Business Organizations Final Outline

Professor Albert – Fall 2009

I. AGENCY
A. Overview and the Agency Relationship:
Agency – a voluntary relationship with a scope of authority (i.e. “You can sign these 3 contracts for me if you wish”; Agent
says yes (voluntary) and can never do more than execute the 3 contracts; Agent cannot buy a car on principle’s behalf on the
way home… exceeds the scope of authority)
- The Principal defines the scope of an agent’s authority
Agency exists where:
(1) one person (the principal) consents that another (the agent) shall act on principal’s behalf and
subject to plaintiff’s control AND
(2) consents so to act
- So it’s a consensual relationship created when Principle manifests an intention that the Agent act on his
behalf, and A agrees
- What does “manifest” even mean?
• An outward expression
• Can be conduct
• Slide A1-4: “A person manifests assent or intention through written or spoken words or other
conduct.”

Agency law is statutory in nature – see slides on A-1

Concept – voluntary relationship

o Agent has scope of authority – what you are told to do, what you have
authority to do by principal
 Agent is told what to do and how to do it
o Agent must agree to say “yes” (must be voluntary)
o If agent does job right, no liability
**Exam – must have consensual relationship
o Manifestation (in any form) from the principal to an agent that the principal
wants the agent to act on the principal’s behalf
Liability
o Agent who exceeds scope of their authority binds themselves to be liable
o When agent acts within scope of agency, there is a chance that the agent will
be liable as well as the principal
Restrictions (conditions) – principal may places conditions upon agent, and if agent
breaks conditions, may be seen to be outside their scope of authority

• Gorton v. Doty (pg. 1): RULE: An agency relationship results from one person’s consent that another will
act on his behalf and subject to his control, and the other person’s consent to act.
Facts: Soda Springs High School teacher volunteers her car to the football coach to take the team to a game
- The school paid for the gas but Mrs. Doty is not compensated in any way
- There is a car accident and Gorton’s son is injured
- Lower Court awards father $870 and $5,000 to the son (it was Mrs. Doty’s money that court awarded)
o Court must have concluded that the coach was acting as Doty’s agent
Issue: Was there an agency here?
- If yes Mrs. Doty was the principal
Agency exists if:
1. A manifestation of consent by Doty to Garst that Garst shall act:
a. On Doty’s behalf
b. Subject to Doty’s control

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 2. Gorsts consent so to act
Held: Lower court finds a manifestation of consent AND an agreement to be bound; Higher court also finds
there to be an agency.
Defendant moves for a mistrial saying that there was no agency… she loses.

Pg. 6 Questions
1. Dissent feels that appellate court applied the right test but did so improperly. Coach was not acting within
the scope of the agency. Doty had not instructed him how or where to drive.
- How can we change the situation to make Mrs. Doty more liable?
o If it was Doty’s responsibility to drive
o If Doty was receiving money from the school

EQUAL DIGNITIES RULE (Slides on A-2) – if the contracts the agent is authorized to sign on behalf
of the principal need to be in writing to be enforceable under the Statute of Frauds, then the agency
agreement also needs to be in writing.
• Does an agency agreement have to be in writing? Not necessarily
If your agent is going to sign contracts that are going to be in writing, the agency agreement must
also be in writing (to satisfy the Statute of Frauds)… The Equal Dignities Rule

Intent is not an element of agency…

- The definition of agency is dispositive (If you match the definition you have agency)
2. Majority stated: “It is not essential… that there be a contract between principal and agent.”
Contract = Agreement [NO INTENT FOR AGENCY NECESSARY]
Intent doesn’t matter
o Only conduct
o If conduct doesn’t satisfy agency, then no agency, regardless of intent
Agency requires an agreement (oral or otherwise)
PAT Triangle
o 1. Agency relationship between P and A
o 2. Look at A’s dealing w/3rd party

2 Questions to Look for When Dealing w/Agency Relationships (Slide A 2-

10)
1. Does an agency relationship exist between P and A
 If no, no analysis is done
 If yes, look to question #2
2. If so, what consequences follow to principal from the interaction between the
agent & the 3rd party

• A. Gay Jenson Farms. Co. v. Cargill, Inc. (pg. 7), (Slides A 4 20-24)- RULE: A creditor that assumes control
of its debtor’s business may become liable as principal for the debtor’s acts in connection with the business.
Facts: Plaintiffs were small farmers in Minnesota who were selling grain to Warrant (who subsequently sold
grain)
o Plaintiffs sue because Warren has no money & doesn’t pay for grain shipments (Warren defaults)
o Warren is judgment proof because he has no cash
o What is the connection between farmers and Cargill?
 Warren buys grain from farmers as agent for Cargill (according to farmers)
 Farmers therefore claim that Cargill is principal, Warren is agent, and they are 3rd parties
Issue: Did an agency relationship exist?
• Important because of the text of § 144 (Slide A 4-23): P is subject to liability upon contracts made by
A acting within his authority if made in proper form and with the understanding that P is a party
Held: Court finds that an agency relationship indeed existed
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 No voluntary traditional agency, but agency found through the conduct of
the P:
o Why Court found agency relationship?
 Constant recommendation by phone
 Right of first refusal, power to inspect financial statements
 Look like creditor is running the business – de facto control
 Cargill has a right of first refusal on the grain (See complete list of Gargill’s control over
Warren (pg. 10-11) – great news for farmers bc Cargill is now liable to them
Controlling Creditor – When does a Creditor become a Principal?
Restatement § 14 O: (Slide A 5-25 - 26)
- A creditor who assumes control of his debtor’s business for the mutual benefit of himself and
his debtor, may become a principal, with liability for the acts and transactions of the debtor in
connection with the business (see Restatement § 14 O)
- Creditor becomes a principal at that point at which it assumes de facto control over the conduct of
the debtor, whatever the terms of the formal contract with his debtor may be
o Nine factors re control
i.e. If a creditor lends $10 million they’re going to want access to the debtor’s business transactions
o Expands scope of liability dramatically
• Ex. Debtor needs creditor permission in order to perform certain acts
o Comments to Restatement 13
 A security holder who merely exercises a veto power over the business acts of
his debtor by preventing purchases or sales above a specified amount does not
thereby become a principal
o When creditor crosses the line and becomes principal – if the creditor takes
over the management of the debtor’s business either in person or through an agent and
directs what contracts may or may not be made, he becomes a principal, liable as any
principal for the obligations incurred thereafter in the normal course of business by the
debtor who has now become his general agent
 Debtor becomes general agent of the creditor
 Debtor assumes de facto control
• At this point no longer a creditor, but has become a manager and thus any
action taken by debtor is taken as the agent for the creditor/principal
o The point at which the creditor becomes a principal is that at which he assumes de
facto control over the conduct of his debtor, whatever the terms of the formal contract
w/his debtor may be

Scope of Authority
• Principal sets up scope of agency
o Sets up what the agent is allowed to do
o **If agent works within scope, they bind the principal and not themselves
o If exceed scope, agent binds both themselves and the principal
o Unauthorized agent – no authority, if do anything at all are exceeding scope

Ways to Create an Agency:

1) By agreement
2) By ratification
3) By estoppel

• Agents acting with authority may bind principals

- Authority is the starting point for analysis
- Authority also is an element in vicarious liability- based tort actions against the principal (esp. the
“scope of employment” requirement)
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Types of authority: Slide A 6-32
- Actual express authority
o § 7; 26; 35
- Actual implied authority
- Apparent authority
o § 8; 27; 159
- See § 34: how to interpret authority
o Inherent: § 8A – we are not discussing this concept

Actual Express Authority (“AEA”) – clearest authority – arises when principal expressly approves the
actions of an agent. Authority goes from principal to agent, and there is a manifestation of consent from
PA.
- Authority that the principal intentionally confers upon an agent
- Principal is thus bound as per § 144
o Most straight-forward
 Best to have when attempting to prove agency
o Just between P and A
o Authority principal intentionally confers of an agent
o If agent does what told and way told to do so, then principal is bound
o Ex – Walmart wants Federline as spokesperson. Board authorizes its President,
Scott, to sign Federline to a contract and he does so
 WalMart – principal
 Scott – agent
 Federline – 3rd party
 When Scott signs up Federline, as per board’s instructions, what kind of
authority is created? – actual express authority
o Must specify how you want something to be carried out on your behalf
o Authority – Restatement 7 (pg 3) – authority is the power to affect the
legal relations of the principal by acts done in accordance w/the principal’s
manifestation of consent to him
o Creation of Authority – Restatement 26 (pg 4) – authority to do an act can
be created by written or spoken words or other conduct of the principal, which
reasonably interprets, causes the agent to believe that the principal desires
him so to act on the principal’s account
 Exception – any transactions by statute to be authorized in a particular
way
o Incidental Authority to Act – Restatement 35 (pg 5) – unless otherwise
agreed, authority to conduct a transaction includes authority to do acts which
are incidental to it, usually accompany it, or are reasonably necessary to
accomplish it
- Limitation – expressly says can’t do something
o Look for limitations and potential limitations to actual authority
- Limitations on authority only binding on third parties who have NOTICE

Actual Implied Authority (“AIA”) - aka Incidental Authority – principal can’t always thinks of
everything that he wants his agent to do at the moment he gives him authority
- What if principal doesn’t specify how they want their actual authority to be carried out?
o Agent can act as he/she sees fit in this case ON BEHALF OF THE PRINCIPAL
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 o Policy: Actual Implied Authority carefully places the incentive to draft good
instructions on the right party
 In a sense, all AIA says is that “if you don’t bother telling your agent how to carry out your
instructions, we’ll let him or her carry them out in the usual manner—and you’ll be bound
by the consequences.”
 If P wants A to do X (whatever), but only in a certain way, AIA gives it
the incentive to drat its authorization carefully
o Incidental Authority - So, if in order to carry out the principal’s explicit
instructions to the agent, the agent takes some other steps necessary to carry
out those instructions, the principal is bound
o Just between P and A
 What is necessary to do the job principal asks
• Even if didn’t specify
o If not specified, then whatever reasonable and necessary to carry out actual
express authority
 How agent does something is up to them
 Reasonableness factor – can do whatever reasonable
o If limit actual authority, has affect on implied authority
- It is actual authority that the principal intended the agent to possess
o What is necessary for an agent to carry out the actual express authority
o Reasonableness factor – agent can do whatever is reasonable
o What happens if P doesn’t exactly specify how wants something to be carried
out? – then, agent can do whatever reasonable to carry out AEA, and principal
bound by the consequences
o Line between AEA and AIA is fuzzy – but both bind the principal

*REMEMBER: AEA and AIA depend on communication between P and A.

Incidental Authority to Act – Restatement 35 (pg 5) – unless otherwise agreed,

authority to conduct a transaction includes authority to do acts which are incidental to it,
usually accompany it, or are reasonably necessary to accomplish it

Creation of Authority – Restatement 26 (pg 4) – authority to do an act can be created

by written or spoken words or other conduct of the principal, which reasonably interprets,
causes the agent to believe that the principal desires him so to act on the principal’s
account
 Exception – any transactions by statute to be authorized in a particular way
 Conduct or other spoken words ma cause agent to believe the principal desires
him to act in a certain way on the principal’s account
• Example – same facts as actual authority, but when Scott has to meet w/Kevin to
negotiate the contract, he has to fly to Vegas to meet him and rent a car
o Is Walmart obligated to pay for these expenses? – yes
o Ex. Mill Street Church v. Hogan

Apparent Authority (aka Ostensible Authority) – not actual authority but it is the authority the agent is
held out as possessing by the principal to the 3rd party (Slide A 8-45)
- MANIFESTATION OF PRINCIPAL TO 3RD PARTIES
o Agent can hold apparent authority
- What authority the principal allows the 3rd party to think the agent has
- Ostensible Authority (another name) – apparent authority depends in the
communication between the principal and the 3rd party

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 o Though, this may be accomplished through an agent, by authorizing the agent
to make any statement to the 3rd party, creating apparent authority that the
principal might have made directly
o Can’t create apparent authority where there is no authority
o Manifestation from 3rd party, but can flow through other means (agent)
- What to look for - Look for any info 3rd party gets, can the principal really be
the source of that info? – if yes, then there is apparent authority
- Reasonableness – 3rd person must justifiably believe the agent is authorized
to act on behalf of principal
o Turns on the reasonableness of 3rd parties belief that non-agent
was really an agent
 WANT TO PROTECT THE 3RD PARTY
 If doesn’t know about limiting authority or scope, then principal
will still be liable
 Fairness – P should’ve known or could’ve made it known to the 3rd
party any limitations of authority of agent
 Past practice of agent and principal may be key when looking at
whether reasonable for TP to believe person was really an agent
- Depends on the communication between principal and third party (though this may be
accomplished through an agent, by authorizing the agent to make any statement to third party,
creating apparent authority, that the principal might have made directly).
o Pam owns Whiteacre. Al is her real estate broker, her agent. Ted is an outsider who claims that Al
entered into a contract on Pam’s behalf to sell Whiteacre to Ted.
o Suppose Ted seeks to prove the existence of authority by evidence relating to communications
between Pam and Al; maybe a letter from Pam to Al in which Pam directed Al to sell Whiteacre.
o What type of authority is Ted trying to establish?
 ACTUAL AUTHORITY
o But suppose Ted seeks to establish authority by evidence relating to communications from Pam to
Ted.
o Suppose Pam sent Ted a letter in which she said that she had ordered Al to sell Whiteacre.
o In this case, what type of authority would Ted be trying to establish by introducing the letter into
evidence?
 APPARENT AUTHORITY
- The difference between actual and apparent authority arises out of the way in which Ted seeks to prove
that Al empowered to enter into the contract.
In other words, the different categories of authority really are ways of classifying the proof the plaintiff must offer
to bind the principal to the contract.
- Apparent Authority – Restatement 8 (pg 3) – apparent authority is the power to
affect the legal relations of another person by transactions w/3rd persons, professedly
as agent for the other, arising from and in accordance w/the other’s manifestations to
such 3rd persons
o Comment – apparent authority exists only to the extent that it is reasonable
for the 3rd party dealing w/the agent to believe that he agent is authorized
 Further, the 3rd party must believe the agent to be authorized
- Creation of Apparent Authority – Restatement 27 (pg 4) - apparent authority
to do an act is created as to a 3rd person by written or spoken words or any other
conduct of the principal which, reasonably interpreted, causes the 3rd party to believe
that the principal consents to have the act done on his behalf by the person
purporting to act for him (agent)
o Exception – except for the execution of instruments under seal or for the
conduct of transactions required by statute to be authorized in a particular
way

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 - Liability for Principal under Apparent Authority – Restatement 159 (pg 6) -
a disclosed or partially disclosed principal is subject to liability upon contracts made
by an agent acting within his apparent authority if made in proper form and w/the
understanding that the apparent principal is a party

Quick test to determine actual vs. apparent authority – did principal

communicate his consent for A to act for him to agent or 3rd party?
o If to agent – actual express authority
o If to 3rd party – apparent authority
o Typically, both AEA and AA are present
- Requirement – for apparent authority, required that the 3rd party justifiably
relies on the principal’s communication of consent for agent to act on his
behalf
- Policy- apparent authority places the incentive to draft careful authorizations
on the right people
o It the P doesn’t want to be bound by A, then O should tell other people
he will be bound

Hypo: Slides A 9-10: 53, 54, 55

• Agent’s apparent authority is broader than her actual authority
- Principal is still bound despite the letter at the bottom of the agent’s letter
- If the note scrawled on the bottom that limits the agent’s authority is written on letters to BOTH agent and
third party, principal is not bound by apparent authority
Policy: Apparent Authority places the incentive to draft careful authorizations on the right people. If Principal
doesn’t want to be bound by the Agent, then he must make this intention explicit to both Agent and Third Party.

Limitations on Authority – for actual AND apparent

• Limitations on actual authority is binding on 3rd parties that have notice (of
the limitation)
• Limiting apparent authority – impression of authority to others

Actual vs. Apparent Authority

• Depends on evidence
o Showing a letter would be actual authority
o If there was evidence there was a letter but never saw it, then it would be
apparent
• Actual – if limited
o If limit agent authority, and 3rd party doesn’t know, then principal will still be
liable
o If 3rd party knows, then Principal won’t be liable
• Apparent – want to protect 3rd party
o If doesn’t know about limiting authority or scope, then principal will be bound
o Want to protect the 3rd party
 WANT TO PROTECT THE 3RD PARTY
 Fairness – P should’ve known or could’ve made it known to the 3rd party
any limitations of authority of agent
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 • Different categories of authority are ways of classifying the proof the Principal must
offer to bind the principal to the contract
• How – must always look at how the 3rd party learned of the agent alleged authority
and ask whether the principal reasonably can be said to have been the source of that
knowledge
• The ONLY time that an agent can be a vehicle by which a principal creates apparent
authority, is it the principal creates it
o Principal tells the Agent to tell the 3rd party that the agent is the principal’s
agent
o Agent can only do particular acts if authorized
• IMPORTANT – to determine if there us apparent authority, must determine if
there was actual authority
o If no actual authority, then no apparent authority
o How great is Apparent Authority – how reasonable it is for TP to believe that
that person is the principal’s agent
o Reasonable test –reasonableness for TP to believe that the agent had
authority from P

HYPO on Slides A 10-11 59, 60, 61:

• Apparent authority exists only where there is some connection between the third party and the principal.
- The only way the agent becomes the vehicle to establish apparent authority is if he has been authorized to
do so (e.g. If Pam tells Al that he can go to Ted and tell him he’s her agent)
o If Pam was in the room when Al made the statement, Al would have apparent authority because
Pam could have spoken up (3rd Party is protected against claims that Al is not Pam’s agent)
• You must always look at how TP learned of the A’s alleged authority and ask whether P reasonably can be said to
have been the source of that knowledge.
• It’s insufficient for A to make an unauthorized assertion of his authority.
• We need words or conduct by P or some business custom which leads TP to believe that A has the requisite
authority.

• Mill Street Church of Christ v. Hogan (pg. 14) RULE: Implied authority is actual authority that the
principal intended the agent to possess and includes such powers as are practically necessary to carry out the
delegated duties.
Facts: Brothers Hogan paint church for Church Elders
- Bill Hogan was initially hired for the job but it could not be done by one person (Actual Implied
Authority – what is necessary for an agent to discharge a responsibility).
- Bill had been previously hired before, he had contracted the aid of his brother before, and they had both
been paid at the time.
- Bill discussed the possibility of hiring someone else and the Church Elders seemed to be on board with
hiring someone else (suggested a specific person to hire)
- Brother Sam is hired and injured during the course of his duties.
- Bill and Sam are both paid for the amount of time that they worked
o In order for Sam to be eligible for Workers Comp he needs to be in the employ of the church
Holding: Sam is found to be an employee of the Church
o Bill DID NOT HAVE actual express authority to hire Sam
o Bill had actual implied authority as an agent to hire him, based on need and past experience in
hiring helpers for work for the Church;
o Bill had apparent authority based on Sam’s past experience in having been hired to work with
Bill. [remember to look from P to TP for AA, not from P to A.]
Reas.: Court says, “Implied auth. includes such powers as are reasonably necessary to carry out the task.”
• Bill did not have actual auth. to hire Sam but he was instructed to hire someone (they suggested Perry)
Where is the manifestation from Principal to 3rd Party?

