptions: Shareholders will be personally
liable (1) where the corporation is not properly formed; (2) for
unpaid capital contributions that they have agreed to make (e.g. if
youre subscribed for but havent yet bought stock); (3) where the
veil of limited liability is pierced for equitable reasons.
Shareholders are not liable for debts as shareholders,
however, there may be other reasons why a shareholder is
liable for instance, as a guarantor
o General Partnership: partners as individuals can be held jointly and
severally liable for partnership obligations in tort, and jointly in contract.
Partners have the ability to bind the partnership as long as they acted in the
ordinary course of the partnerships business
If there is joint and several, somebody can sue just one partner and
get all the money; if its joint, then a person has to sue all partners
o Limited Partnership: general partners have the same unlimited liability
as partners in a general partnership. Limited partners exposure is limited
to the amount of their investment so long as they dont participate in
management. If you structure it so that the general partner is a
corporation, then nobody is liable as an individual
o LLC: statutes limit the liability of the entitys members and managers for
its obligations but let the members participate in management and still

27

receive limited liability makes it more potentially attractive than a

limited partnership
Management and Control
o Corporation: management is centralized in its BofD elected by the
shareholders. The board is charged with managing or overseeing the
corporations business and affairs. The business judgment rule effectively
protects the directors from monetary liability for their good faith decisions
With smaller and close corps, youre basically allowed to get rid of
the centralized structure but still be a corp
o General Partnership: Not centralized. Management authority is vested in
all partners. Each has an equal voice regardless of capital contribution.
Decisions generally made by a majority. But some things, like
modification of a partners decision-making authority, require unanimous
consent.
o Limited Partnership: general partners have responsibility for most
management decisions. Limited partners cannot participate in management
without losing the protection of limited liability. However, they do
maintain the right to vote on major decisions
o LLC: is either member-managed or manager-managed. In membermanaged, all members have the authority to make management decisions.
In a manager-managed LLC, members are not agents for the entity and
make only major decisions (decentralized).
Continuity of Existence
o Importance generally: allows for long-term planning
o Corporation: Exist in perpetuity unless the articles of incorporation say
otherwise
o General Partnership: can be at will or for indefinite period. Absent
contrary provisions in the partnership agreement, an at-will partnership is
dissolved at the death, bankruptcy or withdrawal of any partner
o Limited Partnership: the business generally continues upon the death,
bankruptcy or voluntary withdrawal of a limited partner but the
partnership agreement must specify the latest date upon which the
partnership must be dissolved.
Absent a provision to the contrary in the partnership agreement, a
limited partnership is dissolved only when a general partner
withdraws, dies, or goes bankrupt.
o LLC: Statutes provide that LLCs exist in perpetuity unless the operating
agreement or articles of organization provide otherwise
Transferability of Interests
o What were transferring: Value (income and residual value like assets if
the business is dissolved); and control (esp. important in partnerships)
o Corporation: Default rule is free transferability of everything. Everything
(right to dividend, residual value, and vote) adheres to the stock
o General Partnership: general rule is that all partners must consent to the
transfer of a partnership interest and admission of a new partner. However,

28

there are exceptions sometimes that give the right to income but not
control or residual value to a trasnferee
o Limited Partnership: Limited partnerships are transferable; general aren
not
o LLC: depends some statutes (esp. recent) allow for free transferability
of member rights; used to be that they could only transfer financial interest
and not management interest w/o unanimous consent of other members
Transfer is controlled by the articles of the LLC
o Which is better?
One thing you get from transferability is the ability to exit
In terms of absolute free transferability corporations are best.
However, there is a glitch if there is no market for the stock, then
you may legally have full transferability but you wont be able to
find anybody to buy your interest. Same with LLCs LLCs change
so much that there often isnt a market for shares of LLCs
o Fiduciary Duties
o The basic fiduciary duties of corporate directors, officers, and controlling
shareholders are the duty of care and the duty of loyalty.
Duty of care requires the directors to act in the corporations best
interests and to exercise reasonable care in making decisions and
overseeing the corporations affairs.
Duty of loyalty requires directors to place the best interests of the
corporation above their own personal interests.
o These duties dont necessarily apply to partnerships or LLCs, which are
contractual in nature, so the parties can agree to limit of expand fiduciary
duties as they wish.
If partnership or operating agreements fail to address fiduciary
duties, the judge may draw on fiduciary duties as theyve been
applied in the corporate context even through the corporation is not
contractual to the same extent as partnerships and LLCs.
o Ability to Raise Capital (equity, not debt)
o Corporations
Sells more stock; can sell to public, but there has to be a market
o Partnerships
Limited to raise more equity capital, you have to bring another
partner in
o Limited Partnership
Can sell more limited partnerships
o LLC
Very flexible

29

The Limited Liability Company

o
o

Has, in recent years, become the preferred form of doing business for many
entrepreneurs and their lawyers.
Elf Atochem North America, Inc. v. Jaffari (Del. 1999)
o Synopsis of Rule of Law. The Delaware LLC statutes give great
deference to the freedom of LLC members to contract, providing the terms
do not overstep any of the mandatory statutory provisions.
o Stuff about LLCS: The Delaware LLC Act was adopted in 1992. The
LLC is an attractive form of business entity because it combines
corporate-type limited liability with partnership-type flexibility and tax
advantages The policy of freedom to contract underlies the Act
theres broad discretion in formulating provisions

Planning Considerations
o Balancing Ownership Interests
o Corporate law favors the interests of majority shareholders. In a close
corporation, a minority shareholder unhappy with the direction of the
business may want to sell her shares. But the majority shareholder is likely
to be the only one willing to buy and probably at a price less than the
minority holder would consider fair. The ability to obtain relief is far less
certain than the ability to withdraw unilaterally form an at-will partnership
and obtain cash payment for the withdrawing partners interest.
o In general partnership, the default rule allowing at-will dissolution is
critical.
Allows parties to get around the unanimous consent rule (can just
dissolve and reform without the person who you dont like (157)
Minority partners can also use at-will dissolution to deal
opportunistically with the majority. For instance, if they have
needed skills, they can threaten to withdraw if they dont get what
they want
** To deal with these sorts of problems, investors planning a
partnership should consider drafting provisions that reduce the risk
of opportunism.
o Tax Considerations (bottom 158)
o Differences between corporations and partnerships in taxation:
A corporation is treated as a taxpaying entity separate from its
shareholders
A partnership is treated as an aggregate of individuals rather than
as a separate entity. All income that the partnership makes is
imputed to the partners and the partners pay it as if it were their
personal income
There might be situations where partnership is
making tons of money but partners cant pay the tax
on it

30

 Corporate partners cannot claim a deduction if the corporation

operates at a loss (its deducted against the corporations income,
not the owners); partners in partnerships can
o There are 2 ways a corporation can distribute money:
Can give money made on shares (increases) as dividends to
shareholders --- then the stock is worth the base value plus the
dividend
If you dont pay dividends, then the stock is worth more and if
shareholders want their dividends, they just have to sell their share
o Limited Partnership: divide income like a partnership
o LLCs are allowed to select how theyll be taxed. By default theyll be
taxed as a partnership
o There are ways by which some corporations can avoid tax at the
corporate level (pay the shareholders salaries, etc all of which are
generally tax-deductible business expenses)
Another option is to qualify as an S corporation these must be
domestic corporations with no more than 100 shareholders. The
shareholders must not be nonresidents, and the corporation can
only have one class of stock
o Need to understand the significance of tax rates
There was a big disparity between corporate tax and individual tax.
This impacted whether corps would pay dividends or not if
corporate tax rates were way lower than personal, it made sense to
not pay dividends then the corporate income would be taxed less
than if the people had to pay the corporate tax and then the
individual (higher) tax on the dividends

Chapter 7: Forming the Corporation

First thing:
o Discuss conflict of interest problem inherent in being an attorney for three
individuals all forming one company
Second:
o Need information about the business they want to found and their own
personal info
Because of liabilities how much liability might they face, do they
have kids that they are saving money for?
o Use this info to determine what kind of corporation we want to be
Third:
o Where to incorporate
o Rule of thumb: incorporate locally unless theres a reason not to
31

Why: local counsel knows local rules; local courts are more
hospitable
o Why incorporate in a different state?
Laws might be more favorable
Large corporations typically go to Delaware
Now what do we do to incorporate?
o 2.01-.02; 3.01-.02; 4.01; 6.01

So all you need to start are: name, name and address of agent; name and address of
each incorporator; class(es) of stock and the legal rights associated with them; and
then you take the form and give it over to the secretary of state.

The Process of Incorporation

o
o

See MBCA 2.01-.07; filing requirements and procedures are simple & quick
After the corp has come into legal existence, an organizational meeting must be
held. At its first meeting, the board accomplishes a number of standard tasks,
including the election of additional directors, if any; the adoption of bylaws; the
appointment of officers; the adoption of a corporate seal; the designation of a
bank as depository for corporate funds; and often the sale of stock to the initial
shareholders
o Choice of State of Incorporation
o Corps. generally incorporate in the state theyre operating in, if only
operating in one state (reduce filing, reporting, tax burdens)
o Other considerations: corporate and franchise tax rates; ease of operating
the corp; regulation of sale of stock and payment of dividends

Lawyers Processional Responsibilities: Who is the Client?

o

o
o
o

This question is important bc lawyers have specific duties to clients that they
dont have to non-clients
o E.g. to deal honestly, to comply with obligations concerning the clients
confidences and property, to avoid conflicting interests
The lawyer as planner might find it difficult to stay neutral since every solution
involves tradeoffs among parties with differing goals
The Model Rule 1.7 of the ABA Model Rules of Professional Conduct permits
multiple representation, albeit with the informed consent of the parties after full
disclosure of the consequences.
A particularly important factor in determining the appropriateness of common
representation is the effect on client-lawyer confidentiality and the attorney-client
privilege. The prevailing rule is that the attorney-client privilege doesnt attach;
so, if litigation eventuates between the clients, the privilege will not protect any
such communications and the clients should be so advised.

32

Model Rule 1.13: (g) A lawyer representing an organization may also represent
any of its directors, officers, employees, members, shareholders or other
constituents, subject to Rule 1.7. If the orgs consent to the dual representation is
required by Rule 1.7, the consent shall be given by an appropriate official of the
org other than the individual who is to be represented, or by the shareholders.
o Entity Theory of Representation
o Many jxs have adopted the entity theory of the corporation as embodied
in Model Rule 1.13. The core of the theory is that the lawyer represents
the corporation, rather than its officers, directors, employees or
shareholders
o Appears to adopt the paradigm of the publicly-held corp: the corp is an
individual, standing apart from its constituents.
o Jesse by Reinecke v. Danforth (1992)
Rule: Entity Rule holds that where a lawyer represents a
corporation, the client is the corporation, not the corporation's
constituents.
RULE (2): Where (1) a person retains a lawyer for the purpose of
organizing an entity; (2) the lawyers involvement with that person
is directly related to that incorporation; and (3) such entity is
eventually incorporated, the entity rule applies retroactively such
that the lawyers pre-incorporation involvement with the person is
deemed to be representation of the entity, not the person
See pg ~ 47 reading notes for determinative facts
o A lawyer can represent a yet-to-be-formed corp the entity theory
applies retroactively
o An alternative view is the aggregate theory - the lawyer is found to
represent the incorporators/constituents collectively as joint clients
Once the corporation is formed, the clients must determine whether
the lawyer will continue to represent all of the constituents and the
entity, or just the entity
** Lawyers must make clear WHO they do/do not represent
With respect to confidentiality obligations, lawyers should specify
how information conveyed to them will be treated for
confidentiality purposes
o Aggregate Theory of Representation
o The lawyer represents all of the owners individually in addition to the
entity
o A lawyer has no duty to keep information confidential among the
shareholders if the information relates to the representation, nor does the
attorney-client privilege obtain if there is litigation between the
shareholders
o Many courts have applied the reasonable expectations test, rather than trying to
apply entity or aggregate theory
o Under this test, as set forth in Westinghouse Elec. Corp. v. Kerr-McGee,
if an attorney leads an individual or entity to believe that they are a client
and the belief is reasonable under the circumstances, an attorney-client

33

relationship will be created, whether or not the client enters into a formal
retainer agreement.
Lawyer for the situation functions vary with specific circumstances --- but
basically, lawyers in these circumstances have a holistic view of everybodys
wants, desires, conflicts, and potential areas for synergies.
o It can be difficult for a lawyer to clearly identify his role as such, however

Problems during Incorporation

o Ultra Vires
o Is a common law doctrine meaning beyond the power a corporation
could not engage in activities outside the scope of its defined purposes.
o Used to be much more important; now really only comes into play in a
few situations like whether charitable contributions constitute a waste of
corporate assets
o Defective Incorporation
o In response to these questions, courts developed the concept that the
business association could be a de facto corporation, even if it was not a
corporation de jure theres also a corporation by estoppel concept
MBCA 2.04 imposes liability on people who act as or on behalf
of a corporation knowing that no corporation actually exists.
o De facto incorporation
Three conditions must be met:
There must be a corporation statute
There must have been a colorable attempt to comply
Have to show that the corporate privilege was exercised
(have to show that the people were acting on behalf of the
corporation)
*This doctrine has come under attack in some jxs because its
so easy to form a corporation or to follow up and find out if the
corporation has been formed
o Pre-incorporation transactions:
o Occur when people want to act on behalf of corporation but know that the
corporation hasnt been created
o What not to do: never sign the name of a corporation knowing that the
corporation doesnt yet exist. If an agent acts on behalf of a non-existent
principle, the agent is the principle (and is held liable as it)
o What could maybe do: could file a boilerplate form of corporate articles
create corp as a shell and then amend once you work out the finances,
etc.
o Or get an option contract (only works where the value of what you want
stays the same at least in short run (like land))
o Another thing to do: insert a clause into the contract signing as a
corporation yet to be formed this gets rid of the misrepresentation

34

grounds for holding you liable. But it doesnt take care of the agency
problem
Its not the lawyers position to choose among these options, but instead to
inform the client of what the options and associated risks are

Chapter 8: An Introduction to Financial Accounting and

Valuation
Financial Accounting Demystified
o
o
o

Generally accepted accounting principles (GAAP)

* there is no such thing as objective truth in accounting *
What gives a company value: Cash; inventory; property; workers; human capital
the relationships built up between people; patents (that we develop) &
trademarks/name; leases

The Balance Sheet

o
o

A snapshot of the financial status of the business at a particular moment; done

yearly
Contains sections for assets, liabilities, and equity.
o Assets include property, both tangible and intangible, owned by the firm
o Liabilities accounts for the amounts that the firm owes to others
o Equity or net worth represents the accounting value of the interest of the
firms owners
o Total assets are always equal to total liabilities plus equity
ASSETS = LIABILITIES + EQUITY

Assets:
o Going concern principle: some assets are of great value to the corp, but only
when the company is in operations. So when youre doing a balance sheet, you
have to assume that the company is a going concern i.e. not going out of
business
o Principle of conservatism: when choosing between two solutions, the one that will
be least likely to overstate assets and income should be picked you have to take
the lower cost or market value of goods into account (e.g. if the market drops out
on something you bought, like steel). This is also called mark to market
o Are listed in order of liquidity, beginning with cash and end with more fixed
assets
o Current assets: include cash and other assets that in the reasonably near future
will be converted into cash. Also include marketable securities, which are mark
to market because theyre marked on the balance sheet to their current market
price.

35

Accounts receivable: are amounts not yet collected from customers to

whom goods have been shipped or services delivered
GAAP require that accounts receivable be adjusted by deducting
an allowance (or reserve) for bad debts; firms usually estimate
the bad debt allowance on the basis of past experience or
experience of similar businesses. Reserve for doubtful accounts
o Notes or Loans Receivable: usually represent a very large portion of the
assets of firms engaged in financing businesses
o Inventory: Represents goods held for use in production or for sale (parts,
finished products, works in progress)
The amount of items sold from inventory is the Cost of Goods
Sold (COGS) and often represents a firms largest cost of doing
business
Firms that cant keep track of the cost of each item in inventory
compute COGS by adding their purchases during a reporting
period to the value of their inventory at the start of the period
(called opening inventory) and then subtract the value at their
closing inventor. The firm can use one of three methods to value its
closing inventory:
The average cost method, which visualizes inventory as
sold at random from a bin; the first in, first out (FIFO)
method, which visualizes inventory as flowing through a
pipeline; and the last in, first out (LIFO) method, which
visualizes inventory as being added to and sold from the
top of a stack
In any period in which prices change significantly, the
inventory method a firm uses can have a material impact on
the value of its inventory account, on COGS, and hence on
the firms reported profits which can be exploited for tax
purposes; see example in CLASS NOTES!!!
o Prepaid expenses: Payments made in advance of services received
o Deferred Charges: Represent a type of asset similar to prepaid expenses,
in that they reflect payments made in the current period for goods or
services that will generate income in subsequent period, such as
advertising for a new product
o Fixed Assets:
o Sometimes referred to as long-term assets or as property, plant, and
equipment, are the assets a firm uses to conduct its operations
o When a firm acquires a fixed asset, it records the asset on its balance sheet
at cost. GAAP then uses depreciation value to reflect more accurately
the value of fixed assets on the balance sheets
What you do is take a certain amount of the cost and assign a
portion of those expenses to each year
o Intangible Assets
o Exs: patents and trademarks

36

GAAP requires firms to carry intangible assets they have purchased at cost
less an allowance for amortization (the equivalent of depreciation, applied
to intangibles)
However, GAAP does not allow a firm to record as an asset the
value of an intangible asset a firm has developed itself, rather than
purchased.
Lots of things dont show up on the balance sheet that are part of what the company is
worth (e.g. workers, patents that we develop, our name and trademarks)
o So there is a concern that our company is worth more than its book value because
these things arent included

Liabilities:
o
o
o

Are usually divided into current and long-term liabilities

Current liabilities are the debts a firm owes that must be paid within one year of
the balance sheet date. Long-term liabilities are debts due more than one year
from the balance sheet date.
Many liabilities dont show up on the balance sheet. However, GAAP requires
companies to put money aside if things like lawsuits occur

