I.

INTRODUCTION
II. THE LAW OF AGENCY
A. DEFINING THE AGENCY RELATIONSHIP
Definition

 §1.01 of Restatement (3rd) of Agency- Agency is the fiduciary relationship that arises when one
person (principal) manifests assent to another person (agent) that the agent shall act on the
principal’s behalf and subject to the principal’s control, and the agent manifests assent or
otherwise consents so to act

Elements

 Principal assents to agents actions on P’s behalf

 Principal “controls” agent’s actions
 Agent agrees

Thayer v. Pacific Electric Railway

 PH: TC judgment for the Plaintiff in the amount of $3,750. Defendant appeals
 Facts: Defendant, carrier, shipped a machine owned by Plaintiff which was damaged in transit.
Hileman was an agent of Defendant. Defendant assented for Hileman to act on its behalf, it
controlled his actions as an employee, and Hileman agrees to be employed. Hileman wrote on the
freight bill that the machine was damaged in order to get P to pay the bill. When Plaintiff went to
recover damages, Defendant refused to pay b/c the bill of lading stated it must be received w/in 9
months of shipment in writing
 Issue: Did the Plaintiff provide notice?
 Holding: Yes
 Rule: Agency is a question of fact, which may be implied from the conduct of the parties.
 Rational: Hileman became the agent of Plaintiff for the purposes of noting on the bill that Plaintiff
intended to claim damages. Plaintiff need not have expressly made Hileman its agent.
 Results: Affirmed

Dual Agency Rule

 An agent cannot act on the behalf of the adverse party to a transaction connected with the agency
without the permission of the principal
 §8.03: an agent has a duty not to deal w/a principal as or on behalf of an adverse party in a
transaction connected with the agency relationship
 An agent can deal with the other party “if such dealing is not inconsistent with his duties to his
principal”
 If 2 principals are unaware of the double employment, the transaction is voidable
 If one principal is unaware of the double employment, the defrauded principal can rescind or
choose to affirm the transaction and recover damages
 Rule does not apply when both principals consent to the situation

Gay Jenson Farms Co. v. Cargill, INC.

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 PH: TC entered a judgment for the Plaintiff. Cargill Appeals
 Facts: Warren borrowed money from Cargill- normally this would be considered a debtor/creditor
relationship. Plaintiff brings suite against Warren when they went bankrupt and sought to enjoin
Cargill in order to get their money.
 Issue: Was there a basis that Warren was an agent of Cargill?
 Holding: Yes
 Rule: A creditor who assumes control of his debtor’s business me become liable as principal for
the acts of the debtor in connection with the business. §14 Rest. (2 nd) of agency.
 Rational: During their relationship Cargill made recommendations to Warren, checked W’s books,
etc. Cargill ended the relationship when it found out the books had been falsified. Here, an agency
relationship was created through its course of dealings
o Consent- directing W to implement its recommendations
o W acted on C’s behalf in procuring grain for C
o Exercise control- C interfered with the internal affairs of W
 Results: Affirmed

B. CONTRACTUAL POWERS OF AN AGENT

 Establish the agency exists first before you look for authority!
 Whether a contract made by an agent on behalf of a principal is binding on the principal turns on
whether the agent had the authority to bind the principal
 3 sources for agents authority:
o Actual Authority- expressions made to the agent by the principal delineating the agent’s authority
o Apparent Authority- representations made by the principal to the 3 rd party about the agent’s
authority
 Agent “appears” to have certain authority to bind the principal
 Something as simple as a title on a business card
o Inherent Authority-derived from the agency relationship (murky) and exists for the protection of
persons harmed by or dealing with a servant or other agent
 Not recognized everywhere
 Two other concepts to an agents authority – estoppel and ratification
o Estoppel -§2.05 Restatement (3rd) of Agency: a person who has not made a manifestation that the
actor has authority as an agent and who is otherwise liable as a party to the transaction
purportedly done by the actor on that person’s account is subject to liability to the third party who
justifiably is induced to make a detrimental change in position because the transaction is believed
to be on the person’s account, if 1) the person intentionally or carelessly caused such belief, or 2)
having notice of such belief and that it might induce others to change their positions, the person
did not take reasonable steps to notify them of the facts.
o Ratification – a principal can ratify (forgive) an unauthorized act of his agent and thereby be bound
by such action.

1. AN AGENT’S EXPRESS AUTHORITY

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King v. Bankerd

 PH: TC granted summary judgment for the Plaintiff for $13,555.05. The COA affirmed
 Facts: King was power of attorney over Bankerd’s property (actual authority) to sell, convey, and
bargain the property. King gifted the property to Bankerd’s former wife.
 Issue: Did the gift fall within the scope of the power of attorney?
 Holding: No.
 Rule: The main duty of an agent is loyalty to the interest of his principal
 Rational: King had a general power of attorney to sell, convey, the property. It did not authorize
him to give it away unless the POA expressly conferred or that was the clear intent of the principal
through evidence based on facts and circumstances.
 Results: Affirmed
 Notes: Special sort of power of attorney is known as “durable” power. They are made possible by
statute, bypassing the common law rule that all agency powers are revoked upon the incapacity of
the principal.

2. AN AGENT’S APPARENT AUTHORITY

Smith v. Hansen

 PH: TC awarded damages to Smith. HH seeks redress from Fentron. TC granted the damages to
HH finding that Foster had apparent authority to bind Fentron
 Facts: Foster was employed by Fentron as “manager of manufacturing” he led Hansen to believe
he had the authority to sell salvage glass. Hansen wrote checks payable to Foster.
 Issue: Whether the TC finding of apparent authority was supported by substantial evidence?
 Holding: no
 Rule: Manifestations to a 3rd person can be made by the principal in person or through anyone
else, including the agent, who has the principal’s actual authority to make them. Manifestations
will support a finding of apparent authority only if they have two effects:
 They must cause the one claiming apparent authority to actually believe that the agent has
authority to act for the principal
 They must be such that the claimant’s actual, subjective belief is objectively reasonable
 Rational: No evidence that Foster’s title is customarily in the business community to have the
authority to sell and the checks were not made out to Fentron, it is insufficient to support a
reasonable inference that the belief was objectively reasonable.
 Results: Reversed with directions to dismiss the complaint.

Apparent Authority

 Is the power held by an agent or other actor to affect a principal’s legal relations with 3 rd parties
when 3rd parties reasonably believes the actor has authority to act on behalf of the principal and
that belief is traceable to the principal’s manifestations

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 C. DUTIES OF PRINCIPALS AND AGENTS

1. DUTIES OF THE PRINCIPAL

 Principal typically is required to compensate the agent and comply in good faith with any
agreements that the parties have
 Duty to indemnify the agent against expenses incurred and claims arising in normal course of
business
o Limitations:
 Losses that result from agent’s own negligence, illegal acts, or other wrongful conduct

2. DUTIES OF THE AGENT

a) Duties of Care
Carrier v. Mcllarky

 D replaced P water heater and told her he believed it was under warranty and he would try and
get a credit from the manufacturer and she consented
o It was not under warranty, thus no credit
 Agents have a duty to conduct the affairs of the principal w/a certain level of diligence, skill, and
competence normally exercised by agents in similar circumstances
o A promise only to make reasonable efforts to accomplish the directed result
o Agent cannot be held liable to the principal simply b/c he failed to procure for him something the
latter is not entitled

Duty of Care of the Agent

 Subject to any agreement w/the principal, an agent has a duty to the principal to act with care,
competence, and diligence normally exercised by agents in similar circumstances.
 Special skills or knowledge possessed by an agent are circumstances to be taken into account in
determining whether the agent acted with due care and diligence

Note:

 A principal may recover from the agent any damages caused by the agent’s negligence

b) Duty of Disclosure
Olsen v. Vail

 P put 2 parcels of land on the open market, D introduced P to L who was interested in buying both
properties
o P decided not to sell prop #2

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o L explored the possibility of purchasing land from R who refused to go through D
o D did not inform P of the negotiations, L bought from R
 An agent is required to disclose to the principal any facts which might reasonably affect the
principal’s decision
o Information must be material
 Per-acre pricing of R’s prop would have been valuable to P but D did not have this info

Note

 An agent acting as an adverse party with the principal’s consent has a duty to deal fairly and to
disclose all facts that the agent should know would reasonably affect the principal’s judgment

c) Duties of Loyalty
Gelfand v. Horizon

 P worked for D as a real estate manager

 P sold a shell corp owned by his wife and son a piece of prop, the corp sold the prop a month later
for a $57,000 profit
 Rule: and agent occupies a relationship in which trust and confidence is the standard
o When an agent places his own interests above those of the principal there is a breach of fiduciary
duty
o The fiduciary is duty bound to make a full, fair and prompt disclosure to his employer of all facts
that threaten to affect the employer’s interests or to influence the employee’s actions in relation to
the subject matter of the employment

Notes

 Principal may obtain rescission of any agreements entered into by the agent
 Economic Loss Rule: a party suffering only economic loss from the breach of a K duty may assert
a tort claim for such a breach only if tort law provides an “independent duty of care”
 Post Termination Competition: common law does not preclude completion from a former
employee, so long as it is fair

D. VICARIOUS LIABILITY FOR NEGLIGENT ACT

1. INTRODUCTORY NOTE ON TERMINOLOGY

2 critical conditions
1. Control- principal must exercise, or at least have the right to exercise, a certain degree of control
over the agent
a. Employer/employee relationship
2. Scope of Employment- the servant/employee must be acting within the scope of employment at
the time of the tortuous conduct

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 2. THE CONTROL TEST
Kane Furniture

 Determining whether one acting for another is a servant or an independent contractor:

o Extent of control, by K, the master may exercise over details of the work
o Whether or not the one employed is engaged in a distinct occupation/business
o Kind of occupation
o Skill required
o Whether the master supplies the tools, instruments, and place of work
o Length of time for which the person is employed
o Method of payment
o Whether the work is part of the master’s regular business
o Intent of the parties
o Whether the principal is or is not a business
 Independent contractors are NOT under the control of the employer
 Employers are responsible for employees under respondeat superior

3. THE SCOPE OF EMPLOYMENT

Clover v. Snowbird

 Z was an employee of D as a chef; he planned to go skiing before he was scheduled to work.

Before he went skiing he checked in on one of the restaurants as was asked of him by his
superior. On his way to begin work for the day he took a shortcut taken by many employees that
had a jump which he took and struck a skier.
 Scope of Employment- those acts which are so closely connected with what the servant is
employed to do, and so fairly and reasonably incidental to it, that they may be regarded as
methods, even though quite improper ones, carrying out the objectives of the employment
 3 Criteria:
o An employee’s conduct must be of the general kind the employee is employed to perform
o Employee’s conduct must occur substantially w/in the hours and ordinarily spatial boundaries of
the employment
 Premises Rule- A person going to and from work, outside scope of employment
o The employee’s conduct must be motivated at least in part, by the purpose of serving the
employer’s interest
 Dual Purpose Doctrine- if an employee’s actions are motivated by the dual purpose of benefitting
the employer and serving some personal interest, the actions will usually be considered w/in the
scope of employment
o If primary motive is personal (even though there are some incidental business duties performed),
the person should not be deemed to be in the scope of his employment

E. VICARIOUS LIABILITY FOR INTERNATIONAL MISCONDUCT

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 The employer is liable for the negligent, willful, malicious, or criminal acts of its employees when
such acts are committed during the course of employment and in furtherance of the business of
the employer
o But when the act is committed solely for the benefit of the employee, the employer is not liable to
the injured 3rd party

Bushey & Sons v. U.S.

 Seaman Lane had been drinking heavily and went back to his ship which was dry docked for
repairs. He turned some wheels that controlled the water intake valves which let water in causing
the ship to slip off its blocks and falling and damaging the dry dock
 Is the government responsible?
 Foreseeability of the employees’ action
 It was foreseeable that a seaman might damage the dry dock, negligently or intentionally

Notes

 Enterprise Liability Test (another “motive” test adopted by some states)- employees’ acts
sufficiently connected with the enterprise are in effect considered are in effect considered as
deeds of the enterprise itself
 An employer is generally not liable for punitive damages when liability is vicarious unless the
employer authorized or ratified the tortuous behavior

Prove elements of agency, and then prove liability

III. THE LAW OF UNINCORPORATED BUSINESS ENTITIES

Sole General Limited Limited Corporatio Limited

proprietor partnership partnership liability n liability
(UPA) (RLPA) company partnership
Form One owner 2 + owners File Un- File articles Register
Just start No written certificate incorporate of in- with
No filing agreement of limited d corporation secretary
No filing partnership File articles of state
Fictitious Detailed of
name rqd. partnership association
agreement
Profit/loss Don't Share Shared Shared Corp has
share equally profit and
loss
Manageme Only you Equal By general By Centralized
nt voice partners manager
or
members
at large
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 Liability Yourself & Unlimited General Limited Sharehold Measure of
Agents for partner partner -- er liability limited
unlimited limited to liability for
Limited investment partners
partners -- (not on
limited to contracts
contributio or own
n torts)
Must
provide
security for
liability
Transfer of No Transfer Transfer Transfer Transfer of
ownership restrictions financial financial financial shares is
but not but not but not transfer of
mgmt mgmt mgmt all rights
and
powers
Continuity None other Dissolves Dissolves Dissolves Perpetual
of existence than owner on death or on death or on death or
withdrawal withdrawal withdrawal
Crossing No No Must Must Must
state lines registration registration register register qualify or
register
Income tax Flow Flow Flow Flow Corporate
status through to through to through to through to profits
personal personal personal personal taxed and
tax tax tax tax dividends
taxed as
personal
income

A. INTRODUCTION
Sole Proprietorship

 No partners
 Personally liable for all debts
 Personally recognize all income/loss on personal income tax return
 Freely commingling business with personal finances

General Partnership

 Default Entity- Do not need a written or even an oral agreement

 2 or more entrepreneurs join together to operate a business
 Need not file any doc w/the state to formalize
 Jointly and severally liable for all debts
 Each an agent for the other

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 Pro rata share of income/loss

Limited Liability Partnership (LLP)

 Partners are not personally liable for the debts and obligations of the business except to the extent
they have agreed to or bear personal fault
 Must file w/the state

Limited Partnership

 Creature of statute
 Must file w/state
 2 Classes:
o General- just like general partners in a conventional partnership
o Limited- not liable for the debts of the business, although care must be exercised in some state
about their participation in control

Limited Liability Limited Partnership (LLLP)

 Limited partnership in which the general partner(s) has limited liability (akin to LLP)
 Must file with the state

Limited Liability Company (LLC)

 Owners (called “members”) are not liable for debts of the business
 LLC can elect to be:
o Manager Managed- only those persons designated as managers have agency authority
o Member Managed- all members have agency authority and participate in management
 Benefits:
o Taxation as a partnership
o Management flexibility

B. GENERAL PARTNERSHIPS

1. THE DEFINITION OF A PARTNERSHIP

 Each state has adopted default rules pertaining to partnerships that describe the rights, duties and
liabilities of partners
o Uniform Partnership Act (1914)
o Revised Partnership Act (1997)

Baker v. Mannes

 PH: The circuit court found in favor of plaintiff. Defendant sought review and the Michigan Court
of Appeals reversed the judgment of the circuit court. Plaintiff sought further review.

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 FACTS: Defendant asserted that he was not in partnership with plaintiff, but was merely an
investor in the various businesses.
 ISSUE: The issue on appeal was whether Michigan partnership law, Mich. Comp. Laws §
449.6(1), required a subjective intent to form a partnership or merely an intent to carry on, as co-
owners, a business for profit.
 Held: Yes
 Rule: pursuant to Mich. Comp. Laws § 449.6(1), in ascertaining the existence of a partnership, the
proper focus was on whether the parties intended to, and did in fact, carry on as co-owners a
business for profit and not on whether the parties subjectively intended to form a partnership
 Rational: to the extent that Morrison v Meister, 212 Mich. 516, and its progeny were read to
suggest that the absence of a subjective intent to form a partnership was dispositive of the
question of whether a partnership existed, such interpretations were in error.
 Result: The matter was remanded to the court of appeals for analysis under the proper test for
determining the existence of a partnership under the Michigan Uniform Partnership Act.
 §202: Formation of Partnership-

2. WHEN A PARTNER IS NOT A PARTNER

Serapion v. Martinez

 P is made junior partner of a law firm which gives her right to participate is meetings of the Board
of Partners. Later she was made a “senior” partner but not at the same level of the proprietors.
She was promised to be made a proprietor which she never was
o Title IV discrimination case- only employees can sue under this, not partners
 Critical attributes of proprietary status:
o Ownership
o Remuneration- individuals compensation is based on profits
o Management

3. PARTNERSHIP PROPERTY
 Problem occurs of who owns what (especially in an informal business situation)?
 RUPA establishes 2 presumptions:
o Property purchased w/partnership funds is partnership property
o Property acquired in the name of one or more of the partners w/out indication of their status as
partners and w/out use of partnership funds is presumed to be the partner’s separate property,
even is for partnership purposes (rebuttable)
 Comingling of property doesn’t automatically make it partnership property
o It may not always be clear what belongs to the partnership

4. KEEPING TRACK OF THINGS ( PARTNERSHIP ACCOUNTING )

5. THE AUTHORITY OF PARTNERS

a) Actual Authority
Summers v. Dooley
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 P and D operated a trash collecting business together as equal partners; P hired a 3 rd person to
D’s objection and paid him out of his own pocket.
o P then sued D for $6K on the basis that D benefited in profits earned by the labors of the 3 rd party
 Rule: Any difference arising as to ordinary matters connected with the partnership business may
be decided by a majority of the partners
o Each partner has equal rights in the management and conduct of the partnership business
o If there are an unequal amt of partners (and they are all equal), the status quo wins when there is
a dispute over changes in management
 Holding: D wins since he continually voiced his objection to the hiring of the 3 rd party, he did not sit
back and acquiesce in the actions of his partner
 If you are the employee and they don’t pay what do you do?
 What if the t 3rd party injured someone while on the job, is the partnership vicariously liable or just
the one partner? Maybe

b) Apparent Authority
RNR Investments v. Peoples First Bank

 RNR’s general partner borrowed more money than was authorized under the partnership
agreement from Bank. RNR defaulted on payment. RNR argues that Bank failed to review the
limitations on the general partner’s authority to borrow in the limited partnership agreement
 Rule: the general partner possess the apparent authority to bind the partnership in the ordinary
course of partnership business or in the business of the kind carried on by the partnership, unless
the 3rd party “knew or had received a notification that the partner lacked authority”
o Absent actual knowledge, 3rd parties have no duty to inspect the partnership agreement or inquire
otherwise to ascertain the extent of the partner’s actual authority in the ordinary course of
business…even if they have some reason to question it
 2 step analysis:
o Whether the partner purporting to bind the partnership apparently is carrying on the partnership
business in the usual way or a business of the kind carried on by the partnership
 Not an issue here since he was borrowing money for normal business expenses
o Whether there are issues of material fact as to whether the Bank had actual knowledge or notice
of restrictions on the general partner’s authority
 Bank had to have actual knowledge or notice of the partner’s limitations
 Nothing in the record indicates they did
 The partnership could have protected itself by:
o Notifying the 3rd party of a partner’s lack of authority or
o Filing a statement of partnership authority restricting a partner’s authority (constructive notice)

6. LIABILITY FOR A PARTNER ’S FRAUD

Rouse v. Pollard

 Fitzsimmons was a member of Riker and Riker law firm. Rouse went to firm for divorce work and
was referred to F. F embezzled $28K from her by saying he and the firm would invest it for her.

11
o The money was deposited in F’s personal account, no part except $350 came to the firm, and no
member of the firm knew of the transaction
o Rouse argued that the investment of the funds in mortgages was w/in the scope of D’s law firm’s
practice or within F’s apparent authority
 It is not a characteristic function of the practice of law to accept client’s money for deposit
and future investment in unspecified securities at the discretion of the attorney
o Although this may be the done in some instances, it is not done with such frequency or
appropriateness as to become a phase of the practice

Notes

 If a partner is party to a breach of trust, knowledge of that breach may be imputed to the other
partners, rendering them jointly liable

7. RIGHTS AND DUTIES AMONG PARTNERS

a) Duty of Care
Moren v. Jax Restaurant

 One of the partners of d brought her son, P, to work where he crushed his hand in a dough press
 D served a 3rd party complaint against the mom (a partner) arguing that in event it was obligated to
pay P, the partnership was entitled to indemnity or contribution from mom for her negligence
 Rule: a partner has a right to indemnity from the partnership, but the partnership’s claim of
indemnity from a partner is not authorized
 B/c her conduct at the time of the injury was in the normal course of business of the partnership,
her conduct bound the partnership and it owes indemnity to her for her negligence

b) Duty of Loyalty (Partnership Opportunity)

Meinhard v. Salmon

 P and D were part of a joint venture of leased property where P provided the funding and D was
the manager. After the lease was up, D entered into a new lease for the same premises without
telling P
 Rule: Joint adventurers, like partners, owe to one another, while the enterprise continues, the duty
of the finest loyalty
 Since the subject matter of the new lease was an extension of the old lease, the co-adventurer
might fairly expect to be reproached
 Dissent: there was no general partnership, merely a joint venture for a limited object to end at a
fixed time with no intent to go further than the original date

Notes

 Duty of loyalty limits the ability of a partner to hire his/her spouse

 JT venture is generally thought to as limited business undertaking by a limited number of
participants, the formal structure of which may take the form of any of the following:
o Corporation
o Partnership(most common)
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o Limited Liability Co.
 All the rules of a partnership apply to JT ventures except the duty of loyalty (perhaps)

c) Duty of Loyalty (Conflict Of Interest)

 RUPA §404(b): a partner’s duty of loyalty is limited to 3 specified duties:
o To account for partnership property
o To refrain from dealing with the partnership as or on behalf of an adverse party
o To refrain from competing with the partnership
 Some states have changed the above language to provide that a partner’s loyalty included those
duties specified, implying that the duty of loyalty may include other duties

d) Contracting Around Fiduciary Duties

 RUPA §103(b)(3): states that the duty of loyalty may not be eliminated by the partnership
agreement, but partners by agreement may identify specific types or categories of activities that
do not violate the duty of loyalty, if not manifestly unreasonable
 §404(e): a partner does not violate a duty or obligation under this Act or under the partnership
agreement merely b/c the partner’s conduct furthers the partner’s own interest

8. THE LLP SHIELD

9. DISSOCIATION AND DISSOLUTION

a) The Dissolution Concept under UPA and RUPA
 UPA: any time a partner left a partnership, for whatever reason, the partnership “dissolved”
o Unless the parties had an agreement that entitled the remaining partners to continue the business,
the partnership was required to liquidate, discharge its debts, and distribute any remaining
proceeds to the partners
 RUPA: a partnership is an entity, thus the departure of a partner would not dissolve that
partnership, except under certain circumstances, rather the departing partner is characterized as
having “dissociated” from the partnership and the partnership continues
o §601 lists 10 events that will cause dissociation
 Death, may be purchased, etc
o Most dissociations result in a buyout of the dissociating partner
o Dissolution provisions are contained in §801
 §801: Events Causing Dissolution and Winding Up of Partnership Business
o §802 Partnership Continues after Dissolution

b) Liquidation Rights
 Unless otherwise agreed, dissolution creates liquidation rights in “each partner, as against his co-
partners” (UPA §38(1))
 UPA appears to mandate a cash liquidation, but courtts are split on whether it demands it (this will
arise in cases where one of the partners wants to continue the business after the dissolution)

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 C. LIMITED PARTNERSHIPS

1. ORGANIZATIONAL REQUIREMENTS
 3 Uniform Acts:
o Uniform Limited Partnership Act (ULPA)
o Revised Uniform Limited Partnership Act (RULPA)
 Most states have adopted this
o Uniform Limited Partnership Act (Re-RUPLA)
 RUPLA requires the orgs make a filing with the state (usually Sec of State)
o Limited partners do not control the business, are not vicariously liable for
debts/obligations
o General partners ARE vicariously liable for debts/obligations
 Limited Liability Limited Partnership (LLLP)- general partners enjoy the same limited liability as
a partner in an LLP

2. THE AGREEMENT OF LIMITED PARTNERSHIP

 Typically set forth the understandings in a written agreement but RUPLA §101(9) states the
agreement may be oral
 ULPA: certificate of limited partnership requires extensive disclosures of the arrangement and
could serve as the agreement
 RUPLA: not nearly the amount of disclosures, certificate of limited partnership could NOT serve as
the agreement
 Interpreting the Agreement: Ambiguities
o Contra Proferentem- ambiguous terms in the agreement should be construed against the
general partners as the entity solely responsible for the articulation of ambiguous terms when
investors had no hand in drafting
o Unless extrinsic evidence can speak to the intent of ALL parties to a K, it provides an
incomplete guide with which to interpret contractual language

3. THE LIMITED PARTNER

a) Participation in the Business of the LP
 What if the limited partner participates in the business?
 ULPA: LP would be liable if he “takes part in the control of the business”
 RUPLA: permitted greater activity by the LP w/out risk of liability
 Re-RUPLA: removed all limitations

Gateway Potato v. GB Inv.

 Sunworth was the general partner and GB was the limited partner.
 Ellsworth, pres. of Sunworth, called Pribula, pres. of Gateway, to buy potato seed. Gateway
resisted knowing Sunworth had file bankruptcy before, but Gateway told him GB was its partner
and was actively involved in the operations of the business. Gateway believed it was doing
business w/a general partnership but never verified. Sunworth defaulted on payment
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 GB testified that is had no control over the day to day operation and the pres. had to report to
them, while Sunworth testified that GB employees had controlled day to day affairs and had told
Gateway of these operations
 Trial Court granted SJ based on RUPLA §303 that the creditor had to have contact with the limited
partner and learned directly from him of his participations and control of the business
 Holding: the creditor can rely on the limited partner’s conduct if it was “substantially the same as
the exercise of power of a general partner”
o It is necessary for a trier of fact to determine whether GB’s activities amount to this type of
“control”

RUPLA §303 (Know This!)

o A limited partner can be liable for debts if: Their conduct was “substantially the same as the
exercise of power of a general partner”; OR They conduct business with the creditor

b) The LP as Agent of the Corporate General Partner

 Sometimes the general partner of a limited partnership is a corporation, the principals of which are
limited partners
 Should they be treated as general partners?

Zeigler v. Wilf

 P was to received $23,000 per year for 16 years as a consultant fee for finding the property sold,
the payments only lasted 2 yrs.
 The property was assigned to Trenton LP, a limited partnership
o The general partner was Trenton Inc (a corp)
o The limited partner was CPA, a general partnership controlled by Wilf
 Trial Ct granted Wilf SJ and found that CPA was liable to P for $456,801
 P argues that the limited partnership statute imposes general liability on Wilf b/c he functioned as
the operating head of the project
 §303 has been amended over the years to provide “Safe harbors” for limited partners. It was
deemed to be against public policy to impose general partner’s liability on a limited partner except
to the extent that a 3rd party had knowledge of his participation in the control of business
 One of the safe harbors is §303(b)(1): a limited partner does not participate in the control of the
business w/in the meaning a subsection a by serving as an officer, director or shareholder of a
corporate general partner
 P’s main argument was based on Wilf’s involvement in the renovation project. Wilf acknowledged
his involvement but stated his actions were taken as VP of Trenton Inc (general partner) pursuant
to the Safe Harbor Rule
 Reliance on the limited partner’s exercise of control?
o Here there was no reliance…P did not claim he was ever misled by who he was dealing with (a
limited partnership and a corp)
 Wilf’s activities were “substantially the same as the exercise of powers of a general partner” of
Trenton LP?

15
o His activities are sanctioned by the Safe Harbor

Wilf was only careless in identifying when he was in each role (officer or limited partner) and P
knew what Wilf was doing
c) Limited Partner’s Right to Maintain a Derivative Action
o Derivative Action - An action on behalf of the limited partner against the general partners

4. THE GENERAL PARTNER

 Owes a fiduciary duties of good faith, due diligence, and loyalty to the limited partners
 The general partner will seek to limit its fiduciary duties by agreement

Appletree v. Investment INC

 P was formed under UPLA

 P (limited partners) purchased a building from D (general partners) who held an interest in the
partnership when the sale transaction occurred
 CRI, who represented P in both the acquisition of the building and later on another transaction,
wrote to sellers requesting any info that would be material. D told CRI to have the building
inspected b/c it had no way of knowing what info would be material
 The building had asbestos and it would cost $10 million to repair
 Trial Ct: under RUPA 305 and the partnership agreement, the seller’s fiduciary duties were only to
render, on demand, true and full info. Since Buyer did not demand info on asbestos, ct granted
seller SJ
 Common Law: relationship of partners is fiduciary and partners are held to a high standard in their
dealings to each other, thus they must disclose material facts to each other and silence may
constitute fraud
 While the TC stated that ULPA changed the common law rule, RUPLA §305(2) did not eliminate
seller’s common law fiduciary duty to disclose material info to their partners
 Partners can change their statutory and common law duties but where the major purpose of a K
clause is to shield the wrongdoers from liability, the clause will be set aside as against public
policy…they are not free to destroy the fiduciary character to invite fraud

Brickell Partners

 Brickell is a limited partner in El Paso and has brought a derivative suit for the purchase of Crystal
Gas
 Crystal Gas was owned by Energy which controlled El Paso’s general partner DeepTech
 P is saying they paid too much for Crystal…they bought it for $170 million when revenues had
been declining
 The only procedural protections used by El Paso to ensure the interests of unit holders other than
Energy was approval by DeepTech’s Conflicts and Audit Committee
 Bracy, director of Deeptech and former employee of Energy
 Church, director of DeepTech

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 P argues that the process was “irreparably impaired” b/c Church and Bracy owed a fiduciary duty
to DeepTech who had conflicting interests
 In the partnership agreement it stated that the “Special Approval” of actions by the General
Partnership shall not be a breach of fiduciary duty
 Special approval came from the Conflicts and Audit Committee
 K precludes claims for breach of fiduciary duty
 Rule: principals of K preempt fiduciary principals where the parties to a limited partnership have
made their intentions plain
 Ct states the language in the provision is plain
 P argues that the language is ambiguous b/c it never defines precisely who serves on the
Conflicts and Audit Committee
 Directors owe duties to 2 entities w/potentially conflicting interests
 The very term “Committee” implies that the group will be comprised of directors of DeepTech

D. LIMITED LIABILITY COMPANY (LLC)

 Combination of the best parts of partnership law and the best parts of corporation law
 Flexibility = there are not a lot of default rules, you can contract your way around things.
 Limited Liability Companies as with Corporations insulate personal assets of owners.
 Continuity of life can be perpetual, similar to that of a Corporation.
 However, there are differences from Corporation:
 Corporation:
 Must obtain a “charter or “franchise”
 Very structured and formalized
 Three-tiered management structure
 Shareholders,
 Directors,
 Officers
 Procedural requirements for meetings and decisions, notice of meetings,
record dates, quorums, decisions based on formal votes, minutes of
meetings, stock registers
 LLC:
 Must file only “Articles of Organization”
 No formal requirements
 Decisions can be made informally, with very few filings
 LLC’s can be a company of one or more.
 All members are free to participate in management without fear of liability.
 Protection by statute, subject to piercing the veil.
 Exceptions:
 LLC’s are responsible for personally guaranteed debt
 Can be held responsible for financial loss caused by careless behavior
 Members can be liable for breach of duty to the LLC.
 They can lose their limited liability if they don’t act fairly and legally
(misrepresentation or fraud), don’t fund the LLC adequately, or keep the LLC
business and personal business separate.
 Based on a contractual model which enables the participants to enter into an agreement to set
forth their relationship as they see fit.
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  It is in favor of contractual freedom.
 Owners of LLC’s invest money or property in the LLC and in return receive a capital interest or
% in the company.
 This capital interest is represented by a certain amount of “membership units” much like
stock in a corporation or it is divided and represented by a percentage of ownership.
 Can be member-managed or manager-managed.
 If it is member-managed, all members have agency authority.
 Member managed- governed by a set of rules similar to that of a partnership
 If it is manager-managed, only managers have agency authority.
 Manager managed- governed by a set of rules more analogous to a corporation
 Other members play a largely passive role.
 HOWEVER, operating agreement may modify these.
 The LLC structure is not the structure to use if it needs to attract outside investors, since a
corporate structure with stock available for sale lends itself to this use.
 Taxed as a partnership unless members choose otherwise.
 Flow-through taxation is the default.
 Flow-through taxation means that the entity does not pay taxes on its income.
 Instead, the owners of the entity pay tax on their "distributive share" of the entity's
taxable income, even if no funds are distributed by the partnership to the owners.
 A corporation is a separate taxable enterprise, taxed independently from the shareholders
 Subchapter S corporations are an exception, and are taxed like a partnership.
Usually the flow-through enterprises are more advantageous, but you have to file
separate forms and there is a waiting period.
 If the corporation makes a profit, it has to pay taxes on the earnings. Then if
dividends are paid to shareholders, the individual shareholders would have to show
the dividend in their individual tax returns.
 Basically it’s a double-taxation.
1. FORMATION; OPERATING AGREEMENT

2. ARTICLES OF ORGANIZATION
 To form a LLC, you file “Articles of organization” with the Secretary of State’s office
 Name (§108): Shall contain either the words limited liability company or limited
company or the abbreviations LLC, LC, L.L.C. or L.C.
 The word limited may be abbreviated as Ltd. and the word company may be abbreviated as
Co.
 The name shall be such as to distinguish it upon the records in the office of the Secretary of
State from other names reserved with the Secretary of State.
 Must be distinguishable.
 Registered Agent (§113): Every limited liability company must continuously
maintain a resident agent and registered office. The resident agent for service of process may be
the domestic limited liability company itself, an individual resident of this state, or a domestic or
qualified foreign corporation, limited liability company or limited partnership.
Elf Atochem North America Inc. v. Jaffari

 Facts: In 1996, Elf Atochem contracted with Jaffari to form an LLC (Malek LLC)
incorporated in Delaware that would produce more environmentally-friendly maskants for the
aerospace and aviation industries. Elf produces solvent-based maskants which have been
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 classified as hazardous. Jaffari provided much-needed financial backing for Elf’s operation, while
Jaffari retained 70% of the profits from the newly formed LLC. The LLC agreement called for all
disputes to be settled through arbitration in San Francisco. Jaffari brought this action in 1998 in a
Delaware court against Elf for breach of contract, breach of fiduciary duty and tortuous
interference. Jaffari argued that since LLC was formed prior to the formation of the LLC
agreement, and because the LLC never signed the agreement then the agreement and its
arbitration provision are not effective over this dispute. Jaffari also argued that the claims were
derivative instead of direct, and that the Delaware Court of Chancery has special jurisdiction.
 Issue: Whether an LLC agreement not executed by the LLC itself is valid.
 Rule:
 It is irrelevant that the LLC itself did not assent to the agreement because
the members of the LLC, the Elf and Jaffari, consented to the agreement.
 This is true regardless of whether the claims are derivative or direct
because the parties agreed that all claims related to the agreement should be subject to the
agreement’s arbitration provisions.
 LLCs are useful because they offer flexibility not available in other entities.
If the parties are not able to effectively meet their objectives through principles of contract, then
LLCs will not retain their usefulness.
 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.
 Contract prevails and it must go to arbitration as described in contract.
 “Because the policy is to give maximum effect to the principal of freedom
of contract and the enforceability of LLC agreements, the parties can contract to avoid statutes.”
 Following Elf, Delaware amended the LLC statute- DC § 18-101(7)

3. OPERATING AGREEMENT
 Once the articles are filed, an “Operating Agreement” is usually created.
 The operating agreement usually includes:
 Members capital interest
 Rights and responsibilities of members
 Allocation of profits and losses
 Management of LLC
 Voting power of members and mangers
 Rules for holding meetings and taking votes
 Buy – sell provisions.
 These are confidential to the members of the agreement
E. THE LLC AS AN ENTITY APART FROM ITS MEMBERS

Abrahim & Sons Enterprises v. Equilon Enterprises

 Facts: Appellants, California gas station operators, leased stations from and had dealer
agreements with Shell or Texaco, both of which merged to form Appellee, Equilon. Shell and
Texaco had 100% of ownership interest in Equilon. Under California law, the franchisor (in this
case Shell and Texaco) shall not transfer its interest without first giving the franchisee (Abrahim)

19
 the opportunity to buy its interest in the property. Shell and Texaco transferred 100% of their
interests to Equilon, without providing Abrahim the opportunity to buy the stations.
 Issue: Whether Shell and Texaco’s contribution of assets is unlawful.
 Whether Equilon is another person.
 Rule: Yes. The transaction was a transfer to another person, Equilon; and therefore it was
unlawful to realize the transfer without first offering to sell the gas stations to Abrahim.
 LLCs are distinct legal entities, separate from their members.
 The acts of LLCs are deemed independent from its members.
 Once members contribute assets to an LLC, those assets become capital of the LLC
and the members lose any interest they had in the assets. Therefore, the contribution was a
transfer to Equilon.
 Diversity jurisdiction- Most courts hold an LLC to be a citizen of a state or state of which its
members are citizens
 ≈ Limited Partnership
 ≠ Corporation
 § 501(a) ULLCA- The property of the business of an LLC is owned by the LLC, not its
members.
Premier Van Schaack Realty v. Sieg

 Facts: Sieg entered into a listing agreement with Premier. The agreement contained a
brokerage fee (7%). Sieg entered into an LLC (MJTM) with DVJ. Sieg conveyed a property
valued at $1.3 million to the LLC for a 40% interest and 9% preferential return on future profits.
Operating agreement says no member is personally liable to any other members for return of any
part of capital contributions. MJTM borrows $1.43 million from bank secured by a lien on property.
MJTM pays Sieg $300k debt with loan from bank. Premier sues for 7% brokerage fee on $1.3
million.
 Issue: Whether a sale or exchange occurred between Sieg and MJTM.
 Rule: No. The transfer of property from Sieg to MJTM was not supported by consideration so
as to constitute a sale or exchange. Therefore, Sieg owes no commission.
 Fact-intensive inquiry- More than a mere showing that an owner transferred his property
to a separate legal entity.
 Where the owner retains essentially the same ownership interest in the property as he
had prior to the conveyance, with plans to develop the interest in the property by improving it with
the possibility of future gains or losses, and can prevent the record owner from encumbering the
property without his permission, such a transaction is not a sale or exchange.
 Because Sieg continued to have substantially the same ownership interest in the
property after the deed to MJTM was executed, there was no consideration and a sale or
exchange as contemplated in the agreement did not occur.
 Other Decisions:
 Gebhardt- Upon executing a deed for the transfer of property from the sole members to the
LLC, the members reaped the benefits of limited liability and estate planning benefits conferred by
law. Thus, having accepted the benefits, the members cannot deny that a conveyance took place.
 Hagan- A transfer of real estate from property owner to an LLC of which the transferor was
one of three members was a sale or exchange for the purpose of a brokerage agreement
previously executed by the transferor.
 The assumption by the LLC of by a first deed of trust and the agreement of the LLC to
place a second lien on the property to secure a note due to the transferor constituted
consideration.
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 Courts may pierce the veil to reach the assets of its members
F. AUTHORITY OF ITS MEMBERS
 Taghipour v. Jerez
 Facts: Taghipour and Jerez form an LLC to purchase land to develop. Operating
agreement says members must approve loans. The statute says: “Instruments and documents
providing for the acquisition, mortgage, or disposition of property of the LLC shall be valid and
binding if they are executed by one or more managers of a manager-managed LLC or one or
more members of a member-managed LLC.” Contrary to the operating agreement, and
unbeknownst to the other members, Jerez entered into a loan agreement on behalf of the LLC.
Jerez misappropriated and absconded the money from the loan, no payments were made, and the
bank foreclosed on the LLC’s property.
 Issue: Can an LLC be held liable for fraud of a member?
 Rule: Yes.
 Court held that the LLC was bound by the loan agreement
 “Instruments and documents providing for the acquisition, mortgage, or
disposition of property of the LLC shall be valid and binding if they are executed by one or more
managers of a manager-managed LLC or one or more members of a member-managed LLC.”
 Rule of interpretation- As this statute was the more specific provision it
applied instead of the more general provision.
 The statute trumps the contract.
 Jerez was designated as a manager in the articles of organization; he
acted on behalf of the LLC, and the LLC was consequently bound.
 Concurring opinion at appeals level- Suggests the strange result in the case is simply a result
of legislative oversight or lapse of some kind.
 ULLCA- Unless the articles of organization limit their authority, any member of a member-
managed company or a manager of a manager-managed company may sign and deliver any
instrument transferring or affecting the company’s interest in real property. The instrument is
conclusive in favor of a person who gives value without knowledge of the lack of authority of
person signing and delivering the instrument.
 If a limitation is included in the articles of organization, it is effective.
 Persons dealing with an LLC must review the articles of organization or bear the
risk of its limitations.
 Look at the statute, articles of organization, and the operating agreement.
G. FIDUCIARY DUTY OF ITS MEMBERS
 Based on tort law- R2d Torts
 Duty of Loyalty
 Underlying basis of good faith and fair dealing
 To adhere to the duties and obligations of good faith and fair dealing, you must disclose all
material and accurate information when there is a fiduciary relationship
 Self-Dealing
 Dealing on behalf of oneself or other entity while in the capacity of the partnership
 Being on both sides of the transaction
 Self-dealing here is a breach of the duty of loyalty
 Self-dealing is okay as long as it’s fair
 Here he was dealing w/himself and not disclosing it to the firm
 Remedy

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  Victim is entitled to his retirement distribution
 Any profits derived from the breach must be paid to the partnership
McConnell v. Hunt Sports Enterprises

 Facts: Appellants, Hunt Sports Enterprises et al., and Appellees, John McConnell et al.,
were part of an LLC that was bidding for a professional hockey franchise. The LLC provided a
non-compete type clause. The principal of one of Appellees, John McConnell, personally made a
bid for a franchise after the principal of one of the Appellants, Lamar Hunt, rejected numerous
lease agreements and stalled the application for the franchise.
 Issue: Whether the operating agreement of the CHL LLC can define the scope of the
fiduciary duties owed by the members to the LLC.
 Rule: Yes. The members of an LLC can define the scope of their fiduciary duty.
Therefore, Appellees did not violate their fiduciary duty owed to CHL when they made a bid for the
NHL franchise, because each member of CHL agreed that members could compete against the
LLC.
 Members of an LLC can agree to limit the scope of the fiduciary duty they
owe to the LLC.
 The court relied on general contract law to justify LLC members to define
their fiduciary duties.
 If parties agree to be held to a certain set of conditions, courts try not to
disturb the agreement unless there are statutory or strong public policy concerns.
 Court read the compete language very broadly to mean that any member
can form a group to compete with the existing group and upheld the contract
Katris v. Carroll

 Facts: Katris asserted a cause of action for collusion against Carroll. Katris, a manager
of the LLC, contended that Carroll colluded with a member of the manager-managed LLC,
Doherty, in the member's breach of his fiduciary duties to Katris and the LLC. In the articles of
organization, Katris indicated that management of the LLC was vested in its managers, Katris and
another, and not retained by its members. The operating agreement also enumerated the powers
of the managers and set forth the rights and obligations of the members. However, none of the
provisions setting forth the rights and obligations of the members provided the members with any
managerial authority.
 Issue: Whether Doherty owed Katris and the LLC a fiduciary duty.
 Rule: No. Doherty owed no fiduciary duties to Katris or the LLC pursuant to the Act.
Katris' collusion claim against Carroll fails as a matter of law.
 A member of a manager-managed LLC (Doherty) exercises no managerial
authority if the LLC's operating agreement precludes the member from doing so.
 Is this a bad decision?
 Facts suggest Doherty was exercising some de facto managerial
authority.
 In a manager-managed LLC, the members do not usually have a
fiduciary duty.
 If however, you assume duties of a manager, like Doherty, you
should also have fiduciary duties (General rules of Agency Law).
 ULLCA § 409(h)-
 Member owes no duties, solely if member.