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 - Sam had previously been hired by the Church through Bill so he could have reasonably assumed apparent
authority
Was there ratification of the employment contract? See Ratification below in outline.
- Sam had been paid for the half hour of work after the Church found out that he had been injured. It appears
that this act had ratified his employment.
- BUT, ratification has a predicate requirement that there be no agency to begin with (Bill had to have no
authority to hire Sam); So, ratification is NOT a viable argument here
Is Sam’s belief relevant to our analysis? YES; see Restatement § 8(c)
- Restatement § 26 - authority to do an act can be created by written or spoken words or other conduct of the
principal which, reasonably interpreted, causes the agent to believe that the principal desires him so to act
on the principal’s account

• 370 Leasing Corp. v. Ampex Corp. (pg. 22) RULE: An agent has apparent authority sufficient to bind the
principal when the principal’s acts would lead a reasonably prudent person to suppose that the agent had
the authority he purports to exercise.
Facts: Kays, Joyce, and Mueller contract to sell and lease computers from Ampex to 370
- Joyce signs for 370 but NOONE else from Ampex signs
- Kays negotiates for Ampex and it appears that they are bound
- The Lower Court finds an acceptance in the letter written by Kays
- Principal (Ampex), Agent (Kays), 3rd Party (Joyce)
Did Kays have actual authority to enter into negotiations with Joyce?
- He is a salesman and likely has implied authority to contract on behalf of Ampex (Look to the inter-office
memo)
- Is there anything that shows that Kays had actual authority to sign the letter?
o NO
Holding: The Court holds for Joyce because of the inter-office memo
Solution for Ampex next time?
- Built-in limitations on authority (e.g. Price ceiling on all contracts, train its agents and give notice to
potential 3rd parties, form contract requiring approval by contract manager)

TERMINATION OF AUTHORITY – former employees

- Firing an agent terminates actual authority
- You need to have:
1. Actual notice to the agent and
2. Constructive notice to everyone else
o Al was Pam’s agent; Al negotiated many contracts of various sorts for Pam. Pam fires Al,
terminating his actual authority
o What should Pam do to ensure that Al no longer has apparent authority?
 Actual notice to all TP’s who dealt w/the agent as agent
• Call, send letter, or some way to let TP’s who deal w/AL as
Pam’s agent know Al is no longer her agent
 Constructive notice -to all other TP’s (who had never dealt w/Al
as agent for Pam)
• Ex. Put notice in paper
• Principal has obligation to let the world know agent is no
longer agent (thus limiting apparent authority)
• Notice must be reasonable (pick a geographic location and scope where it is
likely to be seen) BUT not all 3rd parties have to actually see this
- When you terminate actual authority, must also terminate apparent authority
o 1. Give actual notice to all TP’s that dealt w/agent
o 2. Constructive notice – principal has obligation to let world now
 Ex. P takes out ad saying person no longer her agent
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 o Must put notice somewhere that makes sense
 3rd parties don’t have to actually see, but just have to show there
was actual notice
HYPOS from Slides a 10-11: 78, 79, 80, 81, 82, 83
- Slide 78: Paula is a movie producer who has hired an assistant, Amy. Paula says to Amy, “Go out and hire
a camera person.” How would you characterize Amy’s authority to hire?
o Actual Authority to hire a camera person &
o Implied Authority to do whatever is necessary to find a cameraperson
- Slide 79/80: Amy hires Tom outside of the scope of her actual authority (but it is not outside the scope of
her apparent authority)
o Tom will win a suit against Paula because Paula manifested her scope of authority
o Paula’s telling Amy not to hire Tom – limitation on actual authority but does
nothing to apparent authority
 Limitation on authority is only binding on 3rd parties w/notice
 Tom is reasonable in believing that Amy has authority b/c Paula told
Tom that Amy had authority
 This is manifestation
 If Amy hires Tom, Paula still liable
- Slide 81
o NO DIFFERENCE WITH PREVIOUS HYPOTHETICAL
o The agent can manifest apparent authority in a variety of ways
- Slide 82
o Amy DOES NOT have actual authority to hire Tom and there was NO MANIFESTATION of
apparent authority through the principal (which was present when Paula directly told Tom what she
did in Slide 79); Amy cannot create her own apparent authority without permission from Paula

Restatement § 8, Comment b: “The manifestation of the principal may be made directly to a third person,
or may be made to the community by signs, by advertising, by authorizing the agent to state that he is
authorized, or by continuously employing the agent.”

Hypo: Slides 85-88

- Paula is an undisclosed principal
- Alice had no actual authority OR apparent authority (Because Tom had no knowledge of Paula’s
existence – Paula must be the ultimate source of the authority)

Agency by Agreement (Traditional)

Agency by Ratification (Retroactive Authorization by Principal) -- the opportunity to make the

contract binding as long as the 3rd Party has not already voided a voidable contract.
- When ratification is complete, the fraud is waived because the 3rd party is in no worse position
than he would have been.
• Ratification is where a principal can choose to be bound despite the existence of a contract made on
their behalf that is not binding.
1. Agent acts without authority (of any kind) and there are no grounds for estoppels…
- We will talk about estoppels in the next case – but in brief, it is conduct leading 3rd party to believe that an
agent has apparent authority – if there were grounds for estoppels, you wouldn’t need an ex post
authorization – the law would impose an agency to protect the 3rd party
- But if there are no grounds for estoppels, Principals will only be bound if they ratify the contract
2. After the agent acts without authority (and thus NO agency relationship), the principal, who is not
bound at this point, chooses to be bound. How does Principal ratify and thus become bound?
- Must be a contract or act that would have been valid if authorized initially [can’t be illegal, for
example]
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 o Principal must have been in existence when the unauthorized act was done
- Ratification must be effected with the same formalities that would have been necessary for the
unauthorized act – equal dignities rule
- Principal must know or have reason to know all material facts [including that Agent purported to
act for him]
- Can be express or implied [harder to prove]:
(1) Express affirmation by the principal;
(2) Implied affirmance through acceptance of the benefits of the transaction at a time when it is
possible to decline to accept such benefits
(3) Implied affirmance through silence or inaction – a principal can’t wait forever before
repudiating an unauthorized transaction, a rule based largely on notions of economic fairness;
we don’t give the principal a put;
(4) Implied affirmance through bringing a lawsuit to enforce a contract.
- Ratification is fair to a Third Party as long as they don’t know of the fraud by the Agent
- Definition – affirmance of prior act that didn’t bind you but was said to be
done on your behalf
- If Principal finds someone was claiming to represent them w/o
authority and chooses not to be bound, 3rd party may be out of luck
o Principal may not be bound
o But 3rd party might not want to be part of fraud and can get out of
transaction (separate problem)
- How does Principal show ratification – affirmance
o 1. Treat as authorized
o 2. Engage in Conduct that looks like you agreed to be bound
 Conduct consistent w/honoring contract
 However, need opportunity to say no
o Can be express or implied (harder to show)
REMEMBER:: How find ratification
o A. Agent acts w/o authority
o B. No grounds for estoppel
o Affirmance – Restatement 83 (Slide A 16-91) – above elements
- Ratification – Restatement 82 (pg 5) – ratification is the affirmance by a
person of a prior act which did not bind him but which was done or
professedly done on his account, whereby the act, as to some or all persons,
is given effect as if originally authorized by him
- How ratify – can only ratify after it you could’ve ratified originally
o Can’t be illegal
o If couldn’t have ratified before (incapacity, illegality, etc)
o Can’t use ratification retroactively to make a contract that would not
have been able to be made in the first place
- How – examples to show contract was ratified
o 1. Accept benefits when you don’t have to
o 2. Allow things to continue through silence or inaction
o 3. Express affirmation
o 4. Implied affirmation through bringing lawsuit to enforce the contract
 Can’t let it go too long
- If TP wants out before affirmance – TP is allowed out
o Don’t require 3rd party to stay in deal when there is ratification is
doesn’t want to
11
  B/c TP was victim of fraud
- Need contract for estoppel of ratification
o Can’t be a tort
- Can’t ratify part of contract – all or nothing
Ratification is the opportunity to make the contract binding as long as the 3rd Party has not already voided
a voidable contract.

* Ratification will be denied legal effect where necessary to protect the rights of innocent 3rd parties
• No intervening events: TP withdraws, P loses capacity, change in circumstances, lapse of time. TP
is treated as an offeror, who can withdraw anytime prior to acceptance [absent option contract, part
performance or promissory estoppel]
Pre-condition for ratification – TP must still be in the deal
o If TP opts out before ratification, can’t ratify
o Principal has opportunity to ratify as long as TP hasn’t declared voidable
contract void
• Ratification – remedy to protect the principal

Can you ratify a contract that lacked consideration?

- NO
Examples (pg 39)
1. Pam is writer and husband Alex entered contract w/ABC publishers. ABS sends Pam
check, which she cashes and spends money on. A few months later, she tries to sell her
book to another company and ABC claims the book. Pam claims that Alex had no authority
to act? – What result?
 P – Pam
 A – Alex
 TP – ABC
 If Alex had no authority, then only Alex would be liable b/c agent who
exceeds his authority binds only himself
o Ratification – Pam cashed the check and spent the money
o Based on these facts, Pam will win
o 2. If Pam argues she thought the check was for royalties for one of her
previous books, which ABC had published and says she neither knew or had
reason to know it was for an advance book? – Pam wins, for ratification must
know all material facts
o 3. Paula owns mansion, Alan having no authority to do so enters in contract
w/Ted. Next day mansion burns down, Paula affirms the contract. What result?
 Ted wins
 Fairness – when 3rd party doesn’t know agent lacked authority doesn’t
disadvantage them to have Principal ratify after the fact
 If contract materially changed, don’t want to use that fact to let the
principal get out of being liable
 If TP knows about the fraud and waits on it, will be seen to have waived
opportunity to get out
o Rule- won’t hold TP to contract at his peril
 Can’t authorize after the fact when contract has materially hanged,
need to give TP chance to get out
o When have unauthorized act by agent, where P and TP don’t know, equally
defrauded

A limitation on authority is that it is only binding on 3rd parties who have notice: Apparent authority is
the authority that the principal allows the 3rd party to believe that an agent has.
12
 - So too, think of ratification as a remedy that we use when there is no authority and the principal
chooses to be bound by the contract

• Botticello v. Stefanovicz (pg. 36) RULE: Ratification requires affirmance by a person with full
knowledge of the material terms of a prior act which did not bind him but which was done or
professedly done on his account.
Facts: Mary and Walter Stefanovicz are tenants in common in property
- Walter leases the property to Botticello w/ an option to buy without the permission of his wife
- Botticello made permanent improvements to the land (a donation to the property that you’re leasing)
- Walter has no authority to sell the property without Mary’s permission
- Walter wants to sell and Botticello wants to buy → Mary refuses
- Mary says “I will not sell for $75,000 and I won’t sell for less than $85,000.
- Walter’s marriage to Mary does not create an agency
- Trial Court finds that Walter was her agent and that Mary ratifies
- Court of Appeals finds that there are no facts to support the conclusion that Mary ratified AND that Walter
was not authorized to act
o Don’t permanent improvements show that Mary is affirming (BUT SHE MIGHT NOT KNOW
ALL THE CIRCUMSTANCES)

Ratification – Principal opting in

Estoppel – Principal prohibited from opting out of a contract:

Agency by Estoppel (Restatement § 8B): a person not a party to a transaction purportedly done on his
account can be held liable if he either intentionally or carelessly caused the belief [AA] or failed to
correct the belief, and the 3rd party reasonably relies on the belief.
* Concept is based on detrimental reliance
Agent without authority attempts to bind a principal
- Agency by Estoppel is a remedy imposed on the principal to protect the 3rd Party… (whereas
ratification is a remedy to protect the principal); and agent by estoppels ONLY HAS APPARENT
AUTHORITY
Why is this fair to the principal?
- When principal finds out about an unauthorized agent, they can either ratify or stop them
Agency By Estoppel happens when:
o Principal has opportunity to stop transaction and doesn’t and this makes
principal less likely to be able to get out
o Principal not as equally defrauded as TP
o Reasonable reliance on transaction, even though not a contract
 Like promissory estoppel
• Need contract for estoppel of ratification
o Can’t be a tort
• Elements for Agency by Estoppel
o 1. No agency
 Agent either exceeds authority, or has non
o 2. Principal negligently or intentionally allows agency when there isn’t
 Ex. Koos Bros – would be principal, Koos, created appearance of
authority when they failed to monitor the store, which allowed the
customer to believe he was a salesperson (omissions)- see below
 Longer and more visible this is going on, more reasonable it is to
hold principal responsible
o 3. TP relies on this apparent authority
o 4. TP’s reliance must be reasonable
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• Hoddeson v. Koos Bros. (pg. 40) RULE: If a business proprietor by his dereliction of duty enables one who
is not his agent to act conspicuously as Duch and to transact the proprietor’s business with a patron in the
establishment, estoppel prevents the proprietor from defensively availing himself of the impostor’s lack of
authority in order to escape liability for the customer’s consequential loss
Facts: Mrs. Hoddeson goes to a furniture store and buys furniture from someone who is NOT AN EMPLOYEE of
Koos Brothers
- Important fact to note is the reasonableness of the 3rd party’s belief that there was an agency [Imposter
looked the part of a salesman in the store]
- Hoddeson was attended to by the imposter for 40 minutes
- Principal: Koos Brothers; Agent: Fake Salesman; 3rd Party: Hoddeson
- Hoddeson gave $168.50 to the salesman but never received the furniture
- NOTE: When you sue someone to compel enforcement of a contract the agency by estoppel has NOT been
ratified
- Why is the store litigating a $168.50 claim?
o You have to have zero tolerance to protect yourself from future suits
* A judicially imposed agent has no actual authority (only apparent authority)
Reasoning: Koos Bros. was negligent and created an appearance of authority by failing to act
- The 40-45 minute lapse in time seems enough to suggest an omission on the part of Koos Bros.
The Hoddeson court gives us the commonly accepted elements of estoppel:
(a) Principal creates, through intentional or negligent words, acts, or omissions, an appearance
of authority in the purported agent;
(b) The 3rd party reasonably and in good faith acts in reliance on such appearance of authority;
and
(c) The 3rd party changes her position in reliance upon the appearance of authority.

• Hoddeson acted in good faith and reliance on the salesman’s representations. She acted by paying the
imposter (this is great evidence of “changing her position”)
• Where an agent had authority (of any kind) the subsequent contract is binding on both Prinipal and 3rd
Party.
- Estoppel only binds the Principal.
- In all other types of authority, the contract is binding on Principal and Third Party. ESTOPPEL IS
A ONE WAY STREET. Principal has no cause of action at all in an estoppel situation. Rather,
where the doctrine is applicable, P is estopped from raising the lack of authority as a defense to a
breach of contract suit by TP.

A by Estoppel is aRemedy for TP who negligently or intentionally misled by a principal -

Remedy imposed on principal to protect 3rd parties

Rationale – P allowed TP to believe that an agent had authority and TP had reason to
believe this and Principal did nothing about it
o Takes away principal’s choice not to be bound
o Allowed others to believe that someone was your agent
o If TP reasonably relies on that belief, Principal is bound
 1. Either intentionally
• OR
 2. Carelessly caused belief
• Knowing about someone claiming to be your agent but do nothing about it
o Creates apparent authority based on principal not stopping person from
acting as agent
 Either intentionally or negligently allowed TP to believe there was an
agency when there wasn’t
• Authority – only authority agent by estoppel has is apparent authority
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 • Judicially imposed agency, when no agency in fact exists
o Court imposes agency
o Apparent authority created by Court
o Before impose agency – must show that principal was negligent or allowed TP
to believe there was an agency
• When Principal finds out
o 1. Can choose to be bound – ratification
 Principal trying to get in
o 2. No choice, prohibits principal from getting out – estoppel
 Principal trying to get out
• ELEMENTS OF ESTOPPEL FOR TEST – for test, walk though the 3 elements
(discuss the law, mentioned the Restatement (8B) and then discuss the facts under
each of the elements
o 1. The principal creates, through intentional or negligent words, acts, or
omissions, an appearance of authority in the purported agent
o 2. The third party reasonably and in good faith acts in reliance on such
appearance of authority
o 3. The third party changes position in reliance upon the appearance of
authority
• Estoppel – detrimental reliance
o Law protects you b/c you expected something and you reasonably changed
your position
o Person who allowed this to happen will be liable
• Estoppel only binds the principal
o If 3rd party didn’t want to be bound, wouldn’t have to be
o Brings the principal back into a contract
o 1 way street
o Principal prohibited from getting out of the deal/transaction

Hypos on Slides A 17-100, 101, 102:

o . Alice is Peter’s traveling salesperson, and authorized to collect accounts;
before the agreed termination of the agency, Peter wrongfully discharged Alice
 Then, Alice goes out to see Tim, an old customer, and collects on an
account Tom owes to Peter
 Then she calls on Laura, a new customer and takes a big order, collects
the orders, sends the order to Peter and takes off w/Laura’s and Tom’s
money
o Result – Alice has apparent authority to bind Peter
 Peter needed to tell Tom, who he knew was a client, that Alice was no
longer his agent
o 2. Peter delivers the goods to Laura?
 Peter bound on Alice’s interaction w/Laura
 Appears to be ratification:
• Peter sends the goods to Laura
• Engaging in conduct consistent w/honoring contract (performing
it)
• Evidence of ratification
• If there had been ad in paper saying Alice was no longer his
agent, Peter would no longer be on the hook even if Lauran didn’t
see it
• Rule- anyone who deal w/agent as an agent must be notified individually
• TEST
15
 o 1. Answer question
o 2. Go through law
o 3. Apply facts
o 4. Discuss how law is satisfied or not satisfied

Disclosed/Undisclosed Principals - (Slides A 2-4: 11-19) – All from Restatement 3rd

1. Disclosed principal – when an agent and a third party interact, and the third party has
notice that the agent is acting for a principal and has notice of the principal’s identity
a. Agent for a Disclosed principal: when an agent acting with actual or apparent
authority makes a contract on behalf of a disclosed principal:
i. The principal and the Third party are parties to the contract, AND
ii. The agent is not a party to the contract unless the agent and the third party
agree otherwise
b. Everyone knows that there is a principal and everyone knows the identity of
the principal
c. Agent has no liability if all parties know the existence and identity of
principal
d. Principal has responsibility on the contract
e. Principal has liability on contract made by agent w/authority
f. Agent has no liability UNLESS
i. 1. It is the clear intent of all parties that the agent have
liability
1. OR
ii. 2. Agent exceeds his authority and thus binds only
himself and not Principal
2. Undisclosed principal – when an agent and a third party interact, the third party has NO
notice that the agent is acting for a principal
a. Agent for an undisclosed principal – When an agent acting with actual authority
makes a contract on behalf of an undisclosed princpal:
i. Unless excluded by the K, the principal is a party to the K
ii. The agent and third party are parties to the contract, AND
iii. The principal, if a party to the K, and the third party, have the same rights,
liabilities, and defenses against each other as if the principal made the K
personally, subject to § 6.05-6.09
b. Existence and identity of principal not known to 3rd party
c. TP has no idea someone is acting as an agent for someone else
d. TP thinks he is in deal w/agent b/c doesn’t know that the principal exists
e. IF – if the TP ever figures out who the principal is and that there is one, TP
gets to pick who he wants to be in contract with
i. If existence and identity of principal is discovered
ii. 1 time option switch
1. Usually do this is other person has more money
2. Whoever choose, this is who you are stuck with
f. Agent treated as though a party to the contract (and thus has liability)
3. Unidentified Principal – when an agent and a third party interact, the third party has notice
that the agent is acting for a principal but does not have notice of the principal’s identity
a. Agent for an unidentified principal – When an agent acting with actual or apparent
authority makes a K on behalf of an unidentified principal,
i. The principal and the third party are parties to the K, AND
ii. The agent is a party to the K unless the agent and the third party agree
otherwise
16
 b. Know the existence of the principal but don’t know the identity
i. Ex. Criminal, celebrity (people like to keep identities secret)
c. Put risk of lack of info on the 3rd party
i. Makes sense, they could inquire further
d. Treated same as undisclosed
e. If TP learns of identity of principal, gets to choose
f. Otherwise, stuck w/agent
i. Agent treated as though a party to the contract

Sequential Analysis of Tort Liability – Slides A pgs 18-19

- In order for a principal to have liability for an agent’s tort, there must be:
1) An agency relationship between principal and agent
2) Agent is P’s servant (NOT an independent contractor)
3) If servant, was conduct within the scope of his employment?