Equity:
o
o

Or net worth represents the owners interest in the firm. It is NOT actual $; its
an accounting representation of the book value of a company
A corporations equity has two components:
o The first, often recorded as paid-in capital, reflects the total amount the
corp has received from those who have purchased its stock
o The second, called retained earnings or earned surplus, reflects the
cumulative results of the corporations operations over the period since it
was formed
This amount is also reduced by the distribution of any dividends to
shareholders or any amount the corp has paid to repurchase stock

Analyzing the Balance Sheet:

o
o

One focus is liquidity: does a firm have sufficient cash or assets it is likely to
convert into cash to meet its financial obligations as they come due?
Three commonly used indicators of a firms liquidity are its:
o Working capital, defined as the difference between current assets and
current liabilities
o Current ratio, computed by dividing current assets by current liabilities;
and
o Liquidity ratio, computed by dividing quick assets like cash,
marketable securities, and accounts receivable by current liabilities.
A gradual increase in a firms current ratio, based on a comparison of successive
balance sheets, is a sign of financial strength
37

Creditors often compute a firms debt-equity ratio, dividing long-term debt by

book value of equity. A high ratio may indicate that the firm is relying primarily
on borrowed capital. This can be dangerous for debt holders if the firms business
falters

The Income Statement

o

The income statement is the bridge between successive balance sheets it

records whether the firm realized a profit or loss during the period between
successive balance sheets
o In general: Look at total operating expense to see whether theres profit
--- but we still dont know if the company is actually viable there might
be interest on loans that is greater than the amount of profit after operating
expense
** There are two reasons why a business can fail: underlying
business isnt sound (its losing money); OR it might be financed
in such a way that it cant make money
o GAAP require that most firms use the accrual method of accounting to prepare
their financial statements rather than the cash method. Under the Realization
Principle of accrual accounting, a firm must recognize revenue in the period in
which it ships goods or renders services, even if it does not receive payment for
the goods or services in that period
o Under the Matching Principle, a firm must allocate the expenses it incurs to
generate revenues to the period in which it recognizes the revenues
o Earnings:
o The statement of income starts with net sales represents the total value
of a firms revenue during the relevant year
o Once we know the revenue, we can deduct expenses
First Cost of Goods Sold (COGS). These generally represent the
cost of items sold from inventory
The difference between Net Sales and Cost of Goods Sold is the
companys Gross Profit
Operating expenses are the costs associated with the operation of
a business but not directly related to the costs of goods or services.
These are sometimes referred to as indirect expenses or
overhead
Exs:
o Depreciation expense decrease in value of fixed
assets
o Selling and administrative expense
o Research and development
To obtain operating income, we subtract all of the operating
expenses from gross profit. Operating income is sometimes
referred to as EBIT, Earnings Before Interest and Taxes
o Net Income:

38

o
o
o
o
o

Interest expense represents the amount of interest the firm paid on its debt
during the year
Income before taxes is obtained by subtracting interest expense from
operating income --- this is sometimes called taxable income
Net income is very important and considered heavily by investors. It is the
link to both the balance sheet and cash flow statements.
Whatever is left from net income, after a firm pays dividends, goes to the
retained earnings section of the firms balance sheet
Finally, one indicator of a firms value is its return on equity, which one
can compute by dividing equity at the end of the previous year into the net
income reported for the current year. That percentage can be compared to
the returns available on alternative investments.
Net income is the starting point for the statement of cash flows

Statement of Cash Flows:

o

The Statement of cash flows reports on the movement of cash into and out of the
firm. It is divided into three parts, based on whether the cash flow is from
operating activities, investing activities, or financing activities
o Structurally, the statement of cash flows starts with net income and then
corrects for each of the non-cash changes reflected in the balance sheet and
income statement
o This doesnt let you see whether youre making money on particular items,
however, there are less judgment calls necessary in making a statement of cash
flows than in doing an accrual statement
o Over a long period, cash flow is really preferred
GOOD LAST PARAGRAPH questions to ask --- PG 217.

Valuing the Enterprise

o

In valuing a business, it is extremely important to keep in mind the time value of

money
o The process of figuring out how much future cash flows are worth today is
called discounting
o The value of future cash flows in todays terms is called present value
One good way to value a firms stream of income is to look at earnings of a
comparable firm
o Another way to do this is with operating cash flows rather than reported
profits
Another approach: the discounted cash flow or DCF:
o Estimate the stream of cash flow or earnings the business is expected to
generate in the future and then discount that stream of payments to a
present value
39

Other things: a purchaser should inquire what is behind the COGS, investigate
overhead charges, understand the selling and marketing expenses, determine
whether receivables can really be collected, and ascertain whether inventory is
obsolete; should also inquire as to contingent liabilities
o Consider economic goodwill: the value of the brand, advertising and
marketing, oligopoly or monopoly power, or unique market opportunities

Main places where you get a lot of info:

Look at changes in statements over time you can see things in trends
Various financial ratios that are listed in the book - Use relationship between
two accounts to get information about a company
o For instance, current assets divided by current liabilities. If there is a
decline, thats bad. Tells you whether or not a company has enough assets
to cover liabilities.

Chapter 9: Financial Structure of the Corporation

MBCA 6.01 Authorized Shares
o The articles of incorporation must set forth any classes of shares and series of
shares within a class, and the number of shares of each class and series that the
corp is authorized to issue Except to the extent varied as permitted by this
section, alls hares of a class or series must have terms, including preferences,
rights, and limitations that are identical with those of other shares of the same
class or series
o (b) The articles of incorporation must authorize
o (c) The articles of incorporation may authorize
MBCA 6.21 (a) (e): Issuance of Shares
o (a) the powers granted in this section to the BoD may be reserved to the
shareholders by the articles of incorporation
o (c): Before the corp issues shares, the BoD must determine that the consideration
received or to be received for shares to be issued is adequate
o (e) The corporation may place in escrow shares issued for a contract for future
services or benefits or a promissory note, or make other arrangements to restrict
the transfer or the shares, and may credit distributions in respect of the shares
against their purchase price, until the services are performed, the note is paid, or
the benefits received

40

Corporate Securities
o Corporate securities can be divided into equity and debt
o In general, equity represents permanent commitments of capital to a
corporation, while debt securities represent capital invested for a limited
period of time (e.g. the maturity of a loan)
o Returns on equity securities generally depends on the corporations
earning a profit
o The rights of equity securities are subordinated to the claims of creditors,
including those who hold the corps debt securities
o However, holders of equity securities typically elect the BoD and thus
exert more control over the conduct of the business and the risk it incurs
o Debt securities generally have priority in terms of payment if the firm
becomes insolvent or liquidates voluntarily
Because theyre less risky, debt securities are typically only
entitled to a fixed return
Holders of debt securities can back them by placing liens on some
or all of the corporations assets or by negotiating contractual
covenants restricting the corps operations; aside from this, debt
holders ordinarily play no role in the firms management

Equity Securities
o

o
o

The terms common stock and preferred stock are used to describe the two basic
kinds of equity securities
o Corporate statutes require that at least one class of equity security must
have voting rights and the right to receive the net assets of the corporation
in the event that the corp is dissolved or liquidated.
When a corp is formed, the articles of incorporation will create authorized shares
o Until theyre sold to shareholders, they are authorized but unissued
o When sold, theyre authorized and issued or authorized and
outstanding
o If theyre repurchased by the corp, theyre authorized and issued, but
not outstanding
o Statutes require that the articles of incorp. Include the number of shares
that a corp is authorized to issue and describe certain characteristics of
those shares.
o To issue more stock, the articles must be amended. The BoD must
recommend the amendment, and holders of at least a majority of
outstanding stock must approve
The percentage of the corporations outstanding stock that a persons shares
represent determines her position relative to other stockholders
Common law doctrine of preemptive rights: held that a shareholder had an
inherent right to maintain her interest in a corporation by purchasing a

41

proportionate share of any new stock issued for cash. This was meant to get
around the problem of diluting shareholders stocks
o Now, many states have an opt-in approach to pre-emptive rights.
o This gets complex when you have different classes of stock with different
proportional rights (e.g. common stock with 1 vote, 1 dividend; preferred
stock with no vote, 1 dividend)

Common Stock
o
o

o
o
o

Is the most basic of all corporate securities all corps must have it, and many
have only it. Can have many different classes of it within one corporation, each
with different rights.
Rights (e.g. to income, vote, right on dissolution) are set out in articles of incorp.
o Exception: sometimes you want the BoD to be able to amend the rights
without amending the articles of incorp.
To do this, you allow for blank check stock BoD has the ability
to define the rights of that particular set of securities going forward
o Board has discretion as to issuance of dividend. Large companies typically
issue it quarterly: steady divided = steady income. But this isnt required.
o Voting rights: Common stock normally carries 1 vote. Sometimes, corps
create two classes of common stock e.g. class 1 has one vote and has
100% of the dividend; class 2 will have 10 votes per share and 90% of the
dividend. People can choose but only those that want to run the thing will
go with class 2.
Holders of common stock usually have the exclusive power to elect a corps B oD
(so they have the most control), although some corps have one or more classes of
common stock thats non-voting
o This, combined with the riskiness of their investment, provides common
shareholders with a strong incentive to ensure that the corp is operated
efficiently
Represents a residual claim on both the current income and assets of a corp
o All income that remains after a corp has satisfied the claims of creditors
and holders of more senior securities (debt and preferred stock) belongs
to the holders of common stock
BoD can if this income remains distribute it to shareholders as
dividends or can reinvest it in the business
If holders of common stock want to get out of their investment, they generally do
so by exiting selling their stock to other investors
o There is usually a limited market if the corp is a close corp
Holders of common stock are also the primary beneficiaries of the fiduciary duties
that corporate law places on the BoD
Stock split
o If its 3X 1, then for every share you have, you get 2 more
o This does not change the proportionate shareholder ownership they all
still have the same percentage.

42

Stock splits make it easier to sell the common stock because the price will
be lower. (for instance, if you originally had stock that cost $100, then you
did a 4X1 split, each stock will cost $25)
o Usually the BoD can do it without the permission of the shareholders
o Stock dividend:
o Normally means:
There can be a stock dividend in the normal way one declares a
dividend, except what it gives its shareholders is more of its
common stock
E.g. they get a share for every 10 shares they own
o Rarely means:
Dividends can be given in any currency (money, shares, rights)
E.g. Kamin paid dividend in the form of another companys
stock
o * If its a stock dividend, the BoD has to be able to issue the stock (i.e.
w/in authorized amount). This is not true of stock splits.

Preferred Stock
o

o
o
o

Stock is classified as preferred stock when the articles of incorporation assign to it

economic rights senior to those customarily assigned to common stock
o Discretion to issue dividends rests with BoD = flexibility
o Can have cumulative preferred stock
If it isnt paid, then you have to pay off all of the accumulated
preferred stock before you pay dividends to common stockholders
o Another kind of preferred stock: participating preferred participates
in the success or failure of a company, with payout fluctuating rather than
fixed, based on how the company is doing.
o Convertible preferred stock
Is convertible at request of shareholder into some other kind of
stock
o *** THESE THREE kinds of preferred stock are NOT mutually exclusive
o The value of the preferred varies depending on the market; the success of
the company; the value of the common stock
Voting right: normally doesnt vote but may under specific conditions/on specific
issues
Dissolution rights: Usually cant sell it back to the company. Upon dissolution,
first paid are creditors, then preferred get their accumulated dividends, then the
face amount of the preferred, then pay common
In addition to a dividend preference, preferred stock often has a preference on
liquidation - usually stated as a right to receive a specified amount before any
amounts are distributed with respect to common stock (but are lower on the chain
than creditors)
The voting rights of preferred stock are often limited to specified issues and
circumstances

43

Most corporate statutes allow shareholders to authorize blank check preferred

stock, the essential characteristics of which right to dividends, liquidation
preferences, redemption rights, voting rights, and conversion rights can be set
by the BoD at the time the stock is sold
o This better facilitates the sale of preferred stock in lieu of debt but also
enhances substantially the power of a corps BoD by allowing it to issue
preferred stock with rights that may impinge materially on those of
common stock without first obtaining explicit shareholder approval

Debt Securities
o
o
o
o
o

See example Securitizing PT ~ 35 in class notes!!

Represent liabilities of a corporation. Can be called notes, debentures, or bonds.
Typically, the first two have shorter maturities than bonds.
Typically, debt securities are part of a companys long-term capital structure and
reflect long-term interests in a corporations financial fortunes
Standing rule in bankruptcy law is that all creditors stand equally --- they get
proportional pay offs if the company cant cover the whole debt
There are ways to reset the order in which creditors get paid:
o Secured creditors (secured by mortgages or corporate assets) get right to
security before others are paid out.
o Some creditors might be asked to be subordinated to others (i.e.
preferenced lower).
Why would they do this?
(1) if company is in trouble and needs new debt, somebody
might offer to come in and lend but they want to be first
paid off. It is in the first creditors interest for the company
to get this loan
(2) if the people who own the business are shareholders
AND creditors, those creditors may subordinate their debt
Terms:
o Obligation of the borrower to repay a fixed amount of principal on a
particular date
o Typically requires interest paid at periodic intervals might be fixed or
floating rate
o Typically, in event of default, the entire principal will become due
immediately and this acceleration entitles the bondholders to pursue all
legal remedies for which they have bargained, including the right to
initiate bankruptcy proceedings.
Bonds usually do not carry the right to vote and directors are not considered to be
fiduciaries for the bondholders
o As with dividends on common and preferred stock, the Board has the
option of not paying interest on the bond. But the debt still accrues and the
company will be in default if they go this route. Many bonds have
acceleration clauses in the event of default.

44

In some instances, the terms of the bond will give the bondholder the right
to convert the bond into common stock
Similarly, bonds may be redeemable or callable for a fixed price
at the option of the borrower. This is good because you dont lock
yourself into the interest rate for a long time.
Unless the articles of incorp say otherwise, the BoD has the authority to issue debt
securities without shareholder approval

** A debt holder is viewed as an outsider, entitled only to the protection specified in her
contract. In contrast, the holder of common stock is protected by directors fiduciary
duties.

Options
o
o
o

Are the right to buy stock, typically common stock, at a specified time and price
(i.e. the right to buy or sell something in the future)
** It is a contractual right, not obligation to buy or sell
corporations frequently offer stock options to employees, particularly senior
managers, as compensation gives the holder the right to buy shares of a
company

Corporate Capital Structure Decisions, decisions

Capital structure describes how a company has raised funds using corporate securities
2 main differences between preferred stock or debt
preferred stock is better for the corp because it gives the corp flexibility (doesnt
have to be paid out, whereas debt does)
Dividends are subtracted after taxes; if its interest, interest is deducted as an
expense before taxes are paid. SO it is in the corps best interest to do as much
debt as possible because it will minimize taxes (but then you dont get the
flexibility of when to pay dividends you need to pay interest as it becomes due)
How does leverage affect preferred stock vs debt?
In equity the return can go up and down depending on how well the business
does. In contrast, with debt, the payment on the debt doesnt go up and down
depending on business fluctuations its a set amount. And this is the factor that
leads to leverage no matter how much you profit, you only owe a set amount.
Payout on participating preferred stock goes up and down with the success of the
company, so it is going to act like equity to a certain extent. If you have preferred
that isnt participating, its just like debt: a set payout if earnings go up you
profit, if earnings go down, you can lose more.

45

Tax Considerations
o

The Internal Revenue Code gives corporations a powerful incentive to favor debt
in their capital structure --- allows them to deduct from their taxable income all
interest paid on bonds that they have issued
o Preferred stock has other advantages, however more flexible than debt

Leverage and the Allocation of Risk

o

o
o

The whole point of leverage is increasing your ability to make more money by
borrowing more money. If you can earn more money than the interest youre
paying, then you can leverage your profits. So leverage only works when
profitability rate is greater than interest rate
o When a company is overleveraged, that means theyre doing most of their
financing through debt. That means there is greater volatility in profits
company can make or lose a great amount of money (substantial risk)
because no matter your profits, youre paying a set amount (not the case
with stock dividends)
Highly leveraged means you have a high debt-equity ratio
Deep Rock Doctrine:
o Sometimes, when a company goes into bankruptcy and cannot pay its bills
as they become due AND, also, some of the companys money has been
lent by shareholders, the court will say that the normal rule that all debtors
are treated equally doesnt apply instead, the shareholders debt is
subordinated and other creditors get paid out first.
o Three conditions must be present for this doctrine to apply:
(1) The company has to be thinly capitalized; and
(2) there has to some kind of suspicious or inequitable conduct by
the shareholders; and
(3) the shareholders must have exercised their control of the corp
in order to give themselves an advantage
e.g. using corporate machinery to reclassify my equity as
debt
o ** This is different from piercing the corporate veil --- when applying this,
the shareholders arent losing limited liability. The only money in danger
is that which the shareholders lent the corp creditors cant get to the
personal assets of the shareholders

Regulation of Legal Capital

o Traditional Approach to Regulating Distributions to Shareholders
o Some statutes permit dividends and other distributions to be paid only to
the extent that a corporation has earned surplus, i.e. surplus that arises
from the accumulation of profits during the life of the enterprise

46

More common are statutes that allow dividends and other

distributions to be paid out of surplus, without regard to whether
it is earned or not
Klang v. Smiths Food & Drug Centers, Inc. (Del. 1997)
o SFD wanted to be acquired. To do so, they had to buy back a bunch of
stock. They did this but, since it cost so much, they ended up in a book
deficit. Creditors sued, arguing that by buying all of this stock, SFD wasn't
retaining enough cash to pay back the creditors. That's known as
an impairment of capital.
SFD argued that the par value was jut an arbitrary number, and that
it could and should be changed if a company needs to repurchase
stock.
o Trial court agreed with SFD.
It is unrealistic to hold that a corporation is bound by its balance
sheets for purposes of determining compliance with Section 160.
Thus, corporations are allowed to revalue properly their assets and
liabilities to show a surplus and thus conform to the statute
In the absence of bad faith or fraud on the part of the board,
courts will not substitute our concepts of wisdom for that of the
directors. (bottom, 266)

o Protection against Excessive Distributions under the Model Act

o The MBCA abandons restrictions based on legal capital and employs a
more functional approach to regulating distributions
Pursuant to 6.40(c), it simply prohibits distributions if after the
distribution (1) the corp would not be able to pay its debts as they
become due in the normal course of business; or (2) the corps total
assets would be less than total liabilities plus any sum needed to
satisfy the claims of preferred stockholders in the event of
dissolution
These, respectively, are the equity insolvency test and the
balance sheet test
Class notes on legal capital:
If you are in a legal capital state, it is a state that uses the concept of par value
o Par value can affect the price at which a corp can sell shares; it can affect
the ability of the corporation to declare dividends or have distributions;
and it is accounted for differently than in a non-par value state
o Ex:
Cash (assets):
Amount paid for stock - $500,000
o 5000 shares at $100/share
o Suppose we say par value is $100/share
Equity:
Accounts:
o Stated capital = # shares * par value

47

So here, 5000 X $100 = $500,000

o Capital surplus: Stated capital amount paid
Here, $500,000 - $500,000 = $0
o Retained earnings (earned surplus) is the amount
earned over the years
** Dont get the equity and assets accounts confused. **
There was an attempt to control the quality of what was being paid for shares in
par value states
Only certain kinds of payments can be made to satisfy the rule
about par value you

How it works in a non-par value state:

There is no such thing as stated capital or capital surplus its all lumped into one
account: capital or equity
BoD has discretion on the quality of compensation
BoD sets what it thinks is a reasonable price for its stock
** New system leaves much more discretion in hands of BoD
*** When you get a problem, first analyze: am I in a par value state or not? There is no
concept of par value in a non-par value state, so just look to see if theres a par value;
however, some states let you set par value at 0. This is still a par value regime as the
concept of par value still exists.
In a par value regime, you also have treasury stock. If stock has been issued and corp
buys it back on the market, it becomes treasury stock. It has still be issued but it is no
longer outstanding.
Once a stock has been issued and bought back, the legal capital rules no longer
apply.
Difference between stock split and issuing a share as dividends: if you stock split, you
also split the par value. If you give a stock dividend, that isnt true. This involves
authorizing and giving out more stock.