22
 However, if an employee, perhaps fiduciary duty as an agent.

 ULLCA § 103- Non-waivable provisions in operating agreement.

 May not eliminate duty of loyalty, BUT: May specify activities that do not violate
duty
 May not reduce duty of care, May not eliminate duty of good faith
 DGCL § 1101- Duties may be explanded, restricted or eliminated in LLC Act.
 However, implied contractual minimum of good faith and fair dealing may not be
eliminated.
H. FIDUCIARY DUTY OF MANAGERS
 Managers in a manager-managed LLC owe fiduciary duties of care and loyalty
 Pinnacle Data Services- Some courts look to corporate law to define the duties of
managers
 Blackmore Partners- The court applied the Business Judgment Rule (BJR) to
actions of managers, unless they fail to act in good faith or have a conflict of interest
 There is a presumption that in making the business decision, the
managers acted on an informed basis, in good faith, and in the honest
belief that the action was in the best interests of the company.
 Judges aren’t businessmen and should not be second guessing a
business decision.
 The majority decides for a business.
 It is up to Π to rebut the presumption that that the Business Judgment
Rule applies.
 Some decisions appear on their face to be so irrational that the BJR does not
apply.
 However, in this case the court said that the managers owed an
explanation for their seemingly irrational actions.

 ULLCA § 409(h)-
 Manager- loyalty, accounting, refrain from self-dealing, non-competition, refrain from
gross negligence, good faith, fair-dealing, refrain from acts which are solely self-
interested
 ULLCA § 103- Non-waivable provisions in operating agreement.
 May not eliminate duty of loyalty, BUT:
 May specify activities that do not violate duty
 May not reduce duty of care
 May not eliminate duty of good faith
 Delaware § 1101- Duties may be explanded, restricted or eliminated in LLC Act.
 However, implied contractual minimum of good faith and fair dealing may not be
eliminated.
I. EXPULSION OF A MEMBER
 In an LLC, unless the operating agreement provides otherwise, there is no right to exit
 Under the Uniform Limited Liability Company Act (ULLCA § 601) a member can be
expelled if the operating agreement so provides, and under certain defined circumstances,
by unanimous consent of the members
J. MISCELLANEOUS ISSUES
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  Dissolution
 LLCs are legal entities
 The withdrawal or death of a member does not dissolve the LLC
 Unless the operating agreement otherwise provides, the dissociated member is
generally entitled to a buyout of his interest- ULLCA § 701
 Bankruptcy of a Member
 LLC statutes and operating agreements tyically provide that a person ceases to be a
member of the LLC if the member files bankruptcy- 6 DC § 18-304
 Ipso facto bankruptcy clause
 Claims of a Creditor of a Member
 Creditors of members may get a “charging order” that requires the LLC to remit any
distributions that would otherwise be made to the debtor to the creditor instead.
Because of this remedy, a creditor cannot obtain a seizure and force a sale of the
debtor’s interest in the LLC.
 Under certain circumstances, a creditor may foreclose on the member’s interest and
require a judicial sale.
 The person who purchases the interest is entitled to the member’s distributions, but
cannot participate in the management of the LLC or use the voting rights of the
member.
 Problem p. 133
 Manager-managed LLC. One member has a majority of power (C), one does not
(D). C nominates two managers (C + E), one manager appoints self (D). Managers
have extremely broad authority. Managers may also act with a majority of consent.
Managers plot to push out member with power (C). LLC decides to merge with a
Corp owned by a manager (D), leaving the member (C) with less control than
before- minority control. (C) did not learn of merger until after merger.
 Managers would use BJR.
 C would argue that D acted in bad faith, in breach of a fiduciary duty.

IV. THE PROCESS OF INCORPORATION

A. INTRODUCTION
 Model Business Corporation Act §203- A corporation’s existence begins once the
articles of incorporation are filed and accepted by the Secretary of State.
 Even if there are errors, it is good against the world.
 3 Types of Corporations under Common Law
 De jure- Articles are correct, it is good against all the world
 De Facto- Although articles were filed, something meaningful was erroneous
 General Rule- Participants have limited liability, but Secretary of State can
bring an action against them.
 Estoppel- Articles of incorporation were never filed, but the transaction was entered
into on a corporate basis, and the general partnership thought they had a
corporation and acted as a corporation would, and there was a good faith belief by
the person asserting estoppel
B. MECHANICS OF INCORPORATION
 Standard
 A corporation may have a single shareholder and a single director.
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  However, several states require 2 directors for 2 shareholders and 3 directors for 3
or more shareholders.
 Purpose Clause- Historically, corporations had to state a purpose, but now the MBCA
assumes that if the articles say nothing about the corporate purpose, then it is any lawful
purpose.
 Articles of Incorporation
 MCBA- Only require (MCBA § 2.02(a)):
 A corporate name,
 The number of shares they are authorized to issue,
 The address and registered agent of the corporation, and
 The name and address of each incorporator.
 Delaware General Corporate Law (DGCL § 102)- Requires a statement of 5
or 6 items instead of four:
 Must also state a purpose- It is sufficient to state the purpose is to
engage in a lawful activity
 Board of Directors (BoD)-
 Names and addresses of the persons who will serve as directors until the first
annual meeting of the shareholders
 BUT only if the powers of the incorporator(s) are to terminate upon the filing of the
certificate of incorporation
 Name
 OLD MCBA Provision- Cannot be the same as (or deceptively similar to) another
corporation incorporated in the same jurisdiction.
 Some states allow a company to use the same name with permission.
 Distinguishable
 NEW MCBA provides the name must be “distinguishable.”
 Many states have not adopted the newest MCBA- Retaining the
“deceptively similar test”
 DGCL § 102(1)- Name must be distinguishable
 Rights in name
 Someone may have TM rights in that name used in connection with services
and goods and may be able to bring an action against you for infringing TM
rights
 However, federal filing for trademark will protect you universally
 Do a search- USPTO
 Name cannot imply the corporation is incorporated for another purpose (banking,
insurance)
 Name must contain a word of corporateness (MCBA § 401)
 House rules in each state
 Name squatting is generally not allowed
 Birth of Corporation
 Corporation is effective when filed by Sec. of State
 May also use a delayed effective date
C. TAILORED ARTICLES OF INCORPORATION (PRIVATE ORDERING)
 Optional Charter Provisions
 MBCA §2.02 lists optional provisions that may be included

25
  Issue of whether to include alternative provisions in articles, which are public record,
or include them after incorporation in bylaws or shareholders’ agreements, which
aren’t public.
 Charter Provisions
 Initial Board of Directors
 Naming the initial board of directors eliminates the absolute necessity for an
organizational meeting
 Narrow Purpose Clause
 Regulatory schemes may require a corporation to list a purpose and to
confine its activities to that sphere
 Exculpatory Clauses
 Early statutes allowed exculpation of directors or liability caps for duty of care
violations (but didn’t eliminate the duty)
 MBCA now allows exculpation for directors unless the director received a
financial benefit that they weren’t entitled to, intentionally inflicted harm of the
corporation or shareholders, authorize illegal distributions, or intentionally
violate criminal law
 Special Governance Provisions
 Many states permit but don’t require cumulative voting for director elections,
so it must be provided for in the articles if they want substantial minority
shareholders to have a representative director at meetings
 Preemptive Rights Provisions
 Allows shareholders to maintain proportionate ownership and voting interests
if the corporation wants to offer shares to third parties.
 Doesn’t apply to shares issued for property, in merger, or pursuant to the
corporation’s original financing plan unless provided for in the articles.
 Newer statutes set up a presumption that preemptive rights do not exist.
 Close Corporation Election
 Indemnification Provisions
 Directors are not entitled to indemnification when making contracts the way
agents are under common law
 MBCA §8.52 makes indemnification mandatory (instead of permitted) when
the director has been wholly successful, on the merits or otherwise.
 Filing
 Few states still require a second filing with a local official, in addition to the Secretary
of State filing.
D. STATE OF INCORPORATION
 Large companies usually prefer Delaware
 Delaware- State with best statutes for their purpose
 However,
 Most states have modern incorporation statutes
 Smaller companies doing business in only one state should consider:
 Comp. must qualify as a foreign corporation in its “home state”
 Subject to two taxing authorities
 May be subject to suits in a different states
 US Fed. choice of law rule- State of incorporation law will govern conflicts
among shareholders.
26
  However, the court will uphold jurisdiction over officers and directors in the
state of incorporation.
 Also, corporations must maintain a registered agent and pay fees in the state of
incorporation.
 Thus, if you incorporate in Delaware but operate in Florida, you must pay fees to
register in Florida after incorporating in Delaware.
E. ETHICAL CONSIDERATIONS
 Rules of Professional conduct (RPC) provide that the attorney’s client is the organization
 An attorney should thus disclose past connections with participants in lawsuits with
the organization, and indicate that his intention is to represent the organization and
not individuals within it.
 The attorney must be prepared to resign if he favors another participant in a lawsuit
or an individual member of the organization over the organization itself.
 Problem 2 (p. 143)
 FB practices law with six partners. FB was to be tried malpractice, but settled. The
settlement exceeded the group’s malpractice insurance.
 It doesn’t matter what form of professional entity you form. The person who
commits the tort will likely be held liable.
 Historically, corporations cannot practice professions.
 Now you can. In Oklahoma, look at the professional entity statutes. If you
form a professional corporation to practice law, you cannot likely also use the
corporation to open a restaurant or for another unrelated activity.
F. TAXONOMY OF CORPORATIONS
 Closely Held Corporations v. Other Types of Corporations
 Closely held corporations are generally (but not necessarily) small; there is a
restriction on share transfer to keep shareholders close (among the members of a
family, among employees, etc.)
 Family Corporation v. Family-Owned Corporation
 In a Family Corporation, the interests of the owners (the family members) are co-
extensive with that of the corporation
 A Family-Owned corporation is still owned by a family but due to growth, the
corporation’s interests are larger than those of just the family.
 Small, Quasi Public, and Public Corporations
 Small Corporations – 10 or fewer shareholders
 Quasi-Public – 11-299 shareholders
 Public Corporations – 300 or more shareholders
 According to Securities Exchange Act of 1934, a public corporation is one
with over 500 equity shareholders and $10M+ in assets. – 12(g) classification
 How Shares are Traded
 OTC (Over the Counter) – traded on a dealer basis, at arm’s length
 Exchange Trading – agency traded instead of dealer traded
 Aggregate Value of the Corporation’s Shares
 Small Cap – market capitalization of less than $1B
 Mid Cap – market capitalization between $1B-$5B
 Large Cap – market capitalization over $5B

27
G. THE ORGANIZATIONAL MEETING
 MBCA § 2.05
 Discusses the organizational meeting
 Following the Articles of Incorporation, the corporation will receive a kit
 Minutes of a corporate meeting will be prepared in advance.
 DGCL § 108- An organizational meeting shall be held
 Incorporators or directors may sign an instrument that states the action taken
without a meeting
 MBCA § 2.05- provides the same
 This isn’t possible if the Articles do not name the directors- A board of directors must be
elected at the initial meeting
 At the organizational meeting:
 Incorporators resign
 Directors are elected
 Officers are appointed by directors
 Articles’ provisions will be explained by the attorney
 Directors will examine and adopt bylaws
 Subscriptions of shares should be viewed and accepted
 Directors must evaluate non-cash consideration exchanged for shares
 Corporation issues shares using certificates provided in kit
 Promoters or attorney should lay at feet of board all contracts
 Assignments of leases or other conveyances should be viewed and accepted
 Chair should issue bill of sale to attendees for personal property conveyed
 Instructions- New books should be opened at corporate office
 Instructions- Corporate names should be displayed
 Attorney exhibits a banking resolution for the board to adopt
 Tax matters are discussed
 Sub-chapter S election
 Adoption of a 1244 resolution- if stock is designated as 1244 stock, and the
business goes down, a deduction can be made on ordinary income (50k or
100k)
 Plan for further financing
 Attorney should advise that money cannot be skimmed from top, equipment cannot be
conveyed by members to corporation at mark-up, affairs must be separate from corporation
 No co-mingling – shareholders can’t comingle personal assets with the corporate
assets
 Piercing the corporate veil – holding shareholders personally liable can happen if the
shareholders comingle personal and corporate assets
 Sale and issuance of securities
 Securities laws frequently apply with corporations and have significant
consequences
H. DEFECTIVE INCORPORATION
 De facto vs. De jure
 De jure= good against all the world
 De facto= good against all the world but the state.
 Common law "de facto" doctrine

28
  At common law, if a person made a "colorable" attempt to incorporate (e.g., he
submitted articles to the Secretary of State, which were rejected), a "de facto"
corporation would be found to have been formed.
 This would be enough to shelter the would-be incorporator from the personal
liability that would otherwise result.
 This is the "de facto corporation" doctrine.
 This doctrine had three elements:
 The existence of a law under which a corporation could be
formed;
 A good faith attempt to come under the law;
 There is discussion as to whether something must actually be
filed with the Secretary of State’s office.
 Conduct of the business by the putative shareholders as if the
corporation existed
 Today, most states have abolished the de facto doctrine, and expressly impose
personal liability on anyone who purports to do business as a corporation while
knowing that incorporation has not occurred. MBCA § 2.04
 Corporation by estoppel
 The common law also applies the "corporation by estoppel" doctrine, whereby a
creditor who deals with the business as a corporation, and who agrees to look to the
"corporation’s" assets rather than the "shareholders’" assets will be estopped from
denying the corporation’s existence.
 The "corporation by estoppel" doctrine probably survives in some states, as a judge-
made doctrine.
 Cranson v. IBM- Creditor sues president, Cranson, of a corporation that had never
been formed, because the attorney had failed to file the articles of incorporation he
had prepared. Nonetheless, the creditor had invoiced and sold typewriters to IBM. It
was held estopped to later deny that a corporation existed.
 Where a person erroneously but in good faith believes a corporation
has been created.
Thompson & Green Machinery Co. v. Music City Lumber Co.

 Facts: The president of Music City Sawmill Co., Inc. (defendant) purchased a wheel
loader from the plaintiff, Thompson & Green Machinery Co., Inc. Unbeknownst to
both the plaintiff and defendant Sawmill was not a corporation at the time of the
transaction. Sawmill was not incorporated until one day after the sale of the wheel
loader.
 Issue: Is a corporate officer personally liable if he enters into a contract before the
date of incorporation?
 Rule: Yes. In Tennessee, the concept of de facto incorporation and incorporation by
estoppel have been abolished by statute.
 De facto corporation and corporation by estoppel don’t survive under
modern statutes.
 Before the issue of the certificate of incorporation, individuals and not
the corporation, are liable.
 Robertson v. Levy- Corporation by estoppel is also likely done away with.
 However, the Comment to MBCA § 2.04 does not foreclose the possibility of
corporation by estoppel.
29
  Timberline Equip. Co. v. Davenport- If an attempted incorporation is defective, only
persons who assume to act as a corporation will be personally liable
 Does not include those whose only connection with the group is as an investor
 Does include those who have made an investment and actively participate in the
policy and operational decision
 MBCA § 2.04- Joint and several liability for those who act on behalf of a corporation,
knowing there was no incorporation
 DGCL does not have any language to indicate whether de facto corporation or corporation
by estoppel is an available defense (may be available in Oklahoma).
 So, REFRAIN from doing business UNTIL you have FORMED A DE JURE
CORPORATION
 Nothing short of correctly filing the articles of incorporation creates limited liability

I. CORPORATE DEATH (INVOLUNTARY DISSOLUTION)

 A shareholder may petition the court for involuntary dissolution. Many state statutes authorize
this. Courts are often reluctant to do this, some states have provided alternative remedies, such
as court ordered buy-back at fair market value.
 This is only in extreme cases. Must show that the acts of the directors are illegal,
oppressive, or fraudulent.
 BUT Supreme Court has held that in cases of close corporations complaining shareholder
need only show not meeting reasonable expectations, express or implied among the
participants.
 Expectations can be as they exist at inception or as they develop during the course
of the shareholders relationship.
 Where a minority shareholder(s) can prove oppression, corporate waste, or any
other valid statutory grounds for involuntary dissolution the court may grant a
shareholder petition for dissolution.
 This action for involuntary dissolution under the statutes often serves as an
alternative in the close corporation in an action for breach of fiduciary duty when
what the shareholder wants is to get out (have a buyout).
Equipto Division Aurora Equipment Co. v. Yarmouth

 Facts: Certificate of incorporation was issued to J& R (Yarmouth), but the annual dues
weren’t paid and the Secretary of State dissolved the corporation. Yarmouth entered into contracts
for corporation in good faith, was sued personally.
 Issue: Can a corporation be dissolved if it doesn’t pay its annual dues? Does § 2.04
apply where a corporation was never formed or to corporations that lose their status as such?
 Rule: Yes, the state may dissolve a corporation. § 2.04 applies to both situations.
 Court applied agency principles – basically a negligence principle
 A person who purports to contract in the name of a principal that
exists but lacks capacity to contract may be liable on the contract, but only if he knows or
should know of the principal’s lack of capacity, and the other contracting party does not
 MBCA §2.04- More beneficial to the shareholders
 All persons purporting to act as or on behalf of the
corporation, knowing there was no incorporation under this title, are jointly and severally
liable for liabilities created while so acting except for any liability to any person who also
knew that there was no incorporation
30
 Note: § 2.04 is titled to be applicable to pre-incorporation transactions.
The dissent (which was edited out) felt that § 2.04 should not be applicable. Thus, if there is no
corporation, the person should be held personally liable.
J. PROMOTER’S LIABILITY ON PREINCORPORATION CONTRACTS
 Promoters knowingly enter into a contract on behalf of the corporation.
 Promoter= Take the steps necessary to get a corporation up and running
 Not the same as an incorporator, who signs the articles of incorporation and
may have other tasks
 Promoters may be incorporators, but do not have to be
 Promoter needs to get legal advice before they enter into a contract for a corporation that
will be incorporated in the future because they could be personally liable unless they make
a clear indication in the contract
 The corporation can adopt the contract once they come into existence
 They must have a novation – the creditor agrees to dismiss the promoter and look
only to the corporation for the debt. There is no benefit to them for doing this.
 For the promoter to not be liable, there must be strong and clear language in the
contract
 Promoters are often found to be liable (contrary to what the book says)
 Principle of Agency- If you contract on behalf of a non-existing party,
you are personally liable because someone is intended to be bound
(the promoter)
 Promoter must sign the contract with care- Promoter must:
 Clearly indicate the non-existence of the principal
 Must indicate his representative capacity (using words such as:
promoter, founder, etc.)
 If not, both the promoter and the corporation will be bound
 Colonial Baking- When the promoter failed to indicate he was acting in a
representative capacity, both he and the corporation were bound.
 UCC § 3-403(2)- A person is held personally liable if he does not indicate that he
signed in a representative capacity
 Goodman- A promoter is bound by an agreement to arbitrate disputes because he
was not expressly or impliedly released
 Quaker Hill- Court looks to the intent of the parties to hold promoters not liable.
 To protect the promoter, an attorney should advise the promoter:
 To indicate the non-existence of the principle
 Sign in a representative capacity
 Provide that when it comes into existence the corporation will be bound
 Corp. cannot ratify it (principles of agency), but it can ADOPT it
 Mere adoption does not relieve the promoter, the relief from obligations
must be express
 Affirmatively provide that the promoter no longer will be held responsible
K. LIABILITY ON PREINCORPORATION CONTRACTS- THE CORPORATION’S VIEWPOINT
 A corporation may become liable if they accept performance by the other party under a
contract by the corporation’s promoter

31
 A corporation may become liable through acquiescence, if the other party proves that the
corporation had knowledge of the contract and allowed time to pass, even if they accepted
no benefits from it.
 McArthur- Used a finding of acquiesence to hold a newspaper corporation bound by an
employment contract its promoter had negotiated on its behalf
L. ULTRA VIRES

1. INTRODUCTION
 Ultra vires describes actions which are, or are alleged to be, beyond the powers or
purposes of the corporation
 Corporate purpose- the end (goals) of the corporation, in articles of
incorporation
 Now- tends to be any lawful purpose
 Corporate powers- Manners and methods of pursuing the purposes, do not
have to appear in articles of incorporation or certificate of incorporation
 MBCA § 3.02- Grants corporations all the powers a natural person has
(lists powers)
 DGCL § 122- Delaware equivalent
 Decline of the ultra vires doctrine
2. REASONS FOR THE DECLINE OF THE DOCTRINE
 Judicial Hostility- Corporations attempted to use narrow wording in purpose clauses
as an excuse for non-performance when it was convenient
 Ashbury Ry. Carriage & Iron Co.- allowed non-performance of a contract
after finding it to be ultra vires. This result led courts to abandon this doctrine,
except in executory contracts where the corporation had been one of the
parties.
 Broad Purpose Clauses- Corporations may be formed for any lawful purpose. Thus,
the law assumes the corpoartion’s purpose is broad.
 Ease of Amendment- Corporations without a broad purpose clause may easily
amend their articles to broaden purpose clauses.
 Grants of Implied Powers- Judicial and legislative grants of implied powers
legitimated activitites even though the corporation’s purpose clause did not
enumerate them specifically
 MBCA § 3.02- Every corporation has the same powers as an individual to do
all things necessary or convenient to carry out its business and affairs
 DGCL § 111- Every corporation, its officers, directors, and stockholders shall
possess and may exercise all of the powers and privileges granted… together
with any powers incidental thereto, so far as the powers and privileges are
necessary or convenient to the conduct, promotion or attainment of the
business or purposes set forth in its certificate of incorporation.
 Statutes- Legislatures in some states forbid the use of the ultra vires defense
3. ULTRA VIRES STATUTES
 MBCA §3.04
 (a) Except as provided in subsection (b), the validity of corporate action may
not be challenged on the ground that the corporation lacks or lacked the
power to act.
32
  (b)(1) a shareholder can file proceedings against a corporation seeking to
enjoin the act (a corporation cannot use ultra vires to get out of a transaction)
 The drafters never intended for a shareholder to act on behalf of the
corporation to use the ultra vires doctrine, this defense should not be
allowed by a court, as it is not consistent with the spirit of § 3.04
 (c) A shareholder isn’t automatically entitled to this. The court may enjoin if it’s
equitable and if all affected persons are party to the proceeding. The
contractors can still bring suit against the other parties for breach of contract
and misrepresentation and get anticipated profits
 More likely to see (b)(2): proceeding by the corporation which may be direct
(corporation brought it) or derivative (brought on behalf of the corporation by a
shareholder) against the shareholders who performed the ultra vires act – this
is a proceeding for damages and perhaps for a declaratory judgment
 Note that a creditor can’t enact the statute because the purpose is to promote
commercial certainty, not to get out of a contract
 DGCL § 124- in substance the same as MBCA § 3.04
 Total Access, Inc. v. Caddo Electric Cooperative
 Facts: Total, an Internet service provider and competitor of Caddo, sued
Caddo, alleging Caddo was unable to operate an Internet service provider
because it was an ultra vires action.
 Issue: Can a competitor who is not a shareholder or the corporation bring suit
on the grounds of ultra vires acts?
 Rule: No. Total lacks standing.
 Only those mentioned in the statute may bring suit on the
grounds of lack of capacity of a corporation to act.
 Remaining Vitality-
 Municipalities- Units and subdivisions of govt. are essentially corporations.
 Continued use of the ultra vires doctrine
 City of Frederick
 HG Brown Limited Partnership
 Jeffrey Lake Development Co.
 Gifts to Charity
 Corporations may make gifts to charity
 MBCA § 3.03(13)
 DGCL § 122(9)
 Courts look at whether the gifts are reasonable in amount related to
the corporation’s profitability, and the corporation’s business
 To challenge a gift to charity, you must allege a breach of fiduciary
duty against corporate officers
 Guarantee the Debts of Another Person
 Directly Beneficial Standard- to be enforceable, the guaranty must be
directly beneficial to the corporation granting the guaranty or providing
the collateral
 Unanimous Shareholder Approval Standard-
 Cf. Real Estate Capital Corp.- The voluntary transfer of
property by a corporation to secure the individual indebtedness
of one of its officers is binding upon the corporation only if the
stockholders assent thereto
33
  Breach of Fiduciary Duty vs. Ultra Vires- Courts tend to use the ultra
vires doctrine when a corporation guarantees or secures the debts of
another instead of the breach of fiduciary duty
 Upstream Guarantees- Parent corporation may offer to have subsidiary
corporation guarantee repayment of a loan for the parent corporation
 If minority shareholders exist, they may be prejudiced- They are
entitled to have the subsidiary use benefits for the subsidiary
and not the parent
 Minority can attack the minority BoD for breach of fiduciary duty,
or sue the parent for breach of fiduciary duty
 Cross-stream and Downstream Guarantees
 Cross-stream guaranty= When a subsidiary corporation
guarantees a loan to another subsidiary corporation
 Subsidiaries have a common owner
 Problem (p. 161)
 B and P want to form a corporation to produce music. P has concerns about
B. What can P do to restrict B from opening a nightclub?
 Use a restricting clause in the contract

V. THE REGULATION OF SECURITIES OFFERINGS

A. WHAT IS A SECURITY?
 Security=
 Defined in SA § 2(a)(1) and SEA § 3(a)(10)- "Security" is defined very broadly. It
includes not only ordinary "stocks," but "bonds," "investment contracts," and many
other devices.
 Federal and State Laws
 Federal- These two states have formed the springboard for extensive federal
regulation of the internal affairs of publicly held corporations
 Securities Act of 1933 (SA),
 Securities Exchange Act of 1934
 States
 Different in every state
 Often based on Uniform Securities Act
 Failure to recognize a security is present is disastrous!!! (SA § 12- Money back
guarantee)
Wartzman v. Hightower Productions, Ltd.

 Facts: The Appellee, Hightower, was formed for the purpose of breaking the
Guinness World Record for flagpole sitting. The Appellee hired the Appellant, Paul Wartzman, as
a lawyer to incorporate the venture. The Appellee informed the Appellant that it needed to sell
stock to raise the funds necessary to finance the project. After the Appellee began selling the
stock, the Appellant informed the Appellee that the corporation was “structured wrong” and was
not properly authorized to sell stock. The Appellee also advised the Appellant to retain a securities
attorney to correct the problem, which would cost approximately ten to fifteen thousand dollars.
The Appellee’s shareholders elected to abandon the project. The Appellee then filed suit on
breach of contract and negligence grounds seeking damages for expenses incurred in reliance of

34
 the contract, including the promoters’ initial investments, shareholders’ investments, outstanding
liabilities, liability to talent consultants and accrued salaries to employees.
 Discussion: This case is in the casebook simply to scare you
 Lawyer was held liable for damages ($170k in 1983) due to
unregistered securities, under SA § 12
 Normal malpractice insurance won’t cover this
 This requires special securities coverage
1. TYPES OF SECURITIES
a) Stock
 Landreth Timber- Common stock having the attributes normally associated
with this instrument is a security
 Rejects “Sale of Business Doctrine” – incidental transfer of stock to
manifest the sale of a closely-held business is not a security with
respect to those who are entrepreneurs.
 Characteristics of Common Stock
 The right to receive dividends contingent upon an
apportionment of profits
 Negotiability
 The ability to be pledged or hypothecated
 The conferring of voting rights in proportion to the number of
shares owned
 The capacity to appreciate in value
b) Notes
 Reves- The Court rejected Landreth Timber in the note context.
 Congress did not intend to regulate notes under securities law- Not
necessarily securities
 Family Resemblance Test-
 Motivations of the reasonable buyer and seller to engage in the
transaction
 Plan of distribution
 Reasonable expectations of the investing public
 Presence of a risk-reducing factor.
 One-on-one transactions where a note is executed are unlikely to be
securities
c) Investment Contracts
SEC v. W.J. Howey Co.

 Facts: Howey owned large tracts of citrus groves in Florida. Howey kept
half of the groves for its own use, and sold real estate contracts for the other half to finance its
future developments. Howey would sell the land for a uniform price per acre (or per fraction of an
acre for smaller parcels), and convey to the purchaser a warranty deed upon payment in full of the
purchase price. The purchaser of the land could then lease it back to the service company Howey-
in-the-Hills via a service contract, who would tend to the land, and harvest, pool, and market the
produce. The service contract gave Howey-in-the-Hills “full and complete” possession of the land
specified in the contract, leaving no right of entry nor any right to the produce harvested.
Purchasers of the land had the option of making other service arrangements, but W. J. Howey, in
35
 its advertising materials, stressed the superiority of Howey-in-the-Hills’ service. Howey marketed
the land, promising significant profits in the sales pitch it provided to those parties who expressed
interest in the groves. Most of the purchasers of the land were not Florida residents, nor were they
farmers. Rather they were business and professional people who were inexperienced in
agriculture and lacked the skill or equipment to tend to the land by themselves. Howey had not
filed any registration statement with the Securities and Exchange Commission. The SEC filed suit
to obtain an injunction forbidding the defendants from using the mails and instrumentalities of
interstate commerce in the offer and sale of unregistered and nonexempt securities in violation of
5(a) of the Securities Act of 1933.
 Issue: Whether the offer of a land sales and service contract was an
“investment contract” within the meaning of the Securities Act of 1933.
 Rule: In this case, YES.
 “Investment contract” has been construed to mean a contract or
scheme for the placing of capital in a way intended to secure income from its employment.
 THE HOWEY ANALYSIS TEST is whether the scheme involves an
investment of money into a common enterprise with profits to come solely from the efforts of
others.
1. Has an investment been made? - usually money; means a capital appreciation
2. Common enterprise? - all the investors have a joint interest in mutual success (horizontal
commonality); common enterprise between promoter and investor is vertical commonality, which
may not be sufficient in some cases
3. Expectation for profit? - generally refers to dividends or participation in earnings (even fixed
payments are allowed, as long as it is risk-taking)
4. Do investors participate or only efforts of others? - the expectation of profits must be derived
from the efforts of others (although in this case they said “solely from the efforts of others”); lower
courts have read this to mean essentially from the efforts of other (meaning that the other is
performing essential managerial efforts); currently courts read this as “essentially from the efforts
of others” in an economic reality
 Immaterial whether the enterprise was speculative or non-
speculative or whether there is a sale of property with or without intrinsic value
B. THE EXEMPTION-REGISTRATION QUERY
 NO SALE OF A SECURITY GENERALLY CAN TAKE PLACE UNLESS A
REGISTRATION STATEMENT IS IN EFFECT (SA § 5)
 (SA § 5) makes it unlawful (subject to exemptions) to sell any security by the use of
the mails or other facilities of interstate commerce, unless a registration statement is
in effect for that security. This "registration statement" must contain a large amount
of information about the security being offered, and about the company that is
offering it (the "issuer"). Additionally, § 5 prohibits the sale of any security unless
there is delivered to the buyer, before or at the same time as the security, a
"prospectus" which contains the most important parts of the registration statement.
 The entire scheme for regulating public offerings works by compelling
extensive disclosure. The SEC does not review the substantive merits of the
offering, and cannot bar an offering merely because it is too risky, overpriced,
or valueless.
 Two general types of exceptions:
 Transactional Exemptions-
 Securities Exempt from Registration- Specific securities or categories of
securities which are never required to be registered under § 5
36
  Burden of proving the exemption is on the party seeking to assert the exemption; if there is
a registration violation, all investors are entitled to get their money back (strict liability).
 You cannot register some securities issued under one rule and other securities
under another
 Antifraud provisions apply both federal and state, most frequent provisions are §17(a) of
the Securities Act, §10(b) of the Securities Exchange Act, and Rule 10b-5 promulgated by
the SEC pursuant to its § 10(b) rulemaking authority.
 State “blue sky” laws also frequently apply and present additional dilemmas for the
corporate practitioner and his or her client
 The securities regulations of each state where any offer or sale is made also must
be satisfied
 Coordination of federal and state exemption scheme
 (SA § 11)- Imposes a due diligence requirement
 Creates civil liability for false registration statements- If there is a material
misrepresentation or nondisclosure in the registration statement, parties subject to §
11 liability can avoid such liability only by showing an exercise of due diligence
 Attorneys, as long as they are not experts, are not subject to § 11 liability
 Costs of having a registered offering under the Securities Act frequently will be substantial
 By going public, other provisions of the Securities Exchange Act, such as record
keeping and internal accounting control provisions, also will become applicable
 Until recently the Exchange Act required enterprises with 500 or more equity owners
and $10 Million in total assets to register with the SEC as a public reporting
company even if never had a registered offering. In 2012, Congress passed the
Jumpstart Our Business Startups Act (JOBS ACT), now enterprises are not required
to register unless its equity securities are held by 2000 people or 500 persons who
are not accredited investors. Employees who own securities issued to them as part
of a compensation plan are not counted.
 The Sarbanes-Oxley of 2002 and the Dodd-Frank Act of 2010 is also applicable,
meaning the enterprise, by having a registered offering, will be faced with public
scrutiny, high accounting, high legal fees, persistent threat of litigation due to
consequences of public disclosure
 In most situations, counsel will seek the viability of a transactional exemption before
advising that a registered offering go forward
C. EXEMPTIONS FROM REGISTRATION- THEY ARE NOT EXCLUSIVE
504
Exemption (not available to public 505 506
companies)
Securities act § 3(b) Securities act §
Statutory Securities act § 3(b) small
small offering 4(2) non-public
authority offering exemption
exemption offering exemption
1,000,000 5,000,000
Dollar limit Unlimited
(12 months) (12 months)
35, not counting
Number of 35, not counting
Unlimited accredited
purchasers accredited investors
investors
Limit on
number of None None None
offerees
37
Purchaser
Sophisticated
qualificatio None None
investors only
n
No general
Manner of Limitations on manner of No general solicitation
solicitation or
offering offering not applicable or general advertising
general advertising
Limitations on resale not
Resale Restricted Restricted
applicable
To investors who are To investors who
Disclosure None required
not accredited are not accredited
Form D must be
Notice of Form D must be filed with Form D must be filed
filed with the SEC
sale the SEC (rule 503) with the SEC (rule 503)
(rule 503)

1. STATUTORY PRIVATE OFFERING EXEMPTION (§4(2))

 Exempts transactions by an issuer not involving a public offering from registration
requirements.
 Congress’s intent to exempt those transactions from registration “where
there is no practical need for such application… or where the public benefits are too remote.”
 Courts have looked to a number of factors in determining the availability of
the §4(2) private offering exception, starting with SEC v. Ralston.
SEC v. Ralston Purina Co.

 Facts: Respondent (Ralston) has facilities scattered throughout the nation

staffed by 7,000 employees. The company has a policy of encouraging stock ownership among its
employees. Selling nearly $2,000,000 of stock to them without registration. The company offers
stock to “key employees.” This characterization is not based on an organization chart. It includes
an individual eligible for promotion, one who influences others, whom the employees look to in a
special way, or who is sympathetic to management among other factors. The Securities and
Exchange Commission brought this complaint seeking to enjoin Respondent’s unregistered
offerings.
 PH: The District Court held the exemption applicable and dismissed the suit. The
Court of Appeals affirmed.
 Issue: Whether Respondent’s offerings of treasury stock to its “key employees”
are exempt as transactions by an issuer not involving any public offering.
 Holding: No.
 Rule: Whether a transaction by an issuer involves a public offering
depends on the need of the offeree for the protections afforded by registration.
 Rational:
 An offer doesn’t need to be open to the world to be public
 The remedial purposes of federal securities legislation impose the burden
of proof on an issuer to prove its transaction is exempt.
 The question of exemption turns on the knowledge of the offeree, not the
motivations of the issuer.
 Must look to whether the offeree needs the protections afforded by
registration
 Here, the employees were not shown to have access to the kind of
information which registration would disclose.

38
 The opportunities for pressure and imposition make it advisable
that the transaction not be entitled to exemption.
 Issuer cannot engage in general solicitation or advertising
 Results: Reversed
 Notes:
 Principles regarding the construction of § 4(2)
1. The exemption turns on whether all offers (rather than actual purchases) are
made in accordance with the emption
 A single noncomplying offer may invalidate the entire offering
 5th Cir. held the defendant must establish that each and every offeree
either had the same information that would have been available in the registration statement or
had access to the same information. Swenson v. Engelstad
2. There are certain limits in certain circumstances to the number of offers that can
be made un § 4(2)
3. The issuer cannot engage in general solicitation or advertising
 What constitutes general solicitation is unclear
4. An issuer should take certain precautions against resales, such as obtaining
written commitments by purchasers that they are acquiring for investment purposes, placing
appropriate legends on the certificates, and issuing stop transfer instructions
5. All offeree must be financially sophisticated or be advised by someone who has
the requisite acumen.(called an offeree representative). ACME Propane v. Tenexco
 Wealth ≠ sophistication
6. Sophistication is not a substitute for the kind of information that a registration
statement would disclose. Doran v. Petroleum Management Corp.
 All offerees must be provided with the type of information that would be
contained in a registration statement or have access to such information
7. State regulation also applies and states have authority to prosecute or to provide
redress for fraud.
2. RULE 506 OF REGULATION D- EXEMPT FROM STATE REGISTRATION
 A “safe harbor” to the §4(2) exemption- an alternative method to perfect the
private offering exemption
 Available to any issuer, no limit to the price of security offered or the number of
offerees, but there can be no advertising or solicitation
 Regulations for non-accredited purchasers
 Limited to 35
 If any purchasers are not accredited, then specific disclosers must be
made to all nonaccredited purchasers (NAP).
 No requirement under 506 for issuer to determine if the purchaser can
bear the economic risk of investment, however, a suitability
determinations must be made for all nonaccredited purchasers (NAP). The
issuer prior to the sale must “reasonably believe” that each NAP alone or
with his offeree representative, have knowledge and experience in
financial and business matters to be capable of evaluating the merits and
risks of the prospective investment.
 Issuer must take actions to guard resale in order to ensure “distribution” does not
occur.

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  Issuer is to provide written disclosure on limitations on resale with respect
to restricted securities
 Accredited investors irrebuttably are deemed to have access to registration type
information and to possess an investment sophistication
 Accredited investor (Rule 501(a) (pg. 769)= There are eight that can be
broken into two groups
 Institutional investors
 Fat cat investors =
 Net worth at time of purchase exceeds $1 million; OR
 Those whose individual income exceeds $200k in two most
recent years, and reasonably anticipate such an income for the
current year (or $300k joint income with one’s spouse)
 Resulted from the changes made under Dodd-Frank (1992),
excluding the value of the home
 Expands the § 4(2) private offering exemption in two ways
 Rule 506 (pg. 781) focuses on the purchaser qualification
 Institutions and wealthy individuals irrebuttably are deemed under Regulation
D to be sophisticated and to have access to the type of information that a
registration statement would provide
 State Registration
 Exempt, but the state can ask you to file several forms, collect those fees.
They also retain authority to enforce fraud under those offerings. However,
once an issuer shows that it has met the requirements for the exemption
under 506, the state no longer have any role. (“Substantial Compliance
Defense”).
3. LIMITED OFFERING EXEMPTIONS
 § 4(5) Exemption - Exempts sales to one or more accredited investors if the total
offering price does not exceed the amount permitted under the Act (currently $5M-
provided by 3(b))
 No general advertising, public solicitation
 Form D notice
 § 4(6) Exemption – The JOBS act created new funding source called “crowdfunding”
for startups.
(6) Transactions involving the offer or sale of securities by an issuer (including all
entities controlled by or under common control with the issuer), provided that—
(A) the aggregate amount sold to all investors by the issuer, including any
amount sold in reliance on the exemption provided under this paragraph during
the 12- month period preceding the date of such transaction, is not more than
$1,000,000;
(B) the aggregate amount sold to any investor by an issuer, including any amount
sold in reliance on the exemption provided under this paragraph during the 12-
month period preceding the date of such transaction, does not exceed—
(i) the greater of $2,000 or 5 percent of the annual income or net worth of
such investor, as applicable, if either the annual income or the net worth of
the investor is less than $100,000; and
(ii) 10 percent of the annual income or net worth of such investor, as
applicable, not to exceed a maximum aggregate amount sold of $100,000,
40
 if either the annual income or net worth of the investor is equal to or more
than $100,000;
(C) the transaction is conducted through a broker or funding portal that complies
with the requirements of section 4A(a); and
(D) the issuer complies with the requirements of section 4A(b).