Master-Servant Relationship:
Restatement § 2(2): A servant is an agent performing services in the master’s affairs whose physical
conduct is controlled or is subject to the right of control by the master
- Note that the master does not have to actually exercise control over what the agent does; he or
she merely needs to have the right to control the agent’s physical performance of the assigned
task
- Need minimal level of control
Restatement § 2(3): An independent contractor [non-servant agent] is a person who agrees to carry out
some task but is NOT subject to the principal’s control in doing so
- In other words, where a principal sets forth the desired result but does not have the right to tell
the agent HOW to achieve that result, the agent is an independent contractor
- Agent does what you told him to do but in the way he wants to
3 questions:
- 1. Is there an agency relationship between Principal and Agent? – If
NO, no liability (for P) – Restatement 1
o If yes, must ask:
 Servant agents
 Independent contractor
- 2. Is Agent the Principal’s Servant or an Independent Contractor? (is
this master-servant relationship) – Restatement 2
o Servant – if agent did what TP claims happened, and it happened during
scope of employment, then P may be liable
o Independent contractor – no liability
o What level do we need for principal-agent?
 Need to be able to tell agent what to do and control how
agent will do it
 As long as P can specify tasks and has ability to say how
something is done
- 3. If servant, was conduct within scope of employment?
o If yes, P is liable

17
 o Was agent doing what principal told him to do in the way he told the
agent to do it:
 If YES, then: Vicarious Liability **
o If not, P is not liable, only the agent is liable (b/c exceeded scope)

Vicarious Liability – for negligent conduct only

o Intentional conduct takes you out of the scope and thus only servant
responsible
o No such thing as vicarious liability for criminal conduct (only if told
someone to do it)
o Rule – no vicarious liability for intentional torts

Liability for Principal depends solely on agency status

- All masters are principals, but not all principals are masters
- All servants are agents, but not all agents are servants

• Murphy v. Holiday Inns (pg. 53) RULE: If a franchise contract so regulates the activities of the franchisee as
to vest the franchiser with control within the definition of agency, the agency relationship arises even if the
parties expressly deny it.
Facts: Murphy slips and falls on sidewalk where air conditioner was dripping
- She does not sue the owner of the motel, Betsy-Len Corporation, but instead aims for Holiday Inn [she
must prove that Holiday Inn is Betsy-Len’s master]
- Betsy-Len controls the maintenance of the premises [If we could show that Holiday Inn controlled the
training of Betsy-Len’s maintenance crew we would move further toward the master-servant relationship]
- Betsy-Len sets rates, hires and fires, supervises workers, etc.
o *Betsy-Len is running its own show, but Holiday Inn gets a share of the money and has its name
plastered everywhere
Holding: Court believes that regulatory provisions of the franchise contract did not constitute control
within definition of agency.
There must be an agreement [not necessarily written of course] for an agency relationship to exist. The
contract here expressly denies that the parties are principal-agent (or master-servant). Does the contract
control?
- No. “If a franchise contract so ‘regulates the activities of the franchisee’ as to vest the franchiser with
control within the definition of agency, the agency relationship arises even though the parties expressly
deny it.”
The more Holiday Inn could control the conduct of Betsy-Len the more it could be held liable as a master
(However, Holiday Inn did not control the maintenance obligations of Betsy-Len and therefore Murphy lost a
great opportunity to prove control).
- For Holiday Inn to be liable for the tort, they must be both a principal and a master
- You can’t use estoppel argument against Holiday Inn because there is no contract to rely upon
o Tort creditors suing on an agency capacity are suing for vicarious liability
o Contract creditors would be suing on the binding contract provided that agent had the authority to
make contract (here estoppel is permissible)
o Agency may play a tort role or a contract role

Level of Control necessary for principal-agent relationship?

- Minimal. A principal need not exercise physical control over the actions of its agent so long as
the principal may direct the result or ultimate objectives of the agent relationship
o Hence, the requisite level of control may be found so long as the principal is able to specify
the task the agent is to perform, even if the principal is unable to ensure that the agent
carries out the task
Level necessary to create a master-servant relationship?
- Must specify how to DO that something
18
 - Restatement § 2(2) defines a servant as “an agent employed by a master to perform service in his
affairs whose physical conduct in the performance of the service is controlled or is subject to the
right to control by the master.”
- § 2(3) defines an independent contractor as “a person who contracts with another to do something
for him but who is not controlled by the other nor subject to the other’s right to control with
respect to his physical conduct in the performance of the undertaking.”

Restatement § 220. Definition of Servant

(1) A servant is a person employed to perform services in the affairs of another and who with respect
to the physical conduct in the performance of the services is subject to the other’s control or right
to control.
(2) In determining whether one acting for another is a servant or an independent contractor, the
following matters of fact, among others, are considered:
a. The extent of control which, by the agreement, the master may exercise over the details of
the work;
b. Whether or not the one employed is engaged in a distinct occupation or business;
c. The kind of occupation, with reference to whether, in the locality, the work is usually done
under the direction of the employer or by a specialist without supervision;
d. The skill required in the particular occupation;
e. Whether the employer or workman supplies the instrumentalities, tools, and the place of
work for the person doing the work;
f. …
Will this be helpful in the analysis of whether Holiday Inn controlled Betsy-Len?
- Problems arise because of the vast gray area in the middle. § 220’s factors will be of little help.

Scope of Employment
§ 228. General Statement [of Scope of Employment Doctrine]: conduct of a servant is within the scope of
employment “if but only if”
- It is of the kind he is employed to perform
- It occurs substantially within the authorized time and space limits
- It is actuated, at least in part, by a purpose to serve the master
- Force, if used, is not unexpectable by the master
§ 229. Kind of Conduct Within Scope of Employment: was the conduct of the same general nature as, or
incident to, that which the servant was employed to perform? The section gives us a list of factors
to consider, including whether the act is commonly done by such servants; the time, place and
purpose of the act; prior relationship, if any, between master and servant, etc.
- Helps us figure would when things are outside of the scope of employment
- Typically when you have intentional conduct (criminal or otherwise) you are outside of the scope
of employment

• It makes sense that franchisors DO NOT WANT to be involved in master-servant relationships

- So how do we protect Holiday Inn from the possibility of vicarious liability?
o We will require franchisee to own insurance
o Also, we will avoid discussions of how to run the business

• Clover v. Snowbird Ski Resort (pg. 66)

Facts: Chris Zulliger is a chef at a ski resort and he ignored a sign that advised skiers to move slowly; he
struck a skier and severely injured them on his way from one kitchen to the next [Here he is within the
scope of his agency]

19
 - However, the facts also allege that Zulliger had taken 4 runs for pleasure during the day [If he had been
punched in it’s debatable as to whether or not he was within the scope of his agency – better evidence that
he is]
Rule: When you have a P-A relationship and a M-S relationship you must decide whether or not agent
was or was not within the scope of employment
Procedural: Trial Court rules in favor of resort
Holding: Supreme Court reverses and finds that Zulliger was within scope of employment
- If you are within the scope of the agency vicarious liability will impute to the master
- Not a “total abandonment of his employment”

Fiduciary Duties: Agent’s Duties to Principal:

o Duty of Care and Skill - Restatement 379 (pg 10) – reasonable man standard
 Agent has duty to use reasonable care, diligence, and skill in performing work
 Degree of skill requires is that expected of a reasonable person under similar circumstances
 Duty of ordinary care
o Duty to Give Info – Restatement 381 (pg 10) – agent must give principal info he learns as an
agent
o Duty to Keep and Render Accounts – Restatement 382 (pg 10) – the agent has the duty to keep
and make available to the principal an account of all the property and money received and paid out on
behalf of the principal. And can’t comingle funds:
 Agent must keep separate accounts for the principal’s funds and the agent’s personal funds
o Duty to Obey – Restatement 385 (pg 10) – the agent must follow all lawful and clearly stated
instructions of the principal, and must perform the services specified for as long as and in the way
specified in the contract. Aka: do what you’re told and how you’re told to do it
 Agent incurs liability for any losses caused by disobeying these instructions
o Duties After Termination of Authority - Restatement 386 (pg 11) – relationship over,
obligations to principal go away

o Duty of Loyalty – Restatement 387 (pg 11) – agent cannot put his interests ahead of the
principal
 When an agent, the principal comes FIRST
 Must be selfless, principal comes first
 Duty of loyalty ends when relationship ends
 A is entitled to reasonable compensation from P; and absent agreement with P, the duty of
loyalty forbids A from receiving any other compensation in connection with the agency
relationship unless P knowingly and voluntarily agrees to the contrary.

• Town and Country v. Newberry (pg. 87) RULE: A business proprietor may not solicit his former employer’s
customers who are not openly engaged in business in advertised locations or whose availability as patrons
cannot readily be ascertained, but whose trade and patronage have been secured by years of business effort,
advertising, and the expenditure of time and money.
Facts: Cleaning service has several employees break away and start their own competitor business that
performs the same service
- Competitors use the client list of Town & country that was put together using the company’s blood, sweat,
and tears
Issue: Are defendants permitted to use the client list?
Holding: NO
Reasoning: Did these agents, in the scope of their agency, usurp an opportunity afforded their principle?
- Is there a difference between cleaning houses and practicing law?
o Should lawyers be able to take clients with them when they change firms?
o The relationship between lawyer and client is a fiduciary one – you would be hard pressed to
characterize the relationship between housekeeper and homeowner as a fiduciary relationship
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II. PARTNERSHIP – a voluntary association of 2 or more persons to carry on as co-owners of a
business for profit
- All partners are agents of each other and can bind the partnership

A. Statutes
• 1. Uniform Partnership Act (UPA) (1914)
• 2. UPA (1997)
• Each states chooses to adopt 1
• ***On exam USE THE ONE THAT YOU ARE TOLD TO USE****
o Bound by the terms of the UPA unless you opt out of them
• UPA has rules to determine partnerships
o Either partnership agreement is accepted in its entirety or partnerships agree
to opt out of some or all of the UPA
 Up to the partnership to decide
UPA § 6(1): “A partnership is an association of two or more persons to carry on as co-owners a
business for profit.” (Must be for-profit entity, no non-for-profit partnerships)
• All partners have unlimited personal liability for all partnership debts
- Have to be carrying on a business (cannot be a passive investment)
- Must have co-ownership (split profits – this is BEST EVIDENCE of co-ownership)
- Profits – revenue generated minus expenses (those paid expenses are NOT profit shares) – money
lef over after everyone has been paid
o Profit sharing: formula for after everyone is paid, how money that is left will be split up
o If you are sharing them, you are partners

Just b/c say something is a partnership, doesn’t mean there is one

• Is it possible to have partnership and not know it? – yes, intent doesn’t
matter (look at conduct)
o Opposite is true, can think you have partnership but really don’t
o Look at the conduct of the parties
• Governing agreement – the partnership agreement
o Generic rules
o If don’t specify rules, UPA kicks in
o If don’t specify otherwise, will split profits equally
• Where there is a partnership and didn’t know it or no partnership
agreement – this is where the UPA comes in
o Set of default rules
o UPA acts as partnership
o UPA does not have to bind but you have to opt out of it
 If not, default rule??
o Bound by terms of UPA unless you opt out of them
o Statute measures conduct of the parties and either it satisfies the
statute or it doesn’t
• Agreement – need an agreement to create partnership
o Doesn’t need to be written unless there are statute of frauds issues

• Fenwick v. Unemployment Comp. Comm’n (pg. 91) RULE: A partnership is an association of two or more
persons to carry on as co-owners of a business for profit.
Facts: Fenwick owns a beauty shop and hires Mrs. Cheshire

21
 - After working at the shop for a time Cheshire requests a raise but Fenwick is unable to provide for the
additional rate at this time
- They enter a deal that Mrs. Cheshire would receive a bonus at the end of the year of 20% of the net profits
if the business warrants it (An illusory promise).
- This is not the sharing of profits necessary for a partnership.
→ Issue: Does an Agreement providing a person a potential share in the profits of a business, without
conferring a right to control the business or bear a share of the losses, establish a partnership? NO.

If we were to find a partnership, we would need to see several things:

• UPA serves as a set of default rules [read into any agreement not expressly opted out of in a contract]
- “unless the parties provide otherwise…”
- When there is a partnership that you don’t know about, it is covered by the entire UPA (You are
not bound by the UPA but you MUST EXPRESSLY OPT OUT OF IT in the partnership
agreement)

Evidence of partnership
o 1. Profit sharing
o 2. Sharing of losses
o 3. Discussion over who handles what

• Martin v. Peyton (pg. 96) RULE: A partnership is created by an express or implied contract between two
persons with the intention to form a partnership
Facts: Hall is a partner in the firm KNK; he asks his friends Peyton, Perkins and Freeman to lend him money
- Peyton provides a $500,000 bond for Hall to borrow against. All told the friends provided $2,500,000
worth of securities to borrow against. The only thing the creditors asked was that the bonds not be used in
speculative investments.
- Hall was to be their man on the inside and protect their interests – he doesn’t do this
- Peyton, Perkins, and Freeman were to receive 40% of the profits of the firm until the return was made, not
exceeding $500,000.
o This cap means that P, P, and F were not profit sharers (they were collecting interest – NOT
PROFIT SHARING) – they had the option to buy in which they NEVER took up
- A creditor of KNK is suing the lenders because KNK has no assets
- P, P, and F turned down the opportunity to be partners several times
Are they Partners?
- Are there more than one member? Yes
- Profit sharing? No
- Inspection and Veto Rights? It’s not unusual for a creditor to have entry rights
Holding: Court finds that the conduct of the parties does not satisfy the partnership
Same situation as A. Gay Jensen Farms v. Cargill
- P, P, and F, if found to be partners, would not only lose their $2,500,000 investment but ALSO be liable for
the partnership’s debts\
Under the Agreement, Trustees CANNOT BIND THE FIRM
- What did the “indenture” do?
- What did the “option” do?
Would this case come out differently if KNK was set up as a corporation?
- Investors in corporation have limited liability so P, P, and F would have been shielded regardless

Partnership by Estoppel – when the law imposes a partnership where there is none, to protect a TP
[Remember, Agency by Estoppel is a remedy imposed by law to allow fairness to an aggrieved 3rd Party who has
been tricked into a contract by a false agent, etc. of the principal]
- PARTNERSHIP BY ESTOPPEL is imposed where there is no partnership but to allow fairness to
the 3rd Party – designed to protect the 3rd party!

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 - There was no partnership, but would-be principal negligently or intentionally allowed a 3rd party
to believe there was a partnership
In order to establish a partnership by estoppel, 4 elements must be proven:
1. Plaintiff must establish a representation, either express or implied, that one person is the
partner of another – i.e. that there was a holding out of a partnership
2. The making of the representation by the person sought to be charged as a partner or
with his consent
3. A reasonable reliance in good faith by the third party upon the representation
4. A change of position, with consequent injury, by the third person in reliance on the
representation

• Young v. Jones (pg. 106) RULE: A person who represents himself, or permits another to represent him, as a
partner in an existing partnership or with others not actual partners, is liable to any person to whom such a
representation is made who has, in reliance on the representation, given credit to the actual or apparent
partnership.
Issue: Are Price Waterhouse-US & Price Waterhouse-Bahamas partners by estoppel? NO
Facts: Plaintiffs deposit money in Swiss-American Fidelity (an investment)
- Swiss-American turns out to have no money and is judgment proof
- Audit letters promise to accurately state the financial status of a company [“Clean Audit”]
o “Qualified Audit Letter” – The information, to the best of their knowledge, is accurate
o “Clean Audit Letter” – A confident assertion that the financial statement is accurate
- The audit letter here was falsified and plaintiff’s sue Price Waterhouse Worldwide [as opposed to Price
Waterhouse Bahamas who wrote the letter]
- If plaintiffs can show that PW-Bahamas is in partnership with PW-Worldwide then Worldwide would be
liable for all debts incurred by its partner
- Swiss-American would be the easier suit but they have no money
Examining the Relationship between PW-WW and PW-Bahamas:
- There is value to name recognition
- PW-Bahamas and PW-US hold themselves out to be partners with one another (as evidenced by brochure)
BUT they did not discover this until after initiating suit
- Audit letter is signed only by Price Waterhouse
• Arguments for – same name, brochure that there is one big partnership
• Bad – found brochure after, didn’t rely on this
• Court – no partnership, didn’t meet SC statute for reliance (no extension
of credit)
• If were partners – then PW-US would be liable to plaintiff for PW-
Bahamas

Partnership by Estoppel?
- South Carolina law will impose a partnership if the 3rd Party shows that the principal permitted the 3rd party
to believe that there was a partnership agreement either negligently or intentionally and reliance of a 3rd
Party must be extension of credit
o Audit letter is best evidence of partnership agreement
o 3rd party must rely on and change position by extending credit (Many states, by statute, define how
3rd party reliance must be demonstrated – this is different from agency by estoppel)
- As there is no extension of credit to PW, plaintiffs only option to prove partnership is to prove an actual
partnership
o Must give credit TO THE PARTNERSHIP to successfully assert Partnership by Estoppel

UPA are mid-road, generic partnership rules.

*There is a fine line between monitoring your investment and being a prudent creditor (and taking
control)

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• Meinhard v. Salmon (pg. 109) RULE: Like partners, joint adventurers owe one another the duty of loyalty
Facts: Meinhard and Salmon operate Hotel Bristol at midtown (present day Grand Central)
- They are considered coadventurers, subject to fiduciary duties akin to those of partners
- Just before the lease expires (1 month left on 20 year deal) Salmon leases a larger parcel from the landlord
unbeknownst to Meinhard, who is unhappy to be excluded from the new deal
o Meinhard believes Salmon owes him a fiduciary duty to be included on the new deal
o There was no renewal option in the contract clause between Salmon and Meinhard, but Meinhard
sues anyway
- Trial Court finds for Meinhard and awards him a 25% interest in the new deal (half of the new half of
Salmon’s interest in project) – All parties appeal
- When a contract has a term, it is done. Meinhard was not entitled to ANYTHING.
o Cardozo says that Salmon only had to give Meinhard notice of what he was doing [perhaps
providing an opportunity to participate?]
What if Salmon read about Gerry’s interest in the property and approached him with a proposal (rather than
Gerry approaching him, as actually happened)?
- Perhaps he has more of an obligation to Meinhard
- We are merely leveling the playing field
Holding: Court finds NO PARTNERSHIP b/c Meinhard was a passive investor – he was not carrying on
a business (nor was Salmon)
- The two shared profits and losses but they were NOT RUNNING a business together

Partnership:
- Carrying on a business
- Sharing profits and losses
- Actual for-profit enterprise – doesn’t mean have to make a profit, but that must be purpose

• Bane v. Ferguson (pg. 115) RULE: Former partner is not owed a fiduciary duty to maintain a pension plan
upon termination of the partnership
Issue: Does a retired partner in a law firm have either a common law or a statutory claim against the firm’s
managing council for acts of negligence that, by causing the firm to dissolve, terminate his retirement benefits?
NO.
Facts: Ferguson had been a partner in a firm before retiring
- Pension from firm after retiring was his sole source of income until firm merged with another
o Part of the pension plan required that the firm remain in existence for payment to continue
o Ferguson had paid into pension plan during his course of employment
- Ferguson alleges negligent mismanagement (of pension plan and the firm); Ferguson can bring action for
mismanagement of pension plan AND partnership that he withdrew from
Issue: Whether there is a claim for mismanagement of partnership by former partner.
Reasoning: § 9(3)(c) makes negligent partners NOT liable to 3rd parties
- * When you terminate your partnership relationship you are no longer owed the fiduciary right (he has lost
the legal ability to complain about management of partnership)
Holding: Former partners not able to bring suit against current partners in a business; Plaintiff receives
NOTHING
→ Court suggests that if he had sued on mismanagement of the plan he could bring a contracts cause
of action
RULE: When partnership status ends, fiduciary duties owed to you end also. Partners do not owe fiduciary
duties to former partners.