Corporate Dividend Policy: Legal and Economics Issues

o

Dividend vs. Distribution:

o If you are giving out $ that the corp has earned, thats a dividend
o Distributions are when you give money that the company didnt earn; just
returning equity to creditors
A shareholder in a close corporation often is well advised to enter into an
agreement requiring that the corporation pay dividends under appropriately
defined circumstances
o As they generally cant sell their stock, if they dont receive dividends,
they receive no meaningful economic return for their investments

48

Dodge v. Ford Motor Co. (1919)

o The withholding of the special dividend asked for by Ps is an arbitrary
action of the directors requiring judicial interference
o Courts will not interfere in directors discretion whether to declare a
dividend unless the directors are guilty of a willful abuse of their
discretionary powers, or of bad faith or neglect of duty.
o NOTE: Rare is the case that a corporation has so much $$ and so clearly
profitable that a court will find a boards refusal to declare a dividend
reflects bad faith or an abuse of discretion --- thus, shareholders in a
close corporation face an uphill battle when they bring an action to compel
the BoD to declare a dividend

How dividends are accounted for:

o Paid out of cash. To balance balance sheet, subtract amounts of dividends
paid from returned surplus (or retained earnings)
o RULES:
Delaware has a 2 part test can declare dividends if you meet
either one or the other of the two rules:
(1) Dividends out of surplus
o can declare a dividend in Delaware as long as it will
come out of surplus (the amount in capital surplus
plus retained earnings; some states say it cant come
out of capital surplus)
(2) Nimble dividends rule
o Used when companies are in the red (often early on)
o Says even if a company doesnt have the surplus
necessary to declare a dividend, you can declare a
dividend equal to the net profit I made in the last
year or the year before it
MBCA - Must meet both prongs to declare dividend:
(1) Have to pay debts as they become due
o looking at sales, assets, things that may become due
looking beyond the balance sheet
(2) Balance sheet test cant get rid of all equity

Distributions of Stock
o

Kamin v. American Express Co. (1976)

o Brief Fact Summary. Plaintiffs, Howard Kamin et al., filed a shareholder
derivative suit against Defendant corporation, American Express, and their
officers after Defendants allegedly negligently decided to issue a dividend.
American Express decided to distribute this bad stock as a dividend; those
suing argued American Express would be better off selling the stock
o Synopsis of Rule of Law. A court will not interfere with the decision of a
companys directors unless there is evidence of fraud or dishonest

49

practice. The decision to declare a dividend may be an unwise judgment,

but it is a judgment that is outside the scrutiny of the court.
This is just another application of the business judgment rule,
really

Chapter 11: Piercing the Corporate Veil

If we have to argue for piercing or against it, take this form:
o Lay out the facts that are good for your side. Give a roadmap of why the
corporation should or should not be pierced.
o Factors:
What is the relationship between the parties/companies?
How was the D capitalized? how much money did investors put
at risk? Did they personally guarantee loans? How much money
did they subsequently take out of corporation?
Where corporate formalities followed?
Was there a co-mingling of funds? Are the companies
sending funds back and forth? Are they commingling other
things, like staff or officers?
o If yes, was there a good reason for it?
Was there anything misleading? Or was there misrepresentation?
o ** Measure capitalization at time of formation if we were to measure it
at any other time, people would be forced to keep pumping money into a
failing business to prevent themselves from being liable. This is bad
personally and societally
1. SHORT LIST OF FACTORS (from Freeman v. Complex)
1.
2.
3.
4.
5.
6.
7.
8.
9.

Disregard of corporate formalities

Inadequate capitalization
Intermingling of funds
Overlap in ownership, officers, directors, and
personnel
Common office space, address, and telephone
numbers
Degree of discretion shown by the allegedly
dominated corporation
Whether dealings between entities have been
arms-length
Whether corporations are treated as
independent profit centers
Payment or guarantee of the corporations
debts by the dominating entity

50

10.
Intermingling of property
Analogize to or distinguish from the following cases:

Introduction to Veil Piercing

o

Notwithstanding corporations limited liability, courts sometimes allow claimants

to disregard the corporate entity and recover directly from its shareholders this
is piercing the corporate veil
o Theoretical reasons for piercing:
o Limited liability can result in creditors, rather than shareholders, bearing a
portion of the costs of business failure. Piercing shifts those costs back to
the shareholders
o Businesses wont try and control risks to society if they know they wont
be financially responsible should the risks materialize
o Why limited liability is good (SEE ALSO 09 outline):
o It encourages business to take efficient level of risks, and business puts
money into the economy thereby benefiting society overall. I.e. the
externalities of promoting business outweighs the costs of limited liability
o Some commentators argue that limited liability is justified primarily
because it promotes efficiency by facilitating the organization of large,
public-held corporations (e.g. those with lots of shareholders)
(1) Decreases the need to monitor agents
(2) Reduces the costs of monitoring other shareholders
(3) By promoting free transfer or shares, limited liability gives
managers incentives to act efficiently (to increase value of shares)
(4) Limited liability makes it possible for market prices to reflect
additional information about the value of firms
If there is limited liability, we dont risk having to pay more
as an investor if something goes wrong.
Without LL, the wealth of the other shareholders matters
if all shareholders are liable, how much you have to pay is
a function of the dangers the corporation can get into and
how much money the other shareholders have
o ** WITHOUT LIMITED LIABILITY, the stock
value would vary depending on the wealth of the
shareholder ** (the idea that a share is just a share
depends on LL)
(5) allows for more efficient diversification
If you are diversified and there is no limited liability, you
have a lot of risks; also huge costs in monitoring other
shareholders
o Any one company can cost you your entire wealth if
you dont have limited liability
(6) Facilitates optimal investment decisions
o Others say it evens the playing field, allowing smaller investors to invest
without huge personal risk

51

Reasons why LL isnt so important for small corporations, like our very own PT: small
number of shareholders, so monitoring costs are low, as is risk of moral hazard.
Shareholders often have much of their personal wealth tied into the corporation anyway,
so piercing doesnt pose a the same risk to their assests as would piercing where youve
only invested a bit in the corp.
The way that piercing theory applies to large vs small corporations is very
different. (give some thought to this)
o When the CEO of a huge corporation takes a risk, the beneficiary will
largely be the corporation his personal gain is nowhere near the risk. But
if you look at a small company, thats usually not true hes usually the
owner so he has a lot to gain

Pro rata liability:

o Cap on the amount any one shareholder would have to pay cap based on
proportionate control of the company. Proportion of shares X liability =
pro rata liability
Will never be responsible for more than my share of the liability

Tort Creditors
A voluntary creditor knows she is dealing with a no-recourse corporation and can bargain
for a risk premium, shareholder guarantees, or restrictions on distributions. A tort
creditor, by comparison, cannot easily self-protect
Walkovsky v. Carlton
o Facts: Defendant was a shareholder in ten separate corporations wherein each
corporation has two cabs registered in its name. A single shareholder for multiple
corporations is a common practice for the cab industry. A cab from one of
Defendants corporations hit Plaintiff, and Plaintiff brought this cause of action to
recover. Each cab has only $10,000 worth of insurance coverage, which is the
statutory minimum. Plaintiff contends that Defendant was fraudulently holding
out the corporations as separate entities when they actually work as one large
corporation.
o Held: What matters is whether stockholders are carrying on the business in their
personal capacities for purely personal, as opposed to corporate, ends
o If a stockholder is not conducting business in his individual capacity, it
doesnt matter that the enterprise is actually being carried on by a larger
enterprise entity
o As the defendant complied with the statutory minimum for insurance
coverage, he wasnt undercapitalized and the court refused to pierce.
They said that despite the inequitable result, it wasnt their position to
interfere here its the legislatures.
Radaszewski v. Telecom Corp

52

Facts. This personal injury suit was brought on behalf of Plaintiff who was
injured in an automobile accident by an employee of Contrux, Inc., a subsidiary of
Defendant. The district court held that Contrux, Inc. was undercapitalized in the
accounting sense. Most of the money contributed to it was in the form of loans
and Defendant did not pay for all of the stock that was issued to it. However,
Contrux, Inc., had $1,000,000 in basic liability coverage plus $10,000,000 in
excess coverage. Unfortunately, Contrux, Inc.s excess liability insurance carrier
became insolvent two years after the accident and is now in receivership.
Law/Ps argument: Under Missouri law, a P needs to show three things to pierce
the corporate veil. The second element of the tripartite test is improper
motivation or violation of law. The plaintiff says that, in this case, the
undercapitalization of the subsidiary satisfied this element and thus the subs
corporate veil should be pierced to hold the parent liable.
Holding: Because Contrux had insurance coverage sufficient to satisfy the federal
financial-responsibility requirement, the court refused to pierce.
o If a subsidiary is financially responsible, whether by means of insurance
or otherwise, the policy behind the second part of the Collet test is met.
** Where courts find that they have no basis for making a decision (e.g. what
is/how to measure undercapitalization), they often find for the D not because the
D is right, but because they cant figure out what the damages are what the norm
is that they should apply.

Contract Creditors
Freeman v. Complex Computing Co. Inc.
o Facts: Complex entered an agreement with Freeman to help market the software.
Freeman was not paid for his efforts to market the software. He sued for breach of
contract. Complex had no assets though, so Freeman wanted to pierce to get at the
software developers personal assets.
o Conclusion: The Appellate Court found that even though the D didn't own any
shares in Complex, he was an equitable owner because he exercised considerable
authority over Complex. The Court found that in addition to being an equitable
owner, there must be a showing that the owner must use that control to commit a
fraud or other wrong that resulted in an unjust loss or injury. Since the Trial Court
never asked this second question, the case was remanded back to determine if the
D had committed a wrong.
o We dont have an intent test because its so hard to prove subjective intent.
BUT, if people do say what their subjective intent is (e.g. here, the guy
said that he was doing this because he thought Freeman was earning too
much), then the court might use this to determine whether to pierce
o Holding: Under the doctrine of equitable ownership, an individual who exercises
sufficient control over the corporation may be considered to be an owner, even if
they technically don't own any shares.

53

On remand, the Trial Court found that Glazier's actions were fraudulent because
they left Freeman as "a general creditor of an essentially defunct corporation with
virtually no assets."
o Three part test for equitable owner:
o (1) the owner has exercised such control that the corporation has become a
mere instrumentality of the owner, which is the real actor;
factors for complete control on pg 323
include inadequate capitalization, overlap in ownership,
officers, directors and personnel, and intermingling of
funds, among many others.
o (2) such control has been used to commit a fraud or other wrong; and
o (3) the fraud or wrong results in an unjust loss or injury to P
Kinney Shoe Corp. v. Polan
o Facts: Plaintiff set up a sublease with Industrial, which was the subsidiary of the
Defendant. Industrials only asset was the sublease with Plaintiff. They defaulted on
the sublease and then claimed bankruptcy.
o Held. Plaintiff can pierce the corporate veil and hold Defendant liable for the unpaid
sublease. A plaintiff can pierce the corporate veil if they demonstrated that the totality
of the circumstances evidence that there was a unity of interest between the individual
and the corporation, and that an inequitable result would occur if the individual was
not held personally liable.
o In West Virginia, theres a two part test for piericing:
o First, is the unity of interest and ownership such that the separate personalities
of the corp and the individual shareholder no longer exist; and
o Second, would an equitable result occur if the acts are treated as those of the
corporation alone
o Sometimes a third prong: Must make a reasonable credit investigation or, at
any rate, P will be charged with the knowledge that such an investigation
would have disclosed.
Court said the third prong is permissive, not mandatory
o But there was also discussion of a totality of the circumstances test under which
courts look to such factors as:
o Corporate formalities, undercapitalization, reason for having a subsidiary
o Assumption of risk isnt necessarily dispositive. Moreover, no matter what the
assumption of risk, there are certain times where a court says no, you didnt act like
a corporation, were going to pierce

Piercing to Benefit Contract Creditors

o Piercing most often occurs in a contract case where a corporation had led
potential creditors to believe that it was more solvent than it really was
o In most cases in which no misrepresentation has been made, courts have
refused to pierce

54

Parent-Subsidiary Corporations
o

The division of a business enterprise into multiple corporations is done for the
convenience and profit maximization of the owners

Gardemal v. Westin Hotel Co.

Facts:
o Westin was a parent corporation that owned a number of hotel chains including
one in Mexico. Gardemal's husband drowned while at a Westin hotel in Mexico.
She sued both the American Westin corporation, as well as the Mexican Westin
corporation, in a Texas court.
Holding: The case was dismissed for lack of jurisdiction over the parent, American
Westin. Court stresses why the corporation was set up the way it was: for efficiency. As
long as theres a good reason, court often wont pierce.
o Under the alter ego doctrine, a parent corporation can be held liable for the acts
of another if the subject corporation is organized or operated as a mere tool or
business conduit.
o Moreover, the two didnt act as a single business enterprise --- didnt
integrate resources to achieve common business purposes
o Plaintiffs reasons for so finding alter ego mid 331 parent owned most of
subs stock; the two share common corporate officers; the parent oversees
advertising and marketing; the sub is grossly undercapitalized
o Court says this isnt enough [and theres no evidence of gross
undercapitalization]
There must be evidence of complete domination by the parent
(e.g. of finances, policies, and practices such that the controlled
corporation has, so to speak, no separate mind, will or existence
of its own and is but a business conduit for its principal
o Court finds that there is insufficient evidence that the sub has surrendered
its corporate identity top, 332
OTR Associates v. IBC Services, Inc.
o Facts: Under the terms of Iskander's franchise agreement, Blimpie's subsidiary
corporation, IBC would take out the lease on the property in OTR's mall, and then
sublease the property to Iskander. The sole purpose of IBC was to hold leases for
Blimpie's franchisees. Iskander did not pay his rent and OTR had Iskander evicted
and then sued Blimpie for the unpaid back rent. Blimpie argued that they never
signed a lease for anything, so they shouldn't be responsible.
o Reasoning/Law:
o Courts can only pierce the corporate veil if the parent:
(1) So dominated the subsidiary that it has no separate existence,
but is merely a conduit for the parent, and
(2) The control was used to commit a fraud or wrong, or to avoid a
positive legal duty.

55

Holding: The Court ruled for Plaintiffs after it found that IBC misrepresented
itself in its dealings, leading OTR to believe that they were dealing with Blimpie.
That was fraud because IBC was just a corporate shell created by Blimpie to
avoid liability
BOTTOM LINE: This corporation was set up for no other reason than to hold
the leases. But more important than that was the misrepresentation the third
party that contracted with the defendant thought they were dealing with the bigger
company, not this shell one. So they didnt realize the risk they were taking on.

Veil-Piercing in Limited Liability Companies

o

Because of the differences in the two forms, it may ultimately be slightly more
difficult to pierce the liability veil of an LLC than a corporation
o For example, one of the factors often cited to justify veil piercing in the
corporate context is failure to follow corporate formalities. This factor is
less likely to be present with respect to LLCs because there are fewer
formalities
o Likewise, domination and control by shareholder, another factor cited in
support of piercing a corporate veil, should be less influential in the LLC
form, as it is taken for granted that the managing member of a singlemember LLC will dominate its affairs.

Alternatives to Limited Liability

o
o

A growing body of federal law permits federal courts to find shareholders

personally liable for corporate activities that violate federal mandates
Another means of protecting creditors interests is to set aside transactions that
defraud creditors under the Uniform Fraudulent Conveyance Act (UFCA)
o It protects creditors from two general types of transfers: (1) transfers with
intent to defraud creditors; and (2) transfers that constructively defraud
creditors.
The doctrine of equitable subordination is another method to protect creditors
interests
o It is only applicable in federal bankruptcy proceedings and subordinates
some creditors claims (particular those of corporate insiders) to reach an
equitable result.
o Before courts invoke the equitable subordination doctrine, there must be a
showing of fraudulent conduct, mismanagement, or inadequate
capitalization.
o Equitable subordination also has limitations compared to veil piercing
and fraudulent conveyance principles. It does not increase the overall size
of the pie available to creditors. Nor does it hold shareholders personally

56

liable for corporate obligations. It only alters the normal priority of insider
claims against the available corporate resources.