 § 3(b) Exemptions- Exempt for small offerings where the aggregate amount doesn’t
exceed $5M
 Most significant rules are Regulation A and Rule 504
 Rules 504 (pg. 788)
 Not available for investment companies and reporting entities under
the exchange act
 Issuer need not determine whether purchaser or his rep is
sophisticated
 Rule 504: Rule 504 allows an issuer to sell up to a total of $1 million of
securities. (All sales in any 12-month period are added together.)
 Unlimited number- There is no limit on the number of (unaccredited)
investors in a purchase.
 Disclosure- No particular disclosure is required.
 Issuer may conduct a mini-public offering where general solicitation is
permitted and purchasers acquire freely transferable securities, but
one of two conditions must be met:
 Transactions must be registered under a state law requiring
public filing and delivery of disclosure documents before sale;
OR
 The securities are issued under a state law exemption that
permits general solicitation and general advertising so long as
sales are made on to accredited investors
 If neither condition is met
 Advertising- Generally, the offering may not be publicly advertised or
accomplished by widespread solicitation.

 Rule 503 imposes requirement to file form D (pg. 777)

 May be soon amended to provide additional restrictions (fraud)
 Rule 505 (pg. 779)
 Under Rule 505, the issuer can sell up to $5 million of securities
in any 12-month period.
 Number- The number of investors is limited to 35 non-
accredited and any number of accredited investors (like Rule
506).
 Disclosure: The same disclosure to all investors as would be
required under 506 is required under 505, if there is even a
single non-accredited investor.
 Disclosure requirements depend on a large number of
variables about the company
 If you give accredited investors some info, must
 Tell unaccredited about it AND
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  Disclose upon request
 Type of investor- But 505 (in contrast to 506) imposes no
requirements concerning the type of investor: the investor need
not be either accredited or sophisticated.
 Regulation A registration (actually an exemption)
 Regulation A permits generalized interstate public offerings up to $5 million
during a 12 month period
 No limit on number of offerees or purchasers
 Authorizes the use of broker-dealers to advertise and distribute the securities
 Purchasers are authorized to resell without being subject to restrictions set by
rules 147 505-506
 Contains a “substantial compliance” standard
 Offerings resemble a “mini-public” offering and a “offering statement is
required by SEC.
 There is no §11 liability and no requirement to file with SEC periodical reports
under the Exchange Act
 Its main use is for offerings made under employee stock option or stock
purchase plans.
4. INTRASTATE OFFERINGS
 Section 3(a)(11) exempts securities sold only to persons who live within a single
state or territory where the issuer is a resident doing business in that state
 Rationale- The probability that investors in local enterprise will have adequate
familiarity with such enterprises and an acknowledgment that local issuers will
be relatively small and thus less able to bear the burden of federal registration
 Seeks securities to be issued and rest with local parties
 Issues
 What is resident
 Does doing business count
 How much business
 Resolve issues with Safe Harbor Rule 147- (p. 750)
 Purpose is local financing to a local business by local investors
 Meeting rule 147 means that you meet §3(a)(11)
 147 is sufficient for §3(a)(11) but not necessary
 Allowed because offerees have certain other protections
 State regulation
 Close proximity to serve
 Requirements
 Issuer must be state resident (Rule 147(c)(1))- May not be applicable
in DC
 Issuer must be doing business within state (147(c)(2))
 80% derived revenue must come from state
 80% total assets must be located in the state
 80% use of proceeds of the offering in the state
 home office must be in the state
 The offerees must be state resident (147(d))- This provision helps to
preclude fraud
 Principal office in the state- this excludes mailing addresses
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  Can't form a local organization to only purchase the stock
 Must be a limitation on re-sales (147(e))
 For 9 month period
 To state residents only
 Precautions
 Take precautions against interstate offers or sales (147(f))
D. OVERVIEW OF THE REGISTRATION PROCESS
 Securities Act of 1933
 Provides investors with adequate and accurate information concerning securities
offered for sale
 Prohibits fraudulent practices in the offer or sale of securities
 Main purpose of registration is to provide adequate and accurate material information
concerning the issuer and the securities the issuer proposes to offer
 A number of states may apply merit regulation
 The pertinent state securities administrator can prevent an offering from going
forward because it is not fair, just and equitable
 Adequate disclosure is not the only criterion, the substantive fairness of the offering
may also be scrutinized
 Neither the SEC nor the states verify the truthfulness of the disclosures made in the
registration statement
E. GOING PUBLIC- PROS AND CONS

1. ADVANTAGES OF INITIAL PUBLIC OFFERING (IPO)

a. Funds may be used for capital formation and for existing debts
b. Insiders may sell a substantial portion of stock and become millionaires
c. Enables the company to have access to capital on more favorable terms
d. The enterprise will be in a better position to hire and retain quality personnel
e. Better known company, and improved profits
2. DISADVANTAGES
a. High costs
b. Management may discount long-term strategies to put emphasis on
company’s stock price
c. Management may lose control
d. Enterprise becomes a reporting company
e. Company must now file periodic and annual reports; comply with the Foreign
Corrupt Practices Act; be subject to federal proxy provisions, as well as a
number of other requirements
f. Subject to Sarbanes-Oxley Act
i. CEO and CFO certification of the company’s periodic reports with SEC
ii. Mandates implementation of sufficient internal controls
iii. Delineates the composition and functions of audit committees
iv. Bars company loans to directors and executive officers
v. Bars and auditor from performing certain nonaudit services for a
corporate audit client
g. Subject to Dodd-Frank Act
i. Hold advisory shareholder votes on executive compensation

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 ii. Implement pay verses performance disclosure
iii. Establish a compensation committee comprised entirely of independent
directors
h. The expenses of complying with the Exchange Act and Sarbanes-Oxley Act
requirements will be substantial
i. Insiders lose privacy as many things must be disclosed
j. Greater risk of shareholder litigation
k. Insiders are subject to short-swing six-month trading provisions of § 16 of
Exchange Act, resulting in a loss of liquidity and potential liability
F. A BRIEF LOOK AT THE PROCESS OF A PUBLIC OFFERING
 Distribution Chain: Issuer Underwriters Participating Dealers Investors or Purchasers
 Underwriters agree to purchase securities from the issuer with the intent to resell them to
participating dealers/investors
 Types of underwriting agreements:
 “Firm Commitment Basis”- underwriters agree to purchase the securities from
an issuer with the intent to resell them to participating dealers and/or
investors
 “Best Efforts Basis”- underwriters act as agents for the issuer, locating buyers
using “best efforts”; frequently made on an all or nothing basis
 Obligations of underwriters are subject to various conditions called “outs.”
G. STATE “BLUE SKY” LAW
 Under state laws, ever security offered to be sold must be registered or exempt from
registration
 In many states, the offering must be fair, just and equitable
 Exception: if the securities are going to be offered on the NYSE, AMSE, or NASDAQ the
offerings are exempt from state registration requirements.
 Merit regulation allows them to analyze the securities and terms of the offering to determine
whether the securities were too speculative for public sale
H. THE REGISTERED OFFERING – FRAMEWORK OF § 11
 Investors under certain circumstances may recover their losses if they purchase securities
pursuant to a registration statement which contains a material misrepresentation or nondisclosure
Escott v. BarChris Construction Corp.

 Facts: BarChris built bowling alleys during the pinnacle of bowling popularity, the fifties
and sixties. BarChris had different arrangements with customers when building an alley. They
would either be paid to simply build an alley for customer, or they would sell the interior and lease
the exterior of the building. They also offered financing options that were risky for BarChris.
BarChris instituted a public offering to raise money since their financing plans left them short of
actual cash. BarChris, and competing companies overpopulated the country with bowling alleys,
and many alleys closed. Many customers of BarChris were defaulting on the financing, and
BarChris sold more debentures to keep afloat. The registration statements filed with the public
offerings listed extensive assets liabilities that were later found to be inaccurate. BarChris
eventually declared bankruptcy. Plaintiffs accused Defendants of misstating or omitting facts in the
registration statements.
 Issue: Whether any misstatements or omissions were made by Defendant officers in
the registration statement that were material under the Securities Exchange Act.
44
 Holding: The court reviewed many of the statements contained in the registration
statement filed by Defendants.
 Some of the statements were within normal accounting standards, and some of
the figures were only slightly different from what the court calculated.
 However, other statements were misleading or omitted figures altogether, and
the difference was significant enough to be considered material under the Act.
 A plaintiff does not have a cause of action by just providing evidence of a
misstatement in a registration statement.
 The misstatements need to be material enough to cause an investor to rely
on the statement when they otherwise would not have.
 Defendant corporate officers will be held liable for false or misleading
statements when they materially affect the purpose of the registration statement.
I. THE SARBANES - OXLEY ACT
 Federalizes state corporation law in several ways
 Provisions:
1. CEO AND CFO CERTIFICATIONS
 Requires that CEO and CFOs certify that the company’s financial disclosures are a fair
and accurate representation of the company’s financial position
 There are significant penalties for knowingly false certification; and civil liabilities for
conduct that wasn’t knowing
2. AUDIT COMMITTEE
 The audit committee must have an auditing committee comprised of independent
directors who only get director fees from serving on the board
 Oversees the accounting and financial reporting processes of the company and the
audits of the company’s financial statements
 Establishes procedures for dealing with internal corporate whistle-blowing complaints
concerning accounting or auditing matters
3. FORFEITURE OF BONUSES & PROFITS
 If the financial statements are misstated, the executive officers who derive the bonuses
must give them back to the company
4. OFFICER AND DIRECTOR BANS
 Previously, a court had authority to bar a securities law violator from serving as a
director or officer of a publicly-held enterprise who was found liable for securities fraud and held to
be substantially unfit
 Sarbanes Oxley lowers the standard to “unfitness”
5. PROHIBITION OF LOANS TO DIRECTORS & O FFICERS
 Prohibits loans by a publicly-held company to its executive officers and directors, unless
the business does that in the ordinary course of business
6. MANAGEMENT ASSESSMENT OF INTERNAL CONTROLS
 Requires management to maintain, create, and assess internal controls, and report on
the effectiveness of the controls

45
 Also requires the independent auditor to report on whether the company has adequate
internal controls
 Form 10-K- A report of management addressing the subject company’s internal control
over financial reporting (this was a response to §404 of the Sarbanes Oxley Act
7. REAL-TIME DISCLOSURE
 Requires publicly-held companies to make rapid and current disclosure of material
changes in their financial condition or operations
 Companies usually don’t want to disclose unfavorable news, and this provision forces it
8. ACCOUNTING OVERSIGHT BOARD
 Established the Public Accounting Oversight Board (PCAOB) to oversee the auditing of
public companies in order to help ensure accurate and independent financial reporting by public
companies subject to the securities laws.
 Can establish national standards and bring enforcement actions against auditors

THE DODD – FRANK ACT

VI. `CORPORATE FINANCE, ACCOUNTING & D ISTRIBUTIONS

A. INTRODUCTION AND GLOSSARY

B. BASIC CORPORATE FINANCE

1. CORPORATE SECURITIES
 Equity Securities- basic type of corp securities issued by the corp in exchange for capital-
namely capital and preferred stock- and debt securities
 BOD issues this common stock to the promoters and perhaps others who are or will engage in
the management of the business
 “Equity’ refers to shareholders’ equity or the amount of the difference in value between the
assets and liabilities of the corp, as determined at a particular point in time
 Holders of equity securities have no debt claims against the corp for the amount of their capital
investment and are fully subordinate to the corp’s debt holders

a) Equity Securities
 Issuance is mandatory under modern corp statutes
 At least one share must be outstanding at all times
 Art of Incorp generally set forth:
o # of shares the BOD is authorized to issue
o The classes/type of shares
o Preferences, rights, and limitations to each class and series

(1) Common Stock

46
  Represents the residual ownership interests in the corp after the senior financial
claims of general and secured creditors, and of preferred shareholders (if any)
have been satisfied
 Entitled to what is left over after the company’s debts have been paid and
preferences of any preferred shareholders are satisfied
 Customary attributes:
o Voting Rights- one share=one vote
o Liquidation Rights- right to pro rata distribution of the corp’s net assets
upon dissolution
o Not entitled to dividends
o Not granted conversion rights
o Not granted redemption rights (option to sell or put the shares to the corp)
o Do not have preemptive rights to maintain their proportionate equity
interest in the corp

(2) Preferred Stock

 Stock that is preferred or has preferences over common stock, largely in terms of
dividend payments and fixed payments upon the corp’s liquidation
 Customary Attributes:
o No voting rights
o Entitled to a liquidation preference over the common stockholders upon
dissolution, normally a fixed price per share
o Not entitled to dividends, the declaration of a dividend generally remains
w/in the BOD’s discretion and subject to statutory restraints on
distributions
o May be granted conversion rights by contractual provisions at the time of
issuance.
 Normally, this provides preferred stockholders the option to convert
preferred shares to common stock w/in a prescribed period of time
or upon the occurrence of specified conditions
o No redemption rights
o No preemptive rights

2. DEBT SECURITIES
 Additional capital is frequently obtained through bank loans, usually collateralized by corp
assets and personally guaranteed by the initial shareholders
 Trade Debt (or Open Account Indebtedness)- Another major source of capital is the
extension of credit by suppliers and other trade creditors
o Normally unsecured and not evidences by a promissory note or other debt
instrument

C. FINANCIAL STATEMENTS

1. INTRODUCTION
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 Legal issues are often disguised as accounting issues
 The use of deceptive financial statements to obtain capital constitutes garden-variety fraud,
as to which lawyers and NOT accountants are established experts
2. DOUBLE-ENTRY BOOKKEEPING
 The methodology used in the construction of basic financial statements, requiring every
transaction be reflected in equal and offsetting entries in a corporation’s accounting records
3. BALANCE SHEETS
 Provides a financial photo of a business at a particular point in times, generally year end
 3 Sections:
o Assets- includes cash and other property, generally listed at historical cost
o Liabilities- include bank loans, trade debts, and other liabilities
o Shareholders’ Equity- includes the amounts the shareholders have invested in a
corp’s equity securities, as well as any retained earnings
 Must always equal the difference b/t the assets and liabilities
 A (assets)= L (liabilities) + E (shareholders’ equity)

4. INCOME STATEMENTS
 Provides a view of the corp’s financial operations over a period of time, generally a quarter
or year
 3 Sections:
o Revenues- assets, cash or in-kind, received by the corp on exchange for its
goods/services
o Expenses- costs or assets used in producing revenue
o Net Income (Loss)- the difference b/t the corp’s revenues and expenses
 Cash Basis- recognizes or books revenues and expenses in the accounting period in which
the cash revenues are received or the expenses paid
 Accrual Basis- attempts to match revenues and expenses to the accounting period to which
they pertain
o Accrual of revenue occurs when revenues are recognized in the period that the
services were performed even if the bill for those services has not been paid
o Deferral of revenues occurs when cash paid in advance of performance is not
recognized as revenue until the services are rendered
o Expenses work the same

D. DIVIDENDS & OTHER DISTRIBUTIONS TO SHAREHOLDERS

1. INTRODUCTION
 While distribution may be good for shareholders, it’s not good for the creditors, because
funds are leaving the corporations and away from the ability of the credit holders to reach
those funds.
 Therefore, lenders usually bargain for a limitation on distribution or an outright
prohibition on distribution

48
  General prohibition – two requirements must be met in order for a distribution to be made
(insolvency test)
 After payment of a dividend (or making repurchase or redemption), assets must
exceed liabilities plus any other mandatory payment that is known (legal definition of
insolvency)
 After payment of a dividend (or making repurchase or redemption), corporation must
be able to pay its debts as they occur during the normal course of the business
(equitable definition of insolvency)
 If either requirement isn’t met, it’s an illegal distribution. The board, and possibly the
shareholders, will be held liable.
2. BASIC TYPES OF DISTRIBUTIONS
 Dividends – normally payable in cash to shareholders of record as of a set date
 Redemption – distribution of corporate assets; the corporation involuntary buybacks its
outstanding shares
 Repurchase - distribution of corporate assets; the corporation voluntary buybacks a portion of
its outstanding shares.
 Upon Liquidation – distribution on a pro rata basis to shareholders after claims of creditors
have been satisfied
3. BOARD OF DIRECTORS ’ DISCRETION
 The BoD’s exercise of discretion is largely sacrosanct in publicly held corporations- Business
judgment rule
 Unless the BoD refuses to declare dividends to shareholders of closely held corporations-
Courts look at the reasonable expectations of shareholders, through the fiduciary duty of loyalty or
the duty of good faith

Gottfried v. Gottfried
 Facts: Gottfried Baking Corporation, (Plaintiff), is a closely held family corporation. Most of its
stockholders are children of the founder of the business and their spouses. Until 1945 no
dividends were paid on the common stock although dividends had been regularly paid upon the
preferred stock, and intermittently upon the “A” stock. In 1945, dividends were paid on the
common stock presumably stimulated by the commencement of this suit. Hostility has existed for
a long time between the Plaintiffs and Gottfried Baking Corp., its directors, and Hanscom Baking
Corp., a wholly owned subsidiary, (Defendants), in this case. Plaintiffs contend that the Board of
Directors are motivated by a desire to coerce Plaintiffs to sell their stock to the majority interests at
a grossly inadequate price and have circumvented the need for dividends insofar as they are
concerned by excessive salaries, bonuses and corporate loans to themselves.
 Issue: Whether Defendants withheld the declaration of dividends in bad faith.
 Holding: No.
 Rule #1: If an adequate corporate surplus is available for the purpose of paying dividends,
directors may not withhold the declaration of dividends in bad faith.
 Rule #2: The test of bad faith is to determine whether the policy of the directors is dictated by
their personal interests rather than the corporate welfare.
 Rational: It is true that there is animosity between the majority and minority shareholders of
Gottfried. It is also true that several defendants have received substantial sums in compensation.
Substantial loans have also been made to several of the defendants. However, these were
incurred in large part prior to the controversy surrounding dividends. The evidence with respect to
the financial condition of the corporation and its business requirements does not sustain Plaintiff’s
49
 claims. Evidence shows that expenditures included the retirement of the then outstanding
preferred stocks in the sum $165,000, in which Plaintiffs benefited proportionately. Further,
despite the motivation, dividends were paid in 1945 on common stock.
 Results: It may not be said that the directorate policy regarding common stock dividends at
the time the suit was brought was unduly conservative and inspired by bad faith. The Plaintiff
failed to prove that the surplus was unnecessarily large and failed to prove the defendants
recognized the propriety of paying dividends but refuse to do so for personal reasons. Dismissed
and judgment directed for Defendant.
 MBCA § 6.40- Distributions to Shareholders
 Tells you when it is legal
 Look at definition § 1.40(¶ 6)- (This includes share repurchases)

Dodge v. Ford Motor Co.

 PH: TC ordered Ford to declare a dividend equal to ½ of the accumulated cash surplus on
hand at July 31, 1916. Ford Appealed.
 Facts: Defendant’s corporation was the dominant manufacturer of cars when this case was
initiated. At one point, the cars were sold for $900, but the price was slowly lowered to $440 – and
finally, Defendant lowered the price to $360. The head of defendant corporation, Henry Ford,
admitted that the price negatively impacted short-term profits, but Ford defends his decision
altruistically, saying that his ambition is to spread the benefits of the industrialized society with as
many people as possible. Further, he contends that he has paid out substantial dividends to the
shareholders ensuring that they have made a considerable profit, and should be happy with
whatever return they get from this point forward. Instead of using the money to pay dividends,
Ford decided to put the money into expanding the corporation.
 Issue: The issue is whether Plaintiff shareholders can force Defendant to increase the cost of
the product and limit the money invested into expansion in order to pay out a larger dividend.
 Holding: Yes, Plaintiffs are entitled to a more equitable-sized dividend, but the court will not
interfere with Defendant’s business judgments regarding the price set on the manufactured
products or the decision to expand the business.
 Rule: 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.
 Rational: The purpose of the corporation is to make money for the shareholders, and
Defendant is arbitrarily withholding money that could go to the shareholders. Notably, Ford did not
deny himself a large salary for his position with the company in order to achieve his ambitions.
However, the court will not question whether the company is better off with a higher price per
vehicle, or if the expansion is wise, because those decisions are covered under the business
judgment rule.
 Result: The amount the TC fixed and determined to be distributed to stockholders is affirmed,
All others but cost is reversed.
 Note: The lead plaintiffs, the Dodge brothers, had a motive outside of their position as minority
shareholders. Their own business competed with Defendant, and larger dividends would have
helped finance their business while draining resources from Defendant. There could then be an
argument that Ford’s decision was in the best interests of defendant’s corporation.
 Gottfried vs. Dodge
 Initially, it appears as there was no bad faith withholding of dividends in Dodge, the
earmarks of bad faith don’t appear.
 However, personal interest over the corporate welfare is an earmark of bad faith.
Ford’s personal interest may have dictated the dividend distribution. Thus, this may
in fact be a bad faith withholding of dividends.
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Miller v. Magline, Inc.
 PH: TC concluded that a dividend should be declared but denied the excess compensation
claim, TC ordered the defendant to pay a dividend of $75 per share for period of July 1, 1963-
June 30, 1968; retained jurisdiction to determine if further dividends should be awarded from July
1, 1968-June 30, 1973. Defendant Appealed
 Facts: Plaintiff, Miller, and Defendant, Law, incorporated Magline. Plaintiffs (minority
shareholders) own 41% of Magline stock, Defendants (majority shareholders) own 59%. Despite
success, Magline paid all profits to corporate managers, not in dividends to shareholders that did
not participate as managers. Plaintiff’s moved at board meetings to increase dividends, but were
rejected by the board. Over the course of several years, profits increased dramatically, and so did
bonuses to corporate managers. Plaintiffs sued, alleging that in withholding a dividend,
defendants had violated the fiduciary duty that majority shareholders and directors owe to the
minority shareholders, and refusal to declare a dividend was an arbitrary, capricious, and
unwarranted abuse of discretion.
 Issue: Whether Defendant breached a fiduciary duty by failing to pay dividends.
 Holding: Yes. Defendant breached a fiduciary duty.
 Rule: Breach of a fiduciary duty amounts to a breach of trust, and it has been consistently
recognized by courts as a ground for court intervention. Dodge v. Ford (SC of MI, 1919).
 Rational: Courts should be reluctant to interfere with the business judgment and discretion of
the directors in the conduct of corporate affairs. The facts of this case present a study in the
oppression of minority shareholders of a closed corporation by the majority. The company’s by-
laws cannot be used as a shield behind which breaches of a director’s fiduciary duty to
stockholders can be carried on with impunity. Courts generally recognize that corporate
shareholders are in a fiduciary relationship, and, accordingly, have fiduciary duties to each other in
addition to any fiduciary duties they may owe the corporation as directors, officers, employees, or
majority shareholders.
 Results: Affirmed.
4. LIMITATIONS ON CORPORATE DISTRIBUTIONS UNDER CORPORATE STATUTES
a) Policies Supporting Limitations
 Concerns:
 The corporate debtor’s shareholder-owners have limited liability, and,
unless they have personally co-signed or guaranteed the debts, generally have no
liability to the corporate creditors.
 Once shareholders have been given back their initial investment, they may
have less incentive, as corporate officers and directors, to manage the business
effectively with appropriate avoidance of unreasonable risks.
 Corporate statutes imposing restrictions upon corporate distributions to
shareholders were enacted in response to these concerns.
b) Balance Sheet or Capital Impairment Restrictions
 Statutory approach addressing creditor concerns about corporate distributions to
shareholders under the DGCL:
 DGCL- Distributions generally cannot exceed the corporation’s surplus
 (DGCL § 160)- Share repurchases
 No corporation shall repurchase or redeem when the capital of the
corporation is impaired or redemption would cause an impair So, you must
have a surplus
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  (DGCL § 170(a))- Dividends
 Nimble dividends- Can pay dividends out of earned or capital
surplus
 BUT not if you are insolvent
 MBCA
 Shareholders’ equity (net worth)= the amount of the difference between total
assets and total liabilities
 Stated capital- the arbitrarily set par value, and an amount arbitrarily
allocated by the board to the stated capital account
 Cannot be impaired by distributions
 Paid-in surplus- consideration paid for the shares in excess of stated
capital
 Earned surplus- the amount of earnings from operations retained by the
corporation
 The “surplus” available for distributions is the excess at any given
time of the net assets of the corporation over the determined stated capital
(DGCL § 154)
c) Earned Surplus Restriction
 Followed in an earlier version of the MBCA, and incorporated into many states:
 A corporation may make distributions out of its earned surplus, which refers to
the sum of its net profits and gains over the years, less its losses and prior distributions to
shareholders
 More restricted approach to earned surplus, as opposed to the balance sheet
approach
 However, this protection is illusory as dividends could be paid out of
capital surplus
d) Solvency Restriction
 The current version of the MBCA abandons both the balance sheet approach
and the earned surplus approach
 MBCA now follows a double solvency approach (MBCA § 6.40(c))
 Prohibits distribution if its payment would render the corporation insolvent
under the equity or bankruptcy definitions of the term
 Equity= whether a corporation is able to pay its debts when they
are due
 Bankruptcy= whether a corporation’s assets at least equal the
amount of its liabilities
 The MBCA permits a corporation to make distributions to its shareholders
of all three components of its shareholders’ equity: stated capital, paid-in surplus,
and earned surplus, leaving no remaining equity cushion for the protection of its
creditors
5. DIRECTOR LIABILITY FOR IMPROPER DISTRIBUTIONS
 Most corporate statutes set forth provisions for direct personal liability on directors who voted
for or assented to improper distributions – NOT strict liability though
 MBCA requires the party asserting liability to establish that the directors did not comply with
the directors’ statutory standards of conduct, including good faith and due care.

52
 (MBCA §§ 8.33 & 8.30) Protects directors by protecting their good faith reliance on reports
from corporate officers and employees, lawyers and accountants, and board committees
 (MBCA § 8.33(b)(1) & DGCL § 174(b)) Directors may be able to get a contribution from other
directors who voted for the improper distribution,
 (MBCA § 8.33(b)(2)) Or from each shareholder who received the distribution with the
knowledge of its illegality

Klang v. Smith’s Food & Drug Centers, Inc.

 PH: TC dismissed Plaintiff’s claims
 Facts: Yucaipa, a California partnership, engaged in supermarket industry, tried to acquire
Smith's Foods and Drug (SFD). As part of the deal, SFD agreed to repurchase 50% of the
outstanding SFD stock. SFD talked to their investment firm. SFD decided that the repurchase
would not result in an impairment of capital and went ahead with the repurchase. Klang, one of the
creditors, sued as a class action against SFD. Creditors argued that by buying all of this stock,
SFD wasn't retaining enough cash to pay back the creditors. That was an impairment of capital.
Court of Chancery held judgment favoring SFD.
 Issue: Whether the Court of Chancery was correct in holding that SFD's repurchase of shares
did not violate the statutory prohibition against the impairment of capital.
 Holding: Yes, the Court of Chancery was correct in holding that SFD's repurchase of shares
did not violate the statutory prohibition against the impairment of capital.
 Rule: A corporation may not repurchase its shares except out of surplus, if it would
cause an impairment of capital. (DGCL § 160)
 Rational: no corporation may repurchase or redeem its own share except out of surpluses.
But here, balance sheets were not conclusive indicators of surpluses. Corporations could revalue
assets to show surplus, but perfection in that process was not required. Directors had reasonable
latitude to depart from the balance sheet to calculate surplus, so long as they evaluate assets and
liabilities in good faith.
 Test: A repurchase impairs capital if the funds used in the repurchase exceed the amount of
the corporation’s ‘surplus,’ defined by DGCL § 154 to mean the excess of net assets over the par
value of the corporation’s issued stock. Unless a corporation redeems shares and will retire them
and reduce its capital, a corporation may use only its surplus for the purchase of shares of its own
capital stock.
 Results: Affirmed
6. SHAREHOLDER LIABILITY FOR IMPROPER DISTRIBUTIONS
 Shareholders who receive distributions are not liable to the corporation or creditor as long as
they had no knowledge of the illegality- KNOWINGLY Requirement
 Under common law, the shareholder may be liable to the extent of the distribution, without
regard to fault, where it was from an insolvent corporation
 Bankruptcy Code may require shareholder to return the funds
 Uniform Fraudulent Conveyance Act (UFTA) treats any transfer without a reasonably
equivalent exchange by a transferor who at the time was, or by virtue of the transfer became,
insolvent, as fraudulent
7. CONTRACTUAL RESTRICTIONS ON CORPORATE DISTRIBUTIONS
 Banks and other institutions may impose prohibitions or limitations on the payment of
dividends and repurchases
 It is not uncommon for shareholders to insist that provisions limiting distributions to common
shareholders be included in the corporation’s articles or bylaws
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VII. LIMITATIONS ON LIMITED LIABILITY
A. INTRODUCTION
 As a general proposition, those who own stock in a corporation, either as individuals or
enterprises, are not personally liable for the debts and obligations of the corporation.
 Generally, limited liability status is available to corporations, LLPs, and LLC’s.
 Serves to cap the monetary amount of investor’s risk exposure to the amount contributed by
such shareholder in the enterprise
 The investor is only liable to the corporation’s creditors up to the amount of his/her
investment, including any unrealized gains or capital appreciation
 Promotes capital formation, encourages expansion, encourages what would otherwise be
considered as risky decisions
 Exceptions to the general rule of limited liability:
 Alter ego
 Piercing the corporate veil
 Piercing the corporate veil refers to the judicially imposed exception to the limited liability
principle by which courts disregard the separateness of the corporation and hold a shareholder
responsible for the corporation’s action as if it were a shareholder’s own
 Generally applied to active shareholders, not passive ones
B. GENERAL CHARACTERISTICS OF PIERCING THE CORPORATE VEIL
 Invoked when privately-held corporations have assets that are insufficient to satisfy a claim or
judgment
 It has only been used successfully in the context of privately held corporations whose stock is
owned by another business enterprise (which may be publicly-held) or whose stock is held by
individual equity owners.
 Two general factors are evident in almost every case of veil piercing:
 Domination or control by a shareholder, whether an individual or another corporate
entity, over the subject corporation
 Some type of fraud, wrong, or injustice
 A judge-made doctrine consisting of a fact-based inquiry
 Burden of Proof is placed on the party trying to convince the court to pierce the veil
 Burden is high
C. FACTORS TO PIERCE THE CORPORATE VEIL
 No single factor has proven to be uniformly determinative in allowing the corporate veil to be
pierced, and each may be assigned varying significance:
1. LACK OF CORPORATE FORMALITIES
 Whether the corporation exercised traditional corporate formalities and upheld the
governing structure of the entity
 Formalities include:
 Holding regular board and shareholder meetings,
 Documenting meeting minutes,
 Issuing stock certificates,
 Electing officers and directors, and
 Documenting corporate transactions
 State statutes foreclose the lack of corporate formalities as a consideration in veil-
piercing
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  Texas is an example
2. COMMINGLING OF CORPORATE AFFAIRS
 Playing fast and loose with corporate assets.
 The failure to keep personal and corporate assets separate, which can make it difficult
for creditors to identify the assets and liabilities of the corporation
 Examples:
 Two corporate entities using the same bank account for business transactions,
 Two corporate entities make monetary transfers to one another,
 Two corporate entities make cross-corporate loans
 The fact that a corporation and its assets are used to benefit its owners does not
necessarily mean that veil piercing will occur and shareholders will be personally liable
 Factual analysis- Generally, a finding of misrepresentation, inadequate capitalization,
or fraud
American Trading and Production Corp. v. Fischbach & Moore

 Mere instrumentality doctrine used

 All subsidiary’s directors were also directors and officers at the parent.
 Separate offices, separate directors meetings, Subsidiary has separate bank
accounts and negotiates its own loans.
 Degree of commingling was inadequate
NLRB v. West Dixie Enterprises
 Individuals were held liable for corporate improprieties on a piercing theory where
they used a personal checks to pay for corporate expenses, the corporation paid certain individual
expenses, and separate corporate records were not maintained.
 Be sure to:
 Document all transactions,
 Make sure the transactions are all arms-length,
 Keep a separate corporate bank account,
 Minimize cross-utilization of corporate assets and employees,
 Document all related party dealings.
3. UNDERCAPITALIZATION
 If owners initially incorporated or continue to run the business with insufficient capital,
then they should be personally liable for the claims against the corporation
 If capital is illusory or trifling compared with the business to be done and the risks
of loss, this is a ground for denying the separate entity privilege (Ballantine, Corporations
303)
 Baatz v. Arrow Bar- In case law, this factor alone is not often enough to pierce the
corporate veil.
 In the torts context, a company’s capital includes liability insurance coverage as well as
traditional equity capital
 Courts often inquire into the occurrence of reasonably foreseeable losses and the
corresponding magnitude of such losses as compared with the capital balances maintained to
cover foreseeable losses.
4. TORT VS. CREDITOR

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 The public policy argument is that a voluntary creditor who purposefully executes a
contract with the corporation has the opportunity to investigate the capitalization level of the
company; but when the plaintiff is an involuntary creditor because the company committed a tort,
they didn’t have the opportunity to bargain for protections
 The situation where a shareholder, officer or director actually participated in the tortious
conduct must be distinguished from the corporation committing the tort
 Veil piercing usually when an agent commits the tort
5. MISREPRESENTATION/FRAUD
 Courts are split on whether actual or constructive fraud is sufficient to pierce the veil.
 When actual fraud is required, the plaintiff must show that there was a
representation of fact that is untrue and known to be untrue or recklessly made, and which
was offered to deceive the other party and to induce him to act upon it, causing injury.
 Courts will also accept silence if there was a duty to speak as actual fraud
 Constructive fraud is where there are acts or practices that, although disclosed,
are extremely unfair and may have a capacity to mislead
6. AN EMPIRICAL STUDY
 Robert B. Thompson- trends in the judicial handling of the doctrine
 Piercing the corporate veil only occurs in a small to mid-sized, close corporations
D. CONTEXT MATTERS WHEN PIERCING THE CORPORATE VEIL

1. INDIVIDUAL SHAREHOLDER LIABILITY

a) Individual Shareholder Piercing: Tort
Minton v. Cavaney
 Facts: The Seminole Hot Springs Corporation, hereinafter referred to as Seminole, was duly
incorporated in California. It conducted a public swimming pool that it leased from its owner.
Plaintiffs' daughter drowned in the pool, and plaintiffs recovered a judgment for $10,000 against
Seminole for her wrongful death. Plaintiffs brought an action to hold defendant Cavaney, the
corporate attorney, personally liable for the judgment against Seminole. Cavaney was asked if
Seminole "ever had any assets?" He stated that "insofar as my own personal knowledge and
belief is concerned said corporation did not have any assets." Furthermore, the corporation had
three shareholders. Cavaney was one, and was a director and officer.
 Issue: Whether the veil will be pierced to hold Cavaney personally liable.
 Holding: No, Cavaney cannot be held liable for the debts of Seminole without an opportunity
to re-litigate these issues.
 Rule: Mere professional activity by an attorney at law, as such, in the organization
of a corporation, can constitute any basis for a finding that the corporation is the attorney's
alter ego or that he is otherwise personally liable for its debts, whether based on contract
or tort.
 Rational: Court uses alter ego doctrine – determining if there was a distinction between
the corporation and the individual shareholders
 Lack of corporate formalities (no stock issued, no board or shareholder meetings held)
 Commingling of funds
 Court also looks at equitable considerations – inadequate capitalization
 Only active shareholder was held personally liable
 Result: Reversed

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NLRB v. West Dixie Enterprises
 Facts: West Dixie was a Florida corporation doing business as an
electrical contractor. Paolicelli was the company's owner, sole shareholder, and president. Her
husband directed all of West Dixie's daily operations. Husband made personal loans to West Dixie
and used his personal credit card to order materials and equipment for the company. The
Paolicellis often issued checks from their personal joint checking account to meet the payroll, and
Paolicelli allowed employees to use her personal car for company business. The NLRB found
West Dixie refused to hire three job applicants because of their union membership, and that they
had violated the NLRA. The NLRB conducted an investigation and filed a complaint against West
Dixie. The complaint was later amended to add the Paolicellis as alter egos of the corporation.
 Issue: Whether the Paolicellis were alter egos of West Dixie and were
therefore also liable for the violations.
 Rule: Yes, the Paolicellis are personally liable for West Dixie's violations
of the NLRA.
 Two-pronged test for determining whether owners or operators of a
corporation are personally liable for the unfair labor practices of the corporation:
 There is such unity of interest, and lack of respect given to the separate identity of the
corporation by its shareholders, that the personalities and assets of the corporation and
the individuals are indistinct, AND
 Adherence to the corporate form would sanction a fraud, promote injustice, or lead to an
evasion of legal obligations.
 Comingled funds – mostly for the benefit of the corporation, but
some money did flow the other way.
 Lack of corporate formalities – dissolution of business
 Equitable considerations – dissolution could have affected the
corporation’s ability to meet its obligations resulting from unfair labor practices
 No causation standard was required.

Baatz v. Arrow Bar

 Facts: The Baatz were riding a motorcycle when they were struck by an
automobile driven by Roland McBride, who was intoxicated at the time. Baatz alleges that
Defendant, Arrow Bar, is contributory negligent because it served alcoholic beverages to McBride
prior to the accident despite the fact that he was already intoxicated. The corporation did not have
dram shop liability at the time of the Baatz accident.
 Issue: Whether the corporate veil should be pierced making Edmond and
LaVella personally liable to Baatz?
 Holding: No. There are no facts to support that the corporate veil should
be pierced.
 If you follow all the formalities, even if you have no assets or
insurance, the veil may not be pierced.
 Rule: Factors that courts will consider to determine whether to
pierce the corporate veil are:
 Fraudulent representation by corporation directors;
 Undercapitalization;
 Failure to observe corporate formalities;
 Absence of corporate records,
 Payment by the corporation of individual obligations; or
 Use of the corporation to promote fraud, injustice, OR illegalities.

57
 Rational: A corporation is considered a separate legal entity until
there is a sufficient reason to indicate that the corporate veil should be pierced.
 A personal guarantee that imposes individual liability for a corporate obligation supports the
recognition of a corporate entity.
 The personal guarantee of a loan is a contractual agreement and cannot be used to impose
tort liability.
 Baatz fails to show how the corporation was an instrumentality through which [they were]
conducting [their] personal business (an alter ego).
 The corporation did not fail to adhere to corporate formalities simply for its failure to indicate
that it was a corporation on its signs and advertising. It is sufficient that the corporate name
includes the abbreviation of incorporated.
 Results: Affirm summary judgment dismissing the Neurtoths as individual defendants.
b) Individual Shareholder Piercing: Contract

Brunswick v. Waxman

 Facts: Waxman formed a no-asset corporation to act as a signatory on a

series of sales agreements for bowling alley equipment with Brunswick. The no-asset corporation
then leased the equipment to five separate partnerships which operated five separate bowling
alleys. The bowling alleys failed before the no-asset corporation could pay the entire purchase
price. The corporation held no directors meetings, issued no stock, and adopted no bylaws.
 Issue: Whether the owners are personally liable under the “instrumentality
rule” for the liabilities of the corporation when the creditor knew that the corporation had no assets
at the time of contracting, and did not rely on the owner’s personal guarantee.
 Holding: No, the owners are not personally liable.
 Rule: The instrumentality rule has three factors:
 Domination and control over the corporation by those who are held liable which is
so complete that the corporation has no separate mind will or existence of its own,
 The use of this domination and control to commit fraud or wrong or any other
dishonest or unjust act, AND
 Injury or unjust loss resulting to the plaintiff from such control and wrong.
 Rational: Here, there was no fraud, no misappropriation of
corporate funds, and consequently no fraud to Brunswick.
 Brunswick was under no illusion than the no-asset corporation was merely and agent for its
owners.
 Brunswick, a sophisticated corporation, was not misled. It had full knowledge that it was doing
business with a no-asset corporation, and proceeded anyway.
 It cannot be heard to complain now that the corporation has defaulted.
 Results: Affirmed
 NOTES: Kinney Shoe v. Polan
 Facts: Plaintiff, Kinney, had a lease on a building that they were no longer
using. Plaintiff set up a sublease with Industrial Realty Company, which Defendant, Polan,
was the sole shareholder. Defendant was also the sole shareholder of Polan Industries,
and after Industrial subleased Plaintiff’s building they turned around and leased out a
portion of the building to Polan Industries. Industrial’s only asset was the sublease with
Plaintiff. There was no evidence of any corporate formalities such as the keeping of
minutes or holding meetings. Industrial only made one lease payment. Plaintiff obtained a
58
 judgment for $166,400 but Industrial claimed bankruptcy. Plaintiff then went after
Defendant, claiming Industrial was an undercapitalized shell corporation to shield Plaintiff
from liability. The trial court agreed that Plaintiff demonstrated that there was a unity of
interest between Defendant and Industrial, and that an inequitable result would result if the
corporate liability was to stand. However, the lower court believed that Plaintiff had a duty
to check the background of Industrial before entering an agreement.
 Issue: Whether Kinney can pierce the corporate veil and hold Polan
personally liable.
 Holding: Yes, Kinney can pierce the corporate veil and hold Polan liable
for the unpaid sublease. Polan cannot be relieved from his obligations by saying Kinney
should have known better.
 Rule: A plaintiff can pierce the corporate veil if they
demonstrate 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.
 Rational: The Laya case established a two-pronged test where to pierce the corporate veil,
the plaintiff must show that:
 The distinction between the entity and the person does not exist anymore AND
 An equitable result could be obtained with the existence of the corporation.
 But the district court decided against the plaintiff because it applied
a third prong which says that when it is a money lender that is trying to pierce the corporate
veil, then if it did an investigation, it assumed the risk.
 The district court decided that Kinney assumed the risk. The court of appeals decided that
Kinney was not a money lender, that the third prong was permissive and not mandatory
and that he did not assume the risk.
 They refused to decide if this third prong could be extended to other persons other than
money lenders.
 Results: Affirmed
2. ALTER EGO/CORPORATE FAMILY PIERCING
a) Corporate Family: Tort
 If plaintiff alleges that the tortious corporation is actually part of a larger corporate
entity, the assets from the larger corporate entity may be used to satisfy the debts of the entity
accused of the tort.
 Invoked in two instances:
 When a corporation owns many subsidiaries, all of which are related as
brother-sister sibling corporations
 When one corporation owns another in a parent-subsidiary relationship.