Duty of Partners to Render Info – UPA (1914) 20 (pg 37) – partners on

demand have to render true and full info of all things affecting the partnership to
any partner
Partners Rights and Duties w/Respect to Info – UPA (1997) 403(c)(1) –
difference w/1914, w/o demand, any info concerning the partnership’s business

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 and affairs reasonably required for the proper exercise of the partner’s rights and
duties under the partnership agreement – don’t have to be asked
o Notice – partners on demand have to render true and full info of all
things affecting the partnership to any partner
 If aren’t asked, don’t have to say anything =- 1914 UPA 20
 Some don’t require to be asked – 1997 UPA 403(c)(1)
• Difference w/1914 – don’t have to be asked if deals
w/partnership
 However (either UPA) – if asked about anything affecting
partnership, must answer
o Be careful how you leave a company so as to not breach the duty of
loyalty
o Meehan – including when leaving firm, starting own, taking clients (see
below)
Whenever question about fiduciary duty either:
o 1. Duty of loyalty
o 2. Duty of care

• Meehan v. Shaughnessy (pg. 117) RULE: A partner must render on demand true and full information of all
things affecting the partnership to any partner
Facts: Meehan and Boyle leave Parker Coulter to start their own firm (they believe they’re bringing in
more money that they’re getting back).
- Meehan and Boyle talk to partners and associates asking, “If we were to leave, will you come with us?”
- They pose the same question to clients
- They rent office space, design letterheads, etc.
Partnerships Have:
Duty of Loyalty – Don’t be greedy
Duty of Care – Don’t be sloppy
- Colleagues begin hearing rumors of these plans; on 3 separate occasions Meehan and Boyle outright lied to
partners
- Boyle tells Shafer to delay cases until they are in the new shop → this sounds like a breach of the duty of
loyalty
o However, this was not done; no evidence of inappropriate conduct
- Boyle and Meehan set a Dec. 31 departure date – they are permitted to take cases that they brought in to the
firm but they had to pay to take other cases that they were working on
- Partnership agreement requires 3-month notice before leaving but Meehan and Boyle only give 1 month
because a senior partner had waived the requirement (ANY PARTNER HAS THE ABILITY TO BIND
THE PARTNERSHIP)
- Meehan and Boyle take 142 cases but Meehan leaves some 4,000 asbestos cases that he had attracted to the
firm.
- Court focuses on language in letters to potential clients: “Any notice has to explain to a client that he or
she has a right to decide who will continue representation.”
- UPA (1997) § 403(c) v. UPA (1914) § 20
o 1914 Act – information must be furnished only on demand
o 1997 Act – some information must be coughed up without any demand
* Here, the partners were asked so it doesn’t matter which act applied

Mark and Norma Hypothetical (pg. 125)

• Problems on Pg 125 – Mark and Norma are lawyers and have practiced as partners for 5 years. One day
Peter comes to their law offices, asks to see Mark, and tells Mark he has a brother who has been seriously
injured and needs a lawyer. Mark concludes that Peter’s brother has a strong case and is likely to be able to
receive a large judgment. Mark concludes at that moment that it is time to end his partnership w/Norma

25
 and begin practice on his own. If he does so, what are his obligations to Norma w/respect to the
representation of Peter’s brother?
o This is a violation of the duty of loyalty – taking opportunity away from partner, owe duty o loyalty
(similar to corporate opportunity doctrine)
Change the facts (keep an eye on whether the changes make it more or less of a partnership opportunity)
• 1. What if Peter approaches Mark in a local sports club rather than the office, but knows Mark is a partner
w/Norma? – doesn’t matter where discuss these issues, look at the nature of the relationship
o Look at - what is the partnership opportunity
• 2. What if Mark didn’t know Mark was partner’s w/Norma?
o Doesn’t matter
o If someone approaches you and doesn’t know you are in a partnership, you are still aware that you
are in a partnership
o Still a partnership opportunity
• Mark must be safely out of partnership opportunity before partnership opportunity presents itself
o The more steps that Mark takes while he knows of opportunity and still in partnership, not good
o Looking at the timing
• When can you take partnership Opportunity – shouldn’t come to you while still in partnership, owe
DOL while in partnership
o Cannot compete w/partnership
o If take opportunity from partner, need to show: - waiver from partner
 Can apply some of the corporate opportunity factors (factors will help you make your
case)

Basic Partnership Concepts

- Remember, UPA is our set of default rules, to govern partnerships where there is no
partnership agreement OR the partnership agreement is silent on a particular UPA topic…
o § 103(a): UPA sets out the default rules “to the extent the partnership agreement does not
otherwise provide.” The parties can, for the most part, provide whatever terms they want.
o Exceptions are listed in § 103(b), including:
 The partnership agreement cannot restrict the right to access for books and records
under § 403(b);
 Can’t eliminate the duty of loyalty under § 404(b), but can curtail it;
 Unreasonably reduce the duty of care under § 404(c), eliminate the obligation of
good faith and fair dealing under § 404(d), etc.
o § 301: sets out agency power of partners to bind the partnership to 3rd parties: each
partner is an agent for the partnership for the purpose of its business, and each partners’
acts for apparently carrying on in the ordinary course of the partnership business binds the
partnership, unless the partner had no authority and the third party had notice of this fact
(No actual or apparent authority).
o § 401: sets out partner’s rights and duties between and among themselves only – not
third parties: Some of the default rules [imposed unless the parties agree otherwise] that
we have talked about include:
o (b) profits are split equally, losses like profits;
o (c) partnership must reimburse/indemnify partners for liabilities in the ordinary course of
the partnership;
o (f) each partner has equal rights in the management and conduct of the business.
o (j) in the absence of an agreement to the contrary, matters arising in the ordinary course of
the business may be decided by a majority of the partners.
o Amendments to the partnership agreement and matters outside the ordinary course of the
partnership business require unanimous consent of the partners.
 Some partnerships often require a “super majority”
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  Why is it fair to require unanimous consent?
• Everyone signed on to the original partnership agreement
- Non-waivable Provisions – UPA (1997) 103(b) (pg 50) – there are a few
provisions that partners can’t opt out of, they are mandatory
- Few things can’t opt out of – 103(b) – mandatory provisions
o 1. Can’t restrict the right to access books and records – 403(b) (1997,
pg 57)
 Why? – need access to all books, b/c of unlimited personal liability
on all partnership debts
 Unfair if prohibited from seeing this info
o 2. Can’t eliminate duty of loyalty, but can limit it – 404(b) (1997, 57-58)
 If have prior dealings that might conflict can take this into
considerations
 Can have list of things that are separate
o 3. Can’t unreasonably reduce duty of care – 404(c) (1997, 58)
o 4. Can’t eliminate the obligation of good faith and fair dealing – 404(d)
(1997, 58)
- Partners as Agents – UPA (1997) 301 (pg 52) – each partner is an agent
of the partnership and each partner has the ability to bind the partnership as
long as the act is within the actual and apparent authority (scope)
o Every partner is an agent of the partnership
 Partners have ability to bind partnership w/the world
o Unless the partner has no authority and 3rd party had notice of this fact
o Important is the scope of partnership
o Acts in the ordinary course of partnership business binds the
partnership
o Not in scope – no liability, do not bind partnership
 Individual personally liable
o Partners can bind partnership UNLESS there is no partnership (or
outside scope – actual authority limited) and 3rd the 3rd party has notice
of this fact (no apparent authority)
- Rule – cant bind partnership if you lack actual and apparent authority
o In this situation, your scope has been limited and 3rd party knows this,
so no authority to act
- Partners Rights and Duties – UPA (1997) 401 (pg 56) – partners rights
and duties among themselves ONLY (not 3rd parties)
o Some default rules, imposed unless the parties agree otherwise:
 1. Profits and losses split equally (unless otherwise provided for) –
401(b)
• Agreement can split profits however they want
- 3 scenarios – depending on what is in the partnership agreement
o 1. Both profits and losses then do what provision says
o 2. If provision provides for just profits
 If no loss provision, will follow the profits provision
o 3. Just losses
 If no profits provision, split them equally
o If neither – split both profits and losses equally

27
 - Reimbursement - 401(c) – Partnership must reimburse/indemnify partners
for liabilities in the ordinary course of the partnership or for the preservation
of its business or property (if put money in, must reimburse – Ex. loans??)
o Indemnification – similar to reimbursement, except difference is
exposure to liability
o Partners have to be reimburse and indemnified for losses
- Equal Management Rights - 401(f) – each partner has equal rights in the
management and conduct of the business
o Each partner gets one vote (1 partner, 1 vote)
o Problem might arise if there are only 2 partners – need unanimous votes
in this case
- Unless there is agreement otherwise, these provisions can be waived
o UPA is default, can opt out and make agreements differently
- Majority Needed for Business Decision – 401(j) (pg 57) – unless
otherwise provided, something that happens in the ordinary course of
business may be decided by a majority of partners (problems occur when it is
2 person partnership – need unanimous)
o Usually, agreement might require super majority
o OR unanimous consent
- If outside ordinary course of partnership – if outside course of partnership
need everyone – unanimous
- Amendment to partnership agreement – require unanimous consent
o Why? – need unlimited consent to enter into partnership
 Every partner has unlimited liability for the actions of the other
partners so if you are going to do something that has nothing to
do w/the business and this will make the other partners liable,
they must give permission
• Too much at risk if this would not be required

Partnership Interest – See Slides B 11-15 (pages 2-3)

• Rule – addition of a new partner to a partnership ends the partnership
agreement
o Why? – b/c of unlimited personal liability, want to have control over who
you’re partners with
o Can’t just sell your membership to someone else
o When a partner leaves or a new partner joins, the pre-existing
partnership ends
o Need to reconstitute partnership
• A partner can assign rights under partnership
o Can assign right to receive profits to someone else if you want

Lawlis v. Kightlinger & Gray (pg. 125) RULE: When a partner is involuntarily expelled from a business, his
expulsion must be in good faith for a dissolution to occur without violating the partnership agreement.
Facts: Lawlis was an associate and then a partner in a law firm.
- His partners find out that he is an alcoholic [potentially problematic for his partners]
o Very relevant in partnership context because we have unlimited liability for those problems caused
by our partners
- Firm has a “No Second Chance” policy but they give Mr. Lawlis a second chance; he is forced to promise
never to relapse.

28
 - He has no relapse and wants to regain the powers he had prior to his illness – the partners expel him instead
but give him a unit of profits for 6 months in advance (he also is given health insurance for 6 months also)
o Vote to expel is 7-1 (Lawlis is the lone dissenter)
- Lawlis sues under the No Cause Expulsion Clause – you don’t have to have a reason
- What would be in an Expulsion for Cause Clause?
o Substance abuse
o Stealing
o Arrest
- Bad conduct must be able to fit into the register of For Cause Clause indiscretions
- Lawlis signed the partnership agreement with this No Cause Expulsion Clause.
- The fact that Lawlis was involved in his own expulsion meeting negates his argument that the partnership
was terminated when he was notified of his pending expulsion.
“Predatory Purpose?” – The partners simply wanted a greater share in the profits of the partnership?
- No Cause Expulsion Clause is the partnership agreeing to deviate from the default rules
- Even if court found this to be a predatory purpose it wouldn’t matter because they had the necessary 2/3
vote to do so under the agreement
Violation of the fiduciary duty?
- No breach of fiduciary duty as the executive committee had the right to expel plaintiffs without stating a
reason or cause pursuant to the Partnership Agreement

The Effect of Assigning Partnership Interest: Putnam v. Shoaf – RULE: A partner’s property rights in specific
partnership property, interests in the partnership, and the right to participate in the partnership’s management
Facts: Putnam (Plaintiff) sold all her interest in her partnership to Shoaf (D) in exchange for Shaof’s
assumption of personal liability on a bank note.
Issue: May a former partner recover an interest in a judgment obtained by the partnership after transferring his
or her interest in the partnership without knowledge of the chosen action’s existence? NO. Under the UPA,
a partner’s property rights include rights in specific partnership property, an interest in the partnership, and
the right to participate in the partnership’s management. A partner’s rights in the specific partnership
property, however, are not an “interest” in the partnership, for those rights reflect a mere possessory right to
the equal use of the partnership’s property. A sale of partnership property must be made in the partnership’s
name and not in an aindividual partner’s name. Therefore, Putnam has noo specific interest in the results of
the action against the bookkeeper for banks. Putnam clearly intended to dissolve the partnership by
transferring her interest to Shoaf. Although she was unaware of her full interest in the partnership at the
time of the transfer, she may not reform her agmt to reflect the value of the later-discovered interest. At the
time of the agmt, Putnam’s only interest in the partnership was a share of the prfits and losses, which she
intended to sell to Shoaf. Putnam isthus not entitled to judgement.
Essentially, the Court treats this as an assignment of Putnam’s interest: “The determinative question is: Did
Mrs. Putnam intend to convey her interest in the partnership to the Shoafs.”
Slides B 16- 18 (pages 3-4):
1. IS the Court Right?
a. Effect of assigning one’s partnership interest:
i. The partner’s interest is the partner’s share of profits and losses.
ii. UPA (1997) § 503(a)(2) codifies prior law that transfer of an interest
does not effect a dissolution of the partnership
1. A partner who has transferred his interest remains a partner!
a. See also UPA (1997) § 601(4)(ii), which authorizes
expulsion of a partner who transfers substantially all of
his interest
2. How should the transaction have been effected?
a. They should have dissolved the partnership, distributing the assets to Putnam
and the Charltons
b. Putnam then should have assigned her share of assets and liabilities to the
Shoafs via a quietclaim deed
c. Shoafs and Charltons then should have formed a new partnership,
29
 contributing the assets of the old one

Partnership Profits
- Profits divided equally (pro rata). UPA (1914) § 18(a); UPA (1997) § 401(b)
o This is default room unless partnership agmt says otherwise
- What if one partner contributed 60% of the initial capital? Change in result?
o NO – all partners share profits equally
o EXCEPT in the case of a limited partnership – there is a separate class of partners who
have limited liability, what you contribute to the enterprise determines what you get (get
back what you put in)
- What if one partner does 60% of the work? Change in result?
o YES - ?
- What if agreement allots profits 90%-10%: Alice-Bob but they split losses equally. Is this
enforceable?
o YES – they can opt out of certain default rules for the partnership if they so choose
(freedom to Contract)
o Each partner still has unlimited liability on all debts, however. A creditor is not a party to
the agreement and may sue for any available assets.
o If NO agreement as to profits, split them equally (in case where there is only an
agreement as to losses)
o When an agreement is silent on losses, they will be split in the same way the profits
are split
Example – From Slides B 2-3: 11, 12, 13
Alice is a partner in a three partner law firm who wishes to cash out and retire.
- Can Alice sell her membership in the partnership to Bob?
o NO – an addition to the partnership is an amendment to the partnership agreement (The partnership
is thereby dissolved); Alice does have some assignable rights, though [Right to share her income
from the partnership, etc.]
• A creditor has the ability to go after the personal assets of a partner as each partner has unlimited liability.
- Can a creditor seize partnership assets to satisfy a debt incurred only by a partner?
o NO

What is Partnership Property? Anything bought with partnership funds is partnership property
(except if you buy it with Pfunds then reimburse it yourself)
1. UPA (1997) § 204  Three rules of Partnership Property:
1. Any asset acquired in the name of the partnership is partnership
property
a. A transfer directly to the partnership in its own name
b. A transfer to one or more partners acting in their capacity as
partners AND the name of the partnership appears on the transfer document
2. If the partnership is not named, property acquired by one or more
partners is partnership property IF the document transferring title indicated the buter was
acting in his capacity as a partner
3. Property purchased with partnership funds in presumed to be
partnership property
Related: UPA (1997) § 404(b)(1): “A partner’s duty of loyalty to the partnership and the other partners includes to
account to the partnership and hold as a trustee for it any property, profit, or benefit …derived from a use by the
partner of partnership property, including the appropriation of a partnership opportunity”
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Capital Account – instrument to measure your ownership interest in the partnership (your interest
begins when you enter money into the partnership): it is a running balance reflecting each partner’s
ownership equity [UPA (1997) Sec401(a)]

Service Partnership – When one partner only contributes labor

See Slides – Partnership Capital Account: Loss Allocated (Alice & Bob) – Slides B 24-28
Initial Contributions: Alice- $10,000 / Bob- $1,000
- Allocation of profits increases capital account
- Allocation of losses decreases capital account
- Taking a “draw” (distribution) decreases capital account
See the rest of the slides for how it works out…

****Profits in the absence of an agmt, are split equally****

****Losses, in the absence of an agmt, the losses are split like profits ****
 So, in the absence of both, they are split equally. If you specify profits, then the losses are split that way. If
you only specify losses, profits are split equally.

Section 40 – Rules for Distribution (AFTER DISSOLUTION)

In settling accounts between the partners after dissolution, the following rules shall be observed, subject
to any agreement to the contrary:
The liabilities of the partnership shall rank in order of payment as follows:
I. Those owing to creditors other than partners
a. Outside creditors – like Landlord, Bank, Suppliers, Etc (all creditors who are not partners)
II. Those owing to partners other than for capital and profits,
a. Inside creditors – partners who have also lent money to the partnership (wears two hats:
partner and creditor)
III. Those owing to partners in respect of capital,
a. Capital contributions – capital account gets paid back
IV. Those owing to partners in respect of profits.

For the most part, what you do and what you put in does not matter – if one partner does 60% of
the work but is only entitled to 50% then he only gets 50%.
When a partnership dissolves, someone has to be the one to turn everything into money (selling
furniture, inventory) – this is the SURVIVING PARTNER and he gets “a little extra cash”
at the end
Otherwise, partners do not get paid to be partners

Creditors Access to Firm and Personal Assets

• When partnership creditors seek to attach the personal assets of a partner to collect
a debt, it is allowed
• Creditor can go after a partner’s individual assets for any partnership debts
o Unlimited personal liability (disadvantage of partnerships)
• However
o Personal creditor cannot seek partnership assets

Creditor of firm seeks to attach personal assets of a partner to collect debt. Allowed?
Yes. UPA (1997( Sec 306: all the partners are liable jointly and severally for all
partnership obligations.

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Creditor of partner seeks to attach assets of the partnership to collect debt. Allowed? No, cannot get
partnership assets. Creditor of Partner can only go after partner but cannot go after partnership!!

Abel, Baker, & Charlie form a partnership

Capital Contributions:
- Abel 55%
- Baker 25%
- Charlie 20%
→ Profits Track Capital
•Abel, only, votes to hire secretary. B&C vote no. B&C win. Secretary will not be hired – need majority of
partners to approve anything in the ordinary course of business
•Baker and Charlie vote to admit new partner, A votes no. This is outside the ordinary course of business,
requires an amendment to partnership agreement, so needs UNANIMOUS consent. No new partner.
•Baker and Charlie vote to increase their draw contrary to partnership agreement. A votes no. An amendment
requires UNANIMOUS consent.

Can get around UPA rules with K, except for the things listed in the Perretta case: (see slides 39-40)
• Cannot restrict right to access for books and records
• Can’t eliminate the duty of loyalty under 404(b), but can curtail it
• Cannot unreasonably reduce the duty of care under 404(c), eliminate the oligation of
good faith and fair dealing under 404(c), etc.