Chapter 12: Actions Binding on the Corporation

o
o

MBCA 8.40 and .41 describe officers but dont really say what they do. The point
of not putting into the statute, bylaws or articles the framework for officers duties
is to keep these things flexible.
MBCA: 8.24, 10.01, 10.03, 10.05, 10.20, 8.20, 8.21, 8.22, 1.41, 8.23, 2.07, 8.25

Agency
o

o
o
o

Two animating and sometimes conflicting themes: (1) a desire to protect the
reasonable expectations of outside parties who deal with the corp and thus to
promote easy transaction; and (2) a desire to protect the corporation from
unauthorized or faithless agents whose actions go beyond the corporations
business as determined in its constitutive documents and by its central-decision
making organ- the BoD
The agent is a fiduciary of the principal, meaning he owes to the principal the
duties of care, loyalty, and obedience
Agent has a duty to obey all reasonable directions of the principal within the
scope of the agents service
An agent has the legal power to bind the principal in legal relationships with
third parties
o Sources of power:
Principal may have granted the agent actual authority to bind the
principal.
Actual authority may be express or implied from words or
conduct taken in the context of the relationship between
agent and principal.
o Remember: words or conduct between principal
and agent; no communication necessary with third
party.
An agent may also bind her principal even though she lacks actual
authority. A principal may create apparent authority by conduct
that, reasonably interpreted, causes a third person to believe that
the principal consents to have the act done on her behalf by the
agent purporting to act for her. (e.g. employee of store dressed in
store outfit likely has authority to help customers)
Agents cannot testify to their own authority/third parties
cant rely on agents statements about their authority

57

Note that actual authority depends upon manifestations by the

principal to the agent, whereas apparent authority depends on
communications by the principal or agent to the third party
** SEE ex bottom of pg 343 top 344
An agent may bind her principal by inherent agency power
looks to how the principal ordinarily would conduct her business.
Authority comes from persons position as an officer. See Menard
case.
Finally, a principal can become obligated to a third party by
ratifying the act of another who, at the time of the act, lacked the
power to bind the principal
Relate back doctrine: after ratification, you ratify as of the
date that the transaction was originally made.

Respondeat Superior: Companies are responsible for actions taken by their agents that
are within the scope of the agents business.
o POINT: go behind the agency question and look instead at policy o Fairness, efficiency, preventability
o Who is best able to control the externalities of running the business? Or
the type of risk that materialized?

Summit Properties, Inc. v. New Technology Electrical Contractors, Inc.

o Facts: Summit filed complaint alleging claims against New Tech and its
parent company, Integrated Electrical Services. The parties dispute the validity
of a lease that Summit, as landlord, allegedly entered into with New Tech and
IES.
o Issue: The lease and its modifications violated IES leasing policies in
several respects. Summit argues that even if the lease did not have proper
corporate approval, Crouser had apparent authority to sign it.
o Reasoning:
What matters is whether third parties, such as Summit, reasonably
relied on representations made to the general public
IES had the opportunity when responding to Summits inquiry about
who the tenant was to disabuse Summit of any nothing that the lease
was valid, but it didnt
Summit contends that because New Tech occupied the property for ~ 2
years, it ratified the lease by reaping its benefits
o Holding: The lease is valid as to New Tech without regard to any failures to
adhere to internal corporate procedure in approving the lease. New Tech and
IES acquiesced to the lease. Both of their employees occupied the property for
almost 2 years, with both companies engaging in numerous activities to
maintain the premises, advertise them, and take advantage of them by

58

accepting benefits under the lease, both companies ratified all of the lease
transaction
Menard, Inc. v. Dage-MTI, Inc.
o Case is about inherent agency power
o Facts/conclusion: Menard Inc offered to buy land from Dage. Sterling, Dages
president, accepted the offer in a written agreement in which he represented that
he had the requisite authority to bind Dage to the sale. The Dage BoD did not
approve and refused to complete the transaction. We hold that as president,
Sterling possessed the inherent authority to bind Dage in these circumstances.
o Reasoning/test: An agents inherent authority subjects his principal to liability for
acts done on his account which (1) usually accompany or are incidental to
transactions which the agent is authorized to conduct if, although they are
forbidden by the principal, (2) the other party reasonably believes that the agent is
authorized to do them and (3) has no notice that he is not so authorized
Ascertaining Corporate Authority
o Evidence that the officer has been delegated authority to act on behalf of the
corporation can come in any of these forms:
o A provision of statutory law
o The articles of incorporation
o A bylaw of the company
o A resolution of the BoD
o Evidence that the corp had allowed the officer to act in similar matters and
has recognized, approved, or ratified those actions
o Usually, the best evidence of delegated authority is a copy of the minutes of the
BoDs meeting certified by the corporations secretary

Formalities of Board Action

Two groupings of rules [are supposed to] govern Board actions:
o (1) Technicalities and formalities of Board action; and
o (2) Fiduciary duties
Difference between putting something in the Articles vs in the bylaws:
o Look at MBCA: 10.01, 10.03, 10.05, 10.20
(http://users.wfu.edu/palmitar/ICBCorporationsCompanion/Conexus/ModelBusinessCorporationAct.pdf)
o Pursuant to 10.05, the BoD can amend the Articles. But can only change
formal things BoD cannot amend the articles on anything of substance.
o What controls how you amend the Articles on substance?
10.01; 10.03

59

There are a few minor areas where the BoD can amend the
articles. Other than that, if you want to amend, it requires
approval of both the BoD and the shareholders. Except in
one particular case, the Board has to recommend to the
shareholders that they amend and then the shareholders
vote.
10.20 - Shareholders or BoD can amend the bylaws.
Bylaws can be amended by the directors or shareholders.
o But there are limits on power of directors:
Articles can reserve all power to amend
bylaws to the shareholders
When shareholders pass a particular bylaw,
they can prevent the Board from changing
the bylaw
(So, can write into articles that Board cant
amend bylaws; OR can write it into each
new or particular bylaws)
So, difference between putting something in bylaws or articles:
If you put something in the bylaws, the Board cant block
the shareholders from changing it.
If you put something in the articles, the Board can stop the
shareholders from changing it (as you need their approval
too)
What option do shareholders have if the Board wont amend
the articles?
Get rid of them through elections. Normally, have elections
for Board once a year

Board Action at a Meeting

o

The BoD takes formal action by vote at a meeting. Each director has one vote and
may not vote by proxy (but shareholders can; this is because we want to
encourage Board to act as a discussing, thoughtful unit. Often too many
shareholders to make meeting practicable). Unless the articles of incorp or bylaws
provide otherwise, the vote of a majority of the directors present at a board
meeting at which there is a quorum is necessary to pass a resolution
o Sometimes following all of the formalities is hard. So most states have
enacted statutory provisions allowing informal director action under some
conditions.
MBCA 8.21 for instance allows board action to be taken without
a meeting on the unanimous written consent of the directors
In addition, board meetings need not be conducted in person.
MBCA 8.20(b) permits the board to conduct a meeting by any
means of communication by which all directors participating may
simultaneously hear each other during the meeting such as a
conference call.

60

In the case of a true emergency, the corporation might be able to

get around normal formalities like quorum. This can only be done,
however, pursuant to 2.07 and where the corporation already has
adopted such a provision.

Notice and Quorum

o

o
o
o

Notice and quorum requirements apply to board meetings. For special meetings
MBCA 8.22(b) requires that 2 days notice be given of the date, time and place of
meeting unless the articles of incorp or bylaws otherwise specify. MBCA 8.22(a)
does not require notice of regular meetings
Action taken at a board meeting held without required notice is invalid. Must be
in writing unless oral notice is reasonable given the circumstances ( 141)
See 8.23 for waiving/protesting notice
The statutory norm for quorum is a majority of the total number of directors,
through the articles of incorporation or bylaws may increase this, or reduce it to
no less than one-third of the board. MBCA 8.24. Action taken in the absence of
quorum is invalid

Committees of the Board

o
o

Committee of BoD made up by people who serve on BoD and that committee can
be given the authority of the Board to act.
How to set up a committee:
o Pursuant to (d):
One way: committee can be set up by a majority of the Board
present when the decision is made.
Second & third way: in the Articles or Bylaws
Limits as to what committees can do:
o list of things, (e) AND, Board committee is using the power of the board.
So if the board cant do something, either can the committee
Ex: BoD cannot sell all of the assets of the corp without
shareholder approval; thus, neither can the committee
o Other than these things, the committee can do whatever it wants
o Committees that are authorized to take actions can do so without approval
even if its not in the normal course of business
If you have a Board committee, it can only have Board members on it. If you put
a non-Board member onto a committee, its still a committee, just not a Board
Committee

Chapter 13: Planning in the Close Corporation

o Differences between big and small corporations
61

o
o

In small, it matters who the other shareholders are you work with them,
depend on them; these corps often work like partnerships owners are
managers. So shareholders want a say who gets a shareholder interest in the
corp.
* Control over who you work with and illiquidity are the 2 issues
Inter-relationship between ownership and management in small corps. As
such, there is a much greater identity of interest you know that the people
that are managers are going to try their best because theyre going to gain. So
there is less monitoring required
Because shareholders are managers in small corps, theyre better informed. So
you can trust them more to make operational decisions.
Confidentiality of information:
If you have a large board or shareholders in public corp, you might
worry that things will be leaked. You dont have that in a small corp.
BUT DOWNSIDES:
If you own stock in a large corporation, you know that your
stock is liquid you can exit, sell stock can do this if you
disagree with management or just need the money
In a small corp, you have the legal right to sell the stock, but
there often isnt a market for it and owners in small corps have
a large portion of their wealth in the corporation and depend on
it for their daily income. If they cant sell the stock, that allows
for vulnerability & oppression.
Shareholders want control over way people come into corp (who can buy in)
and mechanisms by which they can leave the corporation. These pressures
have given rise to changes in corporate control, allowing small corporations to
do more of the things they want to do.

Three ways that States have adopted:

o Some have passed small or closed-corporation statutes. See DGCL 341-356
o Some states have amended corporate laws. See MBCA 7.32; 8.01(b)
o Treats all corporations alike but authorizes governance structures that vary
form the traditional model
o Some states havent amended laws, but theyve changed their interpretation of
them

Introduction
o

The traditional rules of corporate law create a permanent structure in which

shareholders cannot liquidate their investment except by selling to others, selling
the corporation itself, or rarely- by dissolving the corporation. But this doesnt
work well in close corporations where shareholders have much of their assets tied
up in the corp and theres no ready market to sell their shares; their shares are
relatively illiquid.

62

Both legislatures and courts have been more lenient in moving away from the
traditional corporate form, creating special rules for close corporations
There is no generally agreed-upon definition of a close corporation
o Courts consider a variety of things, like (1) a small number of stockholders; (2) no
ready market for the corporate stock; and (3) substantial majority stockholder
participation in the management, direct and operation of the close corporation

Realignment of Shareholder Control

o

Close corporation participants can realign the traditional corporate structure at the
shareholder level, the management level, or both.
o The most basic control devices are those designed to assure that all or
certain shareholders are represented on the corporations board. Three
choices are available:
(1) Arrangements that ensure board representation
(2) Arrangements that give some or all shareholders the ability to
veto board decisions with which they disagree; or
(3) arrangements that provide for dispute resolution

Cumulative Voting
Two principal methods for conducting an election of directors:
o (1) straight voting, in which each share is entitled to one vote for each open
directorship. Any shareholder or group of shareholders controlling more than 50%
of the shares can elect all of the members of the board
o (2) Cumulative voting: is a way of guaranteeing that somebody with a certain
number of shares, less than 50%, that theyll be able to direct a certain number of
directors
o Allows shareholders to elect directors in rough proportion to the shares
they own, even if that number is less than 50%. Each share carries a
number of votes equal to the number of directors to be elected, but a
shareholder may cumulate her votes, meaning multiplying the number
of votes a shareholder is entitled to cast by the number of directors for
whom she is entitled to vote.
o The number of shares needed to elect a given number of directors under a
cumulative system may be calculated as follows:
X = (s * d)/(D + 1) +1
X is the number of shares required to elect directors;
S = number of shares represented at the meeting
d = # of directors it is desired to elect; and
D = # of directors to be elected
** The smaller the number of people on the board, the larger
percentage of shares you need to elect a director
o In most states today, cumulative voting is available only if the parties opt
in in the articles see MBCA 7.28; DGCL 214

63

Cons: Injecting factionalism into the boardroom can undermine the

boards functioning as a team.
o What is the importance of having one seat on the Board?
Minority gets to have a voice and put ideas in; hear divergent
POVs.
Also, certain decisions require a unanimous decision or
supermajority, and so you might be able to protect your interests
You get to know all the stuff that goes on at the Board meetings,
even if it isnt made public (so it discourages self-dealing and other
improper conduct by the majority)
o Ways to undermine the effectiveness of cumulative voting:
(1) Stagger the election of directors so each class will be elected
in different years with fewer vacancies to fill, itll be harder to
get a minority groups representative on the board; or
(2) Decrease the board size by doing so, the % of shares
necessary for a minority shareholder to elect one director is
increased
ways around this: draft the articles to require a supermajority vote
to stagger the board or reduce the number of directors

Class Voting
Is a simple technique for ensuring shareholder representation on the board and is
somewhat more flexible than cumulative voting. Class voting entails dividing the stock
into two or more classes, each of which is entitled to elect one or more directors.
o Since it is not necessary to issue the same number of shares for each class, class
voting can be used to guarantee board representation to a shareholder who owns
too few shares to be able to elect a director through cumulative voting or to add a
tie breaker to the board
o Potential downside: what happens when the director dies and is the sole holder of
the stock?

Shareholder Voting Arrangements

o
o

Shareholders typically use one of three classes of devices to limit or control the
manner in which shares will be voted: (1) voting trusts; (2) irrevocable proxies;
and (3) vote pooling agreements
Shareholders can commit themselves to vote as a block. For instance, if you have
3 minority shareholders, each with 20% and one 40% shareholder, the three 20%s
can say that whichever way 2 of them vote, the third will vote. How to do this?
Shareholders create a voting trust by conveying legal title to their stock to a
voting trustee or a group of trustees pursuant to the terms of a trust agreement.
o Today, virtually all jurisdictions have legislation dealing with voting trusts
See MBCA 7.30

64

It is quite common for a shareholder to give a proxy to vote her shares to

someone else and even to give that person entire discretion to decide how they
should be voted.
o the MBCA permits irrevocable proxies when given to (1) a pledgee; (2) a
person who purchased or agreed to purchase the shares; (3) a creditor of
the corporation who extended it credit under terms requiring the
appointment; (4) an employee of the corporation whose employment
contract requires the appointment; or (5) a party to a voting agreement
created under 7.31. MBCA 7.22(d)
o Vote Pooling:
o There is no trustee theres just an agreement that they will vote their
shares as the majority of them wants to vote
o See MBCA 7.31(a) acknowledging this as valid
o Often the difficulty is how theyre enforced (damages arent an
appropriate remedy, so how to enforce?)
These days, people have designed provisions to require specific
performance
o Problem arises if there is a tie. How to get around this?
o Create a share of stock that has no monetary rights; it has one vote; and
can only vote if there is deadlock among the shareholders.
But theres the problem of being totally dependent on that person

Restrictions on Board Discretion

Answers the question: what kind of agreements can you put into voting pools or trusts?..
o Can shareholders bind themselves to vote for who will be in what officer
position?
o At common law no shareholders could not do things that were supposed
to be left to directors, like electing the officers. (can probs cut the below
cases)
o But this common law rule no longer exists. Shareholders can now bind
themselves to elect officers so long as there is no potential for public harm
AND the shareholders are unanimous in their voting decision.
However, there is a concern that the public and creditors esp.
might be hurt by this.
So now there is a notice rule and a provision to limit the
life of voting trusts.
o So because we have new shareholder arrangements and fewer restrictions on
board discretion, there is a greater concern of danger to third parties who might
get trapped in these arrangements
o MCBA 7.32: Shareholder agreements allows for total restructuring of
the corporation. The only thing you cant do, really, is something that
violates public policy. You can even eliminate the BoD entirely.

65

Safety devices built in: Time limit (10 years but renewable (b)
(3)); requires unanimous consent, at least initially. Conspicuous
notice (c). Must be in articles or bylaws (7.32(b)). No longer
applies if you go public (d). (f), however, preserves LL.