Walkovszky v. Carlton
 Facts: Defendant, Carlton, 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 Defendant’s
corporations hit Plaintiff, Walkovsky, 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.
 Issue: The issue is whether Defendant can be held personally liable for
the injuries suffered by Plaintiff.
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 Rule: No, but only because the Plaintiff did not state a correct cause of
action to recover from Defendant.
 Defendant would be held liable under the respondeat superior
doctrine if he controlled the corporation for his personal benefit at the expense of the
corporations benefit.
 An individual can be held liable for the acts of a corporation through the doctrine of
respondeat superior if it can be shown that the individual used his control of the
corporation for personal gain.
 Plaintiff did not offer proof to make that claim, and instead offered proof that the ten corporations
operated as one large corporation.
 The fact that the corporations may have been one large
corporation, however, does not prove that Defendant was controlling the corporations for his own
behalf.
 The dissent wanted to pierce the corporate veil to achieve a more
equitable result, but the majority believed that it was the legislature’s responsibility to raise the
mandatory insurance coverage.
 The majority and the dissent both regard the series of corporate
entities set up by Defendant as a method of limiting Defendant’s liability, but the majority reasons
that the legislature should be the one to correct the abuse.

Gardemal v. Westin Hotel

 Facts: 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. The Trial Court dismissed. Gardemal appealed.
 Issue: Whether Westin was a separate corporate entity from Westin
Mexico that could not be held liable for acts by its subsidiary.
 Rule: Yes, Westin maintained a separate corporate identity, and the two
companies were not so intermingled that they were alter egos of each other.
 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.
 One of the major factors for establishing liability under this doctrine would be if Westin Mexico was
undercapitalized, but there was no evidence of that in this case.
 Gardemal argued that Westin and Westin Mexico operated as a
single business enterprise. However the Court didn't find evidence that this was the case.
 Under the single business enterprise doctrine, a corporation can be held liable for the acts
of another if they are not operated as separate entities, but integrate their resources to
achieve a common business purpose.
 Since piercing the corporate veil done for reasons of equity, maybe
it isn't right to do it when someone is just forum shopping

b) Corporate Family: Contract

OTR Associates v. IBC Services

 Facts: Iskander owned a corporation called Samyrna that in turn owned
some fast food franchises. They opened a Blimpie franchise in a mall owned by OTR. Under the
terms of Iskander's franchise agreement, Blimpie's subsidiary corporation, IBC would take out the
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 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. 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. If OTR wanted their money they
could only sue IBC. Of course, since IBC had no assets, they were unlikely to be able to pay. OTR
argued that IBC was not a real corporation. Therefore they should be allowed to pierce the
corporate veil and sue Blimpie, the parent corporation. The Trial Court found for OTR and told
Blimpie's to pay the back rent. Blimpie appealed.
 Issue: Whether the court should pierce the veil.
 Rule: Yes, the parent corporation, Blimpie’s should be held liable for the
subsidiary, IBC.
 Courts can ONLY pierce the corporate veil IF the parent
corporation:
 So dominated the subsidiary that it has no separate existence, but is merely a conduit for
the parent, AND
 The control was used to commit a fraud or wrong, or to avoid a positive legal duty.
 The Court found that IBC had no office, no staff, and no assets
beyond the leases, it did not have a separate existence.
 The Court 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.
E. REVERSE VEIL PIERCING
 Reverse piercing occurs when a claimant seeks to disregard the corporate form to obtain the
assets of a corporation due to the actions of a dominant shareholder or other corporate insider.
 At times, in very rare situations, a corporation can be held liable for the debts of an
active, inside shareholder
 Majority of courts apply the same alter ego principles

Phillips v. Englewood Post No. 322 VFW

 Facts: Phillips was the majority shareholder of Philsax, Inc., a corporation (“Philsax”).
Phillips’ wife was the only other shareholder of Philsax, and also the majority shareholder of
another Colorado corporation, Action Properties, Inc. (“Action”). The trustee of Phillips’ bankruptcy
estate sought to prevent transfers of property owned by Phillips and Philsax, arguing that Philsax
was the alter ego of Phillips and, therefore, actions taken by Philsax were, in effect, actions taken
by Phillips.
 Issue: Whether Colorado law permits a court to reverse pierce the corporate veil.
 Rule: Yes, Colorado law permits courts to reverse pierce the corporate veil when a
claimant demonstrates that a controlling insider and a corporation are alter egos of each other and
justice requires recognizing the substance of that relationship over the form to achieve an
equitable result.
 Outside reverse piercing occurs when a corporate outsider seeks to disregard
the corporate form and attach liability on the corporation for the obligations of a dominant
shareholder or other corporate insider.
 A court may [outside] reverse pierce the corporate form when:
 (1) the controlling insider and corporation are alter egos of each
other,

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 Phillips and Philsax were alter egos because Phillips used
corporate funds to pay his personal debts and the creditors of the corporation were also his
personal creditors.
 Philsax failed to follow basic corporate formalities; for example, it
had no bank account, no written bylaws, and maintained no written financial statements.
 Philsax also failed to provide written notice of board meetings and
Phillips removed and added directors at will.
 (2) justice requires recognizing the substance of the relationship
over the
form because the corporate fiction is utilized to perpetuate a fraud or defeat a rightful
claim, and
 (3) an equitable result is achieved.
 With respect to the second and third factors, the court noted that,
because transfers may have been made to and among Philsax and Action with the purpose of
avoiding a third party judgment against Phillips, and given that Philsax had no other creditors,
reverse piercing would not prejudice innocent creditors.
 If innocent shareholders or creditors would be prejudiced, an equitable
result would not be achieved and reverse piercing would not be appropriate.
 A court should avoid outside reverse veil piercing when alternative,
adequate remedies are available.
F. EQUITABLE SUBORDINATION: THE DEEP ROCK DOCTRINE
 Involves the order of payment when a corporation goes bankrupt
 Shareholders like to place loans to the company rather than make capital contributions,
because loans can be secured but capital contributions are treated as equity holders
 A secured loan means they will get paid like a creditor if things go wrong
 Additionally, the loan pays interest and it’s a deductible business expense for the corporation
(and a source of income to the shareholder)
 Doctrine says that a loan from a shareholder is actually equity, and they still are at the end of
the line for liquidation distributions
 Requirements
 Inadequate Capitalization
 If a loan is provided, that amount of money would not have been lent by a
reasonable creditor
 Or the loan from a reasonable creditor would not have been on the same terms
 If a reasonable creditor would have made the loan on the same terms, it is still
considered a loan, and not a capital contribution
 Suspicious Conduct
 Not necessarily fraud or misrepresentation
 Note case: person declared distribution to himself, then gave that money back to
the company as a loan (meets the insolvency test, but is still very close to
insolvency)
 Note case: person transferred money and assets worth less than $5K to himself
in exchange for 100% of the corporate stock, then transferred over $75K in
exchange for a demand promissory note, and backdated the deeds. High debt to
equity ratio and the backdating without disclosure is a problem
 ONLY APPLIES TO ACTIVE SHAREHOLDERS
G. PIERCING THE VEIL OF THE LLC
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 ULLCA § 303- Except as otherwise provided . . . the debts, obligations, and liabilities of a
limited liability company, whether arising in contract, tort, or otherwise, are solely the debts,
obligations, and liabilities of the company. A member or manager is not personally liable for a
debt, obligation, or liability of the company solely by reason of being or acting as a member or
manager.
 Generally LLCs are treated the same as corporations for veil piercing purposes
 However, a number of commentators advocate abolishing the veil-piercing doctrine in
the LLC context
 If the legislature intended LLCs to be treated as corporations, they could have
incorporated corporate law doctrines in LLC statutes
H. SHAREHOLDER LIABILITY UNDER FEDERAL LAW: ENVIRONMENTAL VEIL PIERCING

US v. Bestfoods
 Facts: Since 1957, the numerous owners of the site where Cordova Michigan (Cordova
MI) now sits have polluted. In 1965, CPC International Incorporated’s (CPC) wholly owned
subsidiary bought Ott Chemical Company (Ott). The new company kept Ott’s name, managers
and former founder, president and principal shareholder, Arnold Ott, as officers of Ott. In 1972,
CPC sold Ott to Story Chemical Company (Story). Story then sold the plant to Aeroject General
Corporation (Aeroject), which created a wholly owned California subsidiary, Cardova Chemical
Company (Cardova CA), to purchase the property, who in turn created a wholly owned Michigan
subsidiary, Cardova Chemical Company of Michigan (Cardova MI), which manufactured
chemicals at the site until 1986. In 1981, the federal Environmental Protection Agency (EPA)
undertook to clean up the site. Subsequently, the United States filed a claim against CPC,
Aeroject, Cordova CA, Cordova MI, and Arnold Ott. The parties launched claims against one
another. Consequently, the District Court consolidated the cases for trial in three phases: liability,
remedy, and insurance coverage. After completion of the liability phase in favor of the United
States, the District Court determined that CPC and Aeroject were liable as the parent corporations
of Ott and the Cordova companies because they had “owned or operated” the facility within the
meaning of § 107(a)(2). The United States Supreme Court granted certiorari “to resolve a conflict
among the Circuits over the extent to which parent corporations may be held liable under
CERCLA for operating facilities ostensibly under the control of their subsidiaries.”
 Issue: Whether a parent corporation could be liable for its subsidiary’s pollution under
CERCLA?
 Rule: No, unless the corporate veil can be pierced. However, a parent corporation may
be directly liable if it actively participated in and exercised control over the operations of that
facility.
 Under CERCLA, a parent corporation may be liable if the corporate veil can
be pierced.
 Liability under CERCLA is based on the corporation’s “ownership” and
“operation” of the polluting facility.
 A parent corporation is not liable for the acts of its subsidiaries.
 However, the corporate veil may be pierced and the
shareholder may be held derivatively liable for the subsidiary corporation’s conduct if the
corporate form would be “misused to accomplish certain wrongful purposes, notably
fraud, on the shareholder’s behalf.”

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 Alternatively, a parent corporation may be directly liable as an operator of
the polluting facility if it exerted power and control over the operations of its subsidiary
that lead to the pollution.
 To determine direct liability, the test is not “whether the parent operates
the subsidiary, but rather whether it operates the facility, and that operation is evidenced by
participation in the activities of the facility, not the subsidiary.”
 Here, there is some evidence to suggest that CPC acted as an
operator that participated in the facility’s pollution.

VIII. MANAGEMENT AND CONTROL OF THE CORPORATION

A. SOCIAL RESPONSIBILITY
 Whether a corporation has some sort of obligation to contribute to society beyond making a
profit for its shareholders and following the law
 The debate tends to center around justifying corporate behavior that does not maximize
corporate profits on the basis that such behavior furthers other, laudable ends.

AP Smith MFG v. Barlow

 Facts: Plaintiff corporation (Smith), founded in 1896, had a history of donating minor
sums of money to various charities and institutions. In 1956 Plaintiff voted to give $1,500 to
Princeton University. Plaintiff instituted a declaratory judgment action after Defendant stockholders
questioned the proposed gift. Although a state statute allows corporations to contribute to
charities, Defendants (Barlow) assert that the corporation’s certificate of incorporation does not
allow the gift, and the corporation was incorporated prior to the statute that authorizes the gift-
giving.
 Issue: Whether Smith can donate money to a charity without authorization from
stockholders or through the certificate of incorporation.
 Holding: Yes, Smith can give money to charities.
 Rule: Stands for the basic rule (unanimous today) that charitable donations in a
reasonable amount are permitted and authorized aren’t ultra vires
 Rational: Corporate gift-giving increases the goodwill of the corporation, and
public policy should be to encourage corporations to provide to charities in the same manner as
individuals are encouraged to give.
 Corporate gift-giving is an allowable method of increasing goodwill, but the gift
should be less than 1% of capital and surplus and directed to an institution owning no more than
10% of the company stock.
 The court did not accept Barlow’s reasoning that the donation was not allowed
because the corporation preceded the statute authorizing the gift-giving.
 The court explained that the potentially infinite lifespan of corporations would
lead to corporations at varying ages to live under various sets of laws.
 The court also cautions against “pet charities” which do not promote corporate
purposes, but personal purposes of directors.
 In this case, the directors went to Princeton or received honorary degrees
from it.
 Results: Affirmed
 Note: Can a change in the state’s corporate code affect the relationship between the
corporation and shareholders, and between shareholders inter se?

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 YES- The state reserves the power to amend or repeal any part of the corporate code.
(Reserved Power)
 MBCA § 3.02(13)- Authorizes corporations to make charitable donations
 Some states do not even require a benefit to the corporation.
 Milton Friedman encourages corporations (via the shareholders) to choose whether or not to
contribute to charity if it actually promotes the corporation or provides a benefit to the corporation.
 Other Constituency Statute- Some states (30) allow the board may take into account the
effects of its actions on various constituencies of the corporation, including shareholders,
employees, suppliers, customers, creditors, and the communities in which the corporation has
offices or others facilities.
 May challenge the contributions by showing the members of the BoD were conflicted.
B. CORPORATE PURPOSE

Dodge v. Ford Motor Co.

 Facts: Defendant’s corporation was the dominant manufacturer of cars when this case
was initiated. At one point, the cars were sold for $900, but the price was slowly lowered to $440 –
and finally, Defendant lowered the price to $360. The head of Defendant’s corporation, Henry
Ford, admitted that the price negatively impacted short-term profits, but Ford defends his decision
altruistically, saying that his ambition is to spread the benefits of the industrialized society with as
many people as possible. Further, he contends that he has paid out substantial dividends to the
shareholders ensuring that they have made a considerable profit, and should be happy with
whatever return they get from this point forward. Instead of using the money to pay dividends,
Ford decided to put the money into expanding the corporation.
 Issue: The issue is whether Plaintiff shareholders can force Defendant to increase the
cost of the product and limit the money invested into expansion in order to pay out a larger
dividend.
 Holding: Plaintiffs are entitled to a more equitable-sized dividend, but the court will not
interfere with Defendant’s business judgments regarding the price set on the manufactured
products or the decision to expand the business.
 Rule: 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.
 Although the court won’t intrude on a corporation’s strategy to
reduce prices, withholding a dividend because shareholders have had “enough” is not
legitimate
 Rational: The purpose of the corporation is to make money for the
shareholders, and Defendant is arbitrarily withholding money that could go to the shareholders.
 Court determined that the board wasn’t looking out for the best
interests of shareholders, and so declared a special dividend
 Notably, Ford did not deny himself a large salary for his position with the
company in order to achieve his ambitions.
 However, the court will not question whether the company is better off with
a higher price per vehicle, or if the expansion is wise, because those decisions are covered under
the business judgment rule.
 Stands for the proposition that the BoD’s focus is on the best interest of the shareholder while
complying with the law
 Some states allow BoDs to consider other constituents (employees, people with whom
the company does business)
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 C. CORPORATE GOVERNANCE
 Corporate Governance= The allocation of power between and among the corporate board and
shareholders
 Considerations:
 Public corporations- Consider
 The stock exchange rules
 SEC proxy rules
 Closely held corporation- Consider
 Additional fiduciary duties between shareholders
 Special statutes that apply to only closely held corporations
MM Companies v. Liquid Audio- The most fundamental principles of corporate governance are a
function of the allocation of power within a corporation between its stockholders and its board of
directors. The stockholders' power is the right to vote on specific matters, in particular, in an election
of directors. The power of managing the corporate enterprise is vested in the shareholders' duly
elected board representatives.
 Passive role of shareholders There is a separation between ownership and control
 Difficulty presented by manager vs. shareholder dynamic
 When shareholders get involved, the shareholders’ will may be carried out but
likely at a significant economic cost
 Race to the bottom- States reduce limitations placed on corporations to attract
more money for the state but at the cost of the shareholder
 However, shareholders may decide based on the apparent disincentive.
Put in Voting P324
Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling
 PH: TC ordered a new election to be held before a master, and that master should recognize and
give effect to the agreement if its terms were properly invoked.
 Facts: Plaintiff and Haley each owned 315 out of 1000 shares of Defendant company, Ringling
Brothers-Barnum & Bailey Combined Shows, with the remaining 370 shares owned by another
defendant, John Ringling North. The company’s board was comprised of seven members, and if
each shareholder voted independently the most likely outcome would be for each shareholder
electing two board members with North selecting the extra member. However, in 1941 Plaintiff
and Healey contracted to pool their votes, wherein each selected two members and then used
their remaining votes to select a fifth member of their choosing. The contract called for an
arbitrator, Karl Loos, to resolve any disputes. The contract was terminated a year later with the
parties still bound by the arbitrator provision that called for Loos to help decide how to vote. In
1946, Haley could not attend the meeting and sent her husband in her place, and instead of
following Loos’ advice he chose to move for adjournment. Plaintiff and Defendant voted their
shares, and Plaintiff brought this action to force Healey to vote according to Loos’ decision.
Healey argued that the agreement between her and Plaintiff was invalid as it took the voting
power away from the shareholders and gave it to a third party (Loos).
 Issue: The issue is whether the agreement between Healey and Plaintiff to pool their votes was
valid.
 Held: Yes
 Rule: Shareholders can agree to pool their votes and have a third party intercede when there is
any disagreement as to how to vote.
 Rational: The court held that it no other shareholder’s rights were violated and public policy was
not violated, as the result of a pooling agreement. Shareholders should be allowed to benefit as

66
 they see fit from their voting rights, and this often means banding together to strengthen their
position.
 Results: Reversed the TC. The court decided not to invalidate the voting and held that the
members that were voted in by Healey and North would remain.

Mountain Manor Realty v. Buccheri

 Facts: Two corporate directors (Leatherman and Roby) sold their shares and resigned their
positions. Sole remaining director (Conway) called special meeting and elected two directors to fill
vacancy created by resignations and then presented to newly constituted board offer to purchase
shares (13 shares), which, if granted, would give him control of corporation. New board accepted
offer and authorized issuance and sale of shares (Conway is majority shareholder). Dispute arose
between remaining director and purchaser of shares from resigned directors (Buccheri), and
remaining director filed action for declaratory judgment that sale of shares of one resigned director
was invalid and thus purchaser was not lawful owner, that shares issued to remaining director
were validly issued, and that corporate directors selected by him were actual directors. Now
Conway has 35 shares, and says that Buccheri can’t remove the new directors.
 Issues:
 Whether the necessary quorum requirement was fulfilled.
 Whether the motivation for issuing the stocks should be examined.
 Holding#1: Yes, the quorum requirement was fulfilled. The trial court was incorrect when it
declared that the 13 shares were not legally issued to company – MBCA § 8.10(a)(3)
 Quorum issue: Court looks at quorum provision for filling vacancies, not normal quorum
provision. Normally MBCA § 8.24, but for a vacancy, there is another provision that is more
specific to these circumstances MBCA § 8.10(a)(2)
 Exception: Appointment was permissible under statute because Conway was the
only director remaining so even though it’s not a quorum he can elect
 Holding#2: Yes, the motive for stock issuance should be examined.
 Rule#2: Motive for stock issuance which has effect of consolidating or perpetuating
management control, in determining primary purpose and thus the validity of transaction, may be
inferred from effect of transaction, and court may therefore give weight to actual benefits
conferred by or flowing from challenged decision, to both corporation and interested
directors, in determining motivation behind it.
 This is a question for the trial court because it is a question of fact.
 Roby & Leatherman shouldn’t have resigned – instead they should call special
shareholders meeting and remove Conway. They could appoint Buccheri, and then one of them
could resign and Buccheri would appoint someone in that spot. Then the other would resign and
Buccheri could appoint a 3rd person.
 MBCA § 8.05(e)- Director serves until another is found to be qualified
 For how long?
 MBCA § 2.30- may seek judicial dissolution after two years
 DGCL- no time limitation
Input shareholders and directors meetings
D. THE BOARD OF DIRECTORS AND ITS COMMITTEES

1. BOARD STRUCTURES
 Independent Directors
 Under NASDAQ Rules, a majority of the directors on a company’s board must be independent.
 A Board member is not independent if (NASDAQ Rule 4350(c)):
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  The director has been employed by the company in the last three years
 The director or a family member has received compensation in excess of $120K during one
of the last 3 years from the company
 The director has a family member who is an executive officer at the company
 The director is or has a family member who is a partner or controlling shareholder of an
organization the company did business with at certain levels
 NYSE Rule 303A.03- empowers non-management directors to police directors
 Lead director- must be present at all scheduled executive sessions.
 Sarbanes-Oxley Act- Requires independent audit committee if a publicly-held company
 SEC §10A(m)- Cannot receive benefits from corporation
2. DIRECTOR'S ACTIONS
 Meeting
 Authority for meetings
 Look at corporation by laws
 Special meetings - president or director can call - also in bylaws
 Notice – MBCA § 8.22
 Regular meetings - don't have to have notice
 Special meetings - have to have notice
 Waiver of notice – MBCA § 8.23
 Waive by written authorization
 Waive by conduct
 Quorum – MBCA § 8.24
 Majority of board
 Can change number in articles or bylaws
 More or less (to 1/3 only)
 Required number of votes
 Majority of those present assuming a quorum
 Can change number
 Minutes (not required for valid action)
 Prepare
 File
 Proxy-
 Director can't vote by proxy - but can participate by telephone (MBCA § 8.20(b))
 DGCL has a similar provision
 But, you don't have to have meeting with written consent- MBCA § 8.21 (DGCL is
similar)
 Has to be unanimous
 Signature by directors
 May even be on one document
 Must be filed in corporate minute book
 State what happened in consent
3. BOARD COMMITTEE - MBCA § 8.25
 You can transfer duties to a committee or board
 Size of committee
 One or more (DGCL § 141c; MBCA § 8.25(a))

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  MBCA § 8.25- some require at least two qualified members
 Vote requirement for creation of committee
 Look in statute
 Majority of all directors in office must authorize- MBCA§ 8.25(b)
 Look at articles of incorporation
 Terms
 Classify the board of directors
 Staggered board of directors
 Reasons to do
 Provide continuity of management
 To prevent takeover
4. REMOVAL
 Can remove a director with or without cause- MBCA § 8.08(a) ; DGCL
 Unless articles of incorporation provide otherwise
 Common Law only allowed removal with cause
 MBCA § 8.08(d) - removal of director (for annual and special)
 MBCA § 8.09, DGCL § 225(c)- Judicial removal of directors
 Standing
 Corporation
 10% shareholder
 Grounds
 Corporate fraud
 Abuse
 Remedies available
 Removal of director
Superwire.com Inc. v. Hampton
 Facts: In 1998, Superwire and Entrata entered into a loan and option agreement. Superwire
had, on December 12, 2001, taken action by written consent to remove the defendants from
Entrata’s board and to place Superwire’s designees on the board in their place. Super-wire’s
position was that it had majority voting control of Entrata, contending that certain preferred voting
stock issued by the Entrata board was void because the board (allegedly) had failed to comply
with anti-dilution provisions protecting Superwire in a certificate of designations.
 Issue: Whether the extra shares that numerically reduce Superwire's stock ownership to less
than majority voting power are void.
 Holding:
 Make a note of note 2 on 265
 Problem (265)- A, B, C, and D form a corporation, but A, B, C will each hold 30 shares. D
holds 90 shares. All are appointed directors. Should there be removal or removal for cause?
 If D, removal is okay. D would only need to sway one of the other members.
 If A, B, C, then removal for cause would be the better choice.
Schnell v. Chris-Craft Industries

 Facts: After the shareholders of Chris-Craft Industries express their intent to replace the
directors because of the corporation’s poor performance, the directors voted to advance the date
of the annual shareholder meeting by a month. The shareholders sued on the ground that the

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 directors changed the date of the meeting for the purpose of frustrating a shareholder vote on the
issue of replacing the directors.
 Issue: Whether the directors improperly changed the date of the shareholder meeting?
 Holding: Yes, the directors improperly changed the date of the shareholder meeting. Even
though the directors strictly complied with DGCL, it was inequitable for them to profit from their
questionable decision.
 Rule: In the absence of fraud or inequitable conduct, the date of the stockholder’s
meeting and notice thereof, duly established under the by-laws, will not be enlarged by
judicial interference at the request of the dissident stockholders solely because of the
circumstance of proxy contest.
 Rational: The directors changed the date of the shareholder meeting in order to frustrate the
share-holders’ efforts to organize a proxy battle. Directors may not use the corporate machinery in
such a way as to frustrate dissident shareholders’ legitimate attempts to exercise their voting
rights. Even though the directors’ actions technically fall within the boundaries of the DGCL, mere
compliance with the letter of the law does not validate an otherwise inequitable action.
Inequitable action does not become permissible simply because it is legally permissible.
 Results: reversed and remanded to nullify the Dec 8 meeting and reinstate the Jan 11 date.

Blasius Industries v. Atlas Group

 Facts: Blasius Industries was a new stockholder of Atlas Corporation. Blasius ended up with
about 9% of the stock. Blasius sought Atlas' management to increase the size of the board of
directors from seven fifteen, and elect Blasius' two members to those positions. Atlas
management held an emergency meeting of the board. On December 30, 1987 amended the by-
laws to add a few more directors, and appointed two more members to the board.
 Issue: Whether the Atlas' board acted consistently with its fiduciary duty when it acted in good
faith for the primary purpose of preventing or impeding an unaffiliated majority of shareholders
from expanding the board and electing a new majority?
 Holding: No, the Atlas' board did not act consistently with its fiduciary duty when it acted in
good faith for the primary purpose of preventing or impeding an unaffiliated majority of
shareholders from expanding the board and electing a new majority.
 Rule: Deferential Business Judgment Rule- A board may take certain steps - such as the
purchase by the corporation of its own stock - that have the effect of defeating a
threatened change in corporate control, when those steps are taken advisedly, in good
faith pursuit of a corporate interest and are reasonable in relation to a threat to legitimate
corporate interests posed by the proposed change in control.
 A board decision like this does not represent an action over the corporate property or its
rights.
 It simply is a power struggle within the corporation, not covered by the business judgment
rule.
 Rational: Defendants had demonstrated no sufficient justification for the action of December
31 which was intended to prevent an unaffiliated majority of shareholders form effectively
exercising their right to elect eight new directors.
 Even finding the action taken was taken in good faith, it constituted an unintended violation of
the duty of loyalty that the board owed to the shareholders.
 Results: the action was set aside

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 Notes: Blasius adds to Schnell because the reasons for the decision in Blasius were in the
best interest of the company, not simply an attempt to perpetuate control by those in charge (as in
Schnell).
 Problem p. 271- Corporate board meeting called to issue more stock to remove board
member. Look at DGCL
 Right to advanced notice.
5. BOARD COMMITTEES
MBCA §8.25(e)
6. THE ROLE OF OFFICERS
 Corporate officers conduct the day-to-day business and have the duty to act with diligence, in
good faith, and with loyalty. Authority is found in the code, bylaws, employment contracts, board
resolutions, etc.
 MBCA `8.21(b)
 Authorities of the corporate officers are:
Grimes v. Alteon

 PH: TC ruled in favor of the Defendant and dismissed the complaint.

 Facts: Alteon Inc., defendant was Pharmaceutical Company. Plaintiff, Charles L. Grimes was
an investor, who along with his wife often purchased stocks below 10%. Kenneth I. Moch, the
President and CEO of Alton, told Grimes that Alteon Inc. required additional fund. Grimes told
Moch that he would purchase 10% of any such offerings. According to Grimes, Moch promised
orally that he would offer Grimes 10% of the offerings and in return Grimes promised to purchase
the same. Subsequently, Alteon Inc. publicly announced a private offering, but did not allow
Grimes to participate in that. Grimes filed suit claiming that oral promise was enforceable.
Chancery court denied the claim and Plaintiff appealed.
 Issue: Whether an oral agreement made by CEO to a stockholder of a corporation to sell 10%
of the corporation's future private stock was enforceable, where there was no approval of the
agreement by the board of directors.
 Holding: No, an oral agreement made by CEO to a stockholder of a corporation to sell 10% of
the corporation's future private stock was not enforceable where there was no approval of the
agreement by the board of directors.
 Rule: Only the BoD has the authority to authorize and issue stock and options, not the
officers, so the agreement wasn’t enforceable. (statutory support for court’s decision)
 Rational: The relevant statutory scheme, including DGCL § 157 and other provisions of the
Corporation Law established the policy that, commitment regarding the issuance of stock must be
approved in writing by the board of directors.
 Grimes agreement was unenforceable for lack of both board approval and a written
agreement.
 One must read together the various statutes in Subchapter V, particularly §§ 152 and 157.
 The statutory scheme of the DGCL required board approval and a written instrument
evidencing an agreement obligating the corporation to issue stock either conditionally or
unconditionally.
 Result: affirm
E. THE ROLE OF SHAREHOLDERS
 Shareholders have a limited role in corporate governance:

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 They may elect and remove directors
 Shareholder meetings
 General Meetings
 Look at statute
 Look at by-laws
 No notice required, unless by by-laws
 Special meetings
 Notice is required- MBCA § 7.05
 To whom-
 Shareholders entitled to vote- MBCA § 7.05(a)
 For specific types of transactions, different notice and information in the notice may be
required.
 Record shareholders- Person who is reflected on the corporation’s books
 If it is a public company and the broker is the record shareholder, the broker must
notify the actual holder
 It can be waived- MBCA § 7.06 (DGCL § 229)
 Shareholder can waive before or after meeting expressly
 Can waive by conduct - if shareholder comes to meeting, waive notice
 If no notice, must have waiver from all shareholders
 Statutory right under MBCA § 7.02
 Have to demand call on corporation
 Demand corporation to call- Must give notice and this can be difficult, expensive and
time consuming
 Must have 10% of shareholders
 May contract to a different percentage
 DGCL § 211(b) - special meeting is not statutory - must be set forth in articles or by-laws
 MBCA § 7.03 - Court ordered meeting - if special meeting was not called after demanded
 Quorum requirement
 A quorum is a majority of the shares entitled to vote
 Unless articles or by-laws state otherwise
 Articles can provide for greater quorum – MBCA §7.27(a)
 DGCL § 216 - can change in articles or by-laws and can also have less than majority
quorum (at least 1/3)
 Have this b/c with large publicly held corporation it is very hard to get a quorum present
 Cannot break quorum by leaving meeting- MBCA §7.25(b)
 Not all states provide
 Some case law allows break quorum
 Some transactions have different requirements
 Default rules apply if nothing in the charter
 One class → majority of shares entitled to vote = quorum
 MBCA §§ 7.25(a) and 7.26
 DGCL § 216(1)
 Separate classes → majority of shares present = quorum
 MBCA §§ 7.25(b) and 7.26
 DGCL § 216(4)

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 Straight vs. Cumulative Voting- The vote for directors may either be "straight" or
"cumulative." (In most states, cumulative voting is allowed unless the articles of incorporation
explicitly exclude it.)
 Straight- 1 share = 1 vote
 DGCL § 212(a) –straight voting is the default rule
 MBCA § 7.21(a) –straight voting is the default rule
 Majority of the votes will be required to be elected
 Cumulative- In cumulative voting, a shareholder may aggregate his votes in favor of fewer
candidates than there are slots available. (Example: H owns 100 shares. There are 3 board slots.
H may cast all of his 300 votes for 1 candidate.) This makes it more likely that a minority
shareholder will be able to obtain at least one seat on the board.
 Total number of votes = number of shares x number of positions to be filled
 Can spread your votes out to as many candidates as there are seats to be filled or
concentrate them all in one candidate
 Removal of directors- If cumulative voting is authorized, a director usually may not be removed
if the number of votes that would have been sufficient to elect him under cumulative voting is
voted against his removal.
 Plurality of the votes will be required to be elected
 The top candidates regardless of whether they had a majority
 You must opt-in
 DGCL § 214 – must be authorized in the certificate of incorporation
 MBCA § 7.28 – must be authorized in the articles of incorporation

 Meetings and the Shareholder list- MBCA § 7.20

 Must prepare the shareholder for meeting
 Who is entitled to vote, notice, etc.
 When is list subject to inspection?
 Refusal to submit list or prepare does not cause action of meeting to be valid

International Brotherhood of Teamsters v. Fleming Comp. Inc.

 PH:
 Facts: Appellee (IBTGF) owns sixty-five shares of Appellant (Fleming). In 1986 Appellant
implemented a shareholder’s rights plan, commonly referred to as a “poison pill” as an anti-
takeover mechanism. Appellee was critical of this plan seeing it as a means of entrenching the
current board of directors in the event Appellant became the target of a takeover. Appellee passed
a non-binding resolution at the shareholders meeting calling on the board to redeem the existing
rights plan. Appellant’s board was hostile to the resolution and the rights plan remained intact.
Appellee then prepared a proxy statement for inclusion in the proxy materials for the next annual
shareholders meeting. The proposed amendment to the bylaws would require any rights plan
implemented by the board of directors to be put to the shareholders for a majority vote. Appellant
refused to include the resolution in its proxy statement. Appellee brought suit and won. Appellant
appealed and moved to suspend the injunction hoping to postpone shareholder vote on the proxy
issue until after the resolution of this case. The motion was denied. Fleming was forced to allow its
shareholders to vote on the proxy. It passed with 60% of the voted shares.
 Issue#1: Whether Oklahoma law restricts the authority to create and implement shareholder
rights plans exclusively to the board of directors.

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 Issue #2: Whether shareholders may propose resolutions requiring that shareholder rights
plans be submitted to the shareholders for vote at the succeeding annual meeting.
 Holding#1: No, there is no exclusive authority granted boards of directors to create and
implement shareholder rights plans, where shareholder objection is brought and passed through
official channels of corporate governance.
 Rule #1: Shareholders rights plans- Rights or warrants that are adopted by the BoD to
make the corporation more takeover proof.
 Rational #1: Appellant argues that the board of directors only may create and issue rights and
options. Appellant relies on 18 O.S.1991 § 1038 to claim that “corporation” is synonymous with
“board of directors.” The former Business Corporations Act, 18 § 1.2(1) and (23) defines both
terms differently and it is unlikely that the legislature would interchange them as Appellant
contends.
 Holding #: Yes, there is no authority precluding shareholders from proposing resolutions, or
bylaw amendments that restrict board implementation of shareholder rights plans assuming the
certificate of incorporation does not provide otherwise.
 Rule #2: Shareholders may, through proper channels of corporate governance, restrict
the board of directors’ authority to implement shareholder rights plans
 Rational #2: A shareholder rights plan is essentially a variety of stock option plan. Other cases
reveal that stock option plans can be subject to shareholder approval. Nothing in existing case law
indicates that the shareholder rights plan is exempt from shareholder adopted bylaws.
 Primacy of corporate statute controls here.
 Hierarchy: constitution statute articles of incorporation bylaws BoD
resolutions.
 If the articles say something that conflicts with the bylaws, the articles control.
F. DUTY TO CREDITORS
 The general rule is that creditors can protect themselves by contracting for the protections that
they desire. They could in theory, contract for the creation of fiduciary duties between them and
the BoD. They could expressly limit the actions that the corporation can take so as to protect their
interest.
G. SHAREHOLDER VOTING
 Shareholder can vote either In person - physically present or by proxy in writing
1. PROXY VOTING
 Proxy is a person who is authorized by a record shareholder to vote his/her shares (principle-
agent relationship)
 Shareholders can authorize someone else (generally corporate management) to vote their
shares
 “Proxy” may also be used to designate the document that creates the authority, the grant of
authority itself, and the person granted the power to vote the shares
 MBCA limits “proxy” to person with power to vote, refers to the grant of power as “appointment”
of a proxy, and the document creating the same is the “appointment form.”
 Very little state law on this matter.
 Proxy appt. may be revoked either expressly or by implication.
 Under SEC rules, shareholders can direct how the proxy holder should vote the shares
 Action without meeting is allowed by written shareholder consent - very hard to use except in
small corporations in harmony.
 MBCA § 7.04- Consent must be unanimous
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 DGCL § 228- Unanimity is not required
 Electronics
 You can now give electronic notice, you can now participate in a shareholder meeting
without being there if the board allows it
 Does the meeting have to have a physical location or may it be held electronically?
 MBCA- It must have a physical location
 DGCL- It may be held solely in cyberspace.
2. STATE REGULATION

Lacos Land Comp. v. Arden Group, Inc.

 PH:
 Facts: Plaintiff, Lacos, is a stockholder of Arden owning 4.5% of Class A Common Stock.
Briskin, Arden principal shareholder and chief executive officer joined Arden when it was in
desperate condition. During his tenure, the stock price rose from $1to $25 per share. Briskin
presented an idea for a dual common stock voting structure to the board of directors. The board
established a committee to consider the matter. The committee’s report was presented to the
board and approved. The dual common stock voting structure will result in the issuance of Class B
stock, which will have enhanced voting power, diminished dividend rights, and restrictions upon its
transfer. Management of Arden prepared a proxy statement recommending the proposed charter
amendments authorizing the new super-voting Class B Common Stock. The proxy statement
stated that Briskin demanded the amendments threatening to thwart corporate transactions that
may be in the Company’s best interest if the amendments were not approved.
 Issue: Whether the Arden shareholders have effectively exercised their will to amend the
Company’s restated certificate of incorporation so as to authorize the implementation of the dual
class common stock structure.
 Rule: No, the vote was inappropriately affected by an explicit threat of Mr. Briskin therefore the
amendments to Arden’s restated certificate of incorporation purportedly authorized by that vote
are voidable.
 As a director and officer Briskin has a duty to act with complete loyalty to the interests of the
corporation and its shareholders.
 His position in demanding the amendments under threat of thwarting corporate transactions is
inconsistent with that obligation.
 The stockholder vote was fatally flawed by the threats.
 Shareholders were inappropriately placed in a position in which they were told that if they
refused to vote affirmatively Briskin would not support future transactions that might be beneficial
to the corporation.
 A vote of the shareholders under such circumstances cannot satisfy the mandate of §
242(b) requiring shareholder consent to charter amendments.
 A vote of the shareholders cannot satisfy the mandate of § 242(b) requiring shareholder
consent to charter amendments when it is made under threat by the director and chief
executive officer of a corporation that if approval is not given he will thwart future
corporate transactions.
 Coercion is generally frowned upon. Voluntary decisions are optimal.
 Delaware Case Law- When directors go to shareholder to ask for approval, they must make a
fair disclosure of material facts

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Schreiber v. Carney
 PH:
 Facts: A planned restructuring of the company Texas International was delayed by a potential
veto by the company’s largest shareholder, Jet Capital. The restructuring plan called for Texas
International to merge into a holding company, Texas Air Corporation, created specifically for the
restructuring. Jet Capital objected to the merger, though it acknowledged the restructuring would
benefit the corporation and other shareholders, because the stock swap would have created “an
intolerable tax burden” on Jet Capital as the holder of substantial warrants for Texas International
stock. To secure Jet Capital’s vote for the merger, Texas International proposed a loan of $3.3
million to Jet Capital that would carry a five percent interest rate up until the warrants that Jet
Capital held would have expired. Once Texas International’s directors approved the loan plan,
they submitted the plan to the stockholders for a vote. Final approval was contingent upon a
majority vote of all stockholders, as well as a majority vote of all disinterested stockholders. The
shareholder vote met both conditions and Texas International formally approved the loan.
 Issue: Whether vote buying is illegal per se.
 Rule: No, vote-buying is illegal per se only “if its object or purpose is to defraud or
disenfranchise the other stockholders..
 Vote-buying: voting agreement supported by consideration that is personal to the
stockholder (not shared by others), whereby the stockholder divorces his discretionary
voting power and votes as directed by the officer (broad definition)
 This was clearly vote-buying – JC received a loan and thereupon agreed not to
object to the reorganization plan
 Court says that vote-buying is not illegal per se.
 Instead, they say that vote-buying is illegal if it results in injury,
disenfranchises the shareholders, etc.
 Looks at “intrinsic fairness.”
 Because the purpose wasn’t to defraud other shareholders, it’s a voidable transaction which is
permissible/cured if it is approved by a vote of the other shareholders.
 The public policy in which minority shareholders owed each other a fiduciary duty no longer
existed.
 NY has an express provision prohibiting vote-buying. The MBCA and DGCL do not.
 Management can only use corporate funds in an election contest when:
 There are “policy differences” between its nominees and those of the insurgents, as opposed
to mere “personality conflicts.
 The expenses for which management seeks reimbursement must be reasonable and proper
expenses for the solicitation of proxies
 Expenses for vote buying could be deemed reasonable
 If insurgents do prevail in an election contest, they can obtain reimbursement for their
expenses from the corporate treasury, with shareholder approval
3. FEDERAL REGULATION: PROXY SOLICITATION
 SE Act of 1934 § 12
 Must register (with Exchange and SEC) if security is listed on exchange- §12(a)
 NOT the same as registration for initial offerings of securities.
 Must register if assets over $1 million and securities held by 500 or more shareholders- §
12(g)(1)(b)
 Exemptions (DO NOT apply to § 12a)
 Now must be over $10 million- § 12(g)(1)

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  Termination- § 12(g)(4)
 If less than 300 shareholders regardless of assets OR
 Less than 500 persons and less than $10 million for 3 years
 SE Act of 1934 § 14(a)- It is unlawful for any person to solicit any proxy in contravention of the
rules and regulations adopted by the SEC as necessary or appropriate in the public interest or for
the protection of investors- Proxy Statement (Example in supplement is 120 pages!!!)
 Lays out what specific info must be furnished to stockholders, the form of proxy that
may be solicited, etc.
 Who is soliciting proxy (bold)- § 14(a)(1)
 Date space- § 14(a)(2)
 Clearly identify what is to be voted on- § 14(a)(3)
 Must give choice of for, against, abstain- § 14(b)(1)
 Election of directors - for or withhold- § 14(b)(2)
 Rule 14a-9- False or misleading proxy statement
 Prohibits solicitations containing any statement which 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
 J.I. Case v. Borak- A shareholder may maintain both direct and derivative actions for
violations of § 14(a)- Implied private right of action
 Solicitation of proxies exemption- SE Act § 14(a)(2)
 If not the registrant or representative- you can solicit up to 10 people
 A security holder can use forum speech, press release, publish, broadcast, ads to
disseminate how they are going to vote and why - but can't solicit others to vote the
same way

Mills v. Electric Auto-Lite Co.