Partnership Management
• Ways to leave partnership
o Voluntarily leave
o Expelled (usually part of expulsion clause)
o Die
o Become incompetent
• Expulsion clause w/cause – if have caused, need to show it
o Ex. Arrest for crime, substance abuse, etc
o Can’t be discriminatory
 Illegal, won’t be enforced
• After partnership ends – fiduciary duties no longer owed
• Limitation on partnerships – Nat’l Biscuit v. Stroud
o Facts – one partner (A) tried to limit the power of the other (B), said he
wouldn’t be liable for the other partners (B) actions, partner (B) continued to
perform duties for grocery store, made deal w/Nabisco, Nabisco delivered and
wants to be paid, go after A, can they do this? – yes
 Question – is this conduct done within the ordinary course of business
• Yes, therefore don’t need partners’ consent
 Result – this is an invalid limit on apparent authority
• Even though Nabisco informed about limit, doesn’t matter b/c this
limitation on actual and apparent authority not valid
• A cannot escape liability, liable for the other partner’s actions,
liable b/c of the partnership
o Problematic when there is 2 person partnership
 B/c then majority won’t do, need unanimous vote
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 o Rule – each partner possess the power to make ordinary business decisions
that bind the partnership
 These actions done in the ordinary course of business do not require the
other partner’s consent
 Unilateral actions bind the other partners
o Any limitation on partners authority must be unanimous
o Rule – one party cannot unilaterally, w/o the approval of the other partners,
change the partnership agreement (i.e. limit authority)
 Can’t limit other partner’s authority, not binding (must be unanimous)
o How could partner limit liability from other partner? – dissolve partnership
• Partner Agent of Partnership – 301(1) (1997) (pg 52) – each partner is an
agent for the partnership for the purpose of its business; acts of the partners for
apparently carrying on in the ordinary course of the partnership business bind the
partnership unless the partner had no authority to act for the partnership, and the 3rd
party involved had notice
o So the partners (Freeman and Stroud) are agents for the partnership, for the
purpose of its business, which is to sell groceries
o Here – there is no evidence of any limitation on authority, so don’t need to
examine any notice issues – b/c there was no lack of authority to notify 3rd
party about
o Exception – if partner has no authority (actual or apparent) and 3rd party has
notice of this limitation on authority
• Partner’s Liability – 306(a) (1997) (pg 54) – partners are jointly and severally
liable for all partnership obligations
• Partner’s Rights and Duties – 401(f) – (1997) (pg 56) – all partners have equal
rights of management
• Partner’s Rights and Duties – 401(j) (1997) (pg 56) – in the absence of an
agreement to the contrary, matters arising in the ordinary course of the business
may be decided by a majority of the partners

• National Biscuit Company v. Stroud (pg. 140) RULE: Every partner is an agent of the partnership for the
purpose of its business, and every partner’s acts for apparently carrying on in the usual way the
partnership’s business binds the partnership, unless the acting partner has in fact no authority to act for the
partnership and the person with whom he is dealing knows that he has no such authority.
Facts: Stroud and Freeman are running a grocery store
- Definition of what a grocery store is varies GREATLY, but buying and selling bread is certainly within its
normal course of business
- Stroud tells Nabisco that he would not be personally responsible for any bread sold by them to his grocery
store.
- Freeman requests Nabisco sell and deliver bread to the store for the entire month of February.
- Stroud attempted to limit Freeman’s actual and apparent authority. He is UNSUCCESSFUL because:
o Actual Authorities of Partners:
 Buy/Sell groceries
 Buy equipment
 Maintain premises
Reasoning: Invalid limitation on authority
- Under UPA § 301(1), acts of the partners for apparently carrying on in the ordinary course of the
partnership business bind the partnership, unless the partner had no authority to act for the partnership on
this, the third party involved had notice.
- So the partnership is bound on the contract Freeman made with Nabisco, unless he lacked authority
and Nabisco had notice. Here, there is no evidence of any limitation on his authority, so we don’t
need to examine any notice issues- there was no lack of authority to notify Nabisco about.
- So Freeman and Stroud are agents for the partnership Stroud’s Food Center, for the purpose of its business
o Any limitation on this authority requires BOTH PARTNERS’ APPROVAL
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 - Partner had authority to act on behalf of Food Center so the notice to 3rd Party is irrelevant
• Under UPA § 306(a), partners are jointly and severally liable for all partnership obligations.
• Under UPA § 401(f), all partners have equal rights of management
• Under UPA § 401(j), in the absence of an agreement to the contrary, matters arising in the
ordinary course of the business may be decided by a majority of the partners.
What about Stroud’s comment to Nabisco? Does that affect Freeman’s ability to bind the partnership?
o NO – there must be NO ACTUAL AUTHORITY along with no apparent authority
→ Stroud’s only option is to dissolve the partnership if he was truly unhappy

• Summers v. Dooley (pg. 142) RULE: Absent a contrary agreement, each partner possesses equal rights to
manage the partnership’s affairs, and no partner is responsible for expenses incurred without majority
approval.
Facts: Summers and Dooley are partners in a trash collection business (2-person partnership)
- Under UPA § 301(1): every partner is an agent for the partnership for the purpose of its business.
- If someone in the partnership is unable to work they must pay their own replacement (per the contract
agreement)
- Dooley gets sick and hires a replacement. Summers suggests hiring a 3rd full time employee but Dooley
disagrees.
- Summers goes ahead and hires him anyway and he works for 15 months. The 3rd employee is paid by
Summers out of his own pocket.
- It looks as if Dooley is beginning to acquiesce, but Summers wants the partnership to pay half of the salary
(as it is a partnership expense)
o Summers says that Dooley collected profits that the 3rd man was earning for him for 15 months
while only Summers paid his wages (concept of estoppel invoked); Dooley should be estopped
from denying that this is a partnership expense as he approved it by his actions
Held: Court holds that Dooley is not responsible for the wages of the 3rd party
Summers is an agent for the partnership for carrying on trash collection, but Dooley can argue that he did not
authorize Summers to hire the new worker (as in Nabisco, partners cannot change the partnership’s liability
without a majority of the partnership’s approval)
- Stroud’s and Summer’s action are unlawful (Summer’s attempts to broaden, Stroud’s attempts to limit)
o Since a majority of the partners did not consent, the partnership is not bound (the same law is
applied to an attempted limitation or expansion)
o Both partners attempted to change their partnership’s liability on new contracts
•Summers is an example of a lawsuit for contribution
- Dooley correctly argues that Summers’ contribution is not a partnership debt
What kind of authority is involved?
- Summers never purported to hire the man on behalf of the firm, so the apparent authority principles of §
9(1) never kicked in (Summers hired the guy… not the partnership)

• A partner cannot bind a partnership if he has not been granted the authority to do so [he is only
broadening/limiting his personal liability

TO RECONCILE THE CASES: SEE SLIDES B 57-62 (pg. 10-11)

Comparing National Biscuit and Summers:

What is the nature of the claim at issue? Who is suing who?
 In National Biscuit, suit was brought by a third party seeking to hold the partnership liable for the
acts of one of the partners. TP v. P’ship
• In Summers, suit was brought by one partner against the other for contribution towards an
alleged partnership expense. P’ner v. P’ner
What about the kind of authority involved? Did the partner in question
have the authority to bind the principal?

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 • In National Biscuit, Freeman could bind the partnership to 3rd parties because
ordering bread was an act in the usual course of business for his firm, a point that
follows straight from apparent authority principles. The partnership could have
resticted that AA, but not without a majority vote and Stroud did not control a
majority. So no restriction on authority, and the partnership is bound.
• In Summers, arguably, Summer never purported to hire the man on behalf of the
firm, so the apparent authority principles of UPA §9(1) never kicked in. And even if
those principles has applied, they only would have governed the partnership’s
liability to the third party (here, the employee). They would not have governed the
allocation of expenses among partners, as per the partnership agmt or the UPA.
One way of looking at this problem is to see it as a conflict between two basic principles
of partnership law: i.e., the rule that all partners are agents of the partnership with power to
bind the parternship and the rule that all partners have equal rights to participate in the
management of the partnership.
Differences in cases:
o Between partners and some third party – National Biscuit
applies
 All partners are agents of the partnership w/power to bind the
partnership
 Can’t limit another’s authority unilaterally
o Between partners themselves – Summers
 All partners have equal rights to participate in the management of
the partnership
 Can’t hire someone on behalf of partnership w/o consent

Partnership Dissolution
Ways to dissolve a partnership:
1. Expiration of a term of partnership (easiest way to terminate)– UPA 31(1)(a)
(1914) (pg 39-40)
o Pick a point in time when the partnership will expire
o Can leave partnership early, but may have to pay damages
2. One Person leaving a Partnership at will – P.A.W. has no end date – UPA
31(1)(b)
o Voluntary relationship
o Goes on until someone wants out
o Not possible to terminate early, no such thing as early
3. Agreement of all parties (unanimous/majority vote) – 31(1)(c)
4. Expulsion of a partner – 31(1)(d)
o Must look at the terms of the partnership agreement
 Is there no cause expulsion?
 Sometimes might require notice or “for cause” or whatever
 Remember – whatever you set up, may be used against you
5. Subsequent illegality of the partnership purpose – if what you are doing in
partnership is illegal – 31(3)
6. Death of a partner – terminates partnership by operation of law, ends
automatically – 31(4)
7. Bankruptcy of any partner or partnership – partnership ends – 31(5)
o Why? - b/c partnership is subject to unlimited liability and don’t want to
have to pay debts of bankrupt partner
8. Court decree – incompetency, incapacity, misconduct – 31(6)
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 o When seeking to do this, means you are out of options
 Person won’t leave – can’t get enough votes, not able to expel
o Incompetence – if one person incompetent, unfair to ask everyone else
to have unlimited liability for his agreement
o Incapacity – physical incapacity, partner unable to perform partnership
duties
o Misconduct – partner doing illegal things
o Impracticality – partnership can only be operated at a loss
 Usually one person believes it will turn around and others don’t
 Show court no way partnership to make money current way being
operated

• When you fire an agent you terminate the actual authority (But you must also have a limitation on
apparent authority for this to be effective)
- For potential 3rd parties you still need to provide construction notice (newspaper publication, etc.)

Likewise, partners can agree to end their relationship but they still have responsibilities to the world…

REMEMBER: Section 40 – Rules for Distribution (AFTER DISSOLUTION)

In settling accounts between the partners after dissolution, the following rules shall be observed, subject to any
agreement to the contrary:
The liabilities of the partnership shall rank in order of payment as follows:
V. Those owing to creditors other than partners
a. Outside Creditors
VI. Those owing to partners other than for capital and profits,
VII. Those owing to partners in respect of capital,
VIII. Those owing to partners in respect of profits.

Dissolution v. Going out of Business

• A dissolution is simply the “change in relationship of the partners caused by
any partner ceasing to be associated in the carrying on” of the firm’s business.
UPA (1914) § 29. Dissolution is a legal determination.
- First dissolve partnership and then you must “wind up” the partnership
o “Winding Up” – selling all of the partnership’s assets, etc.
 Large chunk of money is then divided up by the partnership’s creditors
1) Pay outside creditors first – like Landlord, Bank, Suppliers, Etc (all creditors who
are not partners)
2) Pay Inside creditors next – these are partners who have also lent money to the
partnership (wears two hats: partner & creditor)
3) Lastly, non-creditor partners are compensated for the investments (any capital
contributions – capital account gets paid back)

• After dissolution a partnership can reconstitute itself with a new guest list (BUT, every time the
guest list changes the partnership ends)
- Upon dissolution, the authority of the old partnership is winding up [UPA (1914) § 33; UPA
(1997) § 804], unless there is a reconstitution

Dissolution Effect on Partnership

o Effect of Dissolution on Authority of Partner – UPA 33(1914); UPA 804
(1997) – upon dissolution, the authority of partners to act on behalf of the
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 partnership is terminated except in connection w/winding up of partnership
business
o If want to continue – UPA 802 – partners continue to continue partnership
after one person leaves, technically creates a new partnership
 Creditors of former partnership automatically become creditors of new
p’ship – UPA 41 (1914)

If new partner joins or a partner leaves – partnership is done, must reconstitute

and create new partnership:
1. Effect on Departing Partner:
o Departing partner is entitled to accounting
 Gets $$ based on fair value of the partnership
 Gets interest since dissolution in the event of an unreasonable
failure to pay
o Creditors of old partnership automatically are creditors of new
partnership and the partner who leaves is paid out - UPA 41 (1914)
o Departing partner remains liable on all former obligations incurred while
they were partner - UPA 36 (1914); 703 (1997)
o For future partnership debts, departing party must provide appropriate
notice to TP’s to cut off his personal liability
 Existing creditors – need actual notice
 All other’s – constructive notice
* A creditor that has lent money to a partnership while the partner was there can hold
partner liable for debts incurred AFTER the partner leaves absent notice of their
withdrawal
o Novation (relief of a debt) – can be released from personal liability if
partnership and creditor agree that leaving partner has no liability
 Absent a novation, withdrawing partner has liability for
anything that happened before he left
o Can a partnership release a former partner for all debts?
 NO – the only way that a partner gets out of liability is if the 3rd party creditor
agrees to the release as well (NOVATION – Agreement between partner,
partnership and 3rd party)
 It makes sense that both creditor and partnership MUST sign off on this agreement
o Options for Departing Partner – debts incurred before partner leaves
 1. Unlimited personal liability b/c no release from partner and no
novation (Likeliest scenario)
 2. If novation, and individual creditor signed off and partnership signed
off – no liability
 3. Partnership releases – binding between them (partnership can’t claim
departing partner is liable) but no legal affect on creditor (creditor can still
come after him)
 More difficult to get out of debts
 ***Multiple Choice Question*** - novation w/creditor, creditor lends
to old partnership again w/o you there, creditor can’t claim that person is
liable b/c creditor has actual notice that you are no longer a partner
o Debts after partner leaves – depends on notice to creditors
 1.Must give notice to 3rd parties so they know you are no longer a
partner, b/c they might act differently if you are no longer a partner
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  2. Must know if this new creditor or existing creditor
• Existing creditor – must have actual notice partner is gone,
otherwise departing partner still has personal liability
o Creditor may have loaned solely b/c of certain partner
o Withdrawing partner has unlimited personal liability on debts after
she leaves prior to creditors if doesn’t give actual notice
• New creditors – no personal liability
o Need to give constructive notice that no longer a partner
2. Effect on New, Incoming Partner – new partners joining existing partnership,
no liability for the debts incurred before you got there, unless expressly agrees to
be so held
If a new partner joins the firm when it continues after a dissolution, the new partner is also liable for
the firm’s old debts, but such liability can only be satisfied out of partnership property (ie capital
contributions). UPA (1914) § 41(1); UPA (1997) § 306(B).
o The new partner cannot be held personally liable for the old debts, unless he or she
expressly agrees to be held so.
o Limit liability to their capital contribution, not unlimited personal
liability
 Whatever you put into partnership when you join
 Ex. Give $10,000 when join, creditors can get that but that is all
 New partner not liable for things that happens before joined
(unless agree)

The Partner – Questions to Ask yourself on Exam??? – SEE ABOVE – OPTIONS FOR DEPARTING PARTNER
- Unlimited personal liability (likeliest possibility)?
- A novation signed off on by both parties and partner?
- A release contract which partner could sue partnership under – partnership releases
- What about debts incurred after she leaves?
- What is her connection to the debt?
- Is this a new creditor or an existing creditor?
o A creditor that has lent money to a partnership while the partner was there can hold partner liable for debts
incurred AFTER the partner leaves absent notice of their withdrawal
NOTE: It’s much more difficult to get out of debts incurred while you were a partner than those incurred after you exit.
- If you have a novation from a creditor and then that creditor is owed a debt by the partnership can you be held liable
on that new debt?
o NO

Term Partnerships
o Explicit term – duration specified in partnership agreement
 Either date or some event or condition being satisfied ends
partnership
 Specific purpose/object is specified in partnership agreement
o Implicit term – even if think joining partnership at will, may be seen to
join partnership for a term, Courts make this determination
 Ex. When partner lends money to firm, and the deal is that the
money will be paid back by partnership profits, courts will read in that
term of partnership that is must be until there are enough profits to pay
back that partner

• Owen v. Cohen (pg. 152) RULE: Courts may order the dissolution of a partnership if the partners’ quarrels
and disagreements are of such a nature and to such an extent that all confidence and cooperation between

38
the parties has been destroyed or if a partner’s misbehavior materially hinders the proper conduct of the
partnership’s business.
Facts: Owen and Cohen become partners in a bowling alley
- Cohen is terrible to work with and Owen sues for dissolution
- Owen had put up $6,986 to be repaid from the profits; treated as a loan (which would be paid first in the
winding up)
- Why would Owen sue for dissolution?
o It’s in his best interest to allow a court to step in and perform the dissolution
 Court read in that this was a partnership for a term [the term was defined as the amount of
time to pay back the $6,986]; judicial determination of status of loan required
 If Owen had attempted to leave before the end of the set term, he would have been deemed
in breach… thus, he opted for a judicial ruling on the issue.
- Potential for wrongful dissolution
o UPA (1914) § 31(b) v. § 31(2)
o Dissolution of a “term partnership” (a.k.a. “partnership for a term”) prior to expiration of the term
is “wrongful”
o Adverse consequences; see UPA (1914) § 38(c)
 Hence, “there always exists the power, as opposed to the right, of dissolution”

Partnership Hypo – SEE Similar Examples on pgs. 13-14 of B SLIDES

- Albert, Bette and Carol each own 1/3 of Roy Lumber Co., a general partnership
- They share profits and losses equally, and all purchases over $500 have to be authorized in advance by two partners,
and only Albert can draw checks.
- Bette, without permission and on the firm’s account, buys a $2500 bracelet, $5000 forklift and $2000 of logs from
Doug who runs a store with an eclectic inventory.
- Before Bette made purchases, Albert told Doug that Bette was not authorized to buy logs.
What kind of authority s Bette have with respect to the purchase of the logs?
- Bette can only buy logs with consent of 2 partners → Bette thus did not have actual authority to buy the logs
o Thus, the partnership has no liability on behalf of Bette to buy the logs
- Albert limited Bette’s apparent authority by speaking to Doug and telling him that Bette had no authority to buy logs
(a limitation on authority and a 3rd party who has notice)
* If there was no $500 limitation on the parties, this would be exactly like the Nabisco case
What about the forklift?
- Albert didn’t tell Doug that Bette couldn’t buy the forklift
- Doug was thus reasonable in believing that Bette was authorized to buy the forklift because this purchase would be in
the ordinary course of running the business [Doug had no notice of the limitation on Bette’s authority]
- Thus, the partnership is bound because Bette operated in the context of her apparent authority
What about the diamond bracelet?
- Buying a diamond bracelet is clearly outside the scope of the lumber business
- Bette has no actual authority in this purchase
- Apparent Authority?
o NO – diamond bracelet is outside of the scope of the lumber business so Bette would have no apparent
authority (She is liable for the debt incurred for the bracelet)

Additional Facts
- Doug comes to Roy Lumber to talk about the outstanding balances owed him. Albert won’t pay for Bette’s purchases.
- Doug calls Albert a bad name and Albert punches him in the nose. While Doug’s lying on the ground, an employee of
Roy Lumber negligently drops a log on Doug’s leg, breaking it.
What are Doug’s rights with respect to (1) the broken nose, and (2) the broken leg?
- Log dropper has liability but Roy Lumber is a bigger pocket (Doug will seek vicarious liability)
- Albert punches Doug (intentional tort) but this action is outside the ordinary scope of business
o The complaint upon the act MUST occur in the scope of business (if you have an intentional tort you
CANNOT HAVE VICARIOUS LIABILITY – i.e. hold the partnership liable)