Manson v. Curtis (1918)

o Facts: The defendant and the plaintiff made an agreement to select passive
directors who would essentially allow plaintiff to run the company.
o Issue: Is such an agreement valid?
o Held: No. The law does not allow stockholders to create a "sterilized" board of
directors. Directors are not employees; they are the exclusive executive
representatives of the corporation, acting as trustees, and derive their original and
undelegated powers directly from the state. Stockholders cannot confer or revoke
these powers, so the agreement is illegal and void.
McQuade v. Stoneham
o Shareholders cannot form an agreement to control the decisions traditionally
vested in the judgment of the directors of a company.
o Shareholders may, of course, combine to elect directors The power to unite is,
however, limited to the election of directors and is not extended to contracts
whereby limitations are placed on the power of directors to manage the business
of the corp by the selection of agents at defined salaries
Clark v. Dodge
o Facts: the agreement had been signed by all shareholders. Dodge was to vote for
Clark as director and general manager, so long as Clark proved faithful, efficient,
and competent. The court sustained Clarks claim for specific enforcement of the
agreement.
o Reasoning: The impairment of the directors powers was slight; additionally,
none of the provisions were harmful to anybody. Significant also was that all the
shareholders had signed the agreement
o *** Following Clark, the state of the law was and remains that all
shareholders can agree to infringe slightly upon the statutory authority of
the BoD. So too a majority can agree to vote for certain persons as directors
Long Park, Inc. v. Trenton-New Brunswick Theaters Co.
o Made clear that the public policy against interfering with the traditional corporate
structure continues to have force.
o Invalidated an agreement made among all of the shareholders that called for one
of them to be manager with full authority to supervise the operation of the
corporation.
Triggs v. Triggs

66

Facts: Father owned business and gave his sons stock in it. The shareholder
agreement had a clause that said if Fredrick died, then Ransford would get the
option of buying all of Fredrick's stock.
o The estate argued that the contract between Fredrick and Ransford was not
approved by all the corporate shareholders. That's illegal because the part
where they agreed to give each other jobs was an impermissible restriction
on the rights and obligations of the Board to manage the business.
(See Manson v. Curtis)
On appeal: The Court found that even if the voting clause in the K was illegal,
that didn't affect the legality of the clause allowing Ransford to buy the stock
this clause didnt sterilize the Board
o so long as an agreement between stockholders relating to the
management of the corporation bears no evidence of an intent to defraud
other stockholders or creditors, deviations from precise formalities should
not automatically call for a slavish enforcement of the statute (from
dissent actually)
In a dissent it was argued that the practical effect of the agreement was irrelevant,
it was illegal on its face because private contracts between shareholders to vote
people into jobs (other than to the board of directors) is not allowed the
underlying agreement is unenforceable in that it improperly sought to limit the
powers of the board of directors to manage the corporation

Fiduciary Duties in Exercising Veto Rights

What are the duties of shareholders who assume management functions or acquire control
prerogatives under a shareholders agreement?
o See MBCA 7.32(e)
Smith v. Atlantic Properties, Inc. (1981)
o Facts: Four investors. There was an 80% provision giving each shareholder a
veto in corporate decisions. One of the shareholders regularly voted against
dividends, though the others wanted. The IRS eventually imposed substantial
penalty taxes on Atlantic for unreasonable accumulation of corporate earnings and
profits.
o Issue: to what extent can a veto power possessed by a minority stockholder be
exercised as its holder wishes, without a violation of the fiduciary duty?
o Holding: guy was found personally liable. Whatever may have been his reason
for refusing to declare dividends, he recklessly ran serious and unjustified risks of
precisely the penalty taxes eventually assessed, risks which were inconsistent with
any reasonable interpretation of a duty of utmost good faith and loyalty

67

Contractual Transfer Provisions

o

Three questions:
o Defining the right or restriction on sale of the stock
o Valuing the shares of the corporation
o Guaranteeing that there are sufficient funds to pay out the amounts that
need to be paid
Timing:
o Sometimes when you want to have rights and responsibilities for voluntary
reasons (e.g. shareholder can come in and say I need to sell.. I need $)
o Sometimes you have things that arent voluntary
E.g. provisions for death
o Rights you come up with might depend on whether its a voluntary
situation or something like death
E.g. whether they get all the money upon the event/asking, or
whether they can only withdraw it over the course of a number of
years

Purposes and Legality of Transfer Provisions

o

Transfer provisions can help control who are the shareholders and restrict
transferability. They accomplish three purposes:
o (1) They allow the shareholders to exercise some control over whom they
might be doing business with in the future
o (2) They can ensure the continuance of a desired balance of control that
might be undone if shares are transferred to a unwanted third parties
o (3) They can provide a means of disposing of otherwise illiquid shares
Today, most corporate statutes expressly authorize transfer restrictions. See
MBCA 6.27

Types of Transfer Provisions

o

Right of first refusal: before a shareholder can sell her shares to a third
party, she must first offer them to the corporation or to the remaining
shareholders (or both) at the same price and on the same terms and
conditions offered by the outsider
o First option provision/Purchase option: Unlike the right of first refusal,
the offer to the corp or remaining shareholders is made at a price and on
terms fixed by agreement rather than by the outside offer
o Consent: Transfers can be conditioned on the consent of the BoD or the
other shareholders
Transfer provisions also often specify the liquidity rights of shareholders who
withdraw from the business:
o Sale Option: the withdrawing shareholder can receive an option to sell
her shares to the corporation or remaining shareholders upon the

68

o
o

occurrence of specified events, such as the death of the shareholder or his

termination
o Buy-Sell agreement: More commonly, the obligation to buy is combined
with a reciprocal obligation to sell. This type of agreement compels the
corporation or remaining shareholders to purchase the shares of another
shareholder upon the occurrence of specified events (e.g. death)
Whether a newcomer is bound by transfer provisions may depend on how the
provisions are documented in the articles of incorporation, a bylaw provision, or
a separate contract among the shareholders. Often the restrictions are in the
bylaws or articles of incorporation so as to bind newcomers
To be valid against a purchaser of shares without notice, a transfer restriction must
be noted conspicuously on the stock certificate itself. MBCA 6.27(b).
Conspicuously is defined in MBCA 1.40(3).
Transfer restrictions can be added later without the consent of all shareholders as
long as there is no unreasonable restraint on alienation.

Valuation of Restricted Shares

o

Book value: popular method, but might be inequitable. Book value might bear
little relationship to its value as an ongoing concern. Plus book value is
ambiguous does it include intangible assets like good will?
o If book value is used, many questions should be anticipated and resolved
in the agreement
o Capitalized earnings: an agreement may establish a formula for capitalizing the
earnings of the business. However, a capitalized rate that captures the nature of
the business when formed may not be appropriate as the business matures
o Right of first refusal: may substantially increase illiquidity since prospective
buyers may well be put off by the risk of negotiating a sale only to have the shares
bought by the corporation or other shareholders
o Appraisal: by neutral third party according to a predetermined procedure.
Disadvantage: might be expensive
o Mutual agreement: parties can set a value and revise it at stated intervals, such
as annually
A valuation method is of little use if the person obligated to purchase lacks the financial
ability to do so.
o If the putative purchaser is the corporation, it can fund the purchase by (1)
establishing a sinking fund in which the corporation regularly sets aside money to
be saved for that purpose; (2) purchasing and maintaining life insurance on the
lives of shareholders; or (3) defer/spread out payment by the use of promissory
notes or installment obligations.
o ** Need to be clear about whether these restrictions are binding on successors.
Also need to be careful about where you put the restrictions. **

69

Ch. 14 Oppression in the Close Corporation

Ways the majority can hurt the minority
o Cut off dividends. Deprive them of offices of employment. Deprive them of
control. Force them to sell their shares at a low price. Decrease the value of the
share of the minority (e.g. through a merger)
But the minority is not powerless, so how do we prevent oppression:
o Supermajority provisions (allow them to block majority action)
o Cumulative voting
o Classes of stock
o Have directors removed only for cause (rather than just at will)
o Shareholder agreements under 7.32 like vote pooling/voting trusts
o Employment contracts
Three different approaches to oppression:
o Fiduciary duty (3 part Wilkes test)
o Contract approach (Nixon)
o Reasonable expectations or equity approach. (Bonavita)
o ... largely just depends on the facts the case presents

Dissension and Oppression in the Close Corporation

o Two kinds of dissension recur frequently:
o (1) Cases in which the majority cuts off minority shareholders from any
return, thus leaving them with illiquid stock that generates no current
income
o (2) Cases in which the majority exercises control to frustrate the
preferences of the minority
o How courts respond to dissension in close corporations has turned on two
factors:
o (1) How the courts view closed corps: like partnerships, wherein the
individuals are held to high standards of fairness, or as traditional
corporations, wherein individuals agree to be bound by the traditional
norms of corporate law, like centralized management and majority rule
o (2) Whether the legislature in the relevant jx has included in its corporate
statute provisions aimed at protecting shareholders in close corporations.
o What constitutes oppression?
o There has to be a total cutoff of benefits. Some courts look to whether the
actions were counter to the persons reasonable expectations.

Judicial Protection of Minority Owners

The Fiduciary Approach

Wilkes v. Springside Nursing Home, Inc.

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Facts: 4 people, equal ownership. Each understood that theyd have a say
in management and have officer position. Theres a falling out. Three of
the four vote so that the other guy gets no position and no salary and
they refuse to declare dividends.
3-part test: (1) Theres oppression (total cutoff). (2) Theres no legitimate
business purpose advanced. (3) If there was a legitimate business purpose,
it could have been achieved by less drastic means.

Nixon v. Blackwell
o
o

Application of strict contract law towards minority shareholder protection

Facts: Under Delaware law, if a company was designated a close corporation
then certain statutory protection would apply to minority shareholders. (8 Del.C
342). However, E.C. Barton was not designated as a close corporation in their
articles of incorporation, and so the statutory protections did not apply to them.
Holding: The Court found that in a corporation, the shareholders did not owe a
fiduciary duty to other shareholders. With this holding, the court aimed to
preserve the freedom to contract; wasnt looking at fairness. Parties could have
contracted to be a close corp but didnt; court wont rewrite the K.
o It would do violence to normal corporate practice and our corporation
law to fashion an ad hoc ruling which would result in a court-imposed
stockholder buy-out for which the parties had not contracted
o * Notice that court assumes the parties are sophisticated and ignores that
there are reasons why people dont contract for everything: time, money,
unforeseeability of events or deterioration of relationships

Contractual and Tort Approaches

o
o

Some argue for a contractual approach to close corporation problems that falls
between the fiduciary approach followed by the Mass. Courts and the traditional
approach of Nixon v. Blackwell.
They argue that the parties, having chosen the corporate form, should be bound by
the terms of their corporate contract. However, courts should read into the
contract the bargain parties would have reached themselves if transaction costs
were zero

Statutory Remedies for Oppression

o Terms and general info:
o Deadlock is when theres a total inability to conduct business because (1)
shares are evenly divided and shareholders cant elect directors; or (2)
deadlock among the directors.
Deadlock is NOT disagreement, its inability to function
71

Many modern statutes grant courts the power to dissolve the corporation if a
shareholder establishes that:
o (A) the directors are deadlocked and the deadlock cannot be broken by
shareholders and it is injuring the corporation or impairing the conduct of
its business; (B) the shareholders are deadlocked and have not been able to
elect directors for two years; (C) Corporate assets are being wasted; OR
(d) those in control of the corporation are acting in a manner that is
illegal, oppressive, or fraudulent. See MBCA 14.30(2)
o The Official Comment to MBCA 14.30 advises courts to be cautious
when considering the claims of oppression so as to limit such cases to
genuine abuse rather than instances of acceptable tactics in a power
struggle for control of a corporation
o Also see MBCA 14.34 this provision stacks the deck against the
person moving for dissolution: the other party has the right to buy them
out
These statutes raise three important interpretative questions:
o (1) When is majority conduct oppressive?
o (2) When a court finds oppression, what remedy is appropriate
dissolution or a buy-out (authorized under 14.34)?
o (3) when a corporation or shareholder elects to exercise buy-out rights
under MBCA 14.34, how is the fair value of the complaining
shareholders stock to be determined?

Dissolution as a Remedy

Bonavita v. Corbo
o
o
o

Application of reasonable expectations test

Facts: 50/50 ownership. Gerald retired. He asked the directors to pay a dividend,
but Alan blocked it. Gerald then died.
Conclusion: There was oppression; even if Alan's refusal to pay dividends was
not wrongful or illegal, it did have the practical effect of destroying any
reasonable expectation that Gerald would have in his investment.
o Court ordered remedy was what they considered to be most equitable
(even though it wasnt one of the statutory options) they ordered Alan to
buy Geralds stock at a reasonable price set by the court.

Oppression of Shareholder-Employees
o

Oppression is often in the eye of the beholder:

o If courts view shareholder oppression from the majority perspective, they
find oppression liability when the majoritys actions arent justified by a
legitimate business purpose.
o Courts viewing the matter from a minority perspective find oppression
liability when majority actions, whether justified or not, harm the interests
of a minority shareholder.

72

Non-Dissolution Remedies in Oppression Cases

o

o
o

As courts have come to understand that a dissolution order essentially forces one
faction to buy out the other, courts have increasingly ordered a buyout on
specified (fair value) terms. MBCA 14.43.
o This provision gives the majority a call right of minoritys shares to
prevent strategic abuse of the dissolution procedure
In Baker v. Commercial Body Builders, Inc., the court listed 10 possible forms of
relief that it could order short of outright dissolution see pg 466/7
Courts dont always honor/give full weight to shareholder agreements of transfers
of stock, especially if there has been oppression or deadlock

Valuation of Minority Shares

o

In ordering a buyout for oppression, should a court consider discounting minority

shares for their lack of control or marketability?
o The difference (in two cases where there was or was not a market
discount) has to do with who is oppressing and who is buying:
marketability discount cannot be used unfairly by the controlling or
oppressing shareholders to benefit themselves to the detriment of the
minority or oppressed shareholders

Chapter 15: Shareholder Voting

Securities Law of 1933
Securities Exchange Act of 1934
Problem Universal (?) BSC (486)
Problem National Mutual Production (?) 495
Borak BSC
TSC v. Northway BSC 500
Mills v. Electric Auto(?) 524
Blue Chip Stamp v. ? Drug 421 U.S. 723 (1975)
Santa Fe Ind. V. Green BSC 510
Virginia Bankshares
Provisions
MBCA 7.04
Dela 228
Rule 14a-9
Rule 10b-5
Rule 14a-1(l)
Rule 14a-6
Rule 14a-3

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Shareholder voting is controlled by both state and federal law, the latter applying only to
public corporations. Powers of shareholders vis a vis the corp are set by state law (e.g.
vote on fundamental transactions). But some procedures that are necessary to effectuate
state law require you to comply with federal law.
Problem addressed by these corps and associated law: how do you get 3000 shareholders
to meet to vote on something?
o How to conduct shareholder vote by meeting (annual or special how you
call special is laid out in articles or bylaws) or by mailing. Proposal for meeting
can come from officers (board puts question to shareholders) or shareholders can
make proposals that other shareholders will vote on. A quorum must be present
either in person or by proxy for action taken at meeting to be effective
o Notice: Have to provide written notice to shareholders entitled to vote at
the meeting. Only matters described in the notice can be considered at a
special meeting. Must set date of the meeting and a record date. Only
shareholders of record as of that date will be entitled to vote at the
meeting.
You can have action by written consent rather than at a meeting.
MBCA 7.04(a) requires consent of all shareholders
entitled to vote on an action
DGCL 228 allows a majority of the shareholders entitled
to vote on an action to act by means of written consent
o Who owns the stock?
Often, stock is registered in street name the formal owner
may be an institution, and the beneficial owner is not registered on
the stock ledger.
Benefits of this system: individual stock owners dont have
to produce the paper certificate. Brokerage houses can just
transfer or lend the net amount of stock from one company
to another after a day of buying/selling just as bank
transfers money (efficiency/ease).
o How to take the vote: MBCA 7.2x
Proxy: defined as the authority or power to act for another
Can give somebody a general proxy or a proxy to vote in a
particular way on a particular issue
Only shareholders can vote by proxy, not directors
Proxy form: short document asking for your proxy. You fill it out
and mail it back
Proxy materials or proxy statement: defined by federal securities
law. Refers to: when, under federal laws somebody solicits
somebodys proxy, that person must provide you with certain
information (e.g. some info in annual reports, like financial
statements). This info is usually mailed out by the company. It can
be mailed out by a different individual (person outside of corp
solicits proxy and must mail out this info w/ the proxy form can
have the corp do it, but the dissenter still has to pay. Rule 14a-7).

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** There is no discussion/argument for determining votes at

shareholder meeting. The nominations have been made and you
essentially just count up the votes/proxy. So if you want your own
nominations in there, you have to do it in advance.
o Removal and Replacement of Directors
Most statutes authorize shareholders to remove directors with or
without cause, unless the articles of incorp provide that directors
can be removed only for cause. See MCBA 8.08
Campbell v. Lowes, Inc.: when the shareholders attempt to remove
a director for cause, there must be the service of specific charges,
adequate notice and full opportunity of meeting the accusation

Federal Regulation
State law authorizes proxy voting; federal law prescribes how it may proceed. It doesnt
substantively regulate market just emphasizes disclosure
o In almost every case in which you need action by shareholders, youre going to
have to solicit proxies. When you do this, you run into federal securities laws that
regulate the solicitation of proxies. So whenever we do something for shareholder
under state law, we do it pursuant to federal law.
o Securities law of 1933
o Only concerns original issuance of securities
o Securities Exchange Act of 1934
o Covers everything except the original issuance of securities
o Regulates Exchanges
(1) Requires companies listed on Exchanges to file with the SEC;
also, duty to file with SEC if youre of a certain size
(2) Regulates conduct of officers/directors of listed companies to
prevent some types of fraud (e.g. if you own more than 10% of the
companys stock, you have to publicly disclose that; regulates
short term trading)
(3) Set up process to promote shareholder democracy penalties
for falsehoods or deception in proxies
(4) Set margin rules: can no longer borrow unlimited amounts of $
to buy stock
(5) Tried to get rid of fraudulent and deceptive devices (14a-9;
10b-5)

Solicitation
o When do you come under the solicitation rules?
o Answer is in definition of solicitation (14a-1(l))
http://taft.law.uc.edu/CCL/34ActRls/reg14A.html
If somebody asks for your proxy, then youre soliciting proxy.
Requests to execute or revote proxy. Furnishing of any

75

communication that is reasonably calculated to result in a

proxy.
Reasonably calculated means likely to result since
purpose of statute is to ensure shareholders are informed
Long Island Lighting Company v. Barbash:
o Facts: Insurgents in a proxy fight took out an ad in
a newspaper criticizing management. Management
sued, claiming that this was a proxy solicitation for
which no proxy statement had been filed, and it was
false and misleading
o Court held that proxy rules apply not only to direct
requests to furnish, revoke, or withhold proxies, but
also to communications that may indirectly
accomplish such a result or constitute a step in a
chain of communication designed ultimately to
accomplish such a result.
The question is whether the challenged
communication, seen in the totality of
circumstances, was reasonably calculated
to influence the shareholders votes. Case
remanded to determine this.
o Deciding whether a communication is a proxy
solicitation does not depend upon whether it is
targeted directly at shareholders.
o What happens if its a solicitation:
o Rule 14a-6: must send proxy materials to SEC in advance.
o Rule 14a-3: information must be distributed either before or concurrently
with solicitation
o * If youve done something reasonably calculated (i.e. likely) to result
in a proxy but havent yet given information to shareholders or SEC
youre in violation of the federal law.
o Downside to solicitation rules/exemptions:
o Institutional investors or other large investors might want to talk to people
about the issues but dont necessarily want to solicit proxies. However,
theres the fear of litigation if people think youre soliciting without
sending information.
So the rules have been changed to allow for more
communication with people that arent managers of corp.
Rule 14a-2: If youre non-management, then youre
exempted from the rules as long as you dont seek proxy
voting authority and/or furnish a proxy form
o Thus, a person can solicit support for a
shareholder proposal so long as she is not asking
for voting authority

76

Moreover, soliciting shareholders need not file notice with the SEC
if the solicitation is oral or by shareholder who owns less than $5
million in company shares.
Pursuant to Rule 14a-1, an announcement by a shareholder of how
she intends to vote and her explanation of her decision is not a
solicitation so the proxy rules dont apply.