 PH:
 Facts: Petitioners were minority shareholders in respondent’s corporation. A shareholder vote
was going to decide whether Respondent would merge into another Respondent company,
Mergenthaler Linotype. Mergenthaler already owned over 50% of Respondent, and in turn
Mergenthaler was controlled by a third respondent company, American Manufacturing.
Shareholders were no told that the directors who recommended the merger were all under the
control of Mergenthaler. Therefore the recommendation came from an interested party. The
District court concluded that the misleading proxy solicitation was material and had a causal
connection to the vote. The Appellate court reversed because Petitioners did not demonstrate the
causal relationship existed and that the fairness of the merger should be reviewed to determine if
there was any merit to the charge.
 Issue: Whether the material misrepresentation in the proxy solicitation is sufficient to establish
the cause of action.
 Rule: Yes, a material misrepresentation or omission is enough to establish a cause of action.
 A material misstatement or omission in a proxy statement is all that is required to
maintain an action under § 14(a)
 The Court noted that misleading material in a solicitation is in itself a violation of § 14(a).
 The United States Supreme Court declined to follow the Appellate court’s “fairness of the
merger” test because it basically removed the shareholders from the voting process.
 A company could release an extremely false proxy statement and justify it as long as they
could demonstrate that the merger was fair.
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 In this case, Petitioner has established facts, namely that shareholders may have been
materially affected by the recommendation of an interested board of directors, which would allow
for a cause of action.
 The Court refused to allow directors to cut out the shareholders of the voting process, and
refused to allow a company to rationalize misconduct by declaring that the merger was fair.
4. FEDERAL REGULATION: SHAREHOLDER PROPOSALS
 Shareholders may, subject to limitations, propose resolutions for consideration by the
shareholders at any annual or special meeting of the shareholders and require a registered
company to include those proposals in its proxy statement and on the proxy card
 Regulation 14A
 Shareholder Proposals - § 14(a)(8) - Solicitation of Proxies
 Look in § 14(a)(8) for definition and examples of proxies
 Eligibility requirements:
 Must be record or beneficial owner of 1% or $2000 worth of voting security
and have had security for 1 year
 Company must put proposal in proxy statement and must provide a place on the
proxy to vote
 Limits
 One proposal per meeting;
 500 words in length total, including supporting statement;
 However, the Company opposition statement doesn't have a word limit
 Company sets deadline for submission
 Most proposals settled at a preliminary stage before the filing of a formal S/H proposal
 If no agreement is possible, management will seek to omit proposal from proxy statement
by seeking a “no action letter”—reflects a decision by the SEC it will recommend that not
action be
 Exclusions of shareholder proposals- "No action” letter
 Company should get SEC to issue letter which authorizes company to ignore
proposal and not get into trouble
 Shareholder can amend proposal and try again
 What types of shareholder proposals must company include in proxy
 These proposals may address levels of executive compensation, discrimination,
affirmative action, treatment of minority groups and environmental concerns
 These proposals call attention to the management to some problem area that
exists in the corporation’s activities
 What can be omitted- § 14(a)(8)(c)(1-13)
 Not proper subject (NOTE: applicable state laws determine if proper state
subject)
 Proposal violates the law
 Contrary to proxy rules - like § 14(q)(9) - misleading statements
 Personal redress of grievance
 Insignificant - less than 5% of gross sales and is not otherwise significantly
related to registrant's business and less than 5% of total assets (de minimis
provision)
 This ambiguity allows plaintiffs to win
 Force feeding geese for pate counts (see Lovenheim, infra p. 71)
 Matter beyond registrant's power
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  Mater relating to the conduct of ordinary business operation (company wins)
 Many cases revolve around this one
 Not shareholder business
 So far down in level of detail to be beyond shareholder
cognizance
 E.g. employment practices
 This has been changed back if a sound policy concern
 Election of office
 Director elections- § 14(a)(8), if:
 It would disqualify a nominee
 It would remove a director from office before end of term
 It questions business judgment, competence, or character of
nominees or directors
 It seeks to include a specific individual in company’s proxy
materials for election to BoD
 It affects the outcome of upcoming election of directors
 Counter to proposal
 Rendered moot (substantially implemented)
 Duplicated proposal
 Repeat proposals that have lost (in the last 5 years)
 1 Meeting - less than 3% vote
 2 meetings - less than 6% vote
 3 meetings - less than10% vote
 Specific amounts of cash or stock dividends
a) The “Not Significantly Related” Exception
Lovenheim v. Iroquois Brands, Ltd.

 Facts: Plaintiff, Lovenheim, wanted to insert a proposal to determine whether a supplier of

pate de fois gras force-fed the geese n order to enlarge the livers. The pate represented
less than .05 percent of Defendants sales, and the product operated at a loss. Therefore
Defendants wanted to omit the proposal. Defendants believed that only a proposal related
to economic purposes are required to be accepted per Rule 14a-8(c)(5), and that the 5%
threshold was not exceeded. Plaintiff argued that material social issues that were relevant
to the business would not fit under the Rule’s exception.
 Issue: Whether a company could refuse a shareholder proposal for a proxy statement if the
proposal concerned less than 5% of the business sales (de minimis), and the proposal was
not economically based.
 Rule: No, the court held that precedent demonstrated that Rule 14a-8(c)(5) would only omit
proposals that were less than the minimum 5% of sales and not significantly related to the
business.
 In this case, the pate issue was significant to its pate business regardless that it did not
comprise greater than 5% of sales.
 Prior cases also demonstrated that Congress wanted to ensure that non-economic
factors could be considered as relevant to the business.
 Both sections of Rule 14(a)(8)(c)(5) need to be met.
 Under Rule 14(a)(8)(c)(5), a shareholder proposed resolution for a proxy
statement can only be turned down when the proposal both:

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 Concerns less than 5% of total earnings or assets, and
 It is not “significantly related” to the business.
 The ruling is consistent with the idea that not all decisions made by a corporation
will be made solely along economic lines.
 The “Ordinary Business” Exception (14(a)(8)(i)(7)) & Socially Significant Issues
 A company may exclude a shareholder proposal if it deals with a matter relating to the
company’s ordinary business operations
 Problem p. 302- Shareholder wants to ask shareholders to adopt a company policy that
patrons be excluded from casino’s premises or be awarded comps on an equal basis.
Shareholder is unsuccessful gambler.
 Not likely successful. This would fall under ordinary business exception or the personal
grievance rule.
b) The “Election of Directors” Exception
 Director elections- § 14(a)(8)(i)(8), if:
 It would disqualify a nominee
 It would remove a director from office before end of term
 It questions business judgment, competence, or character of nominees or directors
 It seeks to include a specific individual in company’s proxy materials for election to BoD
 It affects the outcome of upcoming election of directors
H. SHAREHOLDER INSPECTION RIGHTS
 At common law, courts have recognized right of shareholders to inspect books and records as
an incident of ownership
 Now included in all corporate codes.
 MBCA §§ 16.01-16.05
 Two categories of records:
 Info. that is readily available- Articles of incorporation, bylaws, board resolutions, relating
classes or series of shares, names and addresses of the directors and officers, etc. (§
16.01(e))
 Generally available from public filings
 Written demand five days before inspection
 Info. that may not be easily assembled and that often the corporations wishes to keep
private- Director minutes, accounting records, list of shareholders
 Demand must be made in good faith and for a proper purpose (§ 16.02(c))- State ex. rel.
Pillsbury v. Honeywell
 Shareholder must describe with reasonable particularity his purpose and the records he
desires to inspect
 Records must be directly connected with the purpose
 DGCL § 220
 Who has inspection rights?
 Legal or record owner - mere beneficial owners can't (DGCL § 220)
 OK for beneficial owners/nominees to inspect (MBCA § 16.02(f))
 What can be inspected?
 Very broad - books and records (DGCL § 220)
 Accounting record, minutes, records of shareholders (narrower - not all records
available (MBCA § 16.02(b))
 When can you inspect
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  Typical requirement - proper purposes
 Right to inspect these no matter what (MBCA §§ 16.02(a) & 16.01(e))
 Shareholders can inspect other records but must have good faith and proper
purpose for all other documents (MBCA § 16.02 (b) & (c))
 Proper Purpose
 What is a proper purpose
 Info. about other shareholders to communicate with them regarding a proper
matter
 Valuing shares
 Investigation of corporate mismanagement
 DGCL § 220- proper purpose is related to the interest as a shareholder
 Cases:
 Delaware- Proper purpose if to:
 Communicate with other shareholders about joining in a suit against
the corporation (in direct or derivative action)
 Solicit proxies from fellow shareholders in election of directors
 What is improper purpose?
 Idle curiosity
 Harassment
 To obtain info for improper purpose (MBCA § 16.04(d))
 To promote political or social aims- State ex. rel. Pillsbury v Honeywell
 The law ignores secondary purpose as long as the primary purpose is proper
 Who has burden of proof of proper purposes
 Common law- Shareholders
 (DGCL § 220(c)) It depends
 Burden of proof is on corporation regarding info. on other shareholders
 Burden of proof is on shareholders regarding any other matter
 MBCA - Doesn't say anything about it
 Probably shareholders will have burden of proof

State ex. rel. Pillsbury v. Honeywell

 PH: TC dismissed the petition

 Facts: Petitioner, Pillsbury, was part of an anti-war group that decided to target Respondent,
Honeywell, for their manufacturing of weaponry that would be used in the Vietnam War. Petitioner
decided to purchase shares (for the purpose of this suit, he only owned one share) of Respondent
for the purpose of requesting corporate documents, as a shareholder, in order to identify other
Respondent shareholders in order to inform them of Respondent’s involvement. Petitioner made
two formal demands for the records that were both denied. Petitioner then filed a writ of
mandamus, and he explained his reasons for the inspection. The trial court agreed with
Respondent in finding that there was no proper purpose related to his interest as a stockholder.
 Issue: Whether Pillsbury’s demand for records for the purpose of informing them of
Honeywell’s involvement in the Vietnam War is a proper purpose that would allow for the
inspection.
 Holding: No, Pillsbury’s purpose was not proper.

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 Rule: A shareholder can only demand corporate investor identification
information when the purpose is related to investment concerns traditionally associated
with shareholder concerns.
 The proper purpose has to pertain to investment purposes rather than just
simply whenever a stockholder has any grievance with a company’s management. The
court will not allow an absolute right of inspection.
 Rational: Shareholder’s purpose was not deemed to be proper – he had no
economic concern, he solely wanted to share his social and political concerns. Shareholder was
denied access to inspect the records, even though the request wasn’t unreasonable on its face.
The court is concerned that allowing an inspection by simply being able to be identified as a
shareholder puts an enormous burden on corporations, which can have thousands of
shareholders at any given point, to maintain their corporate records.
 Results: Affirm

Seinfeld v. Verizon Communications Inc.

 PH: Dismissed in favor of the defendant

 Facts: In Seinfeld, the stockholder plaintiff (“Seinfeld”) sent a written demand in
compliance with Section 220 of the DGCL to defendant Verizon Communications, Inc. (“Verizon”),
seeking to inspect Verizon’s books and records based on suspicions of wrongdoing relating to the
compensation of Verizon’s three top executives. Seinfeld specifically alleged that he was
concerned that these executives were being compensated far in excess of the minimum amounts
that they were entitled to receive under their employment contracts. Seinfeld also claimed that the
executives were being paid combined compensation of $205 million to act as three co-chief
executive officers running a single company, and that such compensation was excessive for
duplicative efforts. Verizon refused Seinfeld’s demand to inspect the books and records of the
company on the basis that he had not asserted a proper purpose for the inspection, and Seinfeld
thereafter filed suit in the Court of Chancery. In the “summary” books and records action, Verizon
quickly noticed Seinfeld’s deposition to question Seinfeld as to the good faith of his stated
purpose.
 Issue: Whether the stockholder seeking inspection under DGCL § 220 should be
entitled to inspect the books without showing evidence of a credible basis for wrongdoing.
 Holding: No, the stockholder must meet burden of proof.
 Rule: To meet the requirement of "proper purpose" found in the statute,
"stockholders seeking inspection under § 220 must present “some evidence” to suggest a
“credible basis” from which a court can infer that “mismanagement, waste or wrongdoing
may have occurred.”
 DGCL § 220- Any stockholder shall, upon written demand under oath
stating the purpose thereof, have the right during the usual hours of business to inspect
for any proper purpose
 Rational: Court said that Seinfeld offered no evidence to evaluate whether
there was a reasonable ground for suspicion on the claim- the burden of proof is on the
shareholder to demonstrate proper purpose by a preponderance of the evidence.
 Results: affirmed
 The scope of inspection rights
 MBCA § 16.03 - Can copy records, agents can inspect
 Common law - also supports ancillary rights and don't need statute
 If you are denied inspection rights
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 Common law - bring mandamus action
 Statutes enforceable proceeding (check statutes)
 DGCL § 220(c) proceeding (no penalty)
 Requires a demand under oath
 MBCA
 § 16.04 - summary court proceeding for documents of right
 § 16.04 - expedited court proceeding for docs that require proper purpose
 NY § 624
 Penalties include making the corporation pay the costs
 Court may impose restrictions on use or distribution of information (MBCA § 16.04(d))
 Is the statutory inspection provision exclusive? NO
 Statutory provisions are not exclusive- You can have common law rights of
inspection to look at records
 Important in NY because narrow
 Not important in Delaware because the statute is so broad
 Could be significant in MBCA § 16.02(c)(2)- non-accounting
 How to enforce common law rights of inspection
 Mandamus or mandamus equivalent
 Miscellaneous provisions
 Notice of demand to inspect
 Written demand (MBCA §§ 16.02 (a & b))
 Written demand under oath (DGCL § 220 (b))
 Right to financial statement-Financial statements must automatically be provided
by corp. (MBCA § 16.20)
 Shareholders must demand (NY) Annual report to Secretary of State
 MBCA- Can be viewed by all public (can be administratively dissolved for failure
to provide)
 No Delaware equivalent
 Director's inspection rights
 Corporate director has right to inspect books and records
 DGCL- Only for proper purpose
 MBCA- No mention
 Director's right to inspect may be broader than shareholder's right because of director's
duty to keep informed
 In some jurisdictions, director's right to inspect is unlimited, in others it must have proper
purpose relating to directors duties
 MBCA § 16.21 requires a report for indemnification and shares issued for future
services

IX. P ROBLEMS IN CLOSELY HELD CORPORATIONS

A. INTRODUCTION
 Stock
 Generally held by relatively few individuals
 No market for the stock
 Individuals who own the equity interests generally earn their livelihood by working in
the business
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  Right to Exit
 In a corporation, there’s no right to exit unless shareholder oppression can be shown
 Fear with corporations is that other shareholders will gang up on one, and that
shareholder will become a minority shareholder and thereby suffer injury (loss of
employment, officer position, access to information, etc)
 Capstone of the freezing out technique: offer to purchase the minority shareholder’s
stock at a steep discount from what its worth
 Protection for Minority Shareholders
 Minority shareholders can bargain for protection in the contractual shareholder
agreement (Delaware view – Nixon case)
 In Delaware, if no contractual protection, the court only looks at whether there was a
breach of the duty of care or loyalty
 Other states take a different approach
 MBCA §7.32- If you have unanimous shareholder agreement, they can do anything they
decide as long as it’s consistent with the law (do away with the BoD, declare dividends,
elect officers, etc.
B. FIDUCIARY DUTIES AMONG SHAREHOLDERS

Donahue v. Rodd Electrotype Co. of New England (One of the most important cases in the
book)

 PH: TC dismissed; AC affirmed

 Facts: Donahue was the widow of an employee of Rodd, who rose to the position of Vice
President, and finally owned 20% of the company stock before his death. Harry Rodd owned the
other 80%. Harry Rodd gave some stock to children and sold the remaining stock to the
corporation. Donahue learned of the purchase and demanded the company buy her stock on the
same terms. Rodd refused, and Donahue sued.
 Issue: Whether each shareholder in a closely held corporation owes a fiduciary duty to the
other shareholders.
 Holding: Yes, each shareholder in a closely held corporation does owe a fiduciary duty to the
other shareholders.
 Rule: The relationship of stockholders must be one of trust, confidence, and absolute
loyalty- Shareholders owe one another a strict fiduciary duty
 Shareholders must act with utmost good faith and loyalty
 If a shareholder who is a member of the group controlling the corporation has had his
stock repurchased, the other shareholders must be given the same opportunity to have the
same percentage of their shares repurchased at the same price.
 Every shareholder has equal opportunity to tender pro rata their shares in closely held
corp. only
 Corporation has statutory power to repurchase shares (MBCA §6.31)
 Lack of options of minority shareholder
 Compare to partnership -- can't force dissolution
 Compare to public corp. -- can't sell stock
 Cannot force dividends (business judgement)
 Normally put large assets into close corp.
 If the corporation doesn’t have the money to purchase all the stock, they could rescind the
purchase of Rodd’s stock, so no one’s stock would be repurchased
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 An effort by a shareholder to issue stock in order to expand his holdings or dilute
holdings of other stockholders is similar to a breach of duty.
 THE CASE DOESN’T SAY YOU MUST BE A CORPORATE EMPLOYEE TO BE A
SHAREHOLDER
 THE CASE DOESN’T SAY THAT IF YOU ARE A CORPORATE SHAREHOLDER AND
EMPLOYEE, YOU CANNOT BE FIRED
 Does Donahue create a per se equal opportunity rule? Maybe.
 Yes, but later courts have rejected this rule.
 At face value, Donahue may be too broad- We have to take into account the legitimate
business interests of others and balance them
 You must have a legitimate business purpose (Majority must show this)
 Then minority may show that it could have taken another course of action that would have
been less harmful to the minority
 So why didn’t Donahue talk about legitimate business purpose? NO, because the legitimate
business purpose was not argued by the parties. However, the court could have talked about it in
dicta, if it had chosen to.
 Donahue doesn't apply in Delaware
 There may be a fact pattern on the test in which you should identify the individual
duties of the parties.

Wilkes v. Springside Nursing Home

 PH:
 Facts: Wilkes, Plaintiff, was locally renowned for his profitable real estate dealings, and in
1951 when Defendants heard about Plaintiff’s option to purchase a particular building, they agreed
to partner with Plaintiff on developing a business venture around that option. The parties agreed to
allow each to receive money from the corporation as long as they actively participated in running
the business. The parties then agreed to open a nursing home at the location, and by 1952 the
profit from the business was large enough for them to each draw a salary from the business. One
of the Defendants wanted to purchase part of the property for his own business use, and Plaintiff
forced a higher price for the property than what was expected. This created bad feelings between
the partners until finally, in 1967, Plaintiff notified the other shareholders that he wanted to sell his
share. A month later, but prior to the sale of his shares, Defendants voted to terminate Plaintiff
from his position and took away his stipend- a freezout (despite the fact that another owner at that
point received a stipend while having no day-to-day responsibilities). Defendants argued that they
had the power, under the corporate by-laws, to set salaries and positions.
 Issue: Whether Springside violated a fiduciary duty when they removed Wilkes from his
position after a falling-out between the parties.
 Holding: Yes, shareholders have a duty of loyalty to other shareholders in a close
corporation, and in this case the duty owed to Wilkes by Springside was violated. Therefore
Wilkes is entitled to lost wages.
 Rule: Shareholders in a close corporation owe each other a duty of acting in good faith,
and they are in breach of their duty when they terminate another shareholder’s salaried
position, when the shareholder was competent in that position, in an attempt to gain
leverage against that shareholder.
 Rational: In close corporations, a minority shareholder can be easily frozen out (depriving the
minority of a position in the company) by the majority since there is not a readily available market
for their shares. Although this is traditionally an issue of management, the test for close
corporations, should be whether the management decision that severely frustrates a minority
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 owner has a legitimate business purpose. In the case at issue, Springside’s decision would assure
that Wilkes would never receive a return on the investment while offering no justification.
 Test: Is a legitimate business purpose in the closely held corporation’s actions?; and
 Plaintiff proves there is an alternative method that is less harmful to minority
shareholder then the corporation will lose
 Shareholders had affirmative obligation to show a legitimate purpose for terminating
Wilkes’ employment, officer position.
 If they could show this, burden shifts to Wilkes to show that same means could be
achieved through less drastic alternative.
 The court is reversing a prior line of thought that management decisions are not within
the scope of review of the courts (the Business Judgment Rule).
 The court notes at the negative effects that the prior line of reasoning had wrought, such as the
freezing out or the oppression of minority shareholders.

Smith v. Atlantic Properties

 Facts: Wolfson offered the three Plaintiffs, Paul T. Smith et al., to go in equal shares in the
purchase and development of some real estate. The partners formed Atlantic Properties with each
party becoming a 25% shareholder, and Atlantic then bought the property in 1951. The corporate
by-laws provided that any proposals had to be approved by at least 80% of the directors, meaning
that in real terms for the group of four there would need to be a unanimous vote. The corporation
was profitable every year through 1969 but dividends were only paid in 1964 and 1970. Because
so much of the value of the company was in cash, the Internal Revenue Service assessed penalty
taxes in seven different years for the accumulation of the money. Wolfson was the lone dissenter
for the voting for dividends, and his vote was enough to defeat the proposals under the 80% plan
in the by-laws. Wolfson maintained that he wanted the money for improvements to the property,
and Plaintiffs asserted that he wanted to avoid his own personal tax issues. Plaintiffs then sought
damages from Defendants for dividends, damages due to the tax penalties and legal expenses,
and also asked to remove Wolfson as a director. The lower court agreed with Plaintiffs that
dividends should be issued and that Defendants were liable for the tax penalty amounts.
 Issue: Whether Wolfson owes Plaintiffs the same fiduciary duty a majority would owe a
minority shareholder.
 Rule: The court held that the determining factor for the fiduciary duty owed is whether a
party would be considered a controlling party.
 Because Wolfson was the controlling party in that he alone prevented the dividend payouts
despite no real business justification, the court affirms that a fair dividend should be declared.
 Court held that Wolfson had an ad-hoc controlling interest because of his veto power so he
owed fiduciary duties to the other shareholders as well as the corporation itself
 Wolfson could present a plan where he votes to approve dividends to avoid the tax penalties
but requests reimbursements of the funds to the plan in order to make the improvements. Or he
could buy out the shareholders/be bought out.
 Wolfson was unreasonable and did not demonstrate utmost good faith and loyalty to the
business.
 The court had no problem with the by-law provision that allowed for a minority to veto
dividends, but rather in the manner in which he utilized his powers to unreasonably prevent the
allowance dividends in the face of tax penalties.

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 Minority shareholders owe majority shareholders a fiduciary duty in the same manner
that majority owners owe minority shareholders, and therefore the majority can seek
judicial intervention for decisions that are unjustifiable for the corporation’s interests.
Merola v. Exergen Corp.

 Facts: Merola, a minority stockholder, was terminated. He was originally offered employment
with understanding that he would become majority shareholder.. He then sold stock back to
Exergen at a profit and was terminated without cause. He claims that by firing him the corporation
breached its fiduciary duty to him. His contention is that he wanted to become a majority
shareholder and now that he’s been fired he can’t.
 Issue: Whether Exergen breached a fiduciary duty for terminating the Merola’s employment at
the corporation.
 Holding: No. There was no breach of a fiduciary duty.
 Rule: The controlling group in a close corporation must have some room to maneuver
in establishing the business policy of the corporation.
 Rational: Merola was an at will employee, and although there was no legitimate business
purpose for firing him, the court allowed it. Departure from Wilkes – but this is an odd case
because Merola wasn’t even a shareholder anymore – he had already sold his stock back. Not
every discharge of an at-will employee of a close corporation who happens to own stock in the
corporation gives rise to a successful breach of fiduciary duty claim.
 The plaintiff was terminated in accordance with his employment contract and fairly
compensated for his stock.
 He failed to establish a sufficient basis for a breach of fiduciary duty claim under the principles
of Donahue. There was no breach of fiduciary duty in this case, but it would be a much harder
question if the corporation had not let the plaintiff sell his stock, or had low-balled him.
 Result: reversed

Insert Riblet, Sletteland, Rosenthal, Hagshenas’ cases

C. OPPRESSION, DEADLOCK, & DISSOLUTION
 Involuntary Dissolution of a Corporation
 There is a requirement that directors or those in control have engaged in conduct that is
illegal, oppressive, or fraudulent (MBCA § 14.30(a)(2))
 Standards for oppression must be met –
 Not a single instance of misconduct, but a course of misconduct intended to
harm the interests of the minority shareholder or otherwise frustrate his
expectations
 Typical grounds:
 Directors of the corporation are deadlocked, the shareholders are unable to break
the deadlock, and irreparable injury is threatened
 The shareholders are deadlocked in voting power and have failed in two or more
annual meetings to elect successor directors
 The directors or those in control of the corporation have engaged in conduct that is
illegal, oppressive, or fraudulent
 The corporate assets are being misapplied or wasted
 Majority shareholder in closely held corporations may elect to buy out at fair value the shares
of the minority shareholder to avoid dissolution
 Courts may dissolve:
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  Wind up corporate affairs
 Liquidate assets into cash
 Satisfy creditor claims
 Distribute remaining assets among shareholders based on theior proportion of equity in the
corporation
 Courts may also order a buyout.
Mieselman v. Mielselman

 Facts: Court addressed petition for involuntary dissolution of closely-held corporation

 Issue: Whether a liquidation was reasonably necessary for the protection of the rights or
interest of a shareholder to warrant that shareholder’s petition for involuntary dissolution of the
closely held corporation.
 Holding: Yes. When a minority shareholder’s reasonable expectations have been
disappointed, liquidation is reasonably necessary.
 Rue: Court should give relief – dissolution or some other remedy – to a minority
shareholder whenever corporate managers or controlling shareholders act in a way to
disappoint the minority shareholder’s reasonable expectations, even when the acts fall
within their granted powers
 Reasonable expectations are ascertained by examining the entire history of the
participants’ relationship and includes only expectations embodied in understandings,
express or implied, among participants
 NY § 1104-a- Petition for judicial dissolution
 In NY, there is a 20% threshold to bring the action, as in the case below (Kemp & Beatley)

In the Matter of Kemp & Beatley

 Facts: Dissin and Gardstein were shareholders in Kemp & Beatley. They were also
employees. Kemp & Beatley was a close corporation with only eight shareholders total. Dissin and
Gardstein together held about 20% of all of the corporation's shares. Due to some turmoil in the
corporation, Dissin resigned and Gardstein was fired. The corporation stopped paying them
dividends (aka frozen out). Dissin and Gardstein sued. Dissin and Gardstein argued that the
decision to stop paying dividends constituted an oppressive action, and under New York Law
(Business Corporation Law §1104-a), served as a basis for a court to order dissolution of the
corporation. Since Dissin and Gardstein weren't getting paychecks as employees, and weren't
getting dividends as shareholders, their stock was virtually worthless. There was no market for
them to sell their shares either, so they were stuck with them. The corporation argued that they
never paid out dividends. They only paid out bonuses to employees. Since Dissin and Gardstein
were no longer employees, they get no bonus. Technically, these 'bonuses' were paid out as a
percentage of stock the person owned in the corporation. After Dissin and Gardstein left, the
directors changed it so that it was based on employee performance, which meant that, as non-
employees, Dissin and Gardstein got nothing.
 Issue: Whether Dissin and Gardstein were entitled to a dissolution for oppressive behavior.
 Holding: Yes. It was reasonable for Dissin and Gardstein to expect that the corporation would
pay them a salary as employees or dividends as shareholders.
 Court found oppression using the reasonable expectations test
 §1104-a proscribed "illegal" "fraudulent" and "oppressive" conduct against minority
shareholders, but did not define the terms.

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 The Court defined oppressive conduct as that "conduct that substantially defeats the
reasonable expectations held by minority shareholders in committing their capital to the
particular enterprise."
 Reasonable expectation that they would still participate in the earnings, and without the de
facto dividends, their reasonable expectations were frustrated
 Court ordered corporation to either dissolve or repurchase stock from the two shareholders
 Maybe would be different if dividends were only given to employees, but here they were
proportioned based on percentage of stock owned
 If a minority shareholder had unreasonable expectations, or if they were fired for
misconduct, or if they were acting in bad faith (like getting fired on purpose so they could
petition to the court to dissolve the corporation), then there is no oppressive conduct.

Gimpel v. Bolstein

 Facts: Robert Gimpel is a shareholder in Gimpel Farms, Inc. Gimpel Farms is a family
corporation engaged in the dairy business. Control has now passed through the founder’s heirs of
the second generation (his son and Robert's father, David Gimpel, and his son-in-law, Moe
Bolstein) to his heirs of the third generation (Robert, his brother George, and his cousin Diane
Bolstein Kaufman). Robert owns his stock by gift and bequest from his father.1 He was employed
by the company in an important and sensitive managerial position until 1974, when he was
discharged due to allegations that he had embezzled some $85,000. Since that time, Robert has
received no benefits from his ownership position with this obviously profitable company. In 1980,
when, after his father's death, the other shareholders offered to buy out Robert’s shares at a figure
which he rejected as inadequate. Gimpel seeks dissolution of the corporation for oppressive acts.
 Issue: Whether the conduct of the majority is oppressive by excluding Gimpel from corporate
participation, by excluding Gimpel from corporate dividends, and by excluding him from the right to
examine corporate books, and effectively freezing him out in the corporation.
 Rule: No. The conduct of the majority shareholders with respect to Gimpel, who was
essentially excluded from all participation in operation, management, or profits of the corporation
by reason of that his alleged dishonest acts were not so “oppressive,” that is, burdensome, harsh,
or wrongful, as would warrant dissolution of the corporation.
 The court looked at two different definitions of “oppressive” as the statute did not define it:
 A violation by the majority of the “reasonable expectations” of the minority. (NY)
 The “reasonable expectations” test was held to to be inappropriate, given the corporation's
advanced stage of existence and the plaintiff's place and record.
 Burdensome, harsh and wrongful conduct; a lack of probity and fair dealing in the affairs of a
company to the prejudice of some of its members; or a visible departure from the standards of fair
dealing, and a violation of fair play on which every shareholder who entrusts his money to a
company is entitled to rely. (Great Britain, NY)
 Although a minority shareholder may be in the position of a stranger to them, the
majority must still act with “probity and fair dealing,” and if their conduct becomes
“burdensome, harsh and wrongful,” they may be found to have been guilty of oppression
and the corporation may be subject to dissolution.
 Robert's discharge, as well as his subsequent exclusion from corporate management, were not
oppressive. It was clearly not wrongful for the corporate victim of a theft to exclude the thief from
the councils of power.
 As to Gimpel’s other allegations of oppression, the failures to hold shareholders' meetings, to
issue proper stock certificates reflecting his actual interest in the corporation, or to allow him

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access to stock ledgers may all have been improper, but do not, individually or collectively,
constitute oppressive conduct such as would justify dissolution

 Dissolution under the MBCA § 14.30

 The major judicial remedy for dissension and deadlock is a court order that the
corporation be involuntarily dissolved.
 Dissolution means that the corporation ceases to exist as a legal entity; the
assets are sold off, the debts are paid, and any surplus is distributed to the
shareholders.
 Dissolution is not mandatory, but permissive
 No state gives a shareholder an automatic right to a judicially-ordered
dissolution. Instead, each state has a statute setting forth specific grounds
(strictly construed) on which dissolution may be granted.
 Grounds:
 Under MBCA § 14.30(2), a shareholder must show one of these four things to
get dissolution:
 That the directors are deadlocked;
 That those in control have acted in a manner that is "illegal,
oppressive, or fraudulent";
 That the shareholders are deadlocked and have failed to elect new
directors for at least two consecutive annual meetings; or
 That the corporation’s assets are being "misapplied or wasted."
 Articles can list events that trigger dissolution
 At-will
 Upon contingencies
 Most states hold that even if the statutory criteria are met, the judge still has
discretion to refuse to award dissolution (e.g., when it would be unfair to one or more
shareholders)
 Procedures for dissolution MBCA § 14.31
 Alternatives MBCA § 14.34
 The party opposing dissolution has the right to buy-out the shares of the party
seeking dissolution at a judicially-supervised fair price.
 There are a number of alternatives to dissolution, including:
 Arbitration;
 Court appointment of a provisional director (to break a deadlock);
 Court appointment of a custodian (who will run the business) (§ 14.32);
 Appointment of a receiver (who will liquidate the business) (§ 14.32); and
 A judicially-supervised buy-out in lieu of dissolution.
 DGCL (nor Oklahoma) have no provisions similar to §§ 14.30 or 14.34
 So, the Courts cannot:
 Dissolve corporation (as under MBCA § 14.30)- However, the court may have
inherent equitable power to actually dissolve
 Share repurchase (as under MBCA § 14.34)
 DGCL § 226- Focus is on deadlock to appoint a custodian or receiver
 Standing any shareholder
 § 226(1)- Shareholders are deadlocked and cannot elect successors
 § 226(2)- Directors are deadlocked
 Exisitng corporation may become a closed corporation §§ 342-344
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  IF SOLVENT- Court will likely appoint a custodian- Custodian will not liquidate
assets, he will continue the business
 § 352 - for close corporation - custodian remedy
(supplements/compliments § 226)
 Easy dissolution provision
 If INSOLVENT- Receiver (§291)
 DGCL § 353- Provisional director if there is a deadlock
 Can't contract out of this provision
 The provisional director must be impartial
 Provisional director receives a salary
 May be removed by
 Majority of shareholders
 Court
D. SHAREHOLDER AGREEMENTS AND OTHER CONTROL DEVICES

1. INTRODUCTION
 Shareholders whose expectations are frustrated by the other shareholders may
pursue remedies of breach of a fiduciary duty against other shareholders or seek
involuntary dissolution against the corporation
 However many common difficulties can be resolved by planning-
consideration of usual and reasonable expectations of the shareholders:
 Membership of the BoD
 Voting rights proportionate to investment that cannot be diluted by the
issuance of additional authorized shares
 The right to veto material changes to the structure and purposes of the
venture
 The right to veto or at least approve new owner-shareholders of the
enterprise
 Employment by the corporation as an officer or other primary
employee with reasonable salary and bonuses
 Liquidity rights that facilitate the fair value redemption of shares by the
corporation or other shareholders upon the occurrence of certain
triggering events,
 The equal opportunity to participate in corporate benefits, including
distributions through redemptions and other favorable treatment
accorded other shareholders; and
 Various limitations on the purposes or powers of the corporation,
including prohibitions against entry into related business and against
entry into partnerships.
 Addressed by control devices
2. PREEMPTIVE RIGHTS, SUPERMAJORITY VOTING, AND CLASSIFIED STOCK
a) Preemptive Rights
 Preemptive rights refer to the power often granted to existing shareholders of an
ongoing corp to purchase a proportionate part of new issues of common shares.
 They are designed to permit existing shareholders to retain their relative
ownership interest in the corp. when the corp issues additional stock.

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 Preemptive rights protect shareholders in situations-
 If shares are issued to third person or to existing shareholders not in strictly proportionate
amounts, the voting power of some shareholders will necessarily be reduced.
 Further if the shares are issued disproportionately and for less than current value, both the
voting power and the financial interest of some shareholders in the corp will be diluted.
 Provides the shareholders with the right to keep their proportioned ownership in
the corporation
 They aren’t used very often – must be included in articles to be used
 Unless provided in articles, don’t apply to shares issued as compensation to directors,
officers or employees, to shares issued within the first 6 months of incorporation, or shares
sold otherwise than for money
 MBCA § 6.30
 § 6.30(a)- Must be included in articles of incorporation
 § 6.30(b)- Must include a statement to the effect of- “the corporation elects to have
preemptive rights” (This triggers MBCA rules)
 Preemptive rights don’t apply to shares:
 Issued as compensation for directors, officers, or employees
 Issued as authorized shares within first 6 months of incorporation
 That are sold otherwise than for money
 Preemptive rights are waivable by conduct- if the corp. acts to issue additional
shares, affected shareholders should act promptly to protect shares
b) Supermajority Voting & Quorum Provisions
 Minority shareholder, after making an investment in a corporation, is at the mercy of the
majority
 Can be provided for meetings of shareholders or meetings of directors.
 Special voting requirements for amending the articles- MBCA §§ 10.01-10.09
 Normally, only require a majority (the plurality of votes- MBCA § 7.25(c))
 This is bad for a minority shareholder, but can be overcome by adding a supermajority
requirement to the articles
 Then if minority shareholder fails to attend or departs early, the vote could be held to
be invalid by supermajority requirement
 Supermajority is generally more effective than superquorum provisions.
 Most statutes permit the articles or bylaws to make the voting and quorum more than a
majority (useful as a control device in closely-held corporations). MBCA § 8.24(a).
 Unanimity, or extremely high required voting percentages may prove disadvantageous-
deadlock, stagnation, complete frustration, possibly antithetical to corporate democracy
principles
c) Classification of Stock
 MBCA § 6.01
 Multiple classes of stock and classified BoD in articles can be used to ensure
minority representation
Lehrman v. Cohen

 PH:
 Facts: Giant Food Inc., (Giant), is controlled by the Lehrman and Cohen families each owning
equal voting stock designated as Class AC (held by the Cohen family) and Class AL (held by the
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 Lehrmans). Each class is entitled to elect two members of Giant’s four-member board of directors.
A dispute arose within the Lehrman family and to end the dispute, an arrangement was made
permitting Plaintiff to acquire all of the Class AL stock. In addition, the arrangement established,
and the stockholders unanimously ratified, a fifth directorship to resolve a dead lock which would
have continued if the equal division of voting power between the AL and AC stock were to
continue. A third class of stock was created called AD stock that had the power to elect one
director but was not entitled to dividend or liquidation rights except repayment of par value. By
resolution of the board of directors, the third class of stock was issued to Joseph B. Danzansky
who elected himself as Giant’s fifth director. In 1964 the holders of AC and AD stock voted
together against the holders of AL stock to elect Danzansky president of Giant replacing
Defendant who had been president of Giant since its incorporation. Danzansky then resigned as
director and elected in his place, Millard F. West, Jr., a former AL director. Plaintiff then brought
this suit.
 Issues:
 Whether the Class AD stock arrangement is illegal as a voting trust.
 Whether the Class AD stock arrangement is sufficiently close to the substance and purpose of
§218 as to warrant its being subjected to the restrictions and conditions imposed by that statute.
 Whether the creation of a class of stock having voting rights only and lacking any substantial
participating proprietary interest in the company violates public policy.
 Whether the AD stock arrangement is illegal because it permits the AC and AL directors to
delegate their duties to the AD director.
 Holding: No. The AD stock arrangement is not a voting trust because it does not separate the
voting rights of the AC or AL stock from the other attributes of ownership of those classes of stock.
 Rule: The AD stock arrangement did not separate the voting rights of the AC or AL
stock from the other attributes of ownership.
 Rational: Each stockholder retained complete control over the voting of his stock
 No. The statute only regulates trust and pooling agreements amounting to trusts, not other
arrangements possible among stockholders. The AD stock arrangement became a part of the
capitalization of the company. It is true that the creation of the AD stock may have diluted the
voting power of the AC and AL stock but a voting trust is not necessarily the result.
 § 218 regulates trusts and pooling agreements amounting to trusts but no other types of
arrangements possible among stockholders. The AD stock is neither a trust nor a pooling
agreement and therefore it is not controlled by the Voting Trust Statute. No. The statute permits
the creation of stock having voting rights only as well as stock having property rights only.
 The creation of a class of stock that has voting rights only does not violate public
policy.
 First, there was no separation of the voting rights of the AC or AL stock from the other
attributes of ownership.
 Second, the purpose of the Voting Trust Statute was to avoid secret uncontrolled combinations
of stockholders formed to acquire voting control of the corporation to the detriment of non-
participating shareholders. The AD stock arrangement did not violate this purpose.
 Thirdly, assuming the AD stock arrangement exposes a loophole in § 218 as it was intended to
operate, it is up to the legislature to block it.
 No. The AD stock arrangement is not invalid on the ground that it permits the AC and AL
directors of the company to delegate their statutory duties to the AD director.
 The AD stock arrangement had a proper purpose.
 Stockholders may protect themselves and their corporation by an otherwise lawful plan
against the fatal consequences of a dead lock in the directorate of the corporation.