Same Hypo:
Hypo - A, B, each own 1/3 of Roy Lumber, a general partnership; as per their partnership agreement,
they share profits and losses equally and all purchases over $500 have to be authorized in advance
by 2 partners, and only Albert can draw checks. B, w/o permission and on the firm’s account, buys a
39
$2500 bracelet, $5,000 forklift, and $2,000 of logs from D. Before B made these purchases, A told D
that B was not authorized to buy logs?
o D comes to Roy Lumber to talk about the outstanding balances owed to him. A won’t
pay for B’s purchases. D calls A a bad name, and A punches him. While on the ground, an
employee of Roy Lumber negligently drops a log on D’s leg, breaking it:
What are Doug’s Rights?
o Limitation on actual authority – only binding on 3rd parties that have notice
 If don’t tell TP, will think that all partners have the power (apparent authority)
to bind partnership on all ordinary partnership actions
1. Logs – there is limitation on actual authority which is valid and binding on Better b/c as per
partnership agreement she needed 2/3 majority on any purchase over $500 and logs cost $2,000
and she did not get permission so Bette has liability
o This limitation is binding on D b/c he had notice on limitation on actual authority (and
thus limitation on apparent authority b/c D has notice)
o Even though this is ordinary business practice, Better has no actual or apparent
authority and D has notice of this limitation
o What can Doug do? – partnership has no liability, only Bette has liability
 What if partnership was silent about writing checks? – partnership would be
liable b/c even though D had notice this would be an unreasonable limitation on
partnership agreement
2. Forklift – difference w/the log is D has no notice that B couldn’t purchase forklift and has no idea
about the $500 limit
o Actual authority – limited by partnership agreement
o Apparent authority – no limitation b/c D has no notice of limitation on actual authority
and this purchase was done within the ordinary course of running partnership business
o D’s rights – limitation not binding
 Partnership liable b/c B had apparent authority to make this purchase and D
had no notice of any limitation on B’s apparent authority
3. Bracelet
o Difference – this purchase is outside the scope of a lumber company
o Actual authority –none, can’t purchase anything over $500 w/o 2/3 partner agreeing
o Apparent authority – none, b/c bracelet is out scope of partnership agreement
 B never had apparent authority
 D could not reasonably believe that B had actual authority even though he
didn’t have notice of limitation on actual authority
 Liability – Bette only
4. Broken Nose
o Is there a difference in the injury? – yes, this is a tort
o A punched D
o Vicarious liability – need master-servant relationship, need negligent act within the
scope of agency
 No vicarious liability for intentional tort
 As soon as do intentional act, taken outside scope of business
o Rule – no vicarious liability for intentional torts
o Liability – only on A
5. Broken leg
o Tort
o Worker is servant of lumber company
o Negligently dropped log on Doug
o Done within scope of business
o Tort w/vicarious liability
o Liability
 Tortfeasor (worker) – probably won’t go after b/c has less money
 Partnership

III. CORPORATIONS

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Types:
• Public (aka Publicly Held)
- Shareholders are public and shares are listed for trade in the various stock markets
• Private (aka Closely Held or Private)
- Characterized by absence of a secondary market for its stock
- Often (but not always) a relatively small number of shareholders who actively participate in the
firm’s management
- May display many characteristics of partnerships
o Some are, in a sense, incorporated partnerships

MBCA – not the law, but a statement of what it should be – just a MODEL ACT
- Model Business Corporation Act
- NOT the law ANYWHERE
- DO NOT USE THE MCBA and say that it is the law
o On Exam, must let Albert know that MBCA is not the law, OR that it has been
enacted

5 Critical Attributes of a Corporation:

1) Separate legal entity
- Doesn’t exist physically; only legally
o The Corporation is a separate tax payer
 Double taxation – the corporation pays income tax as an entity and is also taxed on
dividends (disadvantage of corp status) (Partnership is in between for tax purposes b/c it is
not taxed on an entity level, only the profits each partner makes individually – that is why LLCs
came about)
o Has Constitutional Rights
o Corp can be a partner in a partnership
o Can sue AND be sued
 If want to sue, serve proess on agent of the corp (officer, director)
2) Limited Liability for Owners (when done correctly) – owners are shareholders
- Owners liability for firm debts is capped by individual contributions (“shares”)
o The most you can lose is what you put in and own
o Creditors – if run out of money before run out of creditors, creditors go away
- MBCA § 6.22(b): “Unless otherwise provided in the articles of incorporation, a shareholder of a
corporation is not personally liable for the acts or debts of the corporation except that he may
become personally liable by reason of his own acts or conduct.” (REMEMBER MBCA IS NOT
LAW – TELL ALBERT THIS, JUST A MODEL/SUGGESTION)
- i.e. If you behave yourself as a shareholder the most you can lose is the value of your shares [In
sharp contract to a partnership]
o Shareholders that behave properly are not personally liable for the acts or conduct of the
corporation (unless you become personally liable by reason of your own acts or conduct
then can pierce the corporate veil)
3) Separation of Ownership and Control
- MBCA § 8.01(b): “All corporate powers shall be exercised by or under the authority of, and the
business and affairs of the corporation managed by or under the direction of, its board of
directors….”
- Owners – Shareholders
- Board of Directors – manage the day to day operations of the corporation
- What can Shareholders vote on?
o Elect Board of Directors (MBCA 8.03-8.04)

41
  Requirements and Functions of the Board – MBCA 8.01(b)
o Amendments to Articles of Incorporation
o Bylaws – private document that sets out how corp will operate (MBCA 10.03, 10.20)
o Big ticket items (fundamental transactions) i.e. mergers (MBCA 11.04)
o Odds and ends (ie approval of independent auditors)
4) Liquidity
- Assets can be turned into cash (publicly traded stock has much more liquidity than privately
traded)
o Easy to find out liquidity because its traded on market
- Shares of stock are able to be sold UNLIKE PARTNERSHIP INTERESTS (partners can only
sign off on profits)
o Can usually sell share of stock unilaterally
5) Flexible Capital Structure:
- The permanent and long-term contingent claims on the corporation’s assets and future
earnings issued pursuant to formal contractual instruments called securities
o Many ways to package such claims: e.g. stocks and bonds
- Two ways to buy into Corporation:
o Creditors buy bonds, etc. [Creditors interest is paid back in installments]
 Will have to pay it back
 Creditors are NOT owners
o Owners buy stock:
 Doesn’t expire, no date when and where must be paid back
 If want money, can sell your stock (liquidity)

Difference between Debt and Equity Securities:

1. Bonds: Bonds and other debt securities typically consist of two distinct rights:
o The bondholder is entitled to receive a stream of payments in the form of interest over a
period of years
o At the end of the bond’s prescribed term (i.e. at maturity) the bondholder is entitled to the
return of the principal
• Bondholders are creditors, not owners
2. Equity securities (aka shares) represent “the units into which the proprietary interests in the
corporation are divided.”
- Residual claimants: equal right to participate in distributions of the firm’s earnings and, in the
event of liquidation, to share equally in the firm’s assets remaining after all prior claims have been
satisfied
o “Residuary” – those who get everything that’s left after outside/inside creditors are pad and
the shareholders are all paid (Common stockholders are residuaries)
- A limited right to participate in corporate decisionmaking by electing directors and voting on
major corporate decisions

Issuance of Stock:
• Board of Directors Prerogative – they vote on how it will be issued
- Shareholders involved only if:
o Board wants to sell more shares than are presently authorized in its charter (articles of
incorporation) – charter amendment requires shareholder approval
o Board of directors wants to issue a new class of shares not authorized in the charter

42
• If the charter authorizes the class of shares in question and there are sufficient authorized but unissued
shares, the board is free to sell shares for “any valid purpose” as long as the corporation receives adequate
consideration for the shares. (too many unissued can lead to corp takeover, though)
Capital Structure Terminology
- Authorized Shares: The articles must specify the max number of shares the corporation is
authorized to issue.
• Set up in articles of incorporation
• If want more shares – need to amend articles of incorporation
o Any amendment needs shareholder vote
o Want to avoid going to shareholders if you can, so want some
authorized and unissued shares left in corp
• Don’t have to issue all that is authorized
• 1. Some authorized stocks are unissued – powerful tool for board
o Allows them BOD to retain control over company, especially when
need to take issue to shareholders for approval, hold a lot of powerful
over vote if hold onto enough shares
• 2. Other stocks are authorized and issued- to the public
- Issued Shares: Sold to shareholders (the public)
o CANNOT EXCEED THE NUMBER OF AUTHORIZED SHARES
o Company can repurchase
o Outstanding Shares: The number of shares the corporation has sold/issued and not
repurchased.
 Once issued, they are outstanding (they are shares the corp doesn’t have)
 Authorized but unissued shares are shares that are authorized by the charter
but which have not been sold by the firm.
• Don’t want your number of unissued shares to be too high as this may lead
to corporate takeover
o Treasury Shares were once issued and outstanding, but have been repurchased by the
corporation
 This is when company goes back and buys authorized and issued shares
• Not considered issued anymore
• Owned by company
 Cannot be sold again!
So: ISSUED SHARES – OUTSTANDING SHARES = TREASURY SHARES

Example – Slide C-10 (pg. 2)

Charter authorizes the firm to issue up to 10,000 common shares -10,000 authorized (max
company can issue)
Company sells 2,000 shares to investors (These 2,000 are authorized, issued, and
outstanding)
 8,000 left - authorized, not issued or outstanding (just being held on to by company)
 Company buys back 500
• 500 – treasury shares
• Now – 1,500 shares authorized, issued, and outstanding
o Ex – articles provide for 200 authorized shares
 Corp can legally issue up to 200 (doesn’t have to issue any but this is max
they can if they decide to)
 201st share is a bad share, not authorized, legal, or valid
• Does not represent ownership interest I company
• Can only issue up to the amount authorized
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The Incorporation Process – How to Set up a Corporation
Need 3 things: 1. People (incorporators)
2. Paper (Articles of Incorporation)
3. Act (Filing Articles w/Secretary of State & Paying Required Fee)
I. Choosing a State to Incorporate in:
A. Delaware’s Dominance as the State of Incorporation:
- Friendly in allowing companies to come in
- No minimum capital requirements
- The need for only one incorporator (a corporation may be the incorporator)
- Favorable franchise tax in comparison to other states.
- For companies doing business outside of Delaware:
o No corporation income tax
o No sales tax, personal property tax, or intangible property tax on corporations
o No taxation upon shares of stock held by non-residents and no inheritance tax upon
non-resident holders
- 60% of Fortune 500 in Del. / 50% of stock market companies
- You don’t need to be located in Delaware to be incorporated in Delaware (When you
incorporate you want to choose a state that has laws favorable to you)
- A corporation may keep all of its books and records outside of Delaware and may have a
principal place of business/address outside of the state of Delaware as well
- Highly competent judiciary in company law and extensive and detailed case law on this subject
In Sum: People typically pick Delaware because it’s smart, cheap, and fast
B. Effects of choosing a state to incorporate in:
o Can only choose one state
o Can have locations outside of the state you’re incorporated in but can only be inc.
in one state
o Must be qualified to do business there
o Where you incorporate has several effects:
 Jurisdictional implications in lawsuits
 By incorporating there, you agree that that state’s corp law will bind you
• Want to pick law most favorable to your corp
• Internal affairs of corp, such as roles and duties of directors, may be
governed by the law of the state of incorporation (regardless if you don’t do any actual
business in that state)
II. Articles of Incorporation/Charter:
A. Mandatory Terms (MBCA § 2.02(a))
a. Name & Address of Incorporators (must have 1 or more)
i. Incorporator signs and files the articles
ii. Can be a person OR an entity (Majority View), but in NY it must be a person
iii. Often a lawyer
b. Agent for Service of Process
c. Registered Agent’s Address
d. Name of Corporation
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 e. Nature of the business or purposes to be conducted or promoted
f. Must have at least 1 class of common voting stock (the number of shares the corp is
authorized to issue – but remember, they don’t necessarily need to issue them all)
g. Must include corporation suffix: ie. Corp., co., inc. (MCBA 4.01)
B. Optional Terms – 2.02(b) – don’t necessarily need to be in the Articles
a. i.e. Names and addresses of initial directors
C. Must File the charter with the Secretary of State and Pay Required Fee
a. Under MCBA 2.03, Filing with the SOS starts the corporation’s life:
i. Proof of valid formation of business
ii. You are a corporation in the eyes of the law (“de jure corp”)

Post incorporation:
- Draft bylaws (MBCA § 2.06)
o Bylaws – in most states don’t have to have them but it’s a good idea to anyway
 Purpose is for internal governance
• Lays out responsibilities, sets meeting times
 Board of Directors adopts bylaws at organizational meeting
 Shareholders can amend or repeal bylaws (generally speaking)
 Conflict between articles and bylaws? Articles ALWAYS control
• This is bc bylaws are an internal doctrine, whereas the charter is filed with a state
agency
o Articles/Charter is a contract with the state!
- Organizational meeting (MBCA § 2.05)
o Elects first Board of Directors
o Board will then appoint officers
o Board will then approve sale of shares to the shareholders
- Issue stock

Promoters and Pre-Incorporation Liability:

I. Promoter: Someone who purports to act as an agent of the business prior to its incorporation
- He is acting on behalf of the corporation that hasn’t yet been formed
- Gets the corporation up and running (“advance team”)
- He is an organizer, acting as an agent, but isn’t really an agent (cannot be an agent of something
that does not yet existremember he is a promoter pre-incorporation)
- Promoter retains liability on pre-incorporation contracts unless and until promoter gets a novation
- Pay promoter either with stock or money
- EXAM: Whenever have promoter, look for liability – he might enter contract on behalf of the
corporation, but the corp has not yet been formed
Example: Promoter would like to get a deal for office space for a 3 year period
- Corporation he is working for has yet to be incorporated
- Promoter signs as an agent for yet to be formed corporation but he has not been authorized [because
corporation does not yet exist]
- Promoter believes that the corporation will ratify his contract [before this point promoter is an
unauthorized agent and liable for all of this debt]
II. Pre-Incorporation Contracts – contracts BEFORE there exists a legal corp
o Need promoter to enter into them before corp. is officially
formed
III. Liability on Pre-Incorporation Contracts
• Three Possible outcomes for pre-incorporation contracts signed by a promoter:
1. Promoter retains liability, corporation has none
o No novation & Corp did not explicitly or implicity agree to be bound by contract

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 2. Promoter and corporation both have liability
o No novation & Corp agreed to be bound either explicitly (through words) or implicitly (conduct)
 Implicit agmt to be bound- Conduct:
• Moving Into Office Space
• Accepts Benefits of Contract
 As a matter of law, actions taking advantage of the K is the same as explicitly
agreeing to be bound
3. Promoter has no liability, corporation has liability – requires NOVATION
o Only way for promoter to be relieved of liability for
pre-inc Ks is novation (agmt btwn Promoter, Corp & 3d Party). (Promoter retains
liability on pre-inc Ks unless and until he gets a novation)
• For novation, need Corp to agree to release him from the K, that only Corp is
bound, and the Third Party consents and agrees. (i.e. Landlord of Office Space)
Why won’t ratification work for pre-incorporation agreements?
 Ratification only works when there is an unauthorized act that
occurred – act could’ve been authorized at time entered into but wasn’t and
principal agrees to be bound later
 Why ratification won’t work now – can’t ratify b/c the day the promoter
entered into the pre-incorporation contract, there was no corporation in existence
• Corp didn’t exist at time of contract, so couldn’t have
authorized at time contract as made into
• Principal wasn’t in existence when unauthorized act occurred
o Why no agent b/c there was no actual principal (only purported
agent)
• Rule – can never ratify pre-incorporation contract b/c
corporation didn’t exist at time contract entered into
 Principal must be in existence when unauthorized acts occurred
 Need novation, not ratification

Note: Adoption - When a Corporation decides to ADOPT a K (i.e. a lease agmt) that the promoter put
forth pre-inc, it just means the Corp is liable too, but does not relieve the promoter if liability under the
K.

Remember: THIRD PARTY (i.e. Landlord) MUST AGREE TO NOVATION!

De jure v. De facto Corporations:

• De jure corporation: a corporation in good standing under the law, after filing of charter
• De facto corporation: acting like a corporation while not fulfilling legal requirements.
- Focuses on the efforts of the defendant:
o Allows the world to treat the entity as a corporation, if the organizers:
1. In good faith tried to incorporate
2. Had a legal right to do so [the existence of a statute allowing incorporation of
the venture], and
3. Some action as a corporation (carried on as a corp in some capacity)
Notes on De Facto Corps:
o Helps Corporations so SHs won’t be personally liable
for business debts of the Corp
o If found to apply, they are treated as a Corp for
all purposes!
o Gets partners off the hook of personal liability

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 Ex. Incorporators draft articles and mail them to sec of state, unknown
to them the papers get lost in the mail, but in the meantime are acting
like a corp and are unaware of failure to form corp and they have
entered business contract
• Are they liable on that contract – yes, unless the court applies de
facto corp
• Must tell Professor – they are liable b/v didn’t form a de jure
corp b/c never filed articles w/state unless court accepts and
applies de facto corp
o Must meet the 3 requirements
o Fairness plays into it
*See other example (Slide B-23 pg. 4)

Fine distinction to be drawn between De Facto Corporation…

- [often used in place of “actual” to show that the court will treat as a fact authority being exercised
or an entity acting as if it had authority, even though the legal requirements have not been met]
and Corporation by Estoppel.

Corporation by Estoppel
• Corporation by Estoppel is used to foster fairness in the law [the law will find a corporation by estoppel
to stop a 3rd party from benefitting misrepresentation, etc.]
- Treat firm as though it were a corporation if the [TP plaintiff] person dealing with the firm:
o (1) thought it was a corporation all along and
o (2) would earn a windfall if now allowed to argue that the firm was not a corporation
- This doctrine has nothing to do with the defendant making a good try. It comes from the injustice
created when you try to gain an advantage by changing your story as to the existence of a fact or
legal relationship.
- Stop third parties from benefiting from another’s failure to incorporate

• Southern-Gulf Marine Co., No. 9, Inc. v. Camcraft, Inc. (pg. 202) RULE: A defendant may not interpose as a
defense to a breach of contract that a plaintiff corporation lacked the capacity to contract because it was not
incorporated at the time it executed the K, unless the failure to incorporate actually harmed the defendant.
Issue: Does a party’s failure to have incorporated before signing a K with the defendant render the K
unenforceable? NO. LACK OF FORMAL CORPORATE STATUS DOES NOT EXCUSE
NONPERFORMANCE!.
Facts: Letter of agreement between Southern-Gulf and Camcraft, Inc.
- Southern-Gulf signs agreement as a corporation but they are not yet incorporated
- President of Camcraft signs on behalf of his company
- Barrett signs for Southern-Gulf personally and as an agent of the company
- Vessel construction agreement is then signed:
o S-G is considered a Texas corporation but it is chartered under the laws of the Caymans
- Camcraft does not build the boat b/c the contract to build the boat turns out to be not as lucrative as they
had first anticipated
- Camcraft defaults and S-G seeks specific performance as damages
Issue: Is there a valid breach of contract cause of action here?
- We may have a contract between Barrett and Camcraft but NOT between S-G and Camcraft (It was an
illusory contract but Camcraft is benefitting from the failed contract.
Holding: Camcraft is stopped to deny S-G’s corporate status
- Hence, S-G may sue to enforce the contract
Rule of Law: A third party who dealt with the firm as though it were a corporation and relied on the firm, not
the individual defendant, for performance is estopped.
If Camcraft was suing S-G they would not be able to say “Hey we’re not a corporation.”

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 → Thus this case is an upside down estoppel case – the party who is seeking recovery is the one who failed to
incorporate

When does estoppel apply?