Chapter 16: Disclosure Duties to Shareholders

Question addressed: How do we make sure that the information sent to shareholders is
correct? How to prevent false or misleading information or omissions?
o Some overlap between federal and state law (something is either a violation of
state law e.g. fiduciary duties or federal law common law fraud)
o Two key provisions: 14a-9, which relates to proxies. 10b-5, which is not
limited to proxies.
Borak: expanded shareholders ability to sue for proxy fraud under 14a-9 in addition to
10b-5. Also bolstered 14a since SEC cant review the accuracy of every proxy statement.
o Facts: Minority shareholders of the target in a merger felt that they were being
treated unfairly. The merger required proxy solicitation, which triggers 14a-9.
So we have state law claims for breach of fiduciary duties and federal law claims
for misrepresentation in violation of 14a-9.
o Holding: There is an implied private right of action for violation of proxy rules.
o Also, under the statute there is exclusive federal jx, so if you join a federal
claim you can move the suit from state to federal court.

Elements of a Federal Action for Proxy Fraud:

o The purpose of Section 14(a) is to ensure that stockholders have all the info they
need to make an informed voting decision. SEC Rule 14a-9 prohibits a
solicitation made through proxy statement that contains a material misstatement
or omission.
o Elements of federal action for proxy fraud: materiality (TSC & Basic v.
Levinson & Virginia Bankshares), reliance (Mills), causation (Mills &
Santa Fe & Blue Chip Stamp), and culpability.
o TEXT: No solicitation subject to this regulation shall be made by means
of any proxy statement, form of proxy, notice of meeting or other
communication, written or oral, containing any statement which, at the
time and in the light of the circumstances under which it is made, is false
or misleading with respect to any material fact, or which omits to state
any material fact necessary in order to make the statements therein not
false or misleading or necessary to correct any statement in any earlier
communication with respect to the solicitation of a proxy for the same
meeting or subject matter which has become false or misleading.

77

o
o

Misrepresentation is defined broadly (see colored phrases), but some things are
narrow, like material fact
Definition of materiality established in TSC v. Northway
o An omitted fact is material if there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding how to
vote
Some of this makes it hard to prove a violation so that corps dont
flood shareholders with info and bc corps that make good faith
effort should have some leeway
o Basic v. Levinson notes that materiality depends on the facts. Where the
misstatement or omission relates to contingent or speculative information
or events, the test has been expanded so that materiality will depend at
any given time upon a balancing of both the indicated probability that the
event will occur and the anticipated magnitude of the event in light of the
totality of the company activity
Reliance/Causation would be problematic to require proof that a critical mass
of votes relied on the misrepresentation and it resulted in damage. So, different
standard for proof than individual reliance:
o Mills v. Electric Autolite:
(1) If a misstatement in proxy materials is found to be material, it
is sufficient to show that the proxy solicitation itself, rather than
the particular defect in the materials, caused the injury. (pg 527)
So we dont look to individual reliance on misrep, only ask
did the proxy statement containing the misrep lead to
some transaction? and, if so, thats sufficient proof of
reliance.
(2) You can never defend misrepresentation cases based on the
underlying transaction being fair. Why? Because it takes the
decision of whether a merger should go through away from
shareholders and puts it in the courts hands.
Test for causation: that the proxy solicitation was an essential link in the
transaction. See Santa Fe below: no causation if solicitation wasnt required

14a-9 ONLY COVERS PROXIES; certain securities transfers dont involve proxies so
we need some other means of regulating fraud: Rule 10b-5
o Text: (c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person in
connection with the purchase or sale of any security

Is so broad it takes any state fraud law and incorporates it under federal practice.
o However, the Burger Court, which feared regulation and supported big
business, narrowed the scope of suits that could come in under this rule by
focusing on that last clause.
In Blue Chip Stamp Burger Court interpreted this as that the P had
to be either a buyer or seller of a security to bring a claim for
damages due to misrepresentation
See class notes pg 69 for example
78

One of the impetuses for this limiting of suit under 10b-5 was the
business community complaining that an expansive reading of the
statute was enabling strike suits, under which attorneys dont
intend to win, just want to threaten to rack up expenses in order to
get big settlements.
o Santa Fe: put in two more limitations.
o Facts: Arose out of a short-form merger approval of shareholders was
not required, nor were proxies. Majority were controlling faction and
trying to get rid of minority. Amount they offered minority as payoff was
$150/share. The asset value was $640/share. Ps said this was fraud, though
they were given notice of their right for appraisal in state court.
o Holding:
(1) If the disclosure is okay, then the fairness of the transaction has
nothing to do with federal law P can only sue under state law for
breach of fiduciary duty. Here, there was no accusation that Ds
actions involved manipulation or deception.
(2) If the plaintiff shareholders only available remedy is appraisal
(as in case of short form merger, as here), they dont have a
violation under federal securities laws because they didnt vote and
thus could not get damaged by misrepresentation.
** causation cant be established where the solicitation
wasnt legally required or where the soliciting shareholder
owned enough shares to approve the matter being voted on
if there had been no solicitation.
o Virginia Bankshares
o Facts: The proxy statement claimed that by adopting the directors
proposal, shareholders would earn a high value and fair price for their
stock. Can this conclusory or qualitative language purporting to explain
directors reasons for recommending certain corporate actions be
misleading within Rule 14a-9.
o Issue: Do directors recommendations constitute statements of material
fact?
o Holding: If a proxy statement offers opinions rather than facts, there
can still be liability for misrepresentation. P must prove:
(1) Opinion was factually wrong and
(2) The person who signed the opinion/proxy materials knew the
facts were wrong when the statement was made
Note: If you sue for injunctive relief based on misrep in proxy materials, you dont have
to show reliance: there hasnt been any injury yet. Court is being asked to prevent injury
from taking place. So all of the limitations weve been talking about (except Blue Chip
Stamp) are not going to take place if its a suit to enjoin a violation of 14a-9 rather than
seeking damages for it.

79

Chapter 17: Shareholder Rights of Inspection

-

DGLC 220; D513 (933)

Pillsbury (BSC 556)
Credit Bureau (558)
Saito (559)
Seinfeld (563)
o

Why do we have shareholders meetings in the first place?

(1) To give out info; (2) There are some matters on which
shareholders are legally required to vote; (3) Sometimes the
executives or directors in a company want shareholder approval of
something even though they dont really need it; (4) Some
shareholders meetings are required by various regulatory bodies
(like NYSE); (5) Sometimes shareholders are posing questions to
other shareholders (shareholder proposals)
Problems with disclosures:
It may not be in directors best interests to keep shareholders
informed might block some of managements designs/hopes
Problem of policing information that is given out: inaccurate or
misrepresentation of facts/potential for liability
The info might have commercial value and that has 2 different
problems associated with it: (1) shareholder him/herself can try to
personally try to profit from the info; (2) the fact that the info is
disclosed may cost the company lots of $ (e.g. Texas Gulf Sulfur
had they had to give shareholders info about the mineral rights the
company wanted to buy up, other people could have gone and
bought it up first)
How to deal with all of this:
What info is given out is a matter of business judgment of
management of company. But we need some minimal amount of
info if we want shareholders to do what theyre supposed to do.
So we need some enforceable right to challenge withholding of
information.

At common law, as with today, shareholders must have a proper purpose for which
they want the requested information.
Under DGLC: defined as a purpose reasonably related to such persons
interest as a shareholder
Extremes of proper/improper:
o Improper: because of mere curiosity; for mere personal gain; for
harassment in each case, no chance of gain for corporation
o Proper: seeking to take control of company (bc shareholders are supposed
to determine who should run the company and if info is relevant to that,
they ought to be able to get it).
Other proper purposes: info related to shares or dividends,
mismanagement, litigation
80

Pillsbury: Shareholders wanted info related to the production and use of

fragmentation bombs (used in Vietnam War). They wanted to elect new
directors who would stop the production of these bombs because they
considered them inhumane. Court said this was an improper request for
info because, even though shareholders wanted to elect new directors,
their ultimate purpose was not to affect the economic welfare of the
company. Courts looked through why they want control of the corp
and will only allow info if its designed to better economic standing of
company. Probably bad law now.
o Credit Bureau: anytime shareholders want info to change control of
company, thats a proper purpose. Courts should not look past that and
try to determine why you want to change control of company.
Info divided into 2 categories:
Shareholders lists: are necessary if you want to take control of company because
you need to be able to communicate with other shareholders. And its hard to
abuse shareholders lists (to make $ in private sense). Opposite is true about
financial info of company.
o Burden on defendant company to show that shareholder asking for info
doesnt have a proper purpose.
Everything else: Burden on shareholder to show that he has a proper purpose
MBCA 16.02 grants inspection rights to beneficial owners as well as
shareholders of record, but divides corporate records into two categories --shareholders can readily inspect the articles of incorporation, by-laws, minutes of
shareholder meetings and like documents. But to inspect minutes of board
meetings, accounting records, or the shareholder list, a shareholder must have a
proper purpose and describe with reasonable particularity that purpose
and the records to be inspected, which records must be directly connected with
that purpose. MBCA 16.02(d); for Delaware, see 220.

Shareholder Information & Derivative Suits

o

Derivative suits another area where strikes suits come up. As such, Ps in
derivative case must plead facts with particularity that show that the violation
your claiming has taken place.
o Ps cannot count on discovery to get the background information need it
before you get to discovery.
o Under Delaware law 220, demanding information in order to develop a
derivative suit is a proper purpose.
In order to qualify for right to demand info pursuant to 220,
however, there must be some evidence to establish a credible basis
from which the court could infer that legitimate issues exist.
(Seinfeld) Credible evidence may fall far short of proving that
anything has occurred. So shareholders dont need preponderance
of the evidence that wrong occurred to obtain preliminary
discovery under 220, but they must have something.

81

OTHER CASES:
o Saito v. McKesson HBOC:
o Holding: The scope of a stockholders inspection is limited to those
books and records that are necessary and essential to accomplish the
stated, proper purpose
(1) The date of a holders stock purchase should not be used as an
automatic cut off date in a 220 action.
(2) Shareholders can use 220 to investigate third party documents
so long as they are necessary and essential to satisfy the
stockholders proper purpose
(3) Stockholders of a parent corporation are not entitled to inspect
a subsidiarys books and records absent a showing of a fraud or
that a sub is in fact the mere alter ego of the parent

Chapter 18: Mechanics of Corporate Combinations:

Statutory Provisions:
MBCA
o 6.21(f)
o 11.01-11.07
o 12.02
o 13.02
o 13.20
DGLC
o 251
o 253
o 262

Terminology:

Appraisal (dissenters rights)

o The ability of some individuals who vote against the merger to demand
that they be paid off in cash in an amount set by a court
o Used to protect minority from majority
o Covered in MBCA 13.
Before transaction, corp gives shareholders notice of potential right
to appraisal. If you think you might want to exercise right, must
send written notice to corp. Can only vote against merger if you
want to retain appraisal right. If merger goes through, corp sends
written notice and form to each shareholder that registered they
might want appraisal. On the form, corp states what it believes to
be the fair value of shares with appraisal rights. Appraisal is done
using the value of the share immediately before the corporate
transaction. etc etc (see notes from class, Oct 16 ~ pg 76) --82

burden is on the company to start one proceeding to handle

appraisal for all of its shareholders. Corp pays costs unless
shareholders found to have acted in bad faith
Short form merger
o Where parent already owns 90% + of T, P can elect to do a short form
rather than other type of merger. Idea is that we already know the result.
Small scale mergers
o A merger where youre not diluting the stock outstanding by more than
20%. Used in Delaware for same sort of purpose as dilution under MBCA.
Dilution
o The decrease in shareholders proportional rights that results from issuance
of more stock.
o In MBCA: 6.21(f) If a corporate combination results in P diluting its
stock by more than 40%, shareholders get to vote.
In Delaware, they come to the same conclusion but in the reverse
way: under some circumstances, the shareholders always get a
vote, but lose the vote if it is a small scale merger
Market out:
o If the stock you own is publicly traded, then instead of getting appraisal
rights you can sell the stock on the market before the merger goes
through
Triangular merger: target merges into subsidiary of parent. Keep limited liability
on lower corp. Target disappears and sub steps into shoes of target.
o Or, reverse triangular merger: sub of parent merges into the target. In
this way, the target legally remains so there is no problem of having to
change licenses etc.
Corporate combinations:
o It is okay to (1) legally control 2 corporations and hold their operations
separate; or (2) merge to companies into one legal entity and keep their
operation separate.
o You cannot keep 2 corporations separate but merge their operations. This
could lead to problems and abuse, i.e. using claiming that the company
you own less of is responsible for costs and the company you own more of
made all the profit.

Theory/Policy:

Why take over other corporations?

o To increase efficiency of target corp
o Symbiosis: by combining, you can minimize costs and maximize profits.
(e.g. combining steel manufacturing and processing)
o Managers personal interests, rather than corporate interests: bigger the
corp, the more money the CEO gets paid
o Use of mergers to change existing rules under which the corporation
operates (e.g. getting rid of preferred shareholders by merging corp into a
different corp that doesnt have preferred stock)

83

No matter how merger takes place, there is an element of coercion involved.

o Unless you have 100% approval, you have a minority interest that is being
forced to sell what they legitimately own.
Why should individuals be forced to give up what they own?
It can be economically efficient (sell so society can gain)
Prevents opportunistic behavior by minority threatening
to not go along unless theyre given more than their fair
share
What is the danger of having shareholders that opposed the board?
o Could vote the merger down if they have sufficient votes
o Could get hurt with appraisal rights: even if the minority shareholder cant
block the vote, the majority has a problem if dissident shareholders get
appraisal rights and we have to put out a lot of cash

General rules
o

Under MBCA 6.21(f), function trumps form all forms of merger maintain
the same shareholder protections
o So long as Ps shareholders get to vote, they get appraisal rights. They get
to vote if theres dilution. However, appraisal is taken away if theres a
market out, P shareholders keep same stock, or its a short form merger (bc
no vote). Its given back if its a conflict transaction.
o Any time that shareholder rights are changed as part of the plan of
merger i.e. the articles are amended to allow for issuance of more stock
the shareholders of the parent must be given a vote. So given vote not bc
of merger but because youre amending the articles.
In Delaware, rules are formalistic form trumps function.

Statutory merger
Delaware
o Voting:
Board of P votes.
Board of T votes unless it is a short form merger
Shareholders of P vote but not if its a small scale or short form
merger
Shareholders of T vote
** In Delaware, majority of the shares outstanding are required to
approve. This is different from MBCA, pursuant to which the just
need a majority of the voting shares
o Appraisal rights:
Shareholders of T get appraisal rights unless
(1) Its a short form merger; or (2) theres a market out
Shareholders of P get appraisal rights if theyre entitled to vote
So no appraisal rights if (1) small scale merger; or (2) short
form merger
84

 MBCA
o Voting:
Both boards vote (but Ts doesnt if short form)
Shareholders of P vote if theres dilution ( 6.21(f))
Approval required by shareholders is majority of the
quorum: majority of shares voted, not majority of shares
outstanding as in Delaware
No vote if short form merger
Shareholders of T vote unless its a short form merger
o Appraisal:
T gets appraisal unless theres a market out
Gets appraisal back even if market out if its a conflict
transaction
P gets appraisal if they get a vote (i.e. if theres dilution).
No vote if (1) theres a market out; or (2) they keep the
same stock
o But they get the vote back if (1) the merger entailed
amending the articles or (2) it was a conflict
transaction

Triangular Merger
o Delaware
o Voting:
Board of T gets vote unless short form
Board of Ps sub gets vote; board of P is this board
Shareholders of T vote
Shareholders of Ps sub, aka Ps board, vote ---- so Ps
shareholders dont get to vote, even if theres dilution
o Appraisal
Shareholders of P dont vote, so they dont have appraisal rights.
Shareholders of T have appraisal unless theres a market out
o * SO TRIANGULAR MERGERS UNDER DELAWARE LAW result in
Ps shareholders being left without voting and without appraisal rights.
o MBCA
o Treat like straight merger; shareholders retain the same rights.

Asset Acquisition
o Delaware
o P shareholders dont get voting or appraisal rights
o Ts shareholders get to vote only when T has sold off all or substantially
all of its assets. Gimbel.