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 The arrangement was created by the unanimous action of the stockholders of the
company by amendment to the certificate of incorporation.
 Therefore, assuming there is a delegation of duty, it was made by stockholder action.
 Result:
3. SHAREHOLDER VOTING AGREEMENTS & IRREVOCABLE PROXIES

a) Pooling agreements
 Permitted under all laws
 MBCA § 7.31
 MBCA § 7.22- Appointment of an irrevocable proxy
 Allows shareholders to combine votes with others to form a voting block, set forth in an
agreement
 In pooling agreement, shareholders retain all indicia of ownership of shares except the power
to vote.
b) Voting Trusts
 Most often used in creditor situations – until the creditor’s loan is repaid, they get to vote
the controlling shareholder’s stock
 Once a voting trust is lawfully formed, the trustee will have exclusive power to vote the
shares
 Requirements- MBCA § 7.30
 Must be signed by each of the party shareholders
 Agreement and a list of beneficial owners must be delivered to corporation’s principal office
 Transferred shares must be registered in trustee’s name
c) Irrevocable Proxies
 Permitted under all laws
 General rule is that a proxy is freely revocable (Restatement (Third) Agency § 310), but if
it’s coupled with an interest it’s not (MBCA § 7.22(d); DGCL § 212(e); N.Y. §§ 609(f), (g),
620(a))- Codification of the common law
 The proxy holder should have an economic interest in the viability of the corporation that
motivates him
 A proxy is “coupled with an interest” when the recipient of the proxy has a property interest
in the shares, or at least some other direct economic interest in how the vote is cast.
 When the interest is extinguished, the proxy becomes revocable
 In creating this, the parties should state in writing that the proxy is irrevocable, and specify
any limitations on the authority of the holder
4. SHAREHOLDER AGREEMENTS RESTRICTING BOARD DISCRETION
 Minority shareholders’ expectations can be addressed by shareholder agreements.
 Membership of the BoD
 Salaried employment as corporate officers
 Salaried employment as primary employees
 Investment returns through corporate distributions
 Conflict with statement- “all corporate powers shall be exercised by or under the authority
of the BoD” (MBCA § 8.01(b))

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  Stripping powers may also strip away corresponding fiduciary duty of care, loyalty, and
good faith.
 Courts have become increasingly cognizant of the special dynamics of closely held corps
and more permissive of shareholder agreements that control management decisions
 General incorporation statutes were amended to add provisions authorizing shareholder
agreements restricting board discretion
 MBCA § 8.01- All corporate powers must be exercised by the BoD, subject to any limitation
set forth in the articles of incorporation or in an agreement authorized under § 7.32
 MBCA § 7.32 If authorized in articles or bylaws by unanimous vote or in a written
agreement signed by all shareholders at the time, the agreement is effective even if it:
 Eliminates the BoD or restricts its discretion or powers
 Governs corporate distributions (subject to § 6.40)
 Established who shall be directors
 Governs the exercise of voting power by shareholders and directors
 Establishes the terms of transfers of property or provision of services between the
corporation and its members/directors/officers/employees
 Transfers to one or more shareholders the authority to manage the corporation,
including the power to resolve deadlocks
 Requires dissolution at the request of shareholders or upon certain events; and
 Otherwise governs the exercise of corporate powers or management of the
corporation or its relationships, so long as it is not contrary to public policy (MBCA §
7.32(a))

McQuade v. Stoneham

 PH:
 Facts: In 1919, Plaintiff and Defendant John McGraw each purchased 70 shares of NEC
stock from the majority 1,306 shares that Stoneham owned. NEC was the company that
owned the New York Giants. At the time of purchase, the parties agreed to do everything in
their power to keep Stoneham as president, McGraw as vice-president and Plaintiff as
treasurer. Plaintiff and Stoneham had a number of conflicts concerning the operations of
NEC, and in 1928, the 7-member board of directors of NEC voted in a new treasurer
(McGraw and Stoneham abstained from the vote). Plaintiff was not removed for any
misconduct or ineptitude, but rather for his conflicts with Stoneham. Plaintiff brought this
action to be reinstated as treasurer, and he cited the agreement that he entered with
McGraw and Stoneham that provided for each of them to use their “best endeavors” to
keep each other in their respective positions. Defendant argued that the agreement was
invalid because it granted authority to shareholders for a decision that is normally left to the
judgment of directors. The lower court moved to reinstate Plaintiff.
 Issue: Whether the shareholder agreement between Plaintiff and Defendants to use their
best efforts to keep each of the parties in their respective positions is valid.
 Holding: No, the shareholder contract to keep the parties in their positions within NEC was
invalid as a matter of public policy.
 Rule: Shareholders should not be able to usurp the decision-making normally left to
the directors, and directors should be beholden to the corporation and not the
shareholders.
 Rational: The court affirms the validity of shareholders to agree to pool their votes, but they
decline to allow them to use their voting power but not pool the director’s powers. Although
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 the evidence indicated that Stoneham may have exercised bad faith in that Plaintiff was
competent in his position and was ousted over personal disagreements, the director’s
intentions are irrelevant because the court does not want to put directors in a position
wherein they would have to defend future decisions.
 Plaintiff was also ineligible for employment with NEC because he was a City Magistrate.
 Results: reversed and complaint dismissed
Clark v. Dodge

 Facts: Defendant companies, Bell & Company, Inc. and Hollings-Smith Company, Inc.,
were co-owned by Plaintiff (25% of shares) and Defendant (the remaining 75% of shares).
The companies manufactured medicine, the formulae that were known only by Plaintiff.
Plaintiff entered into an agreement with Defendant wherein Plaintiff agreed to disclose the
formulae to the son of Defendant in return for a promise that Defendant would keep Plaintiff
as a director and would be entitled to 25% of all net income providing that Plaintiff was
competent in his position. Afterwards, Defendant did not vote Plaintiff in as director,
stopped delivering 25% of the income to Plaintiff. Plaintiff sought reinstatement and money
owed from the stopping of payments and money wasted by Defendant. Defendant
countered, citing McQuade v. Stoneham (263 N. Y. 323), that the agreement was invalid
because it required Defendant as a shareholder to usurp the directors’ judgment.
 Issue: Whether the agreement between Plaintiff and Defendant was invalid as an over-
reaching agreement between shareholders to control powers of the directors.
 Holding: No. The agreement was not invalid.
 Rule: An agreement between shareholders, wherein the shareholders entering the
agreement are the only shareholders of the company, is valid even if the agreement
contemplates controlling management decisions.
 Rational: The McQuade court invalidated a similar agreement because it affected the
rights of others that were not part of the agreement, and therefore it fell under the public
policy argument. In this case, the only shareholders were Defendant and Plaintiff, and
therefore the agreement between the two did not have any, or at least negligible,
consequences on the public. The court distinguished McQuade, noting that McQuade
will be controlling when there agreements are between shareholders who do not
have 100% ownership of a company. In this case it would be against public policy to
allow Defendant to simply cite McQuade to avoid his obligation to pay 25% of net
income to Plaintiff who already disclosed a trade secret to Defendant.
 Results: Appellate Div. is reversed, special term order is affirmed with cost

Galler v. Galler

 PH: TC granted relief for the Plaintiff, AC reversed

 Facts: Plaintiff’s late husband and his brother, Isadore Galler, owned all but 12 shares of a
close corporation, Galler Drug (each of the brothers sold six shares to a third party that was
subject to a buyback provision allowing each brother to reclaim their six shares). The
brothers, in an effort to provide for their families if something were to happen to either
brother, entered a shareholder agreement that would guarantee that their spouses would
be elected to the board and that each would have equal representation on the board. The
agreement also provided an annual payout to the spouses. There was no set expiration
date of the agreement provisions. After Plaintiff’s spouse’s death, Defendants tried to
destroy all copies of the agreement. Plaintiff sued to review the agreement in order to
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 enforce the provisions therein. Defendant argued that the shareholder agreement was
unenforceable because it violated state statutes that render invalid shareholder agreements
that seek to control management decisions.
 Issue: Whether the shareholder agreement between the majority shareholding brothers
was invalid per statute or public policy.
 Holding: No, the agreement was valid and Plaintiff should be entitled to specific
performance and money that was owed under the agreement.
 Rule: In a closely held corporation, a minority shareholder does not have the ability
to easily unload their shares as someone who held publicly traded shares, and
therefore will have to resort to detailed, comprehensive shareholder agreements in
order to guarantee their rights.
 Rational: Galler Drug was a closely held corporation, and therefore subject to different
circumstances than a shareholder of a large corporation. The court cited a number of prior
cases, including Dodge v. Clark, to support the premise that because this agreement did
not harm the public and was fair to the parties of the agreement, there is no offense
to any public policy concerns. The court weighs this public policy concern against
the public policy concern of independent directors and decided not to follow the
statute that prohibits these agreements, reasoning that the state could not have
meant for the statute to apply in these cases.
 Results: Affirmed in part and reversed in part, and remanded with directions Plaintiff
should be entitled to specific performance and money that was owed under the agreement.
 Notes: Modern statutes, in providing greater contractual freedom to shareholders of non-
publicly held corporations, have followed the basic legal maxim that greater power should
be accompanied by greater responsibility. Where shareholders assume managerial
powers, they also assume the duties of the directors.
 The MBCA relieves directors of liability for breach of a fiduciary duty when the shareholders
have been granted directorial power (MBCA § 7.32(e))
 The DGCL relieves the directors and imposes acts or omissions which is imposed on
directors to the extent and so long as the discretion or powers of the board in its
management of corporate affairs is controlled by such an agreement (DGCL § 350)
5. RESTRICTIONS ON TRANSFER OF SHARES
a) Introduction
 Reasons for use of share transfer restrictions
 To exercise control over whom you do business
 Provide a market for shares if a shareholder dies or leave
 Protect a control arrangement (particular control structure in the corp., e.g. by the family)
 Ensure compliance with exemptions under security laws- SEC R. 147(e), 502(d)
 Protect status as a statutory close corporation (e.g. DGCL § 342(a)(1)&(2))
 Sub S corporation – protect status (to prevent ineligible shareholder or too many
shareholders)
 To establish clear valuation of shared for estate taxes
 Types – MBCA 6.27(d); DGCL 2.02
 First option – like to corporation, shareholder, etc – right of refusal
 Buy-sell – obligate corporation or shareholder to buy the shares
 Approval – corporation must approve (or shareholder) transfer provided it is not
unreasonable
 Transferee – prohibit transfer to certain people if not unreasonable

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 To whom does the right of refusal or the obligation or the option to buy run?
 Corporation
 Are funds legally available for repurchase? See, e.g. MBCA § 6.40; DGCL § 160
 Even if the funds are legally available, does the corporation need available funds as
working capital?
 Other shareholders
 After tax dollars must be used
 Both
 What triggers the restriction?
 Must determine and adequately describe the triggering mechanism
 How will the transfer restriction be interpreted
 Courts narrowly construe transfer restrictions
 Be very specific and make sure language clearly covers this- E.g. What does “sale”
mean in a first option? Does it include a gift?
 Must be specific restriction to be valid
 Careful drafting is required
 How do you set price?
 Know a good accountant
 There are many pricing mechanisms
 Court will usually uphold a mutually agreed methods
 Book value – the historical price (depreciate or appreciate)(not the true value)
 Real estate, inventory, etc
 Fixed price – original purchase price
 Might not be current value
 Periodically review and adjust
 Appraisal – many different ways to appraise – set out guidelines
 By whom?
 Using what method?
 Self-adjusting formula – unlimited formulas
 Ex. Capitalization of earnings
 Measuring period?
 What about unusual (nonrecurring) gains and losses?
 What capitalization should be used?
 May not be accurate in a close corp. because they try to lower this in
with salaries and lease payments to shareholder
 May not be accurate because of unusual profits or losses in a year
 It is important to have a fair valuation provision because:
 You don’t know if you are buying or selling (at the time of the
agreement)
 Courts will generally enforce a valuation provision even if it results in a
very low price
 If the price is very low, then a party may have little to lose by
challenging the valuation provision
 Validity of the share transfer restriction
 Share transfer restrictions are permissible for any reasonable purpose- MBCA §
6.27(c)(3)
 How to impose transfer restrictions- MBCA § 6.27(a)
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  Read the statute.
 Articles of incorporation
 By-laws
 Shareholder agreement
 Agreement b/w shareholder and corporation
 Is the share transfer restriction valid and enforceable against a transferee?- MBCA §
6.27(b), DGCL § 202
 At common law, blanket prohibitions against transfer were invalid; consent
type restrictions were often held invalid
 The modern approach is to enforce share transfers restrictions that are
entered for a reasonable purpose, especially if the restriction is not manifestly
unreasonable
 Against whom is the transfer restriction effective?
 What about persons who do not consent to the restriction?
 What about subsequent transferees?

b) First Options and Refusals

In re Estate of Mather

 PH: TC issued judgment against the executors and ordered specific performance of a written
stock option agreement
 Facts: Written stock option agreement where option price was fixed well below stock’s actual
value ($1.00/share). Executors sued as an unreasonable restraint on alienation.
 Issue: Whether the provision, according to the corporation a right of first option to purchase
the stock at the price which it originally received for it, amounts to an unreasonable restraint.
 Holding: No.
 Rule: Where there is no overreaching or fraud, the great difference between the sales
price and the actual value of the stock is not sufficient, alone or with the additional facts in
the case, to invalidate the agreement or defeat specific performance.
 Rational: A corporate by-law which requires the owner of the stock to give the other
stockholders of the corporation an option to purchase the same at an agreed price or the then-
existing book value before offering the stock for sale to an outsider, is a valid and reasonable
restriction binding upon the stockholders. Court found that there was no overreaching or fraud, so
the shareholders must live with the terms agreed upon. This is purely a matter of contract.
 Results: affirmed cost to be paid by appellants

Lash v. Lash

 PH: TC ruled in favor of the Corp. Plaintiff violated fiduciary duty.

 Facts: Three Lash Brothers owned all of the voting stock of that Barre store, the Lash
Furniture Company of Barre, Inc., in equal shares. Ralph Lash, one of the defendants, was one of
the shareholders in the Barre store and operated it. Wallace Lash, another brother, owned a third,
but had severed all Vermont connections and moved to New York City. Herman Lash, who was
the third shareholder, ran the Burlington operation along with still another brother who does not
figure in this litigation. The dispute arose as a consequence of the sale, by Wallace Lash, of his
stock holdings in the Barre operation. Ralph Lash was the ultimate purchaser. The transfer was
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 challenged because of a corporate bylaw requiring that any stock sold be first offered to the
corporation at the proposed price. This offer was, in fact, made, but under circumstances which
generated an attack on the transaction by the plaintiff. The corporation, by vote, rejected the
opportunity to purchase. Each brother had four voting shares. Wallace, as seller, did not vote.
Ralph voted against purchase of the stock by the corporation and Herman voted in favor of
accepting the offer. Thus, the transaction was not authorized and was lost to the corporation.
Then, Ralph Lash bought Wallace’s stock. This gave him effective control of the Barre
Corporation, since he then held two-thirds of the voting stock. He transferred a voting share to his
wife, Betty, and she became a director, succeeding Wallace.
 Issue: Whether there was a conflict of interest when Ralph Lash voted to reject the purchase
of Wallace’s stock that breached a fiduciary duty to the corporation.
 Holding: Yes.
 Rule: director’s fiduciary duty toward the corporation not to let outside commitments,
personal or otherwise, divert them from their duty to further the interest of the company.
 Rational: Where Ralph voted against acquisition by corporation of another shareholder’s stock
and shortly thereafter purchased the stock himself, giving him effective control of the corporation,
his interest in purchasing the stock conflicted with his obligation to evaluate the purchase from
standpoint of benefit to the company.
 Results: affirmed

c) Mandatory Buy-Outs
 Authorized by MBCA § 6.27(d)(2)
 Cross-purchase agreements. The cross-purchase form of the buy-sell agreement offers
several advantages. The family of the deceased owner will have a tax basis equal to the fair
market value of the decedent’s stock at the date of death, thus avoiding any income tax
consequences as a result of the sale. The fair market value of the shares should be defined by the
buy-sell agreement
 The cross-purchase form of the buy-sell agreement carries several disadvantages. The plan is
difficult to administer if there are numerous shareholders that must buy a plan for each other. For
example, for seven owners to cross-purchase life insurance would require 42 (7 x 6) policies. The
number of policies can multiply even further if disability coverage is also part of the buy-sell
agreement.
 .Stock redemption agreements. Under a stock redemption agreement, the corporation owns
policies on the lives of the shareholders. When a shareholder dies, the corporation buys the
deceased shareholder’s interest in the company with the insurance proceeds. A prime advantage
of the stock redemption agreement is that it is easier to administer for multiple shareholders. An
additional advantage to the stock redemption structuring of the buy-sell agreement is that the
corporation will bear the premium differences associated with age disparities among shareholders.
 A significant disadvantage of the stock redemption form of the buy-sell agreement is that the
remaining shareholders do not get the benefit of a step-up in basis when the corporation
purchases the deceased shareholder’s interest. The continuing shareholders retain their original
bases in the company. Compared to the cross-purchase agreement, the stock redemption
structuring will create greater capital gains upon the ultimate disposition of shares if made before
death. After the stock redemption is accomplished, however, the corporate assets should be
relatively unchanged (the insurance proceeds have been used to purchase the deceased’s
interest), but each owner now enjoys a greater percentage of ownership.
 Russian roulette. A Russian roulette provision requires one of the two deadlocked parties to
serve a notice on the other party, and the serving party will name an all-cash price at which it
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 values a half interest in the business. The party receiving the notice then has the option to either
buy the other party out, or sell out to the other party, at that price.

d) Consent Restraints
 Has received greatest resistance from courts, but is authorized in MBCA § 6.27(d)(3)
 Requirement that shareholders who want to sell shares to a third party first obtain the approval
of the BoD or shareholders.

e) Marketability Restraints
 Prohibit a shareholder’s sale of his shares to persons or types of persons so long as the
restriction is not manifestly unreasonable (MBCA § 6.27(d)(4))
 Generally used to restrict sales to competitors and affiliates
f) Judicial Interpretation
 Narrow construction to promote free transferability
 Some courts hold restrictions to be inapplicable among existing shareholders
 Resistance in testamentary transfers- ambiguities in favor of free transferability
g) Pricing Provisions
 Book Value-most common and is reflected in financial statements
 Capitalized Earnings-common but major disadvantages for closely held Corps.
 Based on a formula of the corporations earnings. The formula must be accompanied by a
clear definition of earnings to be calculated and an appropriate capitalization rate to be
applied.
 Periodic Revisions- based on a set price per share at the time the provision is approved,
subject to reevaluation at regular intervals. Alternatively use an established formula subject to
same reevaluation intervals.
 Appraisals- third party(s) determine price AKA “Arbitration Clause”
 Usually, shareholders don’t want to pay for appraisal
6. FIDUCIARY DUTIES IN IMPLEMENTING RESTRICTIONS ON TRANSFER

Gallagher v. Lambert

 PH: TC denied defendant’s motion for summary judgement. The AC reversed and dismissed
the plaintiff’s claims and ordered payment at the book value.
 Facts: Gallagher purchased stock in the defendant close corporation with which he was
employed. The purchase of his 8.5% interest was subject to a mandatory buy-back provision: if
the employment ended for any reason before January 31, 1985, the stock would return to the
corporation for book value. The corporation fired Gallagher, an at-will employee, prior to the
fulcrum date, after which the buy-back price would have been higher.
 Issue: Whether Gallagher’s employer breached a fiduciary duty of fair dealing by firing
Gallagher, a minority shareholder, in “bad faith” to acquire the stock at a contractually and
temporally measured lower buy-back price formula.
 Holding: No.
 Rule: a minority shareholder in a close held corporation, by that status alone, who
contractually agrees to the repurchase of his shares upon termination of his employment
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 for any reason, acquires no right from the corporation or majority shareholders against at-
will discharge. Ingle v. Glamore Motor Sales
 Rational: There being no dispute that the employer had the unfettered discretion to fire
Gallagher at any time, the agreement should not be questioned. Court said he would be held to
the terms of the contract – there was a written agreement that he was an at-will employee.
 Result: affirmed
 Dissent: The court did not look at the fiduciary duty owed to Gallagher. Gallagher claims
defendants breached two duties related to each other but conceptually unrelated to his at-will
employment status: (1) a duty of good faith in the performance of the shareholders’ agreement,
and (2) a fiduciary obligation owed to him as a minority shareholder by the controlling
shareholders to refrain from purely self-aggrandizing conduct. Neither claim is foreclosed by
plaintiff’s status as an at-will employee.

Pedro v. Pedro

 PH: TC jury awarded damages to Plaintiff. AC determined that the jury only advised damages
and remanded the TC to make findings. The TC awarded damages for breach of fiduciary duty
and wrongful term of lifetime employment. Defendants appeal the TC ruling.
 Facts. Respondent and Appellants were three brothers with equal ownership in The Pedro
Companies. The brothers entered into a stock retirement agreement that allowed them to buy
back shares of a deceased brother at 75% of net book value. Several years afterward,
Respondent, after noticing a discrepancy of $330,000 in the accounting records, demanded an
independent accountant to investigate. After the missing funds could not be located by two
accountants who were frustrated in their investigation by Appellants, Appellants fired Respondent
and took away all of his benefits. Respondent then brought this action, claiming Appellants
breached their fiduciary duty owed to him, that he had a contract for lifetime employment and that
he suffered numerous injuries resulting from the termination. Appellants responded that they did
not breach a duty because the stock value did not diminish
 Issue. The issue is whether Appellants violated a fiduciary duty owed to Respondent by the
termination of Respondent and the subsequent buyout of his shares below market value.
 Held. Yes
 Rule: Majority shareholders who buy back shares from another shareholder are
obligated to pay fair market value if they have breached a fiduciary duty owed to the
shareholder.
 Rational: The duty can be breached in more ways than just a diminishing of the stock value,
such as by terminating Respondent and forcing a share sale at the agreement’s stated price of
75% market value. There was also evidence that, in the facts surrounding the structure of this
close corporation, that there was an expectation of lifetime employment for the shareholders.
 Result: affirmed the trial court, holding that Appellants did breach their duty to Respondent.
 Note: The facts of the case at issue demonstrated a compelling case for the appraisal and
sale of shares back to the corporation from a shareholder who was treated unfairly.

Jensen v. Christensen & Lee Insurance Co.

 PH: TC dismissed case for failure to state a claim for which relief can be granted.
 Facts: Jensen was an employee of Christensen & Lee Insurance for twenty years. It was
alleged and not denied that Jensen was the top salesman in the company. At the time of his
termination, Jensen also had a substantial minority stockholder interest and was a director of the
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 company. In December 1988, the defendants voted to terminate Jensen's employment with the
company. In January 1989, the defendants removed Jensen as a director. The termination of
Jensen as employee and director triggered the purchase of Jensen's stock under a stock
retirement agreement and a deferred compensation agreement. Jensen alleges that the
terminations were made so that the company could pay him a lower amount for his stock than it
would have to pay if he continued his employment until he reached normal retirement age in 1991.
Jensen further alleges that by the terms of the agreements, the stock purchase was to be
triggered only when Jensen voluntarily elected a retirement date or when he reached the
mandatory retirement age of sixty-five. Following his termination, Jensen elected a retirement date
of 1991. Thus, he claims that his stock should be purchased at the 1991 price. Jensen also
alleges that because he was wrongfully discharged, he is owed compensation for lost salary
benefits from December 1988 to his elected retirement date in 1991.
 Issue: 1) The directors breached their fiduciary duty to Jensen as a minority shareholder by
this "squeeze out" action that redounded to their financial benefit. 2) Whether Jensen has a
wrongful discharge cause of action because the defendants brought about the unlawful "squeeze
out" by terminating his employment.
 Holding: 1) Yes. 2) No
 Rule: Section 180.307, Stats., A director of a corporation is liable for a breach of duty to
a shareholder 1) where there is willful failure to deal fairly with the stockholder in a matter
in which the director has a material conflict of interest. Sec. 180.307(1)(a); 2) where the
director derives an improper personal profit in the transaction involving the stockholder.
Sec. 180.307(1)(c); also 3) under Section. 180.355, Stats., that there must be full disclosure
when directors of a corporation vote on a matter in which they have a financial conflict of
interest and that the votes of the interested directors cannot be counted in approving the
transaction.
 Rational: There are sufficient allegations to plead a claim that the defendants breached their
fiduciary duty to Jensen as a minority shareholder of the close corporation. The defendants'
argument that the agreements provide for discharge as a legitimate triggering mechanism for the
company's purchase of stock may be a proper issue in later proceedings. However, it is not
controlling to whether this complaint states a valid claim for relief under the statute.
 Results: affirm TC's dismissal of Jensen's wrongful discharge cause of action for failure to
state a claim for which relief can be granted. Reverse TC’s dismissal of Jensen's cause of action
alleging breach of fiduciary duty to a minority shareholder. Remand for trial on the issue of breach
of fiduciary duty. No costs to either party.

X. FIDUCIARY DUTIES
A. INTRODUCTION

B. THE DUTY OF CARE

 Definition
 Reasonable person test
 Care that you would exercise in your own affairs
 Can’t use hindsight
 Directors not punished for bad judgement – they are not insurers
 This is a due care and not loyalty problem
 Especially unforeseeable events

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  No hindsight allowed
 Inquiry notice may provide liability
 Advice of counsel
 MBCA §§ 8.30 (directors) and 8.42 (officers)
 Standard of Care
 MBCA §§ 8.30 – 8.42
 Is NOT reasonably prudent business person, It’s not whether you know the answer, it is
whether or not you know the question. You must make some attempt to understand. When
you do, you should investigate further to resolve. If have business experience still be held
to higher standard
 Inside director may be held to a higher standard
 Professional may be held to a higher standard
 MBCA § 8.31- Business Judgment Rule
 A director or officer who makes a business judgement, in good faith, fulfills the duty under,
if the director of officer:
 Is not interested in the subject of the business judgement
 Is informed with respect to the subject of the business judgement to the extent the
director or officer reasonably believes to be appropriate under the circumstances,
AND
 Rationally believes that the business judgement is in the best interests of the
corporation
 ONLY APPLIES WHERE YOU ARE REASONABLY INFORMED- there is a presumption
that you are informed
 MBCA § 8.24(d) - You are deemed to have assented unless you specifically object and enter
the objection into the minutes of the meeting, or deliver written notice during or after the meeting.

Brane v. Roth

 Facts: This is a derivative lawsuit involving a dispute between a group of shareholders and the
directors of a rural grain elevator cooperative (Co-op). Pursuant to the facts of the case,
approximately 90% of Co-op’s business was devoted to the purchase and sale of grain. Since Co-
op had economic difficulties, the directors decided to implement a new strategy. Under the new
strategy, Co-op would hedge its grain position to protect itself from the volatility of the grain
market. Although Co-op’s directors authorized the manager to hedge, only a minimal amount was
effectively hedged (US$20,500 out US$7,300,000 of Co-op’s total grain sales). Shareholders
brought a suit alleging that director’s failure to adequately hedge in the grain market had caused
the losses to Co-op.
 Issue: Whether the fiduciary duties of due care owed by directors to the shareholders of a
corporation impose an implicit obligation to hedge.
 Holding: No. speculation is not welcomed at a corporate level since shareholders are by
principle, risk averse. The directors breached a duty of care.
 Rule: A director wishing to invoke the protection of the business judgment rule is in the
obligation to inform himself prior to making any business decision. Once informed, said
director has the additional duty to act with requisite care in the discharge of their duties.

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 Directors who comply with their duty of care (and with their duty of good faith and loyalty)
are protected by the benefit of the business judgment rule.
 The other principle is the BJR, predicated on gross negligence. Because of the application of
the BJR, standard should have risen to gross negligence, where they wouldn’t be found to have
breached.

C. VIOLATIONS OF DUTY

Francis v. United Jersey Bank

 PH: TC ruled for Plaintiff over $10Milllion, AC Affirmed

 Facts: P&B was a broker between ceding insurance companies and reinsurance companies.
They earned a commission on the transactions between the two entities. Typically, brokers in the
reinsurance business hold funds from the ceding and reinsuring companies in a separate account
and pay each party from that account. The former CEO of P&B, Charles Pritchard, Sr. (the
husband of Lillian Pritchard) did not practice this method, but he still ensured that the funds
deposited by third parties were never used as personal funds. Charles Pritchard, Sr., eventually
stepped down and his two sons controlled the business. Once the sons had control they took out
personal loans from the account but never paid back the loans or any interest. This practice of
misappropriating funds continued until P&B could no longer meet their obligations, and they went
into bankruptcy. During the entire period that the sons controlled P&B, Lillian was the majority
shareholder and sat on the Board as a director. During her tenure as director, she never
participated in any business matters of P&B. Defendant argued that Lillian was elderly and sick,
and therefore should be excused for her absence.
 Issue: Whether Lillian Pritchard is personally liable for negligently failing to prevent the
misappropriation of P&B funds by her sons.
 Holding: Yes.
 Rule: A director can be personally liable, even to third parties, if they neglect to provide
the ordinary care of staying current with corporate affairs as one would normally do in that
position, and that neglect is the proximate cause of the damages.
 Rational: Lillian Pritchard, as a director on the Board, had a duty of care in managing
the business. She did not have to know every detail of day-to-day operations, but she needed to
have a baseline understanding of the finances and important activities. If she did not understand
the activities, then she was obligated to consult counsel for advice. Her absence from the
business did not excuse her duties. The court determined that if she did intervene in the dubious
financial decisions of her sons, or at least consulted an attorney or expert, it may have prevented
her sons from fleecing the company.
 Result: Affirmed her lack of care was a proximate cause of the damages to the
company and the third parties who relied upon the company. Because of the nature of the
business (holding assets of third parties), she was liable to the third parties for any damages.
 Notes: The decision makes it impossible for directors to hide their head in the sand to
avoid liability. The amount of oversight required will depend on the nature of the business, so it will
be very fact-specific.
North American Catholic Educational Programming Foundation (NACEPF) v. Gheewalla

 PH:

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 Facts: NACEPF holds radio wave spectrum licenses and entered into an agreement
with other license holders that gave Clearwire rights to the licenses as leases expired if the
lessees failed to exercise their right of first refusal. Gheewalla was a director of Clearwire, and
NACEPF alleges that even though Gheewalla controlled less than the majority of the board, was
able to control the board as the only source of funding was controlled by Goldman Sachs
(Gheewalla). As such, NACEPF was alleging Gheewalla was in breach of his fiduciary duty as a
director by interfering with business opportunities. However, NACEPF was not a shareholder, but
was a creditor of Clearwire. Clearwire was either insolvent, nor was it in the zone of insolvency at
the time when the allegations of direct breach of fiduciary duties.
 Issue: Whether the creditors of a corporation that is either insolvent or in the zone of
insolvency have a right, as a matter of law, to assert direct claims for breach of fiduciary duty
against the corporation’s directors.
 Holding: No. They do not have this right under Delaware corporate law to bring direct
claims of breach of fiduciary duty.
 Rule: Directors owe their fiduciary obligations to the corporation and its shareholders (not
to creditors).
 Rational: When a solvent corporation is navigating in the zone of insolvency, the focus for
Delaware directors does not change: directors must continue to discharge their fiduciary duties to
the corporation and its shareholders by exercising their business judgment in the best interests of
the corporation for the benefit of its shareholder owners.
 However, the creditors of an insolvent corporation have standing to maintain derivative
claims against directors on behalf of the corporation for breaches of fiduciary duties.
 The corporation’s insolvency makes the creditors the principal constituency injured by any
fiduciary breaches that diminish the corporation’s value.
 The court doesn’t discuss where the “zone of insolvency” begins or ends

D. CAREMARK DUTIES

Stone ex rel. Amsouth Bancorporation v. Ritter

 Facts: Plaintiffs William and Sandra Stone owned common stock ‘at all relevant times’ in
defendant AmSouth Bancorporation (AmSouth).AmSouth Bank, a subsidiary of AmSouth, paid $
40 million in fines and $ 10 million in civil penalties to resolve government and regulatory
investigations pertaining principally to the failure by the bank employees to file 'Suspicious
Activities Report (SARs). SARs were required by the federal Bank Secrecy Act (BSA) and various
Anti Money Laundering (AML) regulations. No fines or penalties were imposed on AmSouth's
directors and no other regulatory action was taken against them. A derivative suit was filed by
plaintiffs against fifteen current and former directors of AmSouth for breach of their fiduciary
duties. Chancery court dismissed the plaintiffs' complaint.
 Issue: Whether directors had a duty of due care and good faith for bad business decisions.
 Holding: No.
 Rule: When shareholders claim that the directors were ignorant to liabilities, the
shareholder can only win if they show that there was a “sustained or systemic failure of the
board to establish oversight.”
 Courts will not second-guess the decisions of directors unless the process that
generated those decisions is unsound.

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 Directors are not responsible for ensuring the legality of every act by the
corporation's personnel, even if the illegal conduct would have been discovered if there
hadn't been a failure of the corporate compliance program.
 Delaware courts will not expose directors who exercise due care and act in good
faith to personal liability for bad business decisions.
 The Court found that there is no duty of good faith that forms a basis, independent of
the duties of care and loyalty, for director liability. A claim that directors were subject to personal
liability for employee failures was ‘possibly the most difficult theory in corporation law upon which
a plaintiff might hope to win a judgment. The chancery court properly dismissed plaintiff's
derivative complaint for failure to excuse demand by alleging particularized facts that created
reason to doubt whether the directors had acted in good faith in exercising their oversight
responsibilities.
 Stone accepts Caremark.
 The standard for determining whether directors can be liable for failure to
exercise oversight of employees who fail to comply with their duties was a “lack of good faith as
evidenced by a sustained or systematic failure of a director to exercise reasonable
oversight.”
 That's the same standard that was given in Caremark.
 The Court found that there are two conditions necessary for liability under
the standard set by Caremark: The directors utterly failed to implement any reporting or
information system or controls; OR Having implemented such a system or controls,
consciously failed to monitor or oversee its operations thus disabling themselves from
being informed of risks or problems requiring their attention.
 In either case, imposition of liability requires a showing that the directors
knew that they were not discharging their fiduciary obligations.
 It’s a Demanding Standard- Mere negligence isn’t enough. Must be intentional.
E. PROXIMATE CAUSATION

Barnes v. Andrews

 Facts: Defendant served 2 years as director of a corporation formed for manufacturing.

Defendant missed one of only two directors’ meetings due to his mother’s death. The corporation
failed, due in part to the incompetence of a factory manager.
 Issue: Whether Defendant was liable for the corporation’s failure.
 Holding: No.
 Rule: Plaintiff must accept the burden of showing the performance of defendant’s duties would
have avoided the loss, and what loss it would have avoided.
 Rational: When a business fails from general mismanagement, business incapacity, or bad
judgment, how is it possible to say a single director could have made the company successful.
 Notes:
 Nonfeasance Cases- The plaintiff’s burden seems clearer in a transactional setting than in a
general nonfeasance context
 Superseding Causes- A defendant may avert liability by demonstrating that an intervening
cause superseded any proximate or legal cause that otherwise may have existed
 Requirement of Damages- Unlike in a duty of loyalty cases, in which either damage to a
corporation, or an illicit gain to the officer or director will ground an action, a duty of care case
requires that the directors’ actions have proximately caused the damage to the entity.
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 F. THE BUSINESS JUDGMENT RULE

Smith v. Van Gorkom (This is one of the top ten cases. Viewed as bad for directors by some, but
Arnold says it may in fact be great for directors.)

 PH: TC granted judgment for the Defendant

 Facts: Trans Union had large investment tax credits (ITCs) coupled with accelerated
depreciation deductions with no offsetting taxable income. Their short term solution was to acquire
companies that would offset the ITCs, but the Chief Financial Officer, Donald Romans, suggested
that Trans Union should undergo a leveraged buyout to an entity that could offset the ITCs. The
suggestion came without any substantial research, but Romans thought that a $50-60 share price
(on stock currently valued at a high of $39 ½) would be acceptable. Van Gorkom did not
demonstrate any interest in the suggestion, but shortly thereafter pursued the idea with a takeover
specialist, Jay Pritzker. With only Romans’ unresearched numbers at his disposal, Van Gorkom
set up an agreement with Pritzker to sell Pritzker Trans Union shares at $55 per share. Van
Gorkom also agreed to sell Pritzker one million shares of Trans Union at $39 per share if Pritzker
was outbid. Van Gorkom also agreed not to solicit other bids and agreed not to provide proprietary
information to other bidders. Van Gorkom only included a couple people in the negotiations with
Pritzker, and most of the senior management and the Board of Directors found out about the deal
on the day they had to vote to approve the deal. Van Gorkom did not distribute any information at
the voting, so the Board had only the word of Van Gorkom, the word of the President of Trans
Union (who was privy to the earlier discussions with Pritzker), advice from an attorney who
suggested that the Board might be sued if they voted against the merger, and vague advice from
Romans who told them that the $55 was in the beginning end of the range he calculated. Van
Gorkom did not disclose how he came to the $55 amount. On this advice, the Board approved the
merger, and it was also later approved by shareholders.
 Issue: Whether the business judgment by the Board to approve the merger was an informed
decision.
 Holding: No. The Chancery Court got it wrong. It said that it was irrational, and because the
Board did not disclose a lack of valuation information to the shareholders, the Board breached
their fiduciary duty to disclose all germane facts.
 Rule: A business judgment is presumed to be an informed judgment, but the
judgment will not be shielded under the rule if the decision was unadvised.
 The Delaware Supreme Court held the business judgment to be gross negligence,
which is the standard for determining whether the judgment was informed.
 The Board has a duty to give an informed decision on an important decision such
as a merger and cannot escape the responsibility by claiming that the shareholders also
approved the merger.
 Rational: The directors are protected if they relied in good faith on reports
submitted by officers, but there was no report that would qualify as a report under the statute. The
directors cannot rely upon the share price as it contrasted with the market value. Therefore, the
motive of the director can be irrelevant, so there is no need to prove fraud, conflict of interests or
dishonesty.
 Result: Reversed and Remanded
 Dissent: The dissent believed that the majority mischaracterized the ability of the directors to
act soundly on the information provided at the meeting wherein the merger vote took place. The
credentials of the directors demonstrated that they gave an intelligent business judgment that
should be shielded by the business judgment rule.

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 G. THE DUTY OF LOYALTY

 BJR does NOT apply in duty of loyalty cases

 Intrinsic Fairness Test:
 If the Director has a self-dealing transaction, the burden of proof is on the director who
benefitted from the transaction to show that the procedure taken was fair to the company
 What is self-dealing? It applies, where, through control of the enterprise, the benefitting
fiduciary receives a benefit to the exclusion and detriment of the other shareholders
 Higher standard than the BJR – harder for Plaintiffs to win
State Ex Rel. Hayes Oyster Co. v. Keypoint Oyster Co.