1. After a defective attempt to incorporate, the participants in the venture themselves cite their
defective incorporation in an effort to escape liability on the contract with the plaintiff;
o the court will estop them from asserting the corporation did not exist and therefore the
contract is not enforceable when the contract was made supposedly on their behalf.
 This would apply is SGM if it were SGM who was trying to avoid liability on the
contract.
2. The more difficult application of the concept is to our actual SGM facts. The participants in the
venture [SGM] ask the court to estop a third party they have dealt with from denying the
existence of the corporation. Seems pretty straight forward, at first glance.
o The TP agreed to deal with a corporation, and is trying to weasel out based on facts that
really don’t impact it – they are just looking for an excuse to avoid liability. If they
were permitted to deny the existence of the corporation on these facts, they would get more
than they bargained for – a windfall.
 Reasoning in SGM: on the estoppel claim, the court finds that in order to weasel
out of a K due to the character of the organization to which is it obligated the
defendant would need to show its substantial rights might thereby be affected,
which it was unable to do.
 SGM is not a dejure Texas corp as stated in the K, but that fact hasn’t caused
Camcraft any substantive problems and Bowman was informed of the Cayman
Island incorporation and accepted it. So they are estopped from asserting the P’s
lack of corporate capacity when the Vessel Construction agmt was signed.
Limited Liability
- MBCA § 6.22(b): “…a shareholder of a corporation is not personally liable [Shareholder losses
limited to the amount the shareholder has invested in the firm – the amount initially paid by the
shareholder to purchase his or her stock] for the acts or debts of the corporation [A corollary of
the corporation’s status as a separate legal person; in the eyes of the law, it is the corporation that
incurs the debt or commits the tort and the corporation which must bear the responsibility for its
actions] except that he may become personally liable by reason of his own acts or conduct
[Exception clause encompasses ‘piercing the corporate veil’].”
o Remember: SH losses are limited to the amount the SH has invested in the firm – the amt
initially paid by the SH to purchase his stock
 Unlike partnerships, where creditors can go after personal assets bc of unlimited
personal liability
o No going after personal assets of an SH unless PCV

Tips to avoid PCV:

- Avoid “unity of interest” – respect the separate existence of the corporation, and your clients
probably won’t need to be concerned about personal liability. (*When there is unity of interest
creditors are allowed to disregard the corporate structure)
- Hold your statutorily required meetings, keep minutes, elect officers, etc., but, most
important, keep corporate funds and transactions separate from individual funds and
transactions and not constantly shift money in and out of the corporate account. Substantial
compliance is probably enough.

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Piercing the Corporate Veil (PCV) – exception to limited liability – This is when Shareholders become
personally liable by the reason of their own acts or conduct (usually applies to closed companies). This
allows creditors to disregard corporate structure. What is required to allow PCV:
(1) Unity of Interest = A total disregard for the separate existence of the corporation
a. Treats corporation assets and personal assets as interchangeable
i. Shareholder treats Corp as alter-ego
b. Bad Facts  Strong evidence that need to PCV:
i. No shareholders, No BOD
ii. No minutes, no officers
iii. NO separate bank accts (commingling of funds)
iv. Using company car as personal car
v. Using corp credit card to pay for personal expenses
(2) Injustice elements (NOT required by ALL Courts!!!remember to mention this!)
a. Do all courts require that second element?NO; for some courts, however, a total disregard for
the separate existence of the corporation is enough, on the theory that if the shareholder ignored the
separate existence it would be unjust for the creditor to be required to respect it.
b. For the courts that do require it:
i. Try to avoid fraud or unfairness
ii. Proof required – more than just failure of creditor to receive money
iii. Tort v. Contract – Higher standard for Ks bc it’s a voluntary agmt.
1. The tort creditor is a much less voluntary structure

Remember: Courts are more willing to pierce the corporate veil for TORT than for Contract!

Note: Under CERCLA (Comprehensive Environmental Response, Compensation and Liability Act), a
parent corporation may be liable under traditional PCV principles. It may also be liable for its direct
participation in operating a hazardous waste site, where its agents directly operate, or participate in
operating, the facility on its behalf.

• Walkovszky v. Carlton (pg. 207) RULE: Absent an allegation that the defendant was conducting business in
his individual capacity, a complaint charging that an individual defendant organized a fllet of taxicabs in a
fragmented manner solely to limit his liability for personal injury claims is insufficient to hold the individual
liable for the claim
Issue: May a plaintiff recover against individual stockholders if a corporate structure limits the
corporations’ liability for personal injuries, even if there is no showing that the stockholders used the
companies for person, rather than corporate, gain? NO.
- An attempt to pierce the corporate veil of the cab company
Facts: Plaintiff was hit by a cab and severely injured
- He could sue either the cab driver or the corporation that owns the cab
- Owner owns 10 cabs in 10 different companies to try and avoid liability (each cab only has the minimum
insurance coverage required)
- Plaintiff tries to sue Carlton, cab owner, along with all of his other holdings in the 10 corporations [Carlton
frequently drained corporate assets]
- Plaintiff needs to show unity of interest (plus maybe injustice) to be able to pierce the corporate veil
- Bad facts for the D: companies share same financing, supplies, repairs, employees, garages (But P Loses)
- The 10 corporations use the same premises, phone lines, drivers, etc.
o Enterprise liability?
 All 10 corporations were alleged to be part of a single enterprise that actually conducts the
business, so plaintiff ought to be able to recover from any or all of the 10 in the enterprise.
 Going through the corporation to related corporations
 What we need for enterprise liability is to show that these companies were all the
same entity
o Enterprise liability only works when the companies that you have brought into the corporation have
other assets (“Horizontal Veil Piercing”); Cabs were highly mortgaged and not worth much
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  Looks at a unity of interest between corporations and allows you to sue each as a single
entity
 Enterprise liability allows you to scoop up assets horizontally (through corp to related
corp)
 PCV allows you to get at individual shareholders (Here, PCV is the only option for
plaintiff because the other corporations are basically judgment proof as well)
This case, poss could’ve PCV but P tried for enterprise liability – There is a unity of interests between
and among corporations, but D was separate from all this (stops liability)
Walkovsky’s Alter Ego Doctrine:
- By what standard will the Walkovsky court decide whether to pierce the veil and hold Carlton liable?
o The court will only PCV whenever necessary to prevent fraud or to achieve equity.
Holding: The court thus refuses to pierce the corporate veil.
What could we do to fix this inequitable result?
- Raise minimum insurance rate (but we will all pay the price for this legislative move in the form of higher
premiums)

What does Enterprise Liability depend on?

- It depends on proof that Carlton did not respect the separate entities of the corporations – for example,
here are some factors to consider in determining whether two or more corporations have been operated as
a single business enterprise:
(1) Common employees;
(2) Common record keeping;
(3) Centralized accounting;
(4) Payment of wages by one corporation to another corporation’s employees;
(5) A common business name;
(6) Services rendered by the employees of one corporation on behalf of another;
(7) Undocumented transfers between corporations;
(8) Unclear allocation of profits and losses between the corporations;
(9) The same officers;
(10) The same shareholders; and
(11) The same telephone number.
The Formalities Issue
- Many of these cases place great emphasis on factors like failure to comply with corporate
formalities. Why are such factors relevant?
o If SH won’t treat the corp as a separate entity, the courts won’t prevent creditors from
doing this either

PCV in Illinois: Sea-Land Services, Inc. v. Pepper Source (pg. 212) RULE: In order to pierce the
coporate veil and impose individual liability, a creditor must show (1) that there was such a unity of
interest between the individual and the corporate entity that separate identities no longer existed, and
(2) that a failure to do so would promote “injustice” in some way beyond simply leaving a creditor
unable to satisfy its judgment.
“INABILITY TO SATISFY A JUDGEMENT IS INSUFFICIENT TO PCV”
Facts: Sea-Land shipped peppers for Pepper Source, who never paid the bill
- Pepper Source had no assets even though Sea-Land successfully sued them
- Marchese owns PS and 4 other business entities who had other assets
- Sea-Land thus wanted to go after Marchese by saying ‘unity of interest’ and injustice
- Van Dorn Test for PCV [Illinois] ALBERT- “same in NY”:
(a) A unity of interest and ownership between corporation and shareholder, AND
(b) A situation where failing to PCV would either
i. Sanction fraud [don’t need proof of intent to defraud creditors];
or
ii. Promote injustice.
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Analysis: To determine whether (a) exists, courts look at four factors:
(1) the lack of corporate formalities
(2) the commingling of funds and assets,
(3) under-capitalization, and
(4) the use by one corporation of assets of another [which sounds to me a lot like
commingling]
- Marchese satisfies elements (1), (2), (3), and (4) and meets the (a) prong of the Van Dorn
test.
How do you show that failing to PCV would promote injustice [(b) prong]?
What kinds of behavior would satisfy the court?
- Intentional scheme to hide assets, etc.
Holding: Court finds that fraud and injustice test is met
- Marchese engaged in tax fraud, fraud, and used corporate assets for his own gain (* Using
corporate formalities for his own good)

REMEMBER – SOME STATES ONLY REQUIRE UNITY OF INTEREST OTHERS REQUIRE UNITY
AND FAILURE TO PCV WOLD RESULT IN INJUSTICE OR SANCTIONING OF FRAUD (Ex. IL)
• Enterprise liability (remember, different w/PCV) – going through corp to include
other’s corp’s
o When use – easier to show all corp’s are really 1, 1 payment system, same
owners
 Easier to show this than 1 person was creating fraudulent corp
 Use if when the corp you are suing has nothing, but corp is considered
part of other corp’s that do have assets
 If related corp’s that fall within same business (unity of interest), then
want to bring them in if they have assets
o Won’t use – when non of corp’s have assets
 Then will try to go after shareholder himself (PCV)
 Going through corp to get to the shareholders (piercing)
 When use PCV – when corp has no assets but shareholders does and
claiming he is not observing unity of interests

Derivative Lawsuits - i.e. Shareholder Derivative Actions

o Derivate suit – A suit in equity against a corporation to compel it to sue a third party
o Cause of action to force a corporation to do something
o Shareholder suing to enforce corporation’s claims, NOT personal claim
 i.e. Corp not taking action about something and SHs want something done
o The quintessential derivative suit is a suit by a shareholder to force the firm to sue
a manager for fraud
o SH is plaintiff, sues on behalf of Corp
o Recovery – no personal recovery, any recovery goes to the corporation and not to the
SH (bc there is no personal injury, you were injured as a result of corp being injured)
 Obviously SH benefits proportionately as to amy of shares owned

Shareholder must bring the lawsuit to the attention of the corporation; if corporation does nothing
shareholder has the authority to pursue the cause of action on its behalf. YOU ALWAYS NEED TO
GIVE THE CORPORATION NOTICE – must always give corp. the chance to do the right thing.

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Hypo: You invest in a firm that sells iPod nanos.
- The value of your stock decreases because the asset base decreased
- You are secondarily injured because the company lost money (you are derivatively injured)
o Why can’t shareholders go after directors individually?
 Business Judgment Rule – defense raised by officers/directors who are sued in their
capacity as officers/directors (courts are reluctant to 2nd guess business decisions)
• Court looks to the decision – if it had a rational business purpose and it turned out
to be a bad decision officers/directors have immunity from suit
 Directors would have no time to direct the company if they were inundated by multiple
suits from shareholders [Policy concern – too many cases in the courts]

Direct Suit vs. Derivative Suit

Direct:
- Alleges a direct loss to the shareholder
o i.e. everyone got money from the corp except for the SH
- Brought by the shareholder in her own name
- Cause of action belonging to the shareholder in her individual capacity
- Arises from an injury directly to the shareholder
- Get money directly whereas in derivative only get money proportionately to shares you own
- Ex: if directors reconfigure SHs rights to harm preferred SH to the advantage of the common SH,
then the preferred SH has a direct claim
Derivative:
- Alleges a loss to the shareholder that derives from a loss to the corporation.
- Brought by a shareholder on corporation’s behalf.
o In the corp’s name
o Corp is injured, and as a result, I as SH am also injured (1 step removed from direct)
- Cause of action belongs to the corporation as an entity.
- Arises out of an injury done to the corporation as an entity.
- Ex: if a manager runs away with corp funds, the SHs have a derivative claim

Why would plaintiff rather bring a direct suit than a derivative suit?
- More $ for single plaintiff in a direct suit
- Some states have many procedural hurdles to derivative suits (attempts to weed out “irrelevant and
spurious suits” – e.g. post a bond, etc.)
1. Bond posting statute – statute that requires plaintiff to put up money
o
(security)
 If win – will get it back
 If lose – you pay the expenses
 Rationale – want to eliminate frivolous suits
 Want people to be serious about the suit they are bringing
 Rule – of statute requires bond, can request bond at any time during
pending litigation, don’t have to make request when litigation first filed
(Cohen
• But must request before litigation begins
 It is possible that a bond posting statute may be a bar to bring suit
 If I were lawyer for corp – in articles would have choice of law be a
state that requires bond posting statute
o 2. Demand (more notes below)
What do bond posting statutes add to this and how do they work?
o These statutes create liability for the corporation’s reasonable expenses if
the suit fails by requiring posting of security for the reasonable expenses by SHs

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 owning less than some set percentage or dollar amount of shares who brings a
derivative suit.
- D. Examples
o 1. ABC Corp entered into contract w/Jane Jones
 Jones breached contract, but ABC has not sued
 May a shareholder sue her directly? – no, shareholder not in privity,
can’t stand in the shoes of corp (suffered no personal damage)
 Can sue derivatively, sing ABC to force them to deal w/Jones’s breach
o 2. ABC corp’s treasure embezzles all its money and absconds?
 Shareholder’s stock now worthless
 May not sue directly, only derivatively
 Shareholder stands in the shoes of the corp

Questions to ask when deciding between direct/derivative suit:

• From Tooley v. DLJ
- Who suffered the alleged harm: the corporation or the suing stockholders?
- Who would receive the benefit of any recovery or other remedy, the corporation or the
stockholders, individually?
• For instance:
- If directors reconfigure shareholder rights to harm preferred shareholders to the advantage of the
common, then the preferred have a direct claim;
- If manager absconds with corporate funds, the shareholders have a derivative claim.

Plaintiff Qualifications: shareholder statutes:

• MBCA § 7.41(1): A shareholder may not commence or maintain a derivative proceeding unless
the SH:
o Was a SH of the corporation at the time of the act or omission complained of or
became a SH through transfer by operation of law from one who was a SH at that time;
o So creditors may NOT bring derivative suit
• MBCA § 7.42: more support that plaintiff must be a
shareholder:
o No shareholder may commence a derivative
proceeding until:
o Written demand has been made upon the corporation to take suitable action; and
o 90 days have expired from the date the demand was made unless the SH 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.
Plaintiff Qualification: Fair and Adequate Representative:
• MCBA 7.41(2):
o A shareholder may not commence or maintain
a derivative proceeding unless the shareholder:
 Fairly & adequately represents the
interests of the corporation in enforcing the rights of the corporation

Questions:
On what grounds might one challenge a plaintiff’s fairness or adequacy?
- Must have clean hands [Not a member of board who contributed to wrongdoing]
Why should this matter – what’s wrong with buying a lawsuit?
How about a plaintiff who buys the share after the wrongdoing?

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 * The shareholder is in a fiduciary role
- he is a “self chosen representative” and so courts find it reasonable to impose standards of
“responsibility, liability, and accountability”

Plaintiff Qualifications - more notes

• Rule – once a derivative suit is brought, no other derivative suit for that cause
or action can be brought alter by another shareholder
o Corp will not face multiple lawsuits on the same issue
o Lawsuit can’t be brought again, only chance for fellow shareholders
• A. Shareholder Status – Standing
o Standing – MBCA 7.41(1) (pg 201) – must be a shareholder at the
time the alleged wrongdoing
 Limits standing to shareholders
 Creditors may not bring derivative suits
 Must own shares at time alleged wrongdoing occurred
 If buy later – may benefit, but you cannot be the one to bring suit
• B. Contemporaneous Ownership – must be a shareholder when suit
commenced
o Throughout proceedings? - require that a shareholder remain a
shareholder though final judgment
o Need at least 1 shares
o Need a “horse in the race”
o Rationale – want to weed out those people who have no stake
 Don’t want people “buying a lawsuit”
• C. Adequate and Fair Representative – person pick to bring suit must be a
fair and adequate representative
o Fair and Adequate Representative – MBCA 7.41(2) (pg 201) -
Named plaintiff must be a fair and adequate representative
• D. Role of Shareholder in Derivative Suit – the shareholder is in a fiduciary role
o “Self chosen” representative and so courts find it reasonable to impose
standards of “responsibility, liability, and accountability”
• E. Policy Concerns – derivative suit belongs to corp
o Must look at why corp doesn’t want to sue
 Need rational business purpose for corp’s reason not to sue (BJR)
• F. Why Derivative Suits are good? – way for shareholders to hold directors
accountable
o Must have reasons for decisions made or else shareholders can judicially
question decision
• G. Bad news – potential abuses, a lot of lawsuit, want to filter out the frivolous
suits
• H. Who Gets Recovery? – corporation
o Lawyers – drive litigation b/c they get piece of it
o Would like the shareholder to be a longstanding shareholder
 Don’t like to see someone coming along being persuaded by
lawyer
o Bond posting statute – requires you to put up cash in order to show
claim has merit
• Why should it matter if someone buys shares and then sues? – if not invested
in corporation then have no interest in it
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 o Want someone who is committed to success of corp
o Want owners who have corp’s best interest in mind
o Rule – when corp’s merge out of existence, still have standing
 Usually arguing that corp shouldn’t have merged for some reason
REMEMBER:
Good news: Derivative suits allow shareholders to hold directors accountable
- Supreme Court called it a “remedy born of stockholder helplessness”
Bad news: Derivative suits reap a lot of lawsuits (filter out frivolous suits with requirements)
- Potential abuses like strike suits – meritless nuisance suits brought for settlement value

• Cohen v. Beneficial Industrial Loan Corp. (pg. 232) RULE: A NJ statute that requires a holder of less than
5% of a corporation’s outstanding shares who brings a derivative suit to pay for all expenses of defending
the suit and that requires security for the payment of these expenses should be enforced in cases prosecuted
under federal diversity jurisdiction. Aka: “A COURT MAY REQUIRE A PLAINTIFF TO POST A BOND
IN A DERIVATIVE SUIT”
Facts: Cohen is a shareholder who is upset that the directors and officers were enriching themselves to the
sum of $100 million over 18 years
- Plaintiff owns .0125% of the shares in the company
- Delaware corporation but the court is dealing with an N.J. statute
o N.J. statute permits plaintiffs with $50,000 worth of stocks, only, to bring suit without posting a
bond [to shield against frivolous suits]
o This statute discriminates against small interest shareholders
 Cohen doesn’t own enough to get around this statute; Cohen could have gotten around this
requirement by tacking his holdings on with others
- Delaware HAS NO BOND POSTING STATUTE (Thus Cohen wants DE state law to be controlling)
[FRCP 23.1 does not require bond posting, either]
- The corporation requests that Cohen posts bond 2 years in to the litigation (are they too late?)
o Statute applies to “any case before final judgment”; So NO – Corporation is not too late
- Statute does not offend Due Process Clause because it is not unlawful discrimination
o Since the statute requires the payment only of the corporation’s reasonable expenses, it does not
offend the Due Process Clause. The application of the statute only to those whose shares are worth
$50,000 or less is not a denial of equal protection.
Is it possible that this bond posting may be a bar to bringing a suit?
- Yes, but this cost does not outweigh the danger of too many frivolous suits
See slides re: Cohen: B 13-17 (page 3)

Why does choice of law matter? – some states require bond posting, some
don’t
o DE – no bond posting statute
o NJ – bond posting statute