85

This is both a quantitative and qualitative test. Its not bright line;
fairly nebulous
How court defined: If the sale is (1) of assets quantitatively
vital to the operation of the corporation and (2) is out of the
ordinary and (3) substantially affects the existence and
purpose of the corporation, then it requires shareholder
approval
Also from Gimbel: sales that cause the corporation to
depart radically from its historical line of business do not
constitute a sale of substantially all of the corp's assets
** APPRAISAL? same as usual appraisal unless market out?

o MBCA
o P shareholders only vote if dilution ( 6.21(f))
o P shareholders dont get appraisal because theyre retaining their shares
o T shareholders vote if
Bright-line test: MBCA 12.02(a)
Shareholder vote is required if the corporation sells off
more than 75% of the corporation's consolidated assets and
75% of either its consolidated revenues or pre-tax earnings.
o i.e. (nebulous standard):
Shareholder approval required if the
disposition would leave the corporation
without a significant continuing business
activity

Chapter 19: Corporate Governance & Models

FROM FIRST LECTURE that I missed: Wine and winemakers
Question: why do people need to work together?
o Specialization
o Synergy (parts worth more together than the whole)
o Economies of scale
o * These three make the pie bigger = more to be shared
Question: why do we need managers?
o Coordination
o Problem of shirking: people wont always do the best they can. Its
rational for people to shirk as long as all of the others arent also shirking
Difference between employment and tenancy
o If youre employed, profits go to owner, not to you. The amount of work
you put in doesnt necessarily affect what you get. With tenancy, you rent
the land, so owner get the rent and if you work harder, you get the fruit of
your labor. People can be expected to work harder if theres tenancy
than if theres employment.
How to align best interest of corp with those running it?
o One way stock options
86

How did the modern, large corporation arise?

o
o

Initially, shareholders were the real owners. They risked the capital and got
rewarded when the company prospered. Mangers were just employees.
Berle & Means believed that the above shareholder/owner manager/employee
relationship worked well until the 19th Century when technology made the base of
production bigger and, in order to be efficient, corporations needed a lot of cash.
Because nobody had this capital, corporate managers tapped into many small
investors. With so many investors, there was a need for centralized management.
o Believe that the power of centralized management is dangerously
unchecked since management selects proxy nominees and thus is selfperpetuating and that to protect shareholders (and others, creditors)
from managerial abuse, we need rules like heightened fiduciary duties
and providing greater information to shareholders.
Coase theorem: people begin to organize their production in firms when the
transaction cost of coordinating production through the market exchange, given
imperfect information, is greater than within the firm. So basically, people
organize in the corporate form when its most efficient to do so.
o However, this theory fails to explain why the modern corporation is
organized as it is and what efficiency it results in
Contractarian theory:
o A corporation is a set of relationships nexus of contracts
o There is a restraint on corporate power: the market market restraints
include (1) reputation; (2) initial offerings (people wont buy unless the
offerings are efficient); and (3) the market for corporate takeovers
Economists: believe that the separation of power between shareholders and
managers is actually good; it makes economic sense
o Whereas B&M saw the shareholder as the one making a risky investment,
the average shareholder really has little at stake in the corporation because
(1) the amount of stock they hold in any one corp is usually small; and (2)
they can diversify out of risk. Thus, theyre rationally ignorant; plus there
are collective action problems and they can always just sell their stock,
exit. Corporate managers, on the other hand, put in their human capital,
which (1) isnt diversifiable, and (2) is only valuable so long as they
maintain their position in the organization. We thus end up with corporate
managers, not shareholders, having the greatest interest in the
corporations success
Team production:
o The BoD is the mediating hierarchy, i.e. the focal point for resolving the
claims of all shareholders. Shareholders enter into a mutual agreement to
cede control to the mediating hierarchy in an effort to reduce wasteful
shirking and rent-seeking. And then the courts play a role as a check on
the functioning of the BoD
Director-centric: separation of ownership and control is highly efficient as the
boards contractual obligation to shareholders is to maximize value

87

Why did the Corporation develop as it did and what ramifications does
this have for corporate management going forward?
o
o
o

B&M: corporations fell into current form as unintended consequence of need for
size and capital. Therefore, we need law to manage since theres no natural
restraint on management
Coase doesnt really have an explanation
Contractarians: developed as a nexus of contracts and the restraint on
management comes from the mraket

The purpose of Corporate Law:

o
o

B&M: to restrain accidental accumulation of power

Economists: restraint is inherent in the market. Corporate law is, therefore, not
meant to correct mis-adjustment of power, its meant to facilitate the nexus of
contracts. (This has Coase theorem running through it) corporate law is
meant only to facilitate the making of contracts (by providing defaults but ability
to opt out of default contracts) and enforce them.

Criticisms of Contractarian View:

o
o

The economists view of how corporations came to form is not descriptive, its
normative, tied to efficiency rationale.
Viewing relationship of shareholders/managers as evolving out of efficient
bargaining doesnt work; there really often isnt any bargaining over the K.
o They argue back that our default Ks are efficient so we dont need to
bargain
Theres little evidence that the market really serves as a big restraint on corporate
abuse there arent a lot of takeovers and, when there are takeovers, its generally
not of corporations that arent doing well because of mismanagement, its
takeovers of corporations that are thriving.

A Final, Historical, Path-Dependency View (Rowe)

o

The only reason that the corporate form has taken its shape is because its the
shape its historically taken. We didnt choose a model where lots of small
shareholders bought into corporations, it occurred because we feared large
accumulations of wealth and thus didnt develop big banks and therefore when we
needed to accumulate a lot of wealth, the only way to do so was by getting the
capital from many people.

Looking forward, how will the new role of pension funds and the like as
shareholders affect the corporate form and corporate governance?
Will they act as agents for their principals (the shareholders) and take action to
improve corporate mismanagement? Are they actually interested in improving
corporate management and corporations values, or do institutional investor
competition and other factors prevent such activism?

88

Chapter 21: Role of the Shareholder in Governance

Powers/characteristics of shareholders
Fiduciary Duties
Problem: Universal Netware Pt 2 (648)
Problem (modified) LaFrance Pt 2 (590)
MBCA 8.01
Dela 141(a)
Auer v. Dressel
MBCA 7.32
MBCA 8.08(a)
Campbell v. Lowes
MBCA 8.10
Rule 14a-8
What we view as the proper role of shareholders depends on what governance model
we prescribe to (nexus of contracts? Hierarchical?), as well as the size of the corporation,
the socio-economic/historical moment, and the substantive type of corporation.

Dynamics of shareholder voting and the Collective Action

problem
Shareholders often dont use their voting rights to oppose management
decisions/nominations or to undertake their own proxy solicitation because:
o They are rationally apathetic: generally, the cost of informing themselves
will outweigh the benefits of increased stock prices, especially if they own
few shares, and especially because individual shareholders diversify and
thus the cost of getting informed on all of their investments would almost
surely outweigh the benefit of doing so. This is especially true because
Many people free ride, i.e. realize that others will either get
informed and vote or they wont and, if they dont, then it doesnt
make a difference whether the shareholder in question were to
have voted. Thus, everybody depends on everybody elses action
What about institutional investors?
o Potential to be good monitors:
They have a more stock than individual investors, so more to gain
from rise in stock prices.
They have the manpower/industry expertise to monitor and they
themselves are being monitored by the companies theyre
evaluating
o Reasons why they might not monitor:
Theyre not direct beneficiaries theyre agents for others
They may have conflicts of interest:
Pension funds, for instance, are usually set up by corporate
management for the benefit of their employees. So its a

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closed loop and they dont have much of an incentive to

change themselves through this form
Government-run pension funds: the managers of the
funds may have political ties or aspirations that conflict
with corporate managements ideals. They may have
interests that dont align with getting the best return.
Unlike individual investors that look for the best return value from
their investments, institutional investors are most concerned with
just doing better than other institutional investors
o Collective action problems: theres an assumption that other institutional
investors will monitor, so they dont have to (free riding)
o Exit options: institutional investors value liquidity over making a
corporation more efficient. Tax on investment income doesnt discourage
institutional investors from exiting to the extent that it does individual
investors. However, there are mechanisms (like supply/demand in selling
large swaths of stock) that prevent huge exits from any one corporation.
There has been a steady increase in institutional activism over the past decade.
Some institutional shareholders have mounted withhold campaigns against
directors who are viewed as unsympathetic to shareholder interests. The
Institutional Shareholder Services (ISS), the dominant proxy advisory firm, has
been a leader in recommending withhold votes.

Shareholder Proposals
Question addressed:
(1) First consider state law: defines what shareholders can do vis--vis the board
o Under state law, the corporation is managed by and under the direction
of the directors. Difficulty is determining when something falls within the
directors management sphere vs. within shareholder power.
Shareholders role under state law is limited to matters for which
the statute requires shareholder vote; issues on which management
solicits shareholders vote; or matters that shareholders properly
can raise at a shareholders meeting
o Advantages of board as manager/why we only allow shareholders to
vote on certain matters:
Rational apathy of shareholders; board has shareholders collective
interests in mind, whereas shareholders have only their personal
interests; shareholders buy with expectations that professionals
not other shareholders will make decisions; Board has greater
information and expertise, as well as secret, internal information
upon which to base decisions; easier for board than shareholders to
communicate amongst themselves
(2) Next consider federal law: SEC Rule 14a-8
o Proponent must continuously have held at least 1% or $2000 worth of the
company voting shares for at least one year.

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Proposal has to be submitted 120 days before the annual meeting. It is

included at companys expense. Cannot exceed 500 words.
o Burden is on company to show why a proposal should NOT be included.
And if it excludes improperly, its in violation of Rule 14a-8
If company does not believe that the proposal should be included,
it must send the proposal and a statement from counsel about why
it should be excluded to SEC staff.
It either issues a no action letter (saying we wont oppose
your exclusion of the proposal) or tells the company that, in
its view, the proposal must be included
o Substantive grounds for exclusion:
14a-8(i)(1): not proper subject for action by stockholders under
state law (e.g. relates to management)
If shareholders are proposing that reports be made so as to
ensure that directors are informed, look to the subject
matter of the reports and whether this is within
shareholders power to suggest
** Self-imposed restrictions, e.g. in bylaws, cannot
diminish the shareholders power under state law
As made clear in Auer, the form of the resolution is
important if its just a recommendation, then even if
whats recommended isnt within the shareholders
authority may still have to be included.
14a-8(i)(3): false or misleading statement.
if this is the case, SEC will often give shareholders
opportunity to amend the proposal based on what the
corporation claims is false or misleading
14a-8(i)(4): redress of personal claim or grievance.
* Often comes up when its a shareholder-employee
14a-8(i)(5): Not significantly related to business.
Usually relates to factors that are numerically very small
(<5% of sales, assets or earnings)
HOWEVER, also relates to significant social issues
o Medical Committee for Human Rights v. SEC:
Shareholders trying to stop Dow Chemicals
from continuing napalm production
designed for use on human population. But
the issue was that this was a very small part
of Dow Chemical, so they wanted to exclude
it because it wasnt economically
significant to the company. However, court
said thats not enough: this is a significant
social issue
Moreover, the production of napalm wasnt
part of Dows normal business operations,
it was based on the directors social morals

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and idea of patriotic duty, so their social

morals shouldnt be allowed to trump those
of the shareholders.
14a-8(i)(7): Corp can omit a proposal that involves ordinary
business operations.
This is usually very similar to the (i)(1), state law analysis
Antithesis of ordinary business is public policy (though
professor has this under (i)(5))
The shareholder proposal rule specifically excludes proposals that
relate to an election for membership on the companys board of
directors. Rule 14a-8(i)(8)
** On an exam, go through each of these, fighting for or against
exclusion **
Objectives that often come up in proposals:
o Bylaw amendments
o Social issues
o Shareholder power vis--vis directors

Shareholder proposals to amend bylaws to allow for shareholder nominations to the

Board:
CA, Inc. v. AFSCME Employees Pension Plan (2008)
o AFSCME a stockholder of corporation CA - proposed an amendment to
the bylaws whereby, if adopted, would require that the Board reimburse
stockholders for reasonable expenses incurred in a proxy war.
o Holding/reasoning:
If a bylaw is process-related as opposed to procedure-related, its
within the province of the shareholder.
The proposed bylaw had both the intent and effect of regulating the
process for electing directors of CA; therefore, the Bylaw was a
proper subject for shareholder action (but, in this case, it would
have interfered with fiduciary duties since people could get
reimbursed for bad faith proxies, so the court struck the proposal)
Delaware: In 2009, the Delaware legislature established DGLC 112, which
authorizes a corporation to adopt a bylaw granting shareholders the right to
include their nominees (if less than all directors are to be elected) in a
corporations proxy soliciting materials subject to conditions in 113, which
codifies the CA decision and permits a corporation to adopt a bylaw providing for
corporate reimbursement of shareholder expenses incurred in connection with the
election of directors (with certain conditions).
Supporters of mandatory proxy access rules see them as effective mechanism
to improve board performance through the injection of new ideas and threat of
removal for poor performance.
Opponents fear that the rules would turn corporate elections into costly and
disruptive contests and would discourage qualified nominees from being willing
to serve as directors. Think it could undermine board cohesiveness

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Removal:

Default rule is that shareholders CAN remove without cause. Thus, they can call
a shareholder meeting, remove the board, and put in new directors.
o If you want to change it so that shareholders can only remove FOR cause,
it must be in the articles of incorporation
o To remove for cause, you need to have notice/process: must have a
meeting, inform directors of why theyre being removed, and give them an
opportunity to answer (Campbell v. Lowes)
If a director is removed, the MBCA default allows the board or shareholders to
fill the vacancy. This can be amended such that only shareholders have the power
to fill vacancies on the BoD.

Fiduciary Duties (USE EMANUELS as skeleton)

Directors in Large Corporations
Fiduciary Duties
Duty of Care
Problem FiberNet 3
MBCA 8.30
Old MBCA 8.30
Francis
Graham
Caremark
Citigroup
Reliance
MBCA 8.30(d)-(f)
Van Gorkom
FiberNet Pt. 4
Dela 102(b)(7)
MBCA 2.02(b)(4)
Three questions:
what functions do we want directors in large corp to perform?
What types of people do we want serving on the boards?
Who is going to choose the board members?
Inside vs. Outside Directors
Benefits of outside directors:
Can monitor the inner workings, things like shirking more objectively
Can bring in separate expertise and expand breadth of knowledge
Reduce cooperative thinking, mitigating the sometimes dangers trust,
reliance, and consensus among inside directors
Why we dont want all outside directors:

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They are limited in their managerial function because they often dont have a
lot of time to offer any individual board on which they sit
They are dependent on the inside directors to obtain information, though
they have a duty to look beyond the information theyre given
They dont make internal plans, they just veto bad ones

Sources of Bias on a Board

Structural bias: the dynamic of working together leads people to agree more and
more over time. So no matter who you take as independent from outside, if you keep
them on long enough theyll lose much of their objectivity. However, you also dont
want lots of turn over because of the learning curve.
Common culture: boards often consist of old white people, more likely to agree than
more diverse groups
The internal board chooses the directors - its usually too hard for shareholders to
nominate their own candidates. Board members dont want to oppose management
because they might not be re-nominated/might get removed and get a reputation so
other companies wont want them on their board. Directors dont want to make
waves - want to keep their position, want to get hired by other boards
Who Should Nominate Board Members?
Shareholders: Structurally too difficult
Whole board - if we do this, the inside directors would have the most power - would
likely pick people who are their good friends, not people best able to monitor
Rules: nominations committee must be made up of outside directors.
What does it mean for somebody on the board to be independent?
A lack of independence is a lack of:
personal honesty; (i.e. self-interested) or
personal thought (i.e. a person who is dominated)

Overview

Moral view:
Duty of care is duty to make sure you do your job adequately
Duty of loyalty is basic problem of conflict of interest
Economists view:
no matter what system you set up, there are going to be costs. The objective
isnt to reduce the violations of fiduciary duties to zero - its to reduce them
such that the costs of reducing them further outweigh the gain
The law reflects what the economists want but isnt framed in their terms.
The number of situations where violations of fiduciary duties will be found are few
The duties arent always the same for shareholders and directors - directors fiduciary
duties comprise a duty of care and a duty of loyalty. Controlling shareholders also
owe a duty of loyalty, but not care, to minority shareholders.

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Duty of care

Distinguish between process used in making decisions and the substance of the
decisions themselves: we will look at the first, but not at the second
* The duty of care is ALWAYS discussed in conjunction with the BJR
Duty of care analysis:
There is a presumption that the decision was an informed
one. However, this presumption is vitiated if there is an
allegation of a violation of duty of loyalty (i.e. self dealing).
The steps:
(1) Was there a breach of duty of loyalty? If so, BJR doesnt
apply, if not:
(2) Was the decision informed?
(3) Was the decision rational? (i.e. there is SOME reason for
accepting it?) - doesnt have to be reasonable
BJR analysis: to get the benefit of the BJR, a director:
Must not be interested, i.e. have a financial stake apart
from the corporate interest, in the subject matter of the
action
Must be reasonably informed
Must rationally believe the judgment shes making is in the
best interest of the corp - directors rarely fail to
demonstrate this
also cant be in bad faith
Directors must have acted in a non-self-interested
manner (e.g. with the purpose of freezing out a
minority shareholder)
Directors must not have been aware that they were
not discharging their fiduciary obligations (Stone v.
Ritter) - for instance, directors must have put in some
monitoring system and believed that they were doing
some sort of monitoring of data from that system

Three situations:
(1) Business takes a specific action that shareholders think violated a duty.
APPLY BJR (gross negligence standard)
But after Von Gorkom, you need something greater than gross negligence for
liability (bc of Dela 102 and MBCA 2.02) - need bad faith
(2) No decision was being made; instead, shareholders allege that there was a breach
of fiduciary duty for failure to exercise proper oversight
Look to Graham, Caremark, and Citigroup
(3) A combination of the above two: a failure to exercise oversight AND options
were on the table but you didnt act
* The first is easiest to prove; the second the hardest. The first is subject to the BJR
(gross negligence standard)

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The Duty of Care Standard

Old vs. New MBCA 8.30 General note: the standard is aspirational; courts don't enforce it to the
extent that its written. For instance, the court in Van Gorkom applied a gross
negligence standard, which is more lax than the statutory standard.
Old one was a pure negligence standard; the new one is more subjective,
from directors perspective in good faith, what the director reasonably
believes
Rationale behind the lenient standard - The duty of care standard is applied in
situations where the directors have little to gain personally but potentially much to
lose. No rational person would want to be a director unless there were some
safeguards against liability. Moreover, shareholders are voluntarily taking on the risk
of deviation from a lower standard of care by (1) buying stock, and (2) voting for
these directors. Additionally, we dont want to discourage risk-taking, and
shareholders can always diversify out of risk.
MBCA 8.30 - modern
(a) applies to each member; individual standard
(b) is a separate standard that applies to board as a whole
this seems to cure what an individual can do. if the board meets its
standard, then the individual didnt actually do any damage even if
they werent living up to their duty

BJR stuf

The BJR can be overcome if the board action lacked a rational

business purpose - i.e. wasted corporate assets
** Only if a corporate transaction results in no benefit to the
corporation have courts found corporate waste
Rationale for this protection: we presume that managers were
acting in best interest of corp because its in their best interest for the
corporation to succeed and courts are not in a good position to judge business
decisions.

Shlensky v. Wrigley

Brief Fact Summary. Plaintiff, William Shlensky, filed a derivative action against
Defendant director, Phillip Wrigley, to force the installation of lights for night
baseball. Plaintiff alleged that Ds decision to not install the lights was preventing the
company from earning profits for night games
Synopsis of Rule of Law. A court will not interfere with an honest business judgment
absent a showing of fraud, illegality or conflict of interest. Moreover, the decision
was not irrational - there were some reasons for it, like a concern for the impact on
the neighborhood should the lights be installed

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Duty of Oversight
Francis

Take aways:
(1) Rules about attendance: courts rely on a continuing course of conduct if you continuously miss meetings without a good excuse, youre likely to be
found liable.
Missing a meeting here or there for a valid reason is okay, however.
In fact, its presumed in law, as we have quorum requirements
(2) The duty of care standard is mostly subjective (reasonable person in the
same situation), however its objective in the sense that at a certain point,
youll be held liable even if youre in such a bad state that a reasonable
person in your situation would have done what you did: i.e. absolutely
nothing when you should have done something.
Basically, there is a subjective test applied unless the director is in
such a position that s/he simply cant serve in the position (e.g. Ms.
Francis, a drunk basket case), in which case s/he shouldnt be in the
position. Ones total inability to function doesnt make them liabilityproof. You can give the person an honorary position if you want
their presence but theyre not capable of acting as a director.
Summary: The standard for duty of care is more objective on the bottom end of the
spectrum of peoples ability; more subjective/elastic when youre looking at the top
end of expertise/ability
We do take into account peoples heightened expertise as an element of the
situation when determining whether there was bad faith; however, this does
not amount to changing the standard thats being applied.