 PH:
 Facts: Hayes owns 25% of his brother’s oyster company and another percentage of the Coast
oyster company of which he is also CEO. Coast Oyster Company was in bad financial shape and
to solve its cash flow problems sold its valuable oyster beds to another company. His employment
contract had an anti-competition clause, but he helped form a new competitor, Keypoint, to
acquire property that was being sold by his employer. He decides to sell part of Coast to a new
company, Keypoint (and he’ll own half) but he does not disclose to Coast that he will have a role
in Keypoint. Later, Coast wants to take Hayes’ portion and claims that he should not get to keep
his half because of the self-dealing. Coast lost no money in its transaction with Keypoint. All
agree that the oyster beds were worth $250,000 -- the purchase price.
 Issue: Whether Hayes breached a duty of loyalty.
 Holding: Yes. The duty of loyalty was violated.
 Rule: Nondisclosure by an interested director or officer is itself unfair.
 Coast shareholders and directors had the right to know of Hayes' interest in Keypoint in order
to intelligently determine the advisability of retaining Hayes as president and manager.
 Hayes was required to divulge his interest because he might have been placed in a position
where he had to choose between the interests of the two companies
 The fact that it was in secret indicates that it was not fair – full disclosure would indicate
fairness
 Court is trying to create incentives for full disclosure
 Hayes had multiple allegiances -- president, manager, 23% SH of Coast Oyster / co-signor
of note for start-up / capital in Keypoint shareholder in Hayes Oyster, which became 50%
shareholder of Keypoint
 Actual injury is not necessary – the officer does not need to intend to defraud
 Court ordered issuance of new certificate for Keypoint to issue 250 shares of its stock to Coast
 Notes:
 A gain incurred while serving the best interests of a competitor or of one’s self may be
sufficient to ground an action.
 The gain need not necessarily be secret
 Bifurcated process:
 Did a vote of a single director with divided loyalties occur?
 Did this director’s participation taint the deliberations of a collegial body?
 Non Shareholder Constituency Statutes
 The law has never with precision defined what precisely is subsumed in the best interest of the
corporation
 Self-dealing- Use the intrinsic fairness test above

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 Definition
 On both sides of transaction
 Only majority benefits by it (minority excluded)
H. INTERESTED DIRECTOR TRANSACTIONS
 Florida Uses the MBCA but under Conflicts of interest it adopts the Delaware rule.
 DGCL § 144- Interest Directors; Quorum
 Transaction is valid if
 Material facts are disclosed and if the transaction is approved in good faith by disinterested
directors or shareholders
 If there are disinterested directors, DGCL applies the BJR and other courts shift the burden
to Plaintiff to show unfairness.
 If there are no disinterested directors, apply the intrinsic fairness test, in which defendants
who benefitted from the transaction must show that the transaction is fair to the corporation.
 The transaction is fair to the corporation
 Safe harbor– compliance with the statute shifts the burden of proof to the shareholder who is
alleging an unfair transaction. If the director hasn't complied with the statute, burden of proof
remains with him/her.
 Marciano v Nakash
 The court held that § 144 is not per se voidable on transactions that weren't approved
 If can show transactions was intrinsically fair - then can validate the transaction
 Fiduciary has burden of proof
 MBCA Subchapter F
 § 8.60- Conflicting interest
 § 8.62(a)- A transaction that is not a director’s conflicting interest transaction may not be
enjoined, set aside, or give rise to an award of damages
 § 8.62(b)- Conflicting interest transactions also may not be set aside if:
 The director’s action, pursuant to § 8.63, has been taken;
 Shareholder action, pursuant to § 8.63, has been taken; OR
 The transaction is established to have been fair to the corporation
 § 8.63-
 A transaction is approved if it has received the affirmative vote of a majority (but no less
than two) of those qualified directors on the BoD
 Qualified directors also constitute a quorum if they number two or more
 Shareholder Approval
 A BoD may refer certain interested director transactions shareholders’ meetings for
consideration, for at least three reasons:
 Political- A transaction approved by shareholders is easier to defend than on
approved by directors
 At the shareholder level, majority approval may be easier to obtain, as
shareholders are given much more freedom to vote in self-interest
 Shareholder approval may be given more deference than the BJR
 Deference=Waste
 Waste= Transaction in which the consideration the corporation receives
no person of ordinary sound business judgment would deem it worth that
which the corporation has paid
 Interlocking Directorship:
 When the same individual serves as a director on two BoDs of two separate corporations
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  MBCA excludes transactions from a need to be passed through the board EXCEPT:
 The transaction must be of such character and significance that in the normal course of
business it would be brought before the board
 Only if the director is an actual party to the transaction, or has a material beneficial interest
in a party
 Independence
Orman v. Cullman
 Independence involves an inquiry into whether the director’s decision resulted from
that director being controlled by another. Not a question of whether the challenged
director derives a benefit from the transaction that is not generally shared with the
other shareholders.
Aronson v. Lewis
 Interest=The directors can neither appear on both sides of the transaction nor expect
to derive any personal financial benefit from it . . . as opposed to a benefit which
devolves upon the corporation or all stockholders generally
 Sarbanes Oxley
 § 301
I. USURPATION OF A CORPORATE OPPORTUNITY

1. TESTS
 Interest/Expectancy Test: A corporate opportunity exists if the corporation has an active
interest in the business opportunity
 Line of Business Test : A corporate opportunity exists if the business endeavor is within the
same or closely related prospective line of duty as the corporation
 Fairness Test: Examines factual circumstances to determine fairness of the situation and
whether the corporation’s interests call for protection
 By Virtue of the Position Test: A corporate opportunity exists if the officer/director becomes
aware of the opportunity because of their corporate affiliation
 Use of Corporate Assets or Information: A corporate opportunity exists if a fiduciary uses
anything more than a de minimis amount of corporate assets or information to develop the
opportunity
 Economic Capacity Test/Defense: This test supplements other tests. An opportunity is not
improperly taken by the officer if the corporation is financially incapable of exploiting the
opportunity, regardless of whether it is in the corporation’s line of business or whether the
corporation has an interest in the opportunity.
 ALI Test: Layers “virtue of position” “use of corporate assets” and “line of business” tests.
Prohibits the officer from taking a corporate opportunity without first offering it to the company.

Today Homes v. Williams

 PH: TC dismissed Plaintiff’s complaint for failure to meet proof

 Facts: Today Homes was a real estate developer which focused on building single family
homes. Emma Williams was Chesapeake’s vice president of operations. According to the
Supreme Court's decision, her responsibilities included purchasing activities and customer
service, but not land acquisitions. While Williams was still employed at Today Homes, a Long and
Foster real estate agent told her about land (known as the "Sinclair Property") which had a
development plan for a 55 and older adult community. Williams did not think Chesapeake would
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 be interested in the Sinclair Property because Chesapeake was not involved in developing adult
communities. Chesapeake terminated Williams’ employment in March 2003, after which Williams
decided to form her own development company, Majestic Homes. George Woodhouse also
worked at Chesapeake. He became Williams's partner in forming Majestic, but Woodhouse
remained in Chesapeake’s employment for a couple of months after the formation of Majestic.
After forming Majestic, Williams and Woodhouse contacted the listing agent at Long and Foster
and subsequently purchased the Sinclair Property. During the next year, Majestic developed the
property and realized almost $4.5 million in gross profit from the sale of homes.
 Issue: Whether Williams, her company Majestic, and her partner, Woodhouse, breached their
fiduciary duty to Chesapeake by failing to disclose the existence of the Sinclair Property.
(Chesapeake argued that the property was a corporate opportunity belonging to Chesapeake.)
 Holding: No for Williams, Yes for Woodhouse
 Rule: An individual serving as an officer or director must forgo potential personal
opportunities unless disclosure is made and consent is given by the corporation.
 If (1) a corporate opportunity arises while in such a position and (2) the individual acts
on the opportunity, then in all likelihood there will be at least the appearance of -- if not an
actual -- breach of one’s fiduciary duty, and the better course of action is to avoid both.
 Rational: The property was, in fact, a corporate opportunity for Chesapeake.
 Court uses the line of business test and the fairness test. With respect to Williams, the Court
stated that while she was an employee of Chesapeake, she had only “casual knowledge” of the
property’s existence and had not formed the intent to purchase it.
Although a fiduciary obligation can continue after termination of an individual's relationship with a
company, in this case the Court found that Williams had no intention of buying the property while
still employed; therefore, for Williams the corporate opportunity arose only after she no longer
owed a fiduciary duty to Chesapeake (since she’d been terminated).
 The Court analyzed Woodhouse's situation differently. He had continued in Chesapeake’s
employment and was still an officer during the period of time when he and Williams acquired the
property, and for those reasons the Court sent Woodhouse's portion of the case back to the trial
court for additional factual determinations.
 Result: Affirm against Williams, Reverse against Woodhouse
Brandt v. Somerville

 PH: TC Judgment for the Plaintiff, Somerville’s conduct was “ unfairly prejudicial”
 Facts: Brandt and Somerville incorporated Posilock, a closely-held corporation, to
manufacture and market bearing pullers, a product developed and patented by Somerville and
Brandt's deceased father. A Stock Transfer Agreement, which restricted transfers of Posilock
stock, was also executed as part of Posilock's incorporation, and Brandt and Somerville each
received half of the stock of Posilock. Brandt ultimately divided his shares with his brothers, John,
Herman, and Roy Brandt. The Brandt’s involvement with Posilock diminished over the years, and
Somerville's involvement increased. Somerville essentially ran Posilock, and his family developed
and owned other related businesses, including PL MFG, which produced component parts for
Posilock and was formed in 1998 with a $450,000 startup loan procured in Posilock's name. The
start-up costs included a $450,000 loan from Sheyenne Valley Electric Cooperative. Somerville
executed the loan documents and endorsed the check. The proceeds were deposited into an
account for PL MFG, which did not sign a promissory note payable to Posilock until 2000.
 Issue: Whether Somerville breached a fiduciary duty to Posilock and the Brandts.

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 Holding: Yes. Somerville violated duty to the company. Somerville’s involvement with PL MFG
constituted a wrongful appropriation, or usurping, of Posilock’s corporate opportunity to produce
its own parts, and a consequent breach of Somerville’s fiduciary duty to the corporation.
 Rule: The fiduciary obligation of undivided loyalty imposed upon directors and officers
precludes them from appropriating a business opportunity which belongs to the
corporation. A corporate opportunity exists when a proposed activity is reasonably
incident to the corporation's present or prospective business and is one in which the
corporation has the capacity to engage.
 Rational: Posilock had a corporate opportunity to manufacture its own parts, which was
reasonably incident to its present or prospective business, and it had the capacity to engage in
that opportunity.
 Results: Affirmed

J. COMPETITION WITHIN THE CORPORATION

 A corporate director may compete with the corporation on whose board he sits as long as he
does not engage in bad faith, or prohibited competition.
 Bad faith includes the following:
 Use of confidential or proprietary information
 Use of customer lists (S says at all, but especially not those that show additional
information over names and contact information)
 Disparagement of the corporation or its manner of doing business
 Other forms of tortious conduct, such as interference with the corporation’s existing or
prospective business advantage
 Use of more than nominal amounts of the corporation’s assets, facilities, or time.
K. DIRECTORS’ AND OFFICERS’ COMPENSATION
 Executive compensation may be a breach of a duty of loyalty- where compensation appears to
be excessive or based on self-dealing
 MBCA §3.02(12) expressly addresses the power of corporations to provide pension and
similar benefits to present or former employees.
 Executive compensation types
 Stock option
 Stock plan - restricted or phantom
 Stock appreciation rights
 Publicly held corporations usually submit incentive compensation plans for officers and high
level employees (profit sharing plans, stock option plans, etc) to shareholders for approval.
(this doesn’t immunize shareholders from attack though…since a court can say that its
waste of corporate assets)
 Ratification by shareholders doesn’t validate fraudulent, oppressive, or manifestly
unfair transactions involving officers or directors
 First look at what type of corporation it is:
 Closely held corporation?
 First, the problem will be finding out what the heck is going on.
 The directors are also likely the officers, and thus they will also be interested.
 Corporation?
 Revenue Reconciliation Act
 Performance-based compensation-

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  We want to align the goals of the executives and the company
 The CEO and 4 most highly paid officers, the corporation can only give them
$1 million, unless it is performance-based
 The SEC requires the compensation committee to discuss the
corporation’s policies with respect to the one million dollar cap in its
proxy statement
 Requirements :
 Paid pursuant to a plan the shareholders have approved
 The goals must be set by a compensation committee of 2 or more
outside directors
 The committee must certify in writing that the goals have been met
before the compensation is paid
 Claw-backs (Dodd-Frank, Sarbanes Oxley)
 Sarbanes-Oxley provided a limited claw-back provision (1 yr., CEO, CFO)
 Dodd-Frank now covers all executive officers instead of just the CEO and
CFO, and a 3yr. period instead of 1.
 Stock Options
 Back-dating can be used to manipulate compensation because executives are often
given a window in which to buy shares, which may decrease the market price of the
stock for tax purposes.
 This also records more profits for the financial statements of the corporation
because the statements do not reflect the.
 Are these stock options deductible at all for tax purposes?
Ryan v. Gifford

 PH: This is the TC

 Facts: In a stockholder derivative action, the plaintiff alleged, among other things, that
directors of Maxim Integrated Products breached their fiduciary duty by granting backdated
options from 1998 to 2002 to the company’s founder, Chair and Chief Executive. The options had
been issued under shareholder-approved stock option plans that, as described by the court,
Maxim had “contracted and represented” to its shareholders required that the exercise price of all
options would be no less than the fair market value of the company’s common stock, measured by
its publicly traded closing price on the date of grant.
 Issue: Whether the corporation’s failure to disclose the multiple instances of back-dating
amounted to a breach of a duty of loyalty.
 Holding: Yes. It did amount to a breach.
 Rule: The intentional violation of a shareholder approved stock option plan,
coupled with fraudulent disclosures regarding the director’s purported compliance with
that plan, constitute conduct that is disloyal to the corporation and is therefore an act in
bad faith.
 Rational: Option timing decisions by a board that circumvent option plan provisions requiring
all option grants to have “at-the-market” exercise prices cannot be presumed, at least for purposes
of a motion to dismiss, to be entitled to the protections of the business judgment rule because
such actions, as alleged, could not be considered to be taken in good faith. Burden falls to the
fiduciary to prove that this transaction was fair. Can’t prove that because there was non-
disclosure, so it is unfair per se.
 Bad faith and a breach of a duty of loyalty because it wasn’t disclosed.

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 The court commented that it was “unable to fathom a situation where the deliberate violation of
a shareholder-approved option plan and false disclosures, obviously intended to mislead
shareholders into thinking that the directors complied honestly with the … plan, is anything but an
act of bad faith.
 Ritter v. Stone- The Court looked back at this case, and said lying to shareholders amounts to
bad faith
 Look again at DGCL § 102(b)(7)
In re Tyson Foods, Inc., Consolidated Shareholder Litigation

 PH: This is the TC

 Facts: This derivative action presented claims involving numerous alleged improper related
party transactions approved by directors of Tyson Foods, Inc., one of which concerned option
grants between 1999 to 2003 to corporate insiders made “[d]ays before Tyson would issue press
releases that were very likely to drive stock-prices higher . . . .” - “spring-loaded” options.
 Issue: Whether intentional grants of spring-loaded options by directors with inside information
constituted a breach of a duty of loyalty.
 Rule: Yes. With reasoning similar to Ryan, the Court held that the intentional grant of spring-
loaded options by directors having inside information in contravention of a shareholder-approved
stock option plan could support a claim for a breach of fiduciary duty.
 Bullet dodging – granting options to employees after the release of materially damaging
information, apparently having in mind intentionally postponing the recorded grant date until after
negative information drove the trading price of the related stock downwards and thereby achieving
a more favorable exercise price than would have been the case at the originally intended grant
date.
 Spring loading – award options today knowing that the price of the stock will go up
when earnings are announced
 A director who intentionally uses inside knowledge . . . to enrich employees while
avoiding shareholder imposed requirements cannot . . . be said to be acting loyally and in
good faith as a fiduciary.
 When there is intent, it is outright fraud
 Because there was no authorization from shareholders, it is indirect deception
 This conclusion . . . rests upon at least two premises, each of which should be . . . alleged . . .
to show that a spring-loaded option issued by a disinterested and independent board is
nevertheless beyond the bounds of business judgment.
 First, a plaintiff must allege that the options were issued according to a shareholder-approved
employee compensation plan.
 Second, a plaintiff must allege that the directors that approved the spring-loaded . . . options
(a) possessed material non-public information soon to be released that would impact the
company’s share price, and (b) issued those options with the intent to circumvent otherwise valid
shareholder-approved restrictions upon the exercise price of the options.
 Such allegations would satisfy a plaintiff’s requirement to show adequately at the pleading
stage that a director acted disloyally and in bad faith is therefore unable to claim the protection of
the business judgment rule.
 Granting spring-loaded options, without explicit authorization from shareholders,
clearly involves an indirect deception.
 A director’s duty of loyalty includes the duty to deal fairly and honestly with the shareholders
for whom he is a fiduciary.

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 It is inconsistent with such a duty for a board of directors to ask for shareholder approval of an
… option plan and then later distribute shares to managers in such a way as to undermine the
very objectives approved by shareholders.
 This remains true even if the board complies with the strict letter of a shareholder-approved
plan as it relates to strike prices or issue dates.

In re The Walt Disney Company Derivative Litigation

 Facts: In August 1995, Ovitz and the Walt Disney Company entered into an employment
agreement. Ovitz was appointed as President of Disney for five years. Ovitz was terminated by
Disney without cause in December 1996, only fourteen months after he commenced employment.
Ovitz was paid $ 130 million as severance payout. Under the terms of his employment contract,
Ovitz's severance package included approximately $ 38 million in cash payments and $ 91.5
million in stock options. Shareholders of Disney brought a derivative suit against Disney's
directors. Plaintiffs claimed that the directors had breached their fiduciary duties by agreeing to the
terms of Mr. Ovitz's employment contract and by allowing the payment of his severance package.
Chancery Court held that the directors had not breached any of their fiduciary duties or failed to
act in good faith in connection with the hiring or firing of Mr. Ovitz.
 Issue: Whether the directors had breached any of their fiduciary duties.
 Rule: No. The directors did not breach any of their fiduciary duties.
 Courts will not second-guess the decisions of directors unless the process that
generated those decisions is unsound. Delaware courts will not expose directors who
exercise due care and act in good faith to personal liability for bad business decisions.
 The board was negligent, but they are protected under the BJR – they acted with due care and
not in bad faith (DGCL § 102(b)(7))
 Disney's directors acted in good faith and did not breach their fiduciary duties with respect to
hiring or firing of Michael Ovitz as President of The Walt Disney Company.
 Directors had satisfied their duty of care as fiduciaries and that all of their actions had been
taken in good faith.
 Actions of the directors were to be reviewed under the business judgment standard, which
granted directors broad discretion in their efforts to maximize shareholder value, provided that the
directors acted on an informed basis, in good faith and in the honest belief that the action taken
was in the best interest of the corporation.
 Even if they were grossly negligent, the raincoat provision (exculpation agreement)
would cover the case because there was not actual or knowing misconduct.
 DGCL § 141(c)- A board committee may in lieu of the full BoD may authorize compensation
committee to deal with executive compensation

 Reasonable Relationship Test- Rogers v. Hill

 The United States Supreme Court considered another case involving the
reasonableness of compensation. That case arose under the corporate law of New
Jersey. In that case several executives of American Tobacco Co. had received
bonuses that plaintiffs claimed were excessive. The bonuses were paid under a plan
that had been approved by shareholders in the form of a by-law adopted in 1912.
The by-law provided that if the net profits of American Tobacco exceeded about $8.2
million in any year, the president of the company would receive payment of 2.5
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 percent of such excess, and each of five vice presidents would receive 1.5 percent,
an aggregate of 10 percent of the annual net profit exceeding $8.2 million.
 The dissenting opinion of Judge Swan indicates the applicable rule: “If a bonus
payment has no relation to the value of services for which it is given, it is in
reality a gift in part, and the majority stockholders have no power to give away
corporate property against the protest of the minority.”
 What can explain the difference in results under Rogers v. Hill and In Re Walt Disney
Co. other than the passage of 65 years and, perhaps, changing perceptions of what
constitutes corporate waste in the context of executive compensation? Following
are some observations on this point:
 Ovitz's agreement was the result of an arm's length negotiation that resulted in
Ovitz's agreeing to join Disney and thereby giving up his position at Creative Artists
Agency, which he had founded, and from which he reputedly received cash
payments each year in excess of $30 million. It is reasonable to assume that without
such a severance package Disney would not have succeeded in attracting Ovitz
from Creative Artists.
 A by-law net profits bonus adopted by shareholders nearly a decade before the
beginning of the years in question (and nearly two decades before the end of the
period in question) is a rather insensitive compensation instrument for measuring
executive pay year after year. While shareholders could repeal the by-law, it may not
have been an easy task for a dissenting shareholder to obtain a new vote by
shareholders on the by-law.
 Assume that in 1998 the Delaware Chancery Court addressed the facts in Rogers v.
Hill except that the bonus plan, instead of a by-law adopted by shareholders, was a
plan adopted by the board of directors two decades earlier that had not been re-
examined by the board since its original adoption. Perhaps a Delaware court might
find in such circumstances that the bonus was subject to court review, not because
of size alone but because of a 20-year absence of attention to whether it continued
over such period to provide an appropriate formula.
 Such a court might find that these circumstances did not reflect a reasonable
exercise of business judgment by the board of directors. In that case, a complainant
might overcome the presumption of the business judgment rule, even in a Delaware
court, on the basis of an unreasonable absence of attention over a lengthy period of
time, rather than on the basis of the size of the award alone.

 What advice do you give Jones? Explain fully.

 These transactions have been approved by the (disinterested) BoD. DGCL §
144.
 This will shift burden to the other party defeat the BJR or show waste.
 Waste is unlikely.
 Can we defeat the BJR?
 Nope.
 This case is a loser on the information at hand. In a closely held corporation,
the majority rules.
L. AIDING & ABETTING BREACHES OF FIDUCIARY DUTY

Koken v. Steinberg

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 Facts: Deloitte provided auditing and actuarial services to Reliance Insurance. Three years
later, Koken (the liquidator) an action against Deloitte alleging that it “propped up Reliance’s
financial position, deflected regulatory scrutiny, and permitted Reliance to pay out cash to its
unregulated parent companies and undertake additional policyholder obligations when Deloitte
knew or should have known that Reliance was seriously financially troubled and was or would
have been shortly insolvent.” Koken alleged that, in doing so, Reliance overstated Reliance’s
financial condition by one billion dollars and thus harmed Reliance, its policyholders, and
creditors.
 Issue: Whether Deloitte breached a fiduciary duty by acting in concert with wrongdoer,
Reliance.
 Rule: Yes. Deloitte breached a fiduciary duty.
 Requirements:
 Wrongdoer (Reliance) must breach a fiduciary duty
 Aider/abettor (Deloitte) must have knowledge of the breach of fiduciary duty
 Most courts hold that there must be actual knowledge, not just
recklessness
 Aider/abettor (Deloitte) must render substantial assistance or
encouragement in affecting the breach
M. ADDITIONAL DUTIES

1. DUTY OF CANDOR
 Duty of disclosure – part of duty of care and duty of loyalty
2. DUTY OF GOOD FAITH
 Directors may be liable for a good faith violation if they act like they don’t care about
inherent risks in the transaction
3. DUTY TO ACT LAWFULLY

XI. DERIVATIVE LITIGATION

A. INTRODUCTION
 Derivative Suits- Cases in which a minority shareholder sues a director, officer or third
party in the name of the corporation.
 FRCP Rule 23.1
 (a) Prerequisites. This rule applies when one or more shareholders or members of a
corporation or an unincorporated association bring a derivative action to enforce a right that
the corporation or association may properly assert but has failed to enforce. The derivative
action may not be maintained if it appears that the plaintiff does not fairly and adequately
represent the interests of shareholders or members who are similarly situated in enforcing
the right of the corporation or association.
 (b) Pleading Requirements. The complaint must be verified and must:
 (1) allege that the plaintiff was a shareholder or member at the time of the
transaction complained of, or that the plaintiff's share or membership later devolved
on it by operation of law;
 (2) allege that the action is not a collusive one to confer jurisdiction that the court
would otherwise lack; and
 (3) state with particularity:
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  (A) any effort by the plaintiff to obtain the desired action from the directors or
comparable authority and, if necessary, from the shareholders or members;
and
 (B) the reasons for not obtaining the action or not making the effort.
 (c) Settlement, Dismissal, and Compromise. A derivative action may be settled, voluntarily
dismissed, or compromised only with the court's approval. Notice of a proposed settlement,
voluntary dismissal, or compromise must be given to shareholders or members in the
manner that the court orders.
 Shareholder Derivative Actions
 A suit by a shareholder on behalf of the corporation to enforce management’s duties.
 Must claim injury to corporation.
 Shareholder sues in the name of the corporation
 Standing Requirement – To bring a derivative suit a shareholder (MBCA §7.41)
 Must have been a shareholder at the time of the act or omission complained of
(exception: the shares devolve on you by operation of law from someone who was a
shareholder at the time- continuing wrong); AND
 Must fairly and adequately represent the interest of the corporation.
 Demand Requirement – If a claim belongs to the corporation, it is the corporation, acting
through its board of directors, which must make the decision whether or not to assert the claim.
 The demand requirement recognizes this.
 2 Approaches:
 Universal Demand (MBCA §7.42) (MINORITY RULE)– No shareholder may commence a
derivative proceeding until:
 A written demand has been placed upon the corporation to take suitable action; and
 90 days have expired from the date the demand was made unless the shareholder has
earlier been notified that the demand has been rejected by the corporation or unless
irreparable injury to the corporation would result by waiting for the expiration of the 90-day
period.
 Excused Demand
 Demand Excused if Futile – A stockholder filing a derivative suit must
allege either that the board rejected his pre-suit demand or allege with particularity why demand
would be futile.
 Conclusory allegations are not enough.
 Reasons Demand May be Futile under DGCL
 A majority of the board has a material financial or familial interest
 A majority of the board is incapable of acting independently for another reason such
as domination or control
 The underlying transaction is not the product of a valid business judgment.
 Reasons Demand May be Futile under NY
 A majority of directors are interested in the transaction
 The directors failed to inform themselves to a degree reasonably necessary about
the transaction
 The directors failed to exercise their business judgment in approving the transaction.
 A director is self-interested where they would receive a direct financial benefit from
the transaction that is different from shareholders generally.
 Wrongful Refusal
 Different from EXCUSE

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  A stockholder who makes a demand that is refused can use the “tools at hand” to try to
prove that the demand was wrongfully refused, e.g. not independent, disinterested, or with
due care.
 If you make demand you can no longer argue that demand is excused.
 Board gets benefit of Business Judgment Rule if demand is made
 NY § 627- Security for Expenses (not in MBCA or DGCL)
 Makes it risky for small shareholder (> 5% or $50k) to bring derivative suits.
 If >5% of shares or >$50k in shares, you must post a bond (security for reasonable
expenses for defendant corporation).
 Designed to limit small shareholder suits.
 Requirement varies state to state; some states require bond if plaintiff owns less
than a certain percentage of stock, others give courts discretion.
 Covers reasonable litigation expenses of the defending corporation
 MBCA § 7.40-7.48
 § 7.47- If it is a foreign corporation, it is governed by laws of foreign corporation, except §§
7.43, 7.45, 7.46.
B. SPECIAL LITIGATION COMMITTEE AND THE SCOPE OF JUDICIAL REVIEW
 Even if demand is futile a board may be able to take control of litigation by forming an
independent special committee for litigation.
 Court may inquire on their own into the independence and good faith of the committee and
the basis for supporting its conclusion.
 Courts then apply their own business judgment as to whether or the suit should be
dismissed.
Zapata Corp. v. Maldonado

 Facts: There was acceleration of stock options by a board that financially benefitted
from it. Maldonado brought the derivative suit against ten officers and directors of Defendant,
asserting that they breached their fiduciary duties. Plaintiff did not demand that the Defendant
officers bring the action because all the directors at the time were named in the suit. After the suit,
Defendant’s corporation appointed an “Independent Investigation Committee” comprised of two
directors who were not part of the initial suit. The Committee decided that the derivative suits
would be harmful to the company and therefore moved to dismiss the litigation.
 Issue: Whether the authorized committee should be permitted to dismiss pending
derivative suit litigation.
 Rule:
 A tainted board CAN appoint an untainted committee.
 A number of people are of the opinion say no- if because of self-interest
you are disqualified of making the decision, why would the taint go away if you appoint the person
who will make the decision
 An interested BoD can appoint a disinterested Committee.
 The court applied a two-step test to determine if the Committee should be
permitted to dismiss the litigation.
 First, Defendant’s corporation has the burden to prove that the
Committee is independent and is exercising good faith and reasonable investigation.
 If so, under Rule 56 Standards, go on to next step.
 If not, the court will deny the corporation’s resolution.
 Burden is on the corporation to prove this item.
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 Second, the court should apply their independent business
judgment.
 Chancery court should give special consideration to matters of law
and public policy in addition to the interests of the corporation.
 Public interest in having the matter tried to sort out facts
 Use court's independent judgement to balance
 Shareholder's right to maintain suit against
 Board committee's empathy will dismiss all suits
 The court’s two-step test shifts the burden to the corporation to prove the
independence, which limits the advantage to a company of appointing an independent group to
determine the merits of a derivative suit
 Desaigoudar and MBCA § 744 introduce two alternative methods.
Desaigoudar v. Meyercord (takes a BJR approach similar to step #1 of Zapata)

 Facts: A shareholders’ derivative suit had alleged eight directors and officers of California
Micro Devices (CMD) wasted corporate assets and breached their fiduciary duties. CMD invested
in a company called CellAccess. CMD would fund CellAccess in exchange for a 56% interest in
the company. CMD was then accused of accounting irregularities, falsely reporting its revenue
(overstating earnings by 70%), ultimately implicating Desaigoudar in the wrongdoing. A new CEO
was named, Desaigoudar was relieved of his duty, and the new CEO terminated the project with
CellAccess. The plaintiffs, along with Desaigoudar, filed a derivative claim, alleging that if CMD
had not terminated the agreement with CellAccess, it would have a 56% interest in the company,
worth $20 million. The Defendants had allegedly failed to investigate the value of CellAccess
before disposing of CMD’s interest in it.
 Issue: Whether or not the members of the Special Litigation Committee were 'disinterested' or
whether or not the Special Litigation Committee conducted an 'adequate' investigation of the
claims presented.
 Rule: Yes. The Committee was disinterested and conducted an adequate investigation.
 The defendants were successful because they were able to demonstrate that the committee
members:
 Were not involved in the challenged transaction;
 Had the business expertise to evaluate the transaction;
 Retained an outside law firm with expertise to assist them;
 Reviewed a substantial number of documents; and
 Interviewed potential witnesses.
 "Special Litigation Committee" defense to derivative lawsuits (It’s like Zapata Strp #1)
 The BoD of a corporation (including the interested director) can appoint a special
committee of disinterested directors (those not charged with wrongdoing) to investigate
the merits of the alleged action and then give an opinion as to whether the corporation
should pursue the lawsuit.
 If the Special Litigation Committee decides the claims have no merit, the corporation
does not have to take any further action.
 If the decision of the Special Committee is challenged, a court can only consider the
following issues in "two-step" approach:
 Whether the Special Committee members were truly "disinterested," and
 Did they conduct an adequate investigation?
 If the answer to both questions is yes, the Court must overrule the challenge to the decision of
the Special Committee.
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 The burden is on the corporation.
 A properly appointed independent litigation committee can be very good protection for the
corporation, its officers and directors, from claims by shareholders.
 MBCA § 744
 The Model Business Corporation Act in § 744 rejects the second step of the Zapata
process.
 The act provides that the derivative proceeding “shall” be dismissed by
the court on motion if one of the specified groups has determined “in
good faith after conducting a reasonable inquiry upon which its
conclusions are based, that the maintenance in the derivative
proceeding is not in the best interests of the corporation.”
 Dismissal - § 7.44
 Appropriate parties to determine dismissal or sue
 § 7.44(b) - BoD
 Must have quorum
 Independent Directors - §7.44(b)(2)
 2 or more - special committee
 Court can appoint independent panel- § 7.44(f)
 What kind of determination must be made
 §7.44(a)
 Good faith
 Reasonable inquiry to drop suit
 Logical relationship with inquiry and conclusion
 Definition of independent director- §7.44(c)
 Burden of proof- §7.44(d) -(e)
 In most cases, plaintiff must convince court request met unless
majority of board is not independent.
 If you do not have a majority of independent directors, the burden is on
the corporation
 Miller v. Register & Tribune Syndicate
 Iowa is probably the most pro-shareholder state, and the court said that if
dependent directors want a derivative litigation suit dismissed, they should
have the court elect the independent directors rather than doing it
themselves. This hasn’t been adopted outside of Iowa.
C. WHEN IS DEMAND EXCUSED AS FUTILE?
 Demand Required
 To file derivative suit, plaintiff must
 Demand on board
 Board decision
 Don't sue (BJR)
 No recourse for shareholder [Spayel v Bruntrck]
 Sue
 Demand Excused
 Only when demand would be futile [Zapata]
 If demand is excused, plaintiff can bring suit immediately
 Corporation can then set up special litigation committee to determine if suit should
be dropped
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  Statutes
 DGCL § 102(b)(7)
 Delaware adopts a universal demand
 Committee must act independent and in good faith
 Court applies its own BJR
 Committee may not really be independent
 Court should look at public policy and matters of law which might not
be in corporation's best interest
 MBCA § 7.42
 Demand is never excused - always required
 Must make a demand and wait 90 days before bringing suit, unless already
rejected by corporation to bring suit - don't have to wait 90 days
 Give chance to wrongdoer to correct
 Demand does not have to be by the same shareholder that brings suit
 MBCA § 7.44

Aronson v. Lewis

 Facts: Plaintiff’s derivative suit against Defendants is based on Defendants approval of certain
transactions that occurred between Meyers and Defendant Director, Leo Fink (Fink), a 47%
stockholder of Meyers. In particular, Plaintiff challenges an employment agreement between
Meyers and Fink and an interest-free loan by Meyers to Fink. Plaintiff claims he did not make a
demand for action to Defendants before bringing this suit because such a demand would be futile
for the following reasons: (1) Defendants participated in, approved, and may be personally liable
for the wrongs complained of; (2) Fink controls and dominates Defendants because he personally
selected Meyer’s officers and directors; and (3) Defendants would need to sue themselves, putting
the action in hostile hands. The Court of Chancery held that plaintiffs’ allegations raised a
reasonable inference that the Defendants actions were unprotected by the business judgment rule
and thus a demand for action to Defendants would be futile. Defendants appeal.
 Issue: Whether making a demand on a board of directors was excused merely because the
shareholder plaintiff alleged that the board participated in the wrongdoing and consequently was
automatically considered partial or “guilty.”
 Rule: The Plaintiff failed to first make a demand to Defendant Directors before bringing a
derivative suit. Plaintiff further failed to show that such a demand was excused because he did not
allege particularized facts that indicate such a demand would be futile.
 The business judgment rule protects directors’ managerial freedom to make
decisions in the best interest of the company.
 A two-pronged demand futility analysis applies to determine if a complaint has created a
reasonable doubt as to whether the directors, having made a business decision, were
disinterested and independent, or likely entitled to the business judgment rule's protection:
 To raise a reasonable doubt that the directors’ actions would be protected
under the business judgment rule, the plaintiff must allege specific facts that causes
reasonable doubt that:
 The directors are disinterested and independent, OR
 The challenged transaction was otherwise the product of a valid
exercise of business judgment.
 You can meet this prong in two separate manners
 Not the product of a valid BJ, acted in bad faith, not informed
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 Waste- A transaction may be so egregious on its face (gross negligence)
 Awfully high bar (See In re Disney)
 This is a pleading rule
 You must allege with particularity the one of the two prongs is met (show a
causal link)
 Under DGCL, demand is excused when a majority of the board is financially
interested
 To show that directors are not independent and disinterested, you must
show, for example, close family relationships or financial benefit
 Here, Plaintiff’s allegation that Fink dominates and controls the Meyers’ board
based on Fink’s 47% stock ownership and that he personally selected each Meyer director and
officer is insufficient to support a claim that Defendants were not independent actors.
 Plaintiff’s allegation that the board’s approval of the Meyers-Fink
employment agreement violates the business judgment is insufficient to show that the
agreement is a waste of corporate assets.
 Plaintiff’s argument that demand is excused because Defendants otherwise would have
to sue themselves is a bootstrap argument that fails because there are no particularized facts to
overcome the presumption of director independence and proper exercise of business judgment.
 In a Demand Required case, plaintiff will have the burden of rebutting

 MBCA § 7.44(d)- Another pleading rule if a demand is rejected

 Majority of BoD did not constitute independent directors, OR
 Corporation has burden of proving requirements of subsection (a)
 If not, burden falls on plaintiff to prove this
 Requirements of subsection (a) are not met

Shoen v. SAC Holding Co.

 Facts: AMERCO operates as the holding company for business dealings that involve U–Haul
International, Inc. U–Haul was founded by Leonard Samuel Shoen in 1945, and its business
concerns include wholly owned U–Haul centers and a network of independent dealers that sell
moving products and rent trucks, trailers, and self-storage units to “do-it-yourself” movers. In
addition to its U–Haul concerns, AMERCO acquires and develops real property for self-storage
facilities through a subsidiary called AMERCO Real Estate Corporation (AREC). Ultimately,
Leonard transferred most of his AMERCO stock to his thirteen children, including sons Paul,
Edward J. (Joe), James, and Mark, which led, in the 1980s, to an unfortunate and well-
documented family feud between shifting factions for corporate control. In the 1990s, Joe, James,
and Mark formed SAC Holding Corporation and various SAC Self–Storage Corporations and
partnerships to operate as real estate holding companies (the SAC entities). In 1994, however,
before filing for personal bankruptcy, Joe and James2 transferred their shares in the SAC entities
to Mark. Ever since that time, Mark has been the SAC entities' sole shareholder. According to
appellants, Joe, James, and Mark have formed an “insider group.” Through board domination,
appellants claim, the “insider group” brothers have engaged in acts to further their own interests,
to the detriment of AMERCO shareholders, by building a competing business in the SAC entities.
This operation was accomplished, they assert, through the transfer of AMERCO's self-storage
business and assets to the SAC entities at unfair terms. Consequently, appellants filed derivative
suits seeking, among other things, to “halt and unwind” the AMERCO–SAC entities transactions.
But none of the appellants made any pre-suit demand on the AMERCO board of directors or the
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 other shareholders to obtain the corrective action. Instead, appellants alleged in their complaints
that any such demand would be futile, in large part because several board members, while not
voting for the challenged transactions, participated in the wrongdoing and because the board is
dominated and controlled by the interested “insider group”—and in particular, by Joe. The
derivative suits allege that, in addition to owning AMERCO stock, each of the four sons is or has
at relevant times served as an AMERCO director and/or officer. Joe and James have served on
AMERCO's board of directors since 1986. Mark served as a director between 1990 and 1997 and
is also employed as an AMERCO executive officer. While Paul no longer participates as an
AMERCO officer or director, he served on the board of directors for several years before 1991,
and from 1997 to 1998.
 Issue: Whether the complaint's particularized facts show that the board is incapable of
impartially considering a demand—i.e., that a majority of the board members are interested in the
decision to act on the demand or dependent on someone who is interested in that decision.
 Rule:
 In essence, a board of director's duty of care consists of an obligation to act on an informed
basis, and the board's duty of loyalty requires the board and its directors to maintain, in good faith,
the corporation's and its shareholders' best interests over anyone else's interests.
 Balancing a board of directors' duties of care and loyalty is the protection generally afforded
directors in conducting the corporation's affairs by the business judgment rule, which is a
presumption that in making a business decision the directors of a corporation acted on an
informed basis, in good faith and in the honest belief that the action taken was in the best interests
of the company.
 When pleading demand refusal or futility in a derivative action, a shareholder is not required to
plead evidence; nonetheless, mere conclusory assertions will not suffice under the “with
particularity” standard applicable to demand pleading.
 A shareholder's failure in a derivative action to sufficiently plead compliance with the demand
requirement deprives the shareholder of standing and justifies dismissal of the complaint for
failure to state a claim upon which relief may be granted.
 When a shareholder’s demand would be made to the same board that approved the
challenged action, a shareholder asserting demand futility must allege, with particularity,
facts that raise a reasonable doubt as to the directors’ independence or their entitlement to
protection under the BJR.
 When a board does not make a business decision or the BoD has changed since the
transaction, the demand requirement will be excused as futile only when particularized
pleadings show that at least 50% of the directors considering the demand for corrective
action would be unable to act impartially.
 A court must apply the Aronson test as modified by Rales and examine whether
particularized facts demonstrate either:
 One, when the directors approved the challenged transactions, a reasonable doubt that
the directors were disinterested or that the business judgment rule otherwise protects the
challenged decisions, OR,
 Two, when the challenged transactions did not involve board action or the board of
directors has changed, a reasonable doubt that the board can impartially consider a
demand
 Rales test applied to determination of whether shareholders, who filed derivative actions
against board of directors, sufficiently pled demand futility, and thus trial court had to determine
whether shareholders pled particularized facts demonstrating a reasonable doubt that the board of
directors could impartially consider a demand:

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 Where shareholders for the most part were alleging directors failed to properly supervise or
willfully disregarded their duties in regards to unfair transactions between corporation and entities
owned by executive officer of corporation, AND
 Shareholders were not alleging that a majority of the directors participated in any individual
transaction.
 NYSE makes a director per se non-independent if either he or his firm receives $100k or
more annually from the corporation. NASDAQ sets the bar at $60k.
 Friendship or social relationship is insufficient to disable or render not independent.
 Add notes on p. 494
 Verification
Surowitz v. Hilton Hotels
 The FRCP serve first and foremost to insure that justice is served and that
parties to a lawsuit receive a fair trial.
 π did not have to completely understand the pleadings. π’s attorney
verified the complaint and π was told by her son-in-law that the allegations were true.
 Rule 23(b) was created to discourage suits where a complaint is without
merit and filed with the expectation that it would be settled out of court to avoid the expenses of
litigation.
 It is obvious from the affidavits that π intended no harm to ∆ nor was there
any sign of bad faith by π or her attorney in filing the suit.
 The court was supplied with affidavits showing the extensive investigation
that had been made.
D. UNIVERSAL DEMAND
 MBCA § 7.42- Must make a demand, may not have to wait the 90 days
In re Guidant Shareholders Derivative Litigation

 Facts: Guidant Corporation is an Indiana company that develops, manufactures, and

distributes cardiovascular medical products. Endovascular Technologies Inc. is a wholly owned
subsidiary of Guidant. Endovascular designed the Ancure Endograft System to treat abdominal
aortic aneurysms and received FDA approval for commercial sale in the United States in 1999. In
June 2003, after an investigation into defects in the device, the incomplete handling and reporting
of complaints, inadequate corrective actions, and FDA violations, Guidant pled guilty to one felony
count of making false statements to a federal agency and nine felony counts of shipping
misbranded medical devices in interstate commerce. Guidant also agreed to pay a $43.4 million
criminal fine and a $49 million civil settlement.
 Issue: Under the law, regarding futility, by what legal standard should a court evaluate a
shareholder's decision not to make demand to a public corporation's board of directors before
filing a derivative suit?
 Rule: The state’s law retains the futility standard, but narrows its applicability substantially by
authorizing corporations to establish disinterested committees to determine whether the
corporation should pursue certain claims.
 Universal demand requires that a shareholder wait 90 days after a demand is made before
filing suit unless irreparable injury to the corporation would result.
 A shareholder may be excused from making a demand on the BoD before filing a
derivative suit if such demand would be futile.
 Demand isn’t futile simply because it alleges that members of the board are involved in
the wrongdoing
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 The availability of the disinterested committee (SLC) will bar a separate derivative action
unless the derivative π can establish that the committee was not disinterested or that its decision
was not undertaken after a good faith investigation.

 MBCA § 7.42
 Must make the demand “upon the corporation.”
 Reference is not specifically made to BoD, because there may be someone else with
authority to take action.
 To ensure demand reaches appropriate person for review- BoD, CEO and corporate
secretary at central corporate office.
E. AVOIDING DERIVATIVE CHARACTERIZATION— DIRECT VERSUS DERIVATIVE

Tooley v. Donaldson, Lufkin & Jenrette

 Facts: Plaintiffs, Patrick Tooley and Kevin Lewis were former minority stockholders of
defendant, DLJ, a Delaware corporation that engaged in investment banking. DLJ was acquired
by Credit Suisse Group's Fall 2000 merger agreement with AXA Financial, Inc., the majority
stockholder of DLJ. The merger agreement provided for Credit Suisse to make a cash tender offer
for all the minority shares of DLJ, to be followed by second step cash out merger. DLJ's board
later agreed with AXA Financial, Inc., to allow a 22-day delay in the close of the tender offer. The
tender offer closed and plaintiffs' shares were cashed out on November 2, 2000. Plaintiff
stockholders brought class action to enjoin a delay in the closing of a tender offer in the proposed
merger between DLJ and Credit Suisse Group. They planned to tender their shares and alleged
that DLJ board members breached their fiduciary duties by wrongfully agreeing to a 22-day delay
in the closing. Plaintiffs further alleged that they were harmed by this delay because of the lost
time value of the consideration paid for their shares at the close of the tender offer. Defendants
moved to dismiss the complaint for lack of standing. The Court of Chancery granted defendants'
motion to dismiss on the ground that, plaintiffs' claims being asserted derivatively. Thus they were
held not to be direct claims of the stockholders, individually. Court of Chancery held that plaintiffs
lost their standing to bring this action when they tendered their shares in connection with the
merger. Plaintiffs appealed against this decision.
 Issue: Whether the claim was direct or derivative.
 Rule: The claim was direct
 There was no derivative claim asserting injury to the corporate entity.
 There was no relief that would go to corporation.
 There was no basis to hold that the complaint stated a derivative claim.
 The complaint did not claim that the plaintiffs had any rights that had been injured. Their
rights had not yet ripened.
 The Delaware Supreme Court addressed the subtle distinction between direct and
derivative claims.
 Derivative Action – where the harm is directed toward the corporation and all
shareholders will benefit proportionally from recovery. Recovery goes to the corporation, so it’s
better for creditors
 Direct Action – impact the shareholder more directly, and they also suffer more
direct losses. Recovery is to the shareholders
 There is no derivative claim where there is no claim asserting injury to the
corporation and there is no relief that would go to the corporation

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 Distinguishing between direct and derivative actions:
 Who suffered the alleged harm?
 Who would benefit from the recovery or other remedy?

 ALI Principles of Corporate Governance § 7.01(d)

 In the case of a closely held corporation, the court in its discretion may treat an
action raising derivative claims as a direct action, exempt it from those restrictions
and defenses applicable only to derivative actions, and order an individual recovery,
if it finds that to do so will not:
 (i) unfairly expose the corporation or the defendants to a multiplicity of
actions,
 (ii) materially prejudice the interests of creditors of the corporation, or
 (iii) Interfere with a fair distribution of the recovery among all interested
persons.”
 DGCL § 145
 Procedurally complicated indemnification
 Section 145 of the DGCL addresses indemnification and advancement of expenses.
 Corporation has the power to indemnify
 Direct
 What can it indemnify against?
 A broad range of things- Expenses, attorneys’ fees, fines, judgments
 What are the conditions? Corporation can directly indemnify person if acted:
 In good faith (basic)
 Reasonably believed to be in best interest of corporation or not
opposed to corporate interest
 If criminal, no reasonable cause to believe conduct was unlawful
 Derivative suits.
 What can it indemnify against?
 Only attorneys’ fees.
 What are the conditions? Corporation can derivatively indemnify person if
acted:
 In good faith (basic)
 Reasonably believed to be in best interest of corporation or not
opposed to corporate interest
 DGCL § 145 - (MBCA § 8.50 - 8.57)
 Grants power, doesn't require
 Broad provision
 Except arbitration (DGCL- Not explicit)
 MBCA expressly allows
 Except suits by corporation or on behalf of corporation
 Statute put to corporation to indemnify
 Corporation can indemnify person
 If acted
 In good faith (basic)
 Reasonably believed to be in best interest of corporation or not
opposed to corporate interest
 If criminal, no reasonable cause to believe conduct was unlawful

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  Pays for expenses, attorney's fees, fines, settlements, and judgments
 Corporation is plaintiff or derivative suit (145b)
 If acted
 In good faith
 Or if reasonably believed to be in best interest of corporation or not
opposed to corporate interest
 Pays for expenses, attorney's fees (nothing else) (there are no fines given in
derivative suits)
 Mandatory right to indemnify if successful on the merits or otherwise (145c)
 Expenses and attorney fees
 Agent and employee dropped in text
 § 8.53 adds restrictions
 Procedure to exercise (145d)
 Must be authorized by (§ 8.53)
 Majority vote of directors (if not in suit)
 Outside counsel OR
 Shareholders
 Advance expenses by corporation (including attorney fees) but have to promise
corporation that will pay it back if not entitled to indemnification (145e)
 § 8.53 requires statement of good faith, but no ability to pay back
 Not exclusive of indemnification, can get relief in other ways (145f)
 Corporation is empowered to purchase insurance for directors and officers (145g)
 Questions to ask
 Who can be indemnified
 Standing
 Who makes determination
 What types of things can be indemnified against
 Advance expenses, etc.
 Don't have to notify shareholders of indemnification (no requirement in § 145)
 MBCA § 16.21 - in some cases you have to inform shareholders of indemnification
 Sarbanes Oxley says you can’t make loans. So a public company can’t advance
expenses

XII. SECURITIES LITIGATION

A. SECTION 11 OF THE SECURITIES ACT

Escott v. BarChris Construction Corp.

 PH: This is the TC

 Facts: BarChris built bowling alleys during the pinnacle of bowling popularity, the fifties
and sixties. BarChris had different arrangements with customers when building an alley. They
would either be paid to simply build an alley for customer, or they would sell the interior and lease
the exterior of the building. They also offered financing options that were risky for BarChris.
BarChris instituted a public offering to raise money since their financing plans left them short of
actual cash. BarChris, and competing companies overpopulated the country with bowling alleys,
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 and many alleys closed. Many customers of BarChris were defaulting on the financing, and
BarChris sold more debentures to keep afloat. The registration statements filed with the public
offerings listed extensive assets liabilities that were later found to be inaccurate. BarChris
eventually declared bankruptcy. Plaintiffs accused Defendants of misstating or omitting facts in the
registration statements.
 Issue: Whether any misstatements or omissions were made by Defendant officers in
the registration statement that were material under the Securities Exchange Act.
 Holding: Yes
 Rule: §11 of the Securities Act of 1933- A plaintiff does not have a cause of action
by just providing evidence of a misstatement in a registration statement. The
misstatements need to be material enough to cause an investor to rely on the statement
when they otherwise would not have. Defendant corporate officers will be held liable for
false or misleading statements when they materially affect the purpose of the registration
statement.
 Rational: The court reviewed many of the statements contained in the
registration statement filed by Defendants. Some of the statements were within normal accounting
standards, and some of the figures were only slightly different from what the court calculated.
However, other statements were misleading or omitted figures altogether, and the difference was
significant enough to be considered material under the Act.
B. SECTION 10(B) OF THE SECURITIES EXCHANGE ACT

1. THE “DECEPTION” OR “MANIPULATION” REQUIREMENT

Santa Fe Industries, Inc. v. Green
PH: TC dismissed the case, AC Reversed
Facts: Defendant acquired a 60% share in Kirby in 1934. By 1974, Defendant owned 95% and
wanted to own the entire 100%. Defendant utilized Delaware’s short-form merger statute that allowed
a parent corporation owning at least 90% of the stock to merge with the subsidiary and force the
minority shareholders to sell their shares. The minority shareholders must be notified within ten days,
and Defendant did so in this case. Defendant offered $150 per share after it was valued by Morgan
Stanley at $125. However, Kirby’s assets were valued to be $640 per share. Delaware law allows a
minority shareholder to petition the Delaware Court of Chancery if they believe the payout is unfair.
Instead, Plaintiffs brought an action under federal law, claiming that the majority owed a fiduciary duty
to the minority, and that breach violated Rule 10b-5. The trial court believed that fiduciary duty
breaches were not covered under the federal law, but the Court of Appeals reversed, concluding that
it was within the purview of the federal law.
Issue: The issue is whether a breach of fiduciary violates Rule 10b-5.
Held: The United States Supreme Court held that Rule 10b-5 will not govern breaches of fiduciary
duty.
Rule: Section 10(b) of the Securities Exchange Act and Rule 10b-5 prohibit conduct involving
manipulation or deception, but are not so expansive as to govern incidences of fiduciary breach.
Rational: The language used by the legislature in Section 10(b) refers to manipulation and deception
and there is no evidence that the legislature meant to have an expansive reading of those terms. The
Court did not want to open the door to more litigation by expanding the scope of the statute. The
states traditionally regulated the behavior at issue, and the Court reasoned that it was up to the
legislature to act if they felt there was a need to have uniformity across the states.
Result: Reversed
Dissent: The dissent agreed with the appellate court.

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Concurrence: The concurring opinions believed that there was no need to decide whether fiduciary
breaches were under federal law because there was no actual breach by Defendant.
Discussion. The Court is not getting rid of any remedy for breaches of fiduciary duty, but a plaintiff will
have to use state courts.

2. MATERIALITY
Materiality signifies that the misstated or omitted fact, if accurately disclosed, would have been
considered important by a reasonable investor in making his/her voting or investment decision.
[A]n omitted fact is material if there is a substantial likelihood that a reasonable
shareholder would consider it important in deciding how to vote. This standard is fully
consistent with Mills' general description of materiality as a requirement that "the defect
have a significant propensity to affect the voting process." It does not require proof of a
substantial likelihood that disclosure of the omitted fact would have caused the
reasonable investor to change his vote. What the standard does contemplate is a
showing of a substantial likelihood that, under all the circumstances, the omitted fact
would have assumed actual significance in the deliberations of the reasonable
shareholder. Put another way, there must be a substantial likelihood that the disclosure
of the omitted fact would have been viewed by the reasonable investor as having
significantly altered the "total mix" of information made available. – TSC Industries, Inc.
v. Northway, Inc., 426 U.S. 438. 449 (1976).
SEC Bulletin 99
Among the considerations that may well render material a quantitatively small misstatement of a
financial statement item are –

 whether the misstatement arises from an item capable of precise measurement or whether it
arises from an estimate and, if so, the degree of imprecision inherent in the estimate14

 whether the misstatement masks a change in earnings or other trends

 whether the misstatement hides a failure to meet analysts' consensus expectations for the
enterprise

 whether the misstatement changes a loss into income or vice versa

 whether the misstatement concerns a segment or other portion of the registrant's business that
has been identified as playing a significant role in the registrant's operations or profitability

 whether the misstatement affects the registrant's compliance with regulatory requirements

 whether the misstatement affects the registrant's compliance with loan covenants or other
contractual requirements

 whether the misstatement has the effect of increasing management's compensation – for
example, by satisfying requirements for the award of bonuses or other forms of incentive
compensation

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  whether the misstatement involves concealment of an unlawful transaction.

3. THE RELIANCE REQUIREMENT

Basic, Inc. v. Levinson

PH: TC adopted a presumed reliance by members of the plaintiff class upon corp public statements
that enabled the court to conclude that common questions of fact or law predominated over the
individual plaintiffs. AC affirmed the class cert, by accepting the “fraud on the market theory” to create
a rebuttable presumption that plaintiffs relied on corp material misrepresentations, noting that without
the presumption it would be impractical to certify a class under FRCP 23(b)(3).
Facts: Petitioners made chemical refractories for the steel industry. A second business, Combustion
Engineering, Inc., targeted Petitioner as a good acquisition. During merger discussions, the volume of
trading for Petitioner’s stock increased and the price was increasing, seemingly due to rumors of a
potential acquisition. Petitioner publicly refuted the rumors of a merger. Shortly thereafter Petitioner
requested to suspend trading because of merger talks. Respondents sold their shares before the
suspension but after the public denials of merger discussions. Therefore Respondents claimed that
Petitioners violated Section 10(b) of the Securities Exchange Act and of Rule 10b-5.
Issue: The issue is whether the misleading statements regarding ongoing merger discussions were
material enough to alter the decision of a reasonable investor.
Held: The court determined that determining whether misleading statements or omissions were
material under Rule 10b-5 would require a fact-based assessment. The court did not adopt
Petitioner’s “agreement-in-principle” test that would have considered only misstatements after an
agreement was made in principle. The court did not think that the probability of a failed merger
outweighed the importance of providing the information to the investor. The court instead took a fact-
based approach, reasoning that the probability would be weighed against the magnitude of the facts.
In this case, a merger has a high magnitude on investor decisions and therefore the probability of a
successful merger does not have to be as absolute as more trivial topics. The misstatements would
still need to be material.
Rule: Misleading statements during merger discussions will be material under Rule 10b-5 if the
misstatements would have changed the view of the total information by a reasonable investor.
Rational:
Result:
Discussion: The court does not want the investors to be treated as a group that is incapable of
understanding corporate goings-on. However, they still require that the misstatements be material. At
one point, they note in Footnote 17 that a “no comment” may be a safe alternative for corporate
officers who would otherwise feel the need to offer a misleading statement.

4. FORWARD LOOKING STATEMENTS

Asher v. Baxter International, Inc.

XIII. INSIDER TRADING

A. INTRODUCTION
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 1. OVERVIEW
 SEA of 1934 § 10b & Rule 10b-5 the basic federal anti-fraud prohibition (cite both the
statute and the rule)
 These are the principal statutory weapons against fraud.
 Section 10b is the antifraud provision of the Exchange Act, while Rule
10b-5 is the rule the SEC promulgated under that section.
 Scope is very broad-
 Applies to any Security, registered on SEC or not,
 Applies to public and private companies
 Applies to any person with a duty
 Jurisdictional means- Every case will involve instrumentality of
interstate commerce (even if only intrastate)
 Just about anything- mail, checks, couriers
 It is unlawful to use/employ in purchase/sale of security any
manipulative or deceptive device or contrivance in contravention of such rules and
regulations.
 Rule 10b-5 prohibits the use of any "device, scheme, or artifice to
defraud," and creates liability for any misstatement or omission of a material fact, or one that
investors would think was important to their decision to buy or sell the stock.
 Based on § 17-a of the 1933 SEA
 It shall be unlawful for any person, directly or indirectly, by
use of any means or instrumentality of interstate commerce, or of the mails or of any
facility of any national securities exchange,
 (a) To employ any device, scheme, or artifice to defraud,
 (b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statement made not misleading, or
 (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
 . . . in connection with the purchase or sale of any security.
 Neither has a private cause of action
 Kadon v National Gypsum Co. – Court creates implied civil remedy for
violation of § 10b and Rule 10b-5.
 Insiders are economic actors; they make decisions based on what is advantageous to
them as individuals based upon information they have, not available to market
 Insiders have undisclosed material information. → they can beat the market.
 Insider trading→ officers/ directors/corporate actors who are engaging in trading
transactions of company stock while in possession of material non-public information
 What is material? They are using information to manipulate price in market
2. THE MEANING OF “MATERIAL” AND “NONPUBLIC” INFORMATION
a) Material
 Information that a reasonable investor would consider important. The more
important the matter (greater magnitude), the less probability is required for it to be material
 Based on two types of information:
 Internal information – company’s profits, losses, etc.
 Market information – takeover bids, strategic buyers, etc.
 They are treated the same – neither can be traded provided that principles set
forth apply
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 Materiality- Balancing the probability that something will occur with the magnitude
of its impact
b) Nonpublic
 Doesn’t mean confidential
 Rumors verified by an inside source, for example
 In order for information to be public, there must be absorption and dissemination
of the information by the investing public so its meaning is understood
 SEC says there is a time period in order for absorption to take place
 Time period is determined on a case-by-case basis
B. THE DUTY THEORY
 Pre-Chiarella, the courts adopted an equal access approach. The purpose of 10b and 10b-5
was to equalize access among market participants.
SEC v. Texas Gulf Sulpher Co. (disclose or abstain)

 Court restricts trading activities of officers/directors within corporation when they have
non-public information that is material
 Materiality is huge issue because there must be complete & accurate disclosure in
public market (thus, disclosure of material information).
Chiarella v. U.S.

 Facts: Petitioner worked for a financial printing company, Pandick Press, as a markup
man. Petitioner handled documents announcing corporate takeover bids. The names of the
acquiring and takeover corporations were disguised, but Petitioner was able to deduce the
companies by other information on the documents. Petitioner purchased stock in the target
companies and sold the shares immediately after the takeover attempts were announced to the
public, making $30,000 in profit over a 14 month period. In May 1977, Petitioner entered into a
consent decree with the Securities Exchange Commission (SEC) to return his profits to the sellers
of the shares. In January 1978, he was indicted and later convicted on 17 counts of violating
Section: 10b and SEC Rule 10b-5. The Court of Appeals for the Second Circuit affirmed his
conviction. The United States Supreme Court granted certiorari. The issues involving Rule 10b-
5(b) were dismissed.
 Issue: Whether a person who learns about a corporation’s plan to take over a target
corporation through confidential papers discovered while working at a financial printer violates §
10b if he fails to disclose the impending takeover before trading in the target company’s securities.
 Rule: No. Silence does not amount to fraud under §10(b) if there is not a duty to
disclose based on a confidential relationship between the transacting parties.
 The language of Rule 10b-5 and § 10b encompasses the principle that a
person has an absolute duty to disclose misappropriated nonpublic information or to
refrain from trading if he does not disclose.
 The court adopted a fiduciary duty rationale – must have a fiduciary duty or
duty of trust and confidence
 Petitioner’s conduct was fraudulent under the meaning of § 10(b) and Rule
10b-5 because he wrongfully acquired confidential information and participated in manipulative
trading based on it.
 Imposition of liability under 10(b) is premised on duty to disclose.

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 Here it doesn’t arise from mere possession, but it’s based on a
fiduciary relationship.
 ∆ owed relationship to employer, but he bought stock from
someone with which he has no relationship, so he owed no duty to disclose.
 Silence in connection with the purchase or sale of securities is actionable
as fraud under § 10(b) if there is a duty to disclose such information arising from a
relationship of trust and confidence between parties to a transaction.
 Here, Petitioner did not have a duty to disclose because he had no
special confidential relationship with the transacting parties.
 Chiarella was a stranger to the parties, thus he had no duty to disclose.
 Dissent:
 Burger: Because he obtained the information by stealing it, he also obtained a
fiduciary duty.
 If this case was decided today, ∆ would be liable under
misappropriation rule from O’Hagan
 Duty can arise from insider status or status as a fiduciary to a party to the transaction.
 R3d Agency- An officer is an agent, an agent is a fiduciary. An agent has a duty of
loyalty.
C. “TIPPER-TIPPEE” LIABILITY
Dirks v. SEC

 Facts: An insider that worked for Equity Funding of America told Petitioner that the
company was overstating their assets and that Petitioner, who was an officer that provided
investment analysis for a broker-dealer firm, should investigate the fraud. Petitioner interviewed
other employees who corroborated the fraudulent allegations. Petitioner contacted a bureau chief
at The Wall Street Journal and offered his findings for the purpose of exposing the fraud. The
bureau chief, fearing a libel suit, declined to pursue it. During this time, Petitioner told investors
and clients about the fraud, and they reacted by selling their stake in the company. When the
stock was being heavily traded and dipped from $26 to $15, the New York Stock Exchange halted
trading and Respondent, The Securities and Exchange Commission, investigated and found
fraud. Respondents then filed suit against Petitioner for violations of § 10(b) of the Securities and
Exchange Act of 1934 for using the insider information and perhaps receive commissions from
those clients. The trial court and appellate court agreed with Respondent, reasoning that anytime
a tippee knowingly has inside information that they should publicly disclose it or refrain from acting
upon it.
 Issue: Whether Petitioner violated § 10(b) when he disclosed material nonpublic
information to clients and investors.
 Rule: No. § 10(b) should not be read so broadly as to hold tippees liable when
they use inside information received by insiders who were not breaching their fiduciary
duties in their disclosure.
 There is no duty to disclose by tippee simply for receiving the tip from the
insider tipper.
 The insider must first breach a fiduciary duty and then the tippee’s conduct
will be examined to see if they breached a duty.
 The tippee’s duty of derivative of the tipper’s duty.
 The Court leaves it for the legislature to extend the statute if they want to punish
what may be unethical behavior by tippees.

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 But an argument can be made that shareholders benefit when insiders, such as
in this case, disclose the information to someone, especially when the insiders do not personally
seek a benefit.
 Before this case liability for the tippee was based on the liability of the tipper-
Therefore, if the tipper had a duty not to trade on the information, the tippee could not trade on the
information either
 New approach – Must determine if the tipper acted with motivation of
personal gain or as a gift.
 If not, the tipping is not illegal. Therefore, tippee can trade.
 If tipper acted for financial gain or as a gift, tippee should know
motivations and can’t trade on the information.
 Multiple levels of tippees- The SEC can go down four or five levels
 If the tippee knows there is a breach of duty, he is liable
 TEST (Two prongs):
 Breach by insider tipper in disclosing the information to the tippee.
 Was the tipper an insider?/ Was there a fiduciary duty?
 Is there a breach of a duty by providing the info.?
 Did the insider receive a benefit (directly/indirectly) from the knowledge?
 Does not have to be a pecuniary benefit, may be a reputational benefit.
 Mutual benefit of mutual tipping? I tip you, you tip me.
 Tipping as a benefit to the tippee?
 I gift the benefit to you.
 Functional equivalent of trading and then giving
the earnings to the tippee.
 The tipper breaches by disclosing
 Did the tippee know or should have known?
 Very consistent with common law/tort law
 Dissent: The problem is with the motivational requirement.
 If you tip and breach a duty, you are liable for the tippee’s profits despite the fact that
the tippee is also liable.
 Quasi-Insider trading – if one is an outsider but obtains insider information with the
understanding that the information is to remain private and confidential, then you are treated as an
insider for trading purposes (applies to lawyers, accountants, etc.)
 SEC v. Switzer
 10(b) doesn’t bar trading on the basis of material that was inadvertently revealed
by an insider
D. THE “MISAPPROPRIATION” THEORY
 A person commits fraud in connection with a securities transaction when he misappropriates
confidential information for securities trading purposes, in breach of a duty owed to the source of
the information.
United States v. O’Hagan

 Facts: O’Hagan (Respondent), was an outsider who had access to confidential

information, and he profited from the information at the expense of the company and other
shareholders. Respondent was a partner in a law firm, Dorsey & Whitney, which was representing
a company that was potentially tendering an offer for common stock of the Pillsbury Company.
Respondent was not personally involved in the representation, but he was aware of the
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 transaction enough to know that if he purchased Pillsbury securities now that they would increase
in value once the offer went through. Respondent was going to use the profits from this
transaction to replace money that he embezzled from the firm and its clients. After the offer went
through, he made a $4.3 million profit. The SEC investigated Respondent’s transactions and
claimed he violated § 10(b) and § 14(e) for misappropriating confidential information. A jury
convicted Respondent.
 Issue:
 Whether Respondent violated § 10(b) and Rule 10b-5 when he misappropriated
nonpublic information to personally benefit through the trading of securities.
 Whether Rule 14e-3(a) exceeds the SEC’s rule-making authority as granted by
the Securities and Exchange Act.
 Rule:
 Yes. Respondent did violate § 10(b) and Rule 10b-5 because all of the element
of the rule were met.
 Respondent did use deceit in connection with the purchase of securities.
 He did not disclose to the firm or the client that he was using the nonpublic
information, and his use of it was at the expense of the client.
 He did not necessarily have to deceive the seller in order to violate the
Rule.
 As a matter of public policy, it would not make sense to limit the
scope of the Act to only prohibit certain kinds of activities that endanger a fair market.
 No. Rule 14e-3(a) did not exceed the SEC’s rule-making authority.
 Again, the purpose of the Act is to provide safeguards to ensure that the
market is operating fairly and that investors can rely on the market.
 Rule 14e-3(a) does not require a demonstration of a breach of duty in
order to find a party liable for violations of the Act.
 There will be instances where justice would deem this appropriate, such
as in this case.
 An outsider who misappropriates confidential information to personally
benefit violates § 10(b) because there is deception in connection with the purchase or sale
of a security.
 The Court has now reversed the decision in Dirks v. SEC, or at least
distinguished it, by not requiring a breach of a fiduciary duty as called for in § 14e-3(a).
 The court stresses their concern to uphold the public policy behind
the Act, namely to ensure the fairness of the market.
 If there is a duty owed to the source of the information, and someone
trades on that information, they are liable under 10(b)
 Deception occurs not when one learns the information, but when he
uses the information in trading
 However, if the person discloses that they will trade prior to doing
so, it wouldn’t be a deceptive act, so there is no liability under 10(b).
 Criminal liability may be sustained under misappropriation theory.
 Criminal liability under section 10(b) of the Securities Exchange Act of
1934 may be predicated upon the “misappropriation theory” of inside information; as such, the
SEC may prohibit trading practices involving confidential information even though the transactions
may lack the traditional direct breach of fiduciary duty required as an element of common-law
fraud.
 What about § 20(a)? It does create civil liability.

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 Wherever communicating, or purchasing or selling a security while
in possession of, material nonpublic information would violate, or result in liability to any purchaser
or seller of the security under any provisions of this title, or any rule or regulation thereunder, such
conduct in connection with a purchase or sale of a put, call, straddle, option, privilege or security-
based swap agreement with respect to such security or with respect to a group or index of
securities including such security, shall also violate and result in comparable liability to any
purchaser or seller of that security under such provision, rule, or regulation.
 Warehousing activity, as defined in O'Hagan, involves "the practice by which bidders leak
advance information of a tender offer to allies and encourage them to purchase the target
company's stock before the bid is [publicly] announced.”
E. POSSESSION V. USE
 Rule 10b-5
 In O’Hagan, in the Court’s discussion of James O'Hagan's Rule 10b-5 violations, the
Court analyzed, and ultimately approved, the “misappropriation theory” of insider
trading liability.
 First, the Court required deception.
 Second, the Court appeared to link the concept of deception within
misappropriation to nondisclosure.
 Third, the Court rather narrowly limited liability under the misappropriation
theory to nondisclosure by the trader to the source of the nonpublic
information.
 The duty is to the source of the information.
 The ensuing O'Hagan definition of misappropriation involves:
 (1) deception;
 (2) through nondisclosure;
 (3) to the source of the acquired nonpublic information.
 So, as long as O’Hagan makes it clear that he wants to breach his duty, there is no
deception.
 Rule 10b5-1 addresses the issue of when insider trading liability arises in connection
with a trader's "use" or "knowing possession" of material nonpublic information.
 This rule provides that a person trades "on the basis of" material nonpublic
information when the person purchases or sells securities while aware of the
information.
 However, the rule also sets forth several affirmative defenses, which we have
modified in response to comments, to permit persons to trade in certain
circumstances where it is clear that the information was not a factor in the decision
to trade.
 Rule 10b5-2 addresses the issue of when a breach of a family or other non-business
relationship may give rise to liability under the misappropriation theory of insider
trading.
 The rule sets forth three non-exclusive bases for determining that a duty of trust or
confidence was owed by a person receiving information, and will provide greater
certainty and clarity on this unsettled issue.
 Rule 10(b)(5)-1
 Triggers civil liability exposure when a person purchases or sells securities while
aware of material nonpublic information
 Affirmative defenses are available:

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  If the trading engages in specific transactions pursuant to a pre-existing plan,
contract, or instruction that is binding and specific
 If an entity demonstrates that the individual responsible for the investment
decision on behalf of the entity wasn’t aware of the material inside
information, and the entity had implemented reasonable policies and
procedures to prevent insider trading
 SEC v. Adler- You traded while aware of the information, if you “used” the
information in the trade.
 Rule 10(b)(5)-2
 Situations where persons are deemed to have a relationship of trust and confidence
to invoke the misappropriation theory:
 When recipient explicitly agreed to maintain confidentiality
 When a reasonable expectation of confidentiality existed due to the fact
that persons enjoyed a history, practice, or pattern of sharing
confidences
 When source is a spouse, child, parent, or sibling of person receiving
information, unless proven as an affirmative defense that no reasonable
expectation of confidentiality existed.
 Adopted after the Chestman case, where wife tells husband material information and
husband trades on it.
 Prior to the adoption of the rule, the husband was found to not have a duty to
the wife because it was freely communicated with no promise to keep it
confidential.
F. RULE 14E-3
 SEC § 14e
 The SEC implemented Rule 14e-3 under the authority of § 14(e) of the Securities
Exchange Act of 1934 ("Exchange Act"), as a response to the perceived growth of problems of
securities fraud within the specific realm of the tender offer.
 The RULE:
 [Ilt shall constitute a fraudulent, deceptive or manipulative act or practice
within the meaning of section 14(e) of the Act for any other person who is in possession of
material information relating to such tender offer which information he knows or has reason to
know is nonpublic and which he knows or has reason to know has been acquired directly or
indirectly from:
 (1) The offering person,
 (2) The issuer of the securities sought or to be sought by such tender offer, or
 (3) Any officer, director, partner or employee or any other person acting on behalf of the
offering person or such issuer, to purchase or sell . . .any of such securities . . .unless
within a reasonable time prior to any purchase or sale such information and its sources are
publicly disclosed by press release or otherwise.
 If Chiarella arose today, he would have been liable under this rule.
 For Tender Offers – if one is in possession of material, nonpublic information, regardless of
how it was learned, one cannot trade or tip on that information until it is publicly disclosed.
 Tender Offer – an offer by a bidding corporation directly to the shareholders of the target
corporation. A form of corporate acquisition where you don’t need the approval of the BoD.
Prevents management from vetoing deals

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 Establishes the “disclose or abstain” from trading rule. You either have to not use the
information or make it public to the entire market.
G. DAMAGES AND PENALTIES
 The Insider Trading and Securities Fraud Enforcement Act- Provides an express right of action
on behalf of contemporaneous traders who were trading the same class of securities on the
opposite side of the transaction during the time that the allegedly illegal inside trades occurred. It
doesn’t limit entitlement to private rights of action under other provisions of the Exchange Act (like
10(b)).
H. SECTION 16 — “SHORT-SWING” TRADING
 Congress outlawed short-swing trading, so an officer, director, or person who owns more than
10% of stock cannot buy or sell within a 6-month period and if they do, they must disgorge the
profit, even if they didn’t have insider info.
 Strict Liability – if the board doesn’t enforce it, a shareholder can bring a derivative action
 Upon becoming an officer, director, or 10% equity shareholder (beneficial owner), you must file
a report with the SEC disclosing the number of shares owned [Forms 3 (for statutory insiders) & 4
(for a change in beneficial ownership)]
 What does § 16 do?
 §§ 16(a)&(b) attempt to deter trading on inside information
 § 16(a) attempts to do so by publicity
 § 16(b) attempts to do so by imposing liability
 Who is subject to § 16?
 Statutory insiders (officers, directors, beneficial owners of more than 10%)
 Under §16(a), insiders must report purchases and sales within 2 days of their trade.
 There has been a historic problem with compliance with § 16(a)
 Enforcement of § 16
 Self-executing (not enforced by SEC)
 Incentive to enforce is because of attorney’s fees
 Doesn’t matter who beneficial owner is as long as there is indicia of ownership
 Can buy a share after the fact and sue
 § 16(b)
 § 16(b) is applicable only to matched transactions
 Matched transactions- the purchase and sale/sale and purchase of a security
 § 16(b) applies only to short-swing transactions
 Short-swing- Matching transactions that occur within 6 months of each other
 There is no contemporaneous ownership requirement
 Compare this to FRCP 23.1 and MBCA § 7.41
 The profit recovered goes to the issuer (corporation).
 Comparison of §§ 16b & 10b
 § 16b
 Applies only to equity security that are regulated pursuant to §12
 Only directors, officers & 10% shareholders are liable
 Don't have to show use of insider info
 Profits go to the corporations
 Must show matching transactions
 Civil plaintiffs
 § 10b
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  Any security (much broader)
 Any person with a duty is liable (much broader)
 Have to show use of inside info (maybe only possess)
 Profits go to injured party
 Only have to have 1 sided transaction (either purchase or sale)
 SEC enforces
 Person could be liable under both
I. BLACKOUT PERIODS
 Under Sarbanes-Oxley, officers and directors are prohibited from trading any equity security of
the issuer, acquired through the scope of employment, during a blackout period, when at least 1/2
of the issuer’s individual account plan participants are not permitted to trade in the equity security
for more than 3 consecutive business days. A violation is subject to SEC enforcement action.
J. REGULATION FD
 Regulation FD (Fair Disclosure) is a new issuer disclosure rule that addresses selective
disclosure.
 The regulation provides that when an issuer, or person acting on its behalf, discloses
material nonpublic information to certain enumerated persons (in general, securities market
professionals and holders of the issuer's securities who may well trade on the basis of the
information), it must make public disclosure of that information.
 The timing of the required public disclosure depends on whether the selective disclosure
was intentional or non-intentional; for an intentional selective disclosure, the issuer must
make public disclosure simultaneously; for a non-intentional disclosure, the issuer must
make public disclosure promptly.
 Under the regulation, the required public disclosure may be made by filing or furnishing a
Form 8-K, or by another method or combination of methods that is reasonably designed to
effect broad, non-exclusionary distribution of the information to the public.
 Not part of insider trading law
 If a corporation makes a public disclosure of material information, it must do so to
the market as a whole.
 Selective disclosure is a violation of the regulation
 Doesn’t allow a private right of action

XIV. THE CHAPTER 16 CHANGE OF CONTROL OF THE CORPORATION

Weinberger v. Uop
Brief Fact Summary. Plaintiff, William Weinberger, brought this action to challenge the shareholder
vote for a cash-out merger between Defendant, UOP, Inc., and the Defendant majority shareholder,
The Signal Companies, Inc. Plaintiff asserted that Signal breached their fiduciary duty to the minority
shareholders by withholding relevant information and not disclosing conflicts of interest.
Synopsis of Rule of Law. A majority shareholder owes a fiduciary duty to minority shareholders to
provide all relevant information that would pertain to a proposed cash-out merger.
Facts. Signal sold off a subsidiary company for $420 million in cash and desired to turn around and
reinvest the money. In 1975, Signal decided to purchase a majority stake in UOP. Signal paid $21 per

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share (it was trading at around $14) to obtain 50.5% of UOP’s shares. In 1978, Signal still had a great
deal of money left over, and with no other attractive investments they decided to acquire all remaining
shares of UOP. At this point, Signal had placed seven directors, including the president and CEO
James Crawford, on the 13-member board. Two directors that served on both the board of Signal and
of UOP, Charles Arledge and Andrew Chitiea, performed a study using information obtained from
UOP that determined it would be in Signal’s interest to get the remaining shares of UOP stock for
anything under $24 per share. The Signal board decided to offer between $20-21. Signal discussed
the proposal with Crawford, and he thought the price was generous, provided that employees of UOP
would have access to decent benefits under Signal. He never suggested a price over $21. Crawford
hired James Glanville to render a fairness opinion despite the fact that Glanville’s firm also did work
for Signal. Glanville also had a short amount of time to prepare the opinion, and his number was the
same as Signal’s. The UOP board, using the fairness opinion as its guide but not the Arledge-Chitiea
study, voted unanimously to recommend the merger.
Issue. The issue is whether the majority shareholder breached their fiduciary duty to the minority
shareholders by withholding relevant information from non-Signal UOP directors and minority
shareholders
Held. The Supreme Court of Delaware held that the shareholder vote was not an informed vote and
that Signal breached their duty as a majority shareholder to the minority shareholders. Therefore the
minority shareholders are entitled to a greater value (to be determined by weighing all relevant factors
such as the Arledge-Chitiea study value). The evidence indicated a lack of fair dealing by the
majority, such as withholding the Arledge-Chitiea report from the UOP board and the shareholders.
The only information the outside directors of UOP had at their disposal was a hurried fairness opinion
by an arguably interested party. The board members that served with Signal and UOP breached their
duty as UOP directors as well by not providing Arledge-Chitiea study. They are not exempt from their
duties because the entities are a parent and a subsidiary.
Discussion. The court places the same burden on majority shareholders for mergers as they would
place on them for inside information. A majority shareholder cannot gain in a purchase by withholding
information to a party whom they owe a fiduciary duty.
Unocal Corp. v. Mesa Petroleum Co.
Brief Fact Summary. Defendant, Unocal Corp., appealed the lower court decision that prevented
Unocal from excluding Plaintiff, Mesa Petroleum Co., from participating in Defendant’s self-tender for
its own shares.
Synopsis of Rule of Law. Directors have a duty to protect the corporation from injury by third parties
and other shareholders, which grants directors the power to exclude some shareholders from a stock
repurchase.
Facts. Plaintiff was a corporation led by a well-known corporate raider. Plaintiff offered a two-tier
tender offer wherein the first tier would allow for shareholders to sell at $54 per share and the second
tier would be subsidized by securities that the court equated with “junk bonds”. The threat therefore
was that shareholders would rush to sell their shares for the first tier because they did not want to be
subject to the reduced value of the back-end value of the junk securities. Defendant directors met to
discuss their options and came up with an alternative that would have Defendant’s corporation
repurchase their own shares at $72 each. The Directors decided to exclude Plaintiffs from the tender
offer because it was counterintuitive to include the shareholder who initiated the conflict. The lower
court held that Defendant could not exclude a shareholder from a tender offer.

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Issue. The issue is whether Defendant can exclude Plaintiff from participating in Defendant’s self-
tender.
Held. The court held that Defendant could exclude Plaintiff from its repurchase of its own shares. The
directors for Defendant’s corporation have a duty to protect the shareholders and the corporations,
and one of the harms that can befall a company is a takeover by a shareholder who is offering an
inadequate offer. The directors’ decision to prevent an offer such as the one at issue should be
subjected to an enhanced scrutiny since there is a natural conflict when the directors are excluding a
party from acquiring a majority control. In this case the directors met the burden. There was evidence
to support that the company was in reasonable danger: the outside directors approved of their self-
tender, the offer by Plaintiff included the junk bonds, the value of each share was more than the
proposed $54 per share, and Plaintiff was well-known as a corporate raider.
Discussion. The burden of proof was on the directors to prove that there was a legitimate business
interest at stake to rebut the presumption of their conflicting interest in denying the takeover. This was
well-established, but the allowance by the court to allow the directors to deny the plaintiff from
participating in the resulting repurchase was new ground
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.
Brief Fact Summary. Defendants, Revlon, Inc. and its directors, appealed a decision by the lower
court to enjoin an option granted by Defendants to another Defendant, Forstmann Little & Co. Revlon
sought to avoid a takeover by Pantry Pride, Inc. by offering the option to Forstmann.
Synopsis of Rule of Law. When a takeover is inevitable, the directors’ duty is to achieve the best
price for the shareholder. AKA Revlon duties
Facts. Pantry Pride’s CEO approached Revlon’s CEO and offered a $40-42 per share price for
Revlon, or $45 if it had to be a hostile takeover. The CEO’s had personal differences, and the court
noted this as a potential motivation for Revlon to turn elsewhere. Revlon’s directors met and decided
to adopt a poison pill plan and to repurchase five million of Revlon’s shares. Pantry Pride countered
with a $47.50 price which pushed Revlon to repurchase ten million shares with senior subordinated
notes. Pantry Pride continued to increase their bids, and Revlon decided to seek another buyer in
Forstmann. Revlon offered $56.25 with the promise to increase the bidding further if another bidding
topped that price. Instead, Revlon made an agreement to have Forstmann pay $57.25 per share
subject to certain restrictions such as a $25 million cancellation fee for Forstmann and a no-shop
provision. Plaintiffs, MacAndrews & Forbes Holdings, Inc., sought to enjoin the agreement because it
was not in the best interests of the shareholders. Defendants argued that they needed to also
consider the best interests of the note holders.
Issue. The issue is whether Revlon’s agreement with Forstmann should be enjoined because it is not
in the best interests of the shareholders.
Held. The Delaware Supreme Court affirmed the lower court’s decision to enjoin the agreement.
Revlon’s directors owed a fiduciary duty to the shareholders and the corporation, but once it was
evident that Revlon would be bought by a third party the directors had a duty solely to the
shareholders to get the best price for their shares. Any duty to the note holders is outweighed by the
duty to shareholders. By preventing the auction between Pantry Pride and any other bidders, the
directors did not maximize the potential price for shareholders.

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Discussion. The court held that the Unocal doctrine that outlined a director’s duty to the corporation
and the shareholder no longer extended to the corporation once it was determined that the
corporation would be sold.

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