Reliance (MBCA 8.30(d) - (f))

Pursuant to this rule, directors can rely on such things as opinions, information,
statements or reports of officers or employees of the corp, legal counsel or hired
accountants, or board committees. HOWEVER, this reliance is not unlimited - the
director can only rely when its reasonable given what the individual knows.
This standard varies across the categories of individuals whom one can rely
on, e.g.:
Officers: must be reasonably sure theyre reliable or competent
Professionals: must be reasonably sure its within their professional
competence
Committees: must believe that their determination merits competence
Red flags: if you have specific information that somebody may not be reliable (e.g. if
somebody has a conflict of interest) then its not reasonable to rely on them
What do you have to do if youre relying:
Get informed as best as you reasonably can.

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So, for instance, if youre given a 400-page, hyper-technical report,

ask for a dumbed-down summary or ask somebody to explain it;
must reach your own conclusions if youre competent to do so.
If youre not sure whether something is correct, you have a duty to prove
further and ask questions. Van Gorkom

Van Gorkom

Stands for the notion that while directors have a lot of discretionary protection, its
not limited.
Very fact-specific outcome:
Made a huge decision fairly quickly (2 hrs) and there was no exigency
Why didnt the BJR apply (BJR IS GROSS NEGLIGENCE STANDARD)?
For the BJR to apply, directors need to have been informed and here they
werent.
Wasnt proper for them to rely on the offer price being significantly
greater than the market price because they knew the stock was
undervalued.
They didnt question where the offer price came from; didnt inquire
to find out that it was the lower range of numbers that the CFO
calculated for a transaction of an entirely different type
VG didnt give the board the numbers of reports prior to the
meeting; they basically just took him for his word. > its
not reasonable to rely on a report, figures, statement or
opinion when you dont know where they came from
Board didnt inquire as to why Pritzker put a time limit on the
decision - did ask whether there was a legitimate reason (e.g.
otherwise bankruptcy would occur) or not
Reasoning & Impact of the case:
Court didnt let the boards actions slide under the BJR because
(1) Found that under the totality of the circumstances, the directors
werent reasonably informed;
(2) The board was trying to exploit the system by being asked to be
treated all together - they (especially VG) thought there was no way
that the outside directors could be held liable, so if they were grouped
with the inside directors, the inside directors would get off scot-free.
HA TRY AGAIN BITCHES!
Impact 1: Court was trying to change the psychology of the boardroom forcing board members to question each others conclusions.
Impact 2: The decision resulted in two exculpation clauses - Dela 102 and
MBCA 2.02 see esp 102(b)(7) and 2.02(b)(4)
Boards can now put into their articles of incorp that directors will
only be held to have breached their duty of care if they acted not in
good faith. Good faith reflects some policy consideration limits:

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Delaware: Can still be liable for breach of duty of loyalty;

for acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of the law; for
any transaction for which the director derives a personal
benefit
What is the meaning of not in good faith? What do
you have to prove to show this?
* SUM: will not be held liable for duty of care UNLESS
there was bad faith, intentional misconduct or knowing
violation of law, or the person derived a personal benefit
from the breach
Impact 3: Indemnification: statutes allow comp. to indemnify director for
certain kinds of claims. Sometimes these statutes are permissive (can put
them in), and in others theyre mandatory (e.g. in these cases, the director
will have a claim against the corp - usually where the director is being sued
as a director; esp. where theres no liability found). E.g. DGCL 145
Differences among indemnification statutes: Corporations can
indemnify directors from expenses and judgments reached in cases
that are NOT derivative suits (i.e. person sues director for harming
him/her), but cannot indemnify directors from the judgments
rendered in derivatives suits (because that would be circular as the
corp is suing the director)
* The two different things that might be covered: Expenses of
litigation and settlement or damages
Impact 4: Directors and Officers insurance: doesnt cover illegal conduct
and intentional wrongdoing
Impact 5: New 8.31 (replacing old 8.30, which said you should perform
in the manner of a reasonable person, but it sounded too much in negligence)
New provision says here are the conditions under which you can
hold a director liable for monetary damages, but includes a safe
harbor provision:
Paragraph (1) says that if you come within the bright line
rules in 8.60, you arent liable. These rules clearly establish
how a director can get out of liability, by stating this is what
I reasonably believed.
(b): have to show damage AND proximate cause (action of
director proximately caused damage to the corporation)

Graham
Facts: derivative action alleged that the director defendants either
had actual knowledge of illegal price-fixing or were aware of facts
that should have put them on notice. Court found that absent
cause for suspicion, there is no duty upon the directors to install and
operate a corporate system of espionage to ferret out wrongdoing
which they have no reason to suspect exists, so Ds werent liable

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What standard is laid down in this case?

Red flag test: If directors are -even accidentally- made aware that something
bad is going on, they have a duty to follow-up. This is probably still true
under the exculpation statutes, i.e. thats probably bad faith
What changed is that under Graham, there was no duty to develop a system
absent such red flags; now there is

Caremark

Facts: Caremark was indicted for allegedly violating a federal law

meant to prevent kickbacks and other wrongdoing in the healthcare
system. The company, prior to the indictment, had set up a
monitoring system to try and prevent such violations.
Standard: need a monitoring system for any potential legal
violations - not just once a red flag comes up. The sufficiency of that
monitoring system is reviewed under the BJR. As such, the existence
of a monitoring system will be sufficient to shield you from liability
unless the system is irrational
Only a sustained or systematic failure of the board to exercise oversight such as utter failure to attempt to assure a reasonable information and
reporting system exists - will establish the lack of good faith that is a
necessary condition to liability.
Types of risk being monitored: legal, statutory/regulatory risk - so
failure to comply with antitrust laws or the like, or monitoring for
improper financial dealing

Citigroup

The risk that the corporation had allegedly failed to monitor was a
business risk - the risk associated with your business given the
unsure nature of the housing/investment market.
Whats the difference between business risk and legal risk?
In Caremark, if you can reduce the risk to zero, you
make more money.
In Citigroup, the risk is the risk youre taking to make
profit.
Outcome:
Directors were not liable - the plaintiffs could not point to any
red flags that would have warranted monitoring or that
Citigroup failed to address. Moreover, there was a monitoring
system in place.
Court relied on the notion that a red flag has to be a red flag
AT THE TIME THE DECISION WAS made, not looking back in
time saying that was or should have been a red flag - we
wont judge a business decision ex-post

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SUM OF IT ALL:

Standards of liability expressed in these cases - trying to find what is worse than
gross negligence but not so bad as knowingly doing something wrong:
The BJR says the standard of liability for violation of duty of care is gross
negligence
The exculpatory statutes (post- Van Gorkom) say gross negligence isnt
enough - we have some exceptions - so long as those provisions are placed in
the articles of incorp
The burden required to rebut the presumption of the BJR by
showing gross negligence is a difficult one and the burden to
show bad faith is even higher.
There will be liability for:
Intentional violations of the law
Conscious disregard for your responsibilities
Knowingly failing to act in the face of a known duty to act
Advancing your own best interests, rather than the corporations;
waste
Probably liable if you had constructive notice (i.e. we cant prove
that you knew, but given the circumstances, you should have known)
that there was a duty to act, but D failed to act
With regard to monitoring cases - the case law has put corporations on
notice of their duty to develop a monitoring system, so a failure to put one in
place would be a violation greater than gross negligence because its akin to
failing to act in the face of a known duty to do so.
Additionally, red flag test - if a red flag comes up, you have to
respond, otherwise youre knowingly disregarding your duty

Duty of Loyalty
The BJRs presumption that managers operate in the corporations best interest doesnt
hold true when there's a conflict transaction. We thus have a number of tests for assessing
alleged violations of duty of loyalty in different kinds of conflict transactions:
Statutory regimes: statues that cover director conflict of interests transactions:
Dela 144, old MBCA 8.31, New MBCA 8.60(sub f) - which they want to use to
replace old 8.31
24.1 - 24.4: Conflict between individual directors and statutory regime stuff
e.g. director who wishes to sell her own property to her own corporation
24.5: Corporate opportunity, meaning that there is some chance to make money.
Question is to whom does the chance to make $ belong
25: Executive compensation
Problem: Who sets it? The only group that sets it for the top execs are the top
execs
26.1: Transactions within corporate groups
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ex of parent and sub; parents can decide whether profits go to sub or parent.
How do we determine allocation of the profit?
Conflict is really between controlling shareholders of parent and the minority
shareholders of the sub. Sinclair Oil v. Levien
26.2: Cash-out transactions (pg 116 of class notes)
26.3: Sale of controlling interest
one more (27?)

Director Conflict of Interest Transactions

Dela 144 & former MBCA 8.31
Subchapter F MBCA
Independent Directors

Fundamental point:
Unless its a DCIT, there can be no injunctive relief or damages on the grounds that a
director has an interest respecting the transaction
(b) if there is a DCIT, it cant give rise to equitable relief or other sanctions if:
(1) There was approval by the disinterested directors; OR
I.e. an informed vote by a majority of the disinterested directors or a
majority of the disinterested directors on a committee
* Sometimes, this will be dispositive. Sometimes no - sometimes P
can come in and prove that something is unfair.
(2) There was approval by a majority of the disinterested shares
This is referred to as the majority of the minority
Same question - whats the effect of this vote: is it dispositive, or
does it just put the burden back on the shareholders to prove, for
instance, a lack of fairness
(3) the transaction was fair
this is a hard burden to meet. To get out of it, you want to get one of
the two above votes beforehand.
fair to the corporation is defined in 8.60(6) - means that the
transaction as a whole was beneficial to the corporation, taking into
appropriate account whether it was (i) fair in terms of the directors
dealings with the corp, and (ii) comparable to what might have been
obtainable in an arms length transaction, given the consideration
paid or received by the corporation
Not just about market price - must look beyond this and take into
account the best interests of the corporation
* THIS IS THE SAME STRUCTURE AS 144

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Former 8.31 and DGCL 144

Codified common law development that conflict transactions are not

automatically invalid. However, the statutes dont specify when a
transaction is valid
Contained a lot of ambiguities, e.g. when a director has an indirect
interest
Conflict transactions come up all the time, so lawyers and their
clients wanted more certainty

Subchapter f - applies to Directors conflicting interest

transactions (DCITs)
Tries to set bright-line rule: By providing bright line definitions of
who is an interested director, what constitutes a conflicting
interest transaction, and who are qualified directors, this
Subchapter attempts to provide greater prospective certainty and
reduce judicial intervention
Safe harbor (attempt to create bright line rule)
8.60:
Identifies a directors conflicting interest transaction (DCIT) as a
transaction by the corp in which the director (i) is a party, (ii) has a
material financial interest, or (iii) knows that a related person is party
or had a material financial interest. A material financial interest is
defined as one that would reasonably be expected to impair the directors
judgment when authorizing the transaction
Sections 8.60 and 8.61 attempt to frame a tight definition of who is
interested in a transaction, and what constitutes a conflict of
interest transaction
Take aways: this only applies to [director conflicting interest]
transactions. Any other conflict of interest falls outside of subchapter f
- e.g. corporate opportunities, corporate policies that dont involve
transactions
Transactions that arent DCITs cannot be the basis for
injunctive relief or liability.
Of the transactions that are DCITs, were going to apply
the three-part regime that is very similar to 144 and
8.31 - the question becomes:
1. did you get approval of the disinterested directors;
or
2. did you get approval of disinterested
shareholders?; or
3. is the transaction fair to the corporation?
8.62 and 8.83
Whereas even if 144 1, 2, or 3 was satisfied (e.g. approval or fair)
there might still be liability, there is a bright line under 8.62 that
such approval/fairness is dispositive - no liability.

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8.62 refers to approval by a majority but no less than 2

qualified directors - the definition of qualified director can
be found in beginning of 1.43 - but the definition given is
a bit ambiguous, so were right back into the ambiguity that
subchapter F was trying to get us out of
8.62(a)(2) ensures that the board doesnt just handpick people to sit on the committee of disinterested
directors.
** Court can still always find ways around this bright line,
however, if there is so much unfairness. for example, by
finding a failure to disclose something material.
How do we determine if directors are independent for a particular reason?
Interested means you have a financial interest in the transaction.
Disinterested means you dont have a specific monetary interest in
the transaction. However, one can be disinterested but still not be
independent
When might you not be independent? - when youre beholden or dominated
Beholden: Youre vote isnt independent because somebody has
monetary/material control over you (e.g. they control the benefits that
you want, like keeping your job)
This is a fact intensive inquiry under which a judge must
consider such things as how much keeping the job/benefit
meant to you financially or psychologically
Dominated: You arent able to make your own decisions -because of
psychological, staring-you-down and controlling your brain pressure
Not enough that somebody is simply just responsible for
having gotten the director on the board. Longstanding social
relationship also generally not seen as being enough. Not
enough that they just seem to always have voted the same
way

Case law
Remillard Brick Co. v. Remillard-Dandini Co. (unimportant)
Facts: Ps - minority shareholders of Ds company - assert that the Ds breached duty of
loyalty by self dealing when they had their corp sell all of assets to another corp that they
owned at what was likely below market value
Holding: Court found for shareholders. Director cannot, at the expense of the
corporation, make an unfair profit from his position. Found that the transaction was
unfair to the minority stockholders.
Benihana
Rule: This was in Dela under 144: After approval by disinterested directors, courts
review the interested transaction under the BJR

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Lewis v. Vogelstein
Addresses the question whether approval by majority of disinterested shareholders
should be given conclusive weight, or whether there is still room for the court to
ensure fairness.
In all events, informed, un-coerced, disinterested shareholder ratification of a
transaction in which corporate directors have a material conflict of interest has the
effect of protecting the transaction from judicial review except on the basis of waste
corporate waste can be defined as "an exchange of corporate assets for
consideration so small as to lie beyond the range at which a reasonable
person might be willing to trade.
HOWEVER:
Harbor Finance Partners v. Huizenga
The Court questioned the continued utility of the equitable safety valve provided by
allowing shareholders to void a deal based on corporate waste, reasoning that if
there is a fully informed, uncorked vote of disinterested shareholders, that in itself is
strong evidence that there was a fair exchange, so how could it possibly rise to the
level of corporate waste?
The Concept of the Independent Director:

In re InfoUSA: Vinod Gupta case

Ps didnt seek demand; to survive motion to dismiss, they have to show that demand
would be futile.
Ps must show that 50% or more of the directors are not independent - if there
are 8 directors, you have to show that 4 were not independent.
Why wasnt evidence of the Hummer, catamaran etc enough?
Because it might not overcome BJR - perhaps this was adequate
compensation
If people dont make much money and they make a lot on the board, their position
likely will affect their decision. while we dont like to consider it for social policy
reasons, it is a reality that should be taken into account.
Things the court considers:
Directors fees - how much each director gets paid for their role as director
Legal fees - paid to counsel that sits as an independent director on the BoD
Use of free office space - by some directors
Co-directorships - some served on other boards of companies that Gupta also
owned
as well as several other business relationships between infoUSA, Vinod
Gupta, and his director co-defendants
Contributions to Creighton University - of which some of the directors were
associated as dean or otherwise
Travel

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Form 10-K for 2005: some of the directors allegedly faced a fundamental
conflict of interest due to their approval fo the companys Form 10-K

Oracle

Holding: The SLC was not independent. The question of independence turns on
whether a director is, for any substantial reason, incapable of making a decision with
only the best interests of the corporation in mind. - the independence test
ultimately focuses on impartiality and objectivity
Focused on the personal relationships between the individuals on the board.
The analysis used was different here than in Disney - here, they take into
account anything that could substantially affect the directors reasoning
whereas in Disney they said that the court wouldnt consider the fact that the
womans salary as a board member was much greater than her salary as a
school principal; said that Father ODonnel was independent because as a
Jesuit he couldnt personally take $ (though he obvi wanted to be on the
board to get Disneys CEO as a donor to Georgetown)
Here, the judge probes the actual psychology of the people: says despite the
1100 page report, etc, theyre not independent given the true reality of their
positions/psychology
Procedural posture:
The Ps plead that demand should be excused. An SLC was set up by the
company to evaluate the Ps claims after demand was excused and the SLC
determined that the case should be dropped.
The SLC Committee had the burden of showing that it was
independent, whereas in non-SLC situations, the P has the burden of
showing that the Board is conflicted and thus demand should be
excused

In re eBay Shareholder Litigation

the Court agreed with the shareholders' argument that although the other four
directors were technically outsiders, they all had been given large amounts of
eBay stock options, which would only vest if they remained directors. This made
them very unlikely to do anything that might rock the boat and get them kicked
off the board. (so they didnt have an interest in the deal, but the werent
independent)

What is the law now?

Need to look at whatever could objectively affect the directors decision. Technically,
the deep psychological probing only goes to SLC cases, not cases involving demand
dismissal. on the other hand, other cases demonstrate more wiggle room that some
law and economics arguments, when pushed to the extreme, just dont work. Earlier,
it seemed that you couldnt show cases where things like big monetary differentials

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would be taken into account. it seems that now, where cases are extreme, these things
may be taken into account (Martha Stewart)

Director Liability in Cash-Out Transaction

Weinberg focuses on the duties of the controlling shareholder. But
directors on the subs board, particularly outside directors on the
negotiating committee, have even clearer duties to the minority
shareholders.
They can be liable for breaching their duty of loyalty
(when they act to advance their personal economic interests
in the cash-out transaction) or their duty of care (though
personal liability is tempered by the exculpation clauses)
Finally, directors can be liable for not acting in good faith if
they consciously disregard their duties to minority
shareholders, and that cannot be exculpated by 102(b)(7).

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