• Eisenberg v. Flying Tiger Line, Inc. (pg. 236) RULE: An action seeking to overturn a reorganization and
merger that deprived an acquired corporation’s shareholders from having a voice in the surviving
corporation’s business operations is a person action rather than a derivative action under the NY statute
requiring the posting of security for the corporation’s cost. Aka: “AN ACTION TO REVERSE
CORPORATE ACTIONS THAT DEPRIVED SHAREHOLDERS OF A VOICE IN OPERATIONS IS NOT
DERIVATIVE”
Facts: Flying Tiger is an Air Freight company (an industry heavily regulated by the govt.)
- Flying Tiger sets up the subsidiary Flying Tiger Corp (FTC)
o FTC organizes another subsidiary called Flying Tiger Line (FTL)
- Flying Tiger merges into FTL, and FTL gains all of FT’s assets
o FTL renames itself FT and takes over operations
o Thus, the operating company (FTL) is now owned by its holding company (FTC)
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 - The shareholders of old FT received an identical number of FTC shares
- Flying Tiger owned all shares in FTC; FTC owned all shares in FTL – However, Flying Tiger had MANY
PUBLIC SHAREHOLDERS (including plaintiff)
• FTC is a Holding Company – they don’t do or make anything (due to restrictions on the airline industry this
status allows FTC to do things that FT or FTL could not)
- Shareholders had to give up stock in FT but were given stock in FTC, the holding company
o Eisenberg is angry that he had held shares in an operating company; as a result of this transaction
he obtained shares in a holding company (FTL is now the operating company, and thus Eisenberg’s
right to elect directors is now once removed)
o The series of corporate maneuvers were designed to dilute his voting rights and his ability to
control the air freight company
* A merger needs to be approved by both companies
Is Eisenberg really hurt by the merger?
- All he needed to block the merger was 1/3 of the shareholders’ votes (he voted on fundamental changes in
the operating company – now he votes on fundamental changes in the holding company)
o If he could not contest this reorganization, he could hardly hope to accomplish much with a direct
vote on the operating company
- Because FTC wholly own FT (the new operating company), and those FTC directors vote the FT stock,
they vote on the fundamental changes to FT and elect its directors
- Eisenberg’s interest is a bit more indirect than before, but not by much [He hasn’t lost much by way of
voting rights]
What he argues that managers of FT could now shirk their duties more?
- In other words he might have argued that the shareholders’ DIRECT vote helped to constrain the managers
and ensure corporate efficiency
- This is no longer a direct suit (now this gets into the realm of derivative suits)
So defendant argues:
- FT claimed that Eisenberg’s suit was derivative, and moved for him to be required to post security for the
corporation’s cost.
Why did FT go down a procedural road rather than argue the case on the merits?
- To claim that this was a derivative suit is cheaper than litigating on the merits
o Bond posting statutes tend to have a bit of a chilling effect
See all slides relating to this case: Slides B-18-25 (pgs. 3-5)

Note and Question on Individual Recovery in a Derivative Action: Lynch v. Patterson (pg. 241)
- Unusual fact pattern: in stockholder derivative action, trial court did not err in awarding judgment in favor
of minority stockholder as an individual rather than to corporate treasury, as corporate recovery would
simply return funds to control of wrongdoers, and as ordering payment to corporate treasury would risk
necessitating subsequent suit by minority stockholder to compel directors to declare dividend or apply the
funds to legitimate corporate purposes.
- The court said: Direct recovery assures that Patterson will reap some benefit from his lawsuit.
- * Only possible because by its nature this area of law is equitable

DEMAND
• Most states require P’s in a derivative suit to approach the board
and demand that it sue the alleged wrongdoers
o Must put BOD on notice of the grievance – its possible but unlikely that
corp will respond to this demand
• If demand required – the failure to make demand is a procedural barrier and
the suit will be dismissed (unless and until the demand is met)
o Odds are that if shareholder knows, the board knows (but sometimes
not)

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 • Demand – MBCA 7.42 – requirement that everyone makes demand, must
wait 90 days before suit, but the corp would be irreparably harmed before 90
days, 90 day requirement may be waived
• Waiving of Demand – FRCP 23.1 – demand can be waived if P can show
reasons for failure to receive demand or for not making the effort
o Allowed in most states
• How are MBCA 7.42 and FRCP 23.1 different?
o 7.42 – implies only 90 days can be waived
o 23.1 – implies that demand itself may be waived
 Law it most states excuses demand if futile
• Procedural aspect
• Most states – most states require plaintiffs in derivative suits approach the
board and demand that it sue the alleged wrongdoers on behalf of the corp
o Notice function – puts board on notice that there is some wrongdoing
 Not a personal problem, but shareholder has a problem w/the way
the corp is being run
 Chance corp will take care of it themselves
 Problem – when make demand, waive the right to say didn’t
need to make demand (reason why usually don’t make demand)

What’s the purpose behind the demand requirement?

- According to the Marx court [which sets the standard for demand excusal under NY law], the
purpose of the demand requirement is (**PAY ATTENTION ON EXAM TO WHICH ONE IS
BEING USED WHEN TRYING TO FIGURE OUT WHETHER OR NOT DEMAND
WILL BE EXCUSED**) (Marx Slide B-30 pg. 5)
o To relieve courts from deciding matters of internal corporate governance by giving the
directors the opportunity to correct the alleged abuse
 Court doesn’t want to get involved in the internal operations of the corporation
 Court won’t second guess internal corporate reasons
o Provide corporate boards with reasonable protections from harassment suits on matters
within the board’s discretion
o Discouraging strike suits commenced by shareholders for personal gain and not for the
benefit of the corporation
- According to the Grimes court [which sets the standard for demand excusal under DE law], the
purpose of the demand requirement is (Grimes Slide B-31 pg. 6)
o “by requiring an exhaustion of intercorporate remedies, the demand requirement invokes a
species of alternative dispute resolution procedure which might avoid litigation
altogether.”
o If litigation is beneficial, the corporation, not the shareholder, can control the proceedings;
o If demand is excused or wrongfully refused, the stockholder can control the litigation.
→ Allows the shareholder to give the corporation notice of the case (and allow the corporation to take
over litigation); if the corporation chooses not to take the case the shareholder may thus pursue her claim
derivatively.

• We are concerned about impartiality on the board, however, and asking them to pursue this claim of
wrongdoing is problematic.
- *Corporate officers are protected from bad decisions as long as when they were made the
decisions made good business sense (Business Judgment Rule)

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 o When we doubt that corporate officers were not fair or were acting in their own interest we
will not require a demand [when you make a demand you waive your right to demand
excusal]
o Also, when you make this demand the board has discretion to either refuse or accept
- “Demand is excused if we doubt the business judgment (impartiality) of the board of
directors.”
o Board must show that their actions were reasonable at the time
o Demand futility is found only where there is an inability by the board to practice good
business judgment
 When board is so disabled by conflict of interest to practice impartiality they lose
the protection of business judgment rule

Arguments FOR the corporation controlling the litigation:

- Derivative suits can act as a mechanism of managerial accountability; there is a potential for
bias in interested director transactions – the directors cannot realistically be expected to sue
themselves
- The cause of action belongs to the corporation – like all assets, litigation under control of Board
of Directors
- The shareholder may have interests diverse from those of corporation – shareholders lawyers
often real party in interest
- Therefore, Board of Directors should have some say in whether to go forward

The demand itself: What is it?

Statutory Authority re: the demand:
• MBCA § 7.42: “No shareholder may commence a derivative proceeding until … a written
demand has been made … and 90 days have expired from the date the demand was made …
unless irreparable injury to the corporation would result by waiting for the expiration of the 90-
day period.”
• FRCP 23.1: The complaint shall allege “the efforts, if any, made by the plaintiff to obtain the
action the plaintiff desires from the directors… and the reasons for the plaintiff’s failure to
obtain the action or for not making the effort.”
How are they different?
- MBCA implies that only the waiting period can be waived; *Demand is always necessary
- FRCP implies that demand itself may be waived – the law in most states excuses demand if
futile

What is “The Demand?”

- Typically a letter from shareholder to the board of directors.
o Must request that the board bring suit on the alleged cause of action.
- Must be sufficiently specific as to apprise the board of the nature of the alleged cause of action
and to evaluate its merits:
o “At a minimum, a demand must identify the alleged wrongdoers, describe the factual basis
of the wrongful acts and the harm caused to the corporation, and request remedial relief.”
Otherwise, the Board would be dealing with fishing expeditions

What’s the most accepted excuse for not making the demand?
- Demand futility (concept in Marx and Grimes – which one to apply depends on state you’re in on
exam!)

What are the courts trying to balance when dealing with demand futility?
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 - Directors right to run the company against the shareholders right to hold the directors accountable.

More Notes on Demand Futility – circumstances where making demand is a waste of time (futile =
incapable of producing a certain result) :
• Situations in which P knows the board won’t do anything
o Concerned about the impartiality of the board
• 1. Board directly involved – if you know that the board is directly involved in the
wrongdoing, know nothing will be done if make demand
o Conflicted directors
• 2. Major players – when not entire board involved, but the major players on the
board are involved, know the other members won’t do anything about it
o Concerned about the impartiality of the board
• Can’t just alleged – simply alleging that all the directors are involved in the
wrongdoing will not excuse demand
o Must actually show that all or enough or board members involved before
demand excused
• Demand excusal – when there are doubts as to whether a board can be fair, court
will take away protection of BJR and will not require demand
o Usually try to avoid demand b/c if you don’t, waive right to claim it
would’ve been refused alter
 If don’t make demand and courts says demand was required can always
go back and make the demand after, but can’t do it the other way
around
 If make demand and they say no - then you are done and never get to
argue the merits of why demand would’ve been futile
 If don’t make demand – can argue the merits about the BJR and why
demand futile
• 1. Demand Excusal/Futility
o Don’t have to make demand b/c it would be a waste of time
o Demand excused if we doubt the business judgment or impartiality of the
directors
 Board must show – rational business purpose (BJR)
 If can’t, then hold board responsible
o Demand utility – circumstances where the board is too disabled to render an
impartial decisions
 If all directors involved and demand made, directors won’t do anything
and will refuse the demand and then you are stuck
o Allows P to stop futile path under circumstances where asking BOD would be a
waste of time b/c board so conflicted that they lose the protection of the BJR
on whether to refuse or accept demand
o If don’t have to make demand, P can argue on the merits directly about
why demand would be futile and should be excused
• **BOTH THE DE (Grimes) AND NY (Marx) APPROACHES TO DEMAND
FUTILITY INQUIRY BOIL DOWN THE FOLLOWING INQUIRY: IS THE
BOARD OF DIRECTORS SO CLEARLY DISABLED BY CONFLICTED
INTERESTS THAT ITS JUDGMENT CANNOT BE TRUSTED?
o If so demand is unnecessary and the shareholder should be permitted to go forward.
o If so – absent intervention by a special litigation committee, the shareholder
should be permitted to go forward – demand excused
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  If so involved then their decision as to accept of refuse demand decision
is suspect
 Worried about the BOD’s judgment
 If P can show the court that the BOD is so disabled by their conflicts that
their judgment cannot be trusted as to whether to refuse or accept
demand, don’t have to make demand – Marx or Grimes (NY or DE)
to see requirements
o If not the board should be allowed to decide where the litigation should proceed.
o If not – the board should be allowed to decide whether the litigation should
proceed – demand not excused (shareholder must make demand on BOD)
 If have to make demand and board refuses (common) ad you can’t show
the decision to refuse demand is suspect, you are stuck and that is the
end of litigation
 Have BJR to protect decisions as to accept or refuse demand
 Why making demand can be problematic

What mechanism is there in the MBCA that provides for internal corporate review of a demand?
o MBCA § 7.44 provides two alternatives for internal cor review of
the demand:
o A derivative proceeding shall be dismissed by the court on motion by the corp if one of the
groups specified in subsection B or subsection E has determined in good faith, after
conducting a reasonable inquiry upon which its conclusions are based, that the maintenance of
the derivative proceeding is not in the best interest of the corporation.
o Unless a panel is appointed pursuant to subsection (e), the determination in subsection (a)
shall be made by:
 A majority of qualified directors present at a meeting of the board of directors
constitute a quorum; or
 A majority vote of a committee consisting of two or more qualified directors
appointed by majority vote of the qualified directors present at a meeting of the BOD,
regardless of whether such qualified directors constitute a quorum
o BOTTOM LINE:
 If the independent (i.e. disinterested) directors constitute a quorum, the
demand may be reviewed by the board. Whether or not the independent directors
constitute a quorum, the independent directors may appoint by majority vote a
committee of two or more independent directors.
 If either the board of committee determined in good faith after conducting a
reasonable investigation upon which its conclusions are based that the maintenance of
the derivative proceeding is not in the best interests of the corporation the court shall
dismiss the complaint.
 Under the MBCA’s version in 7.44(e), upon motion by the corporation, the court
may appoint a panel of one or more independent persons to determine whether the suit
should go forward. If that person recommends dismissal, the court shall dismiss the
action unless plaintiff can prove the independent panel failed to act in good faith or
failed to conduct a reasonable inquiry upon which its conclusions were based.
o Who has the burden of proof on this issue?
 If a majority of the board was independent at the time that determination was made,
the burden of proof with respect to the board’s independent disinterest and the
adequacy of its investigation is on plaintiff.
 If a majority of the board was not independent, the burden of proof is on the D.
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Direct v. Derivative:
- The initial issue was whether Grimes’ complaint was derivative or direct.
- The court tells us that “although tests have been articulated many times, it is often difficult to
distinguish between a derivative and an individual action… The distinction depends on ‘the nature
of the wrong alleged and the relief, if any, which could result if plaintiff were to prevail.’”

• Grimes v. Donald (pg. 241) RULE: A shareholder need not make a demand that a company’s board
institute a lawsuit before brgining a derivative suit on behalf of the corporation on a showing the demand
would be futile, and if a demand is made and rejected, a SH may still proceed bu establishing that the
board’s refusal was wrongful. Aka: A STOCKHOLDER GENERALLY UST DEMAND THE BOARD
BRING AN ACTION BEFORE HE OR SHE BRINGS A DERIVATIVE SUIT.
- The Delaware standard for demand excusal/futility
Facts: Employment Agreement Terms:
- Good deal for Donald; provision that was especially disturbing to shareholders was the constructive
termination agreement:
o Continued payment of his “Base Salary” at the level in effect immediately prior to termination for
the remainder of his “Term of Employment,” which, as stated, will be 6 ½ years unless Donald dies
or turns 75 first. In 1992, Donald’s Base Salary exceeded $650,000. (Continued at pg. 243)
 Allows him to unilaterally claim constructive termination without cause – he can declare
that anyone has interfered with his judgment and can quit and take a boat load of money
- Grimes is an unhappy shareholder in this corporation; his complaint alleged:
o Abdication by the board of its duties [direct claim] as per the court, but is the court correct?
o Breach of the duty of care [derivative claim],
o Waste via excess compensation [derivative claim].
Were Grimes’ claims direct or derivative?
- The abdication claim: the severe financial costs [penalties] that the corporation will incur if it tries to
interfere in Donald’s management will “inhibit and deter the Board from exercising its duties under §
141(a).”
- With respect to the abdication claim, Grimes sought only to have the agreements declared invalid and, as
such, that claim was deemed direct.
- Is that correct? Or is this really derivative?
NOTE: Breach of duty of loyalty claims are always derivative

Questions on Case from Slides:

Can directors delegate duties without triggering an abdication claim?
• § 141(a)
- Board shall manage the business and affairs of every corporation and can allow committees to run
certain aspects of the business, but control MUST BE VESTED in the Board
- *When you abdicate responsibility you delegate ALL OF YOUR DUTIES to another

Can the abdication argument ever be a winner? Why did the court say this wasn’t abdication?
- Donald had unfettered control of business affairs BUT the court found that the Board had not
irrevocably given away their power because they had the ability to buy it back (not complete
revocation of power)
- But this was not merely “limiting a board’s freedom” – Donald was calling the shots

Why are severance payments negotiated and so big?

- You want provisions of termination of employment to be enforceable

What standard does the court use to evaluate the BOD’s decision to enter into the employment
contract with Donald?

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 - Business judgment rule – Does the decision make business sense at the time? Is there a valid
business purpose at the time of the contract?
o If there had been an abdication this would not have been considered a valid business
judgment

• Quick and Dirty on the BJR: courts should not second-guess the business judgment of the directors;
the principal function of the business judgment rule is, or at least ought to be, to protect officers and
directors from liability for violation of their DOC.
- Thus, under the BJR, a board decision to incur the risk of such a financial penalty in order to
attract a senior manager was entitled to protection.
- “If an independent (duty of loyalty) and informed board (duty of care), acting in good faith,
determines that the services of a particular individual warrant large amounts of money, whether in
the form of current salary or severance provisions, the board has made a business judgment…
[that] will normally receive the protection of the BJR unless the facts show that such amounts,
compared with the services to be received in exchange, constitute waste or could not otherwise be
the product of a valid exercise of business judgment.”
o If a board has not violated the duty of care and the duty of loyalty they will be protected by
the BJR [a defense that protects only independent and informed boards]
- The BJR is a rebuttable presumption:
o If you can show that an officer breached the duty of care/duty of loyalty then they will not
be protected by the BJR
o What facts must you show to prove that the demand refusal was not warranted (Not
protected by the BJR)?
 1) Conflict of interest
 Failure to investigate the demand

What about a shareholder that doesn’t make the demand?

- Corporation will request a bond posting and failure to make a demand

Why do we even get to the discussion of demands and excusal here?

- The plaintiff made a demand and the board refused it
- Pg. 243 – Decision to refuse the demand is supportable because the Board was independent and
informed: “[Board] has seriously considered the issues set forth in your letter of Sept. 29
- *Board is found to have satisfied the BJR

What was the legal effect of Grimes making this demand on the BOD before filing suit, as required
by the Delaware version of FCRP 23.1?
- You are waiving the right to litigate demand excusal – you can only get to the merits if you show
that the decision of the board violated the duties of care and loyalty
o “If demand is made and rejected, the board rejecting the demand is entitled to the presumption of
the BJR unless the stockholder can allege facts with particularity creating a reasonable doubt that
the board is entitled to the benefit of the presumption.”
o “If there is a reason to doubt that the board acted independently or with due care in responding to
the demand, the stockholder may have the basis ex post to claim wrongful refusal. The stockholder
then has the right to bring the underlying action with the same standing which the stockholder
would have had, ex ante, if demand had been excused as futile.”

• So here’s the problem the plaintiffs from the BJR presumption:

1. Under Delaware law, where demand is made the plaintiff is deemed to have conceded that the
demand was required [waiver of any claim that demand is excused],

62
 2. Which in turn makes the decision of the BOD on whether to dismiss a matter of business
judgment,
3. Which in turn means that the plaintiff loses.
4. Derivative plaintiffs are denied discovery –how can they ever show the factual basis for the
excuse?

• Plaintiff has a choice to make demand or not… if the plaintiff makes the demand then they will go down
a hard road. If they don’t make the demand plaintiff can claim demand futility (with particularized
facts)

Under Grimes the 3 usual bases for excusing demand as futile are (remember for exam – use this if
you are in Delawareand you only need to show ONE of these!)
(1) A majority of the board has a material or familial interest in the challenged transaction (e.g.
raising their own salaries);
(2) A majority of the board is incapable of acting independently, maybe because it is dominated
or controlled by the alleged wrongdoer; or
(3) The challenged transaction was not the product of a valid business judgment. (Hardest to
prove)
- As a result, well-advised plaintiffs in Delaware almost never make demand, since the board always says no
and the BJR presumption supports the board.
- So the issue to be litigated is whether demand is excused.
o If demand is required the complaint is dismissed with leave to amend (with no consequence for not
initially stating demand)

Example of Derivative Action – shareholder has problem w/company

• Shareholder comes to learn that corp has contract with a 3rd party and the 3rd party
breached contract and corp is not suing or doing anything about it
• Shareholder is unhappy, shareholder can make demand on corp to take action
• Corp determines from demand whether to go forward w/suit or not
• 1. Shareholders Makes Demand and Demand Refused - Process under which
corp evaluates demand
o Subject to judicial scrutiny
o Shareholder has only 1 option: go into court and seek to prove that demand
refusal was wrongful
o Standard – BJR
 Rebuttable presumption – P can rebut the BJR by showing a breach of
fiduciary duty but this is extremely hard to show
• ***MUST REBUT BJR AS APPLIED TO DECISION TO REFUSE
DEMAND and not the underlying alleged wrongdoing****
o NOT ARGUING THE MERITS OF CASE, ONLY THAT BJR
DOESN’T PROTECT DECISION TO REFUSE DEMAND
 BJR protects officers and director decisions made in good faith
• Protects against bad decisions, even horrible ones
 If P can show breach of duty of care or loyalty, board or officers not
entitled to BJR protection
o What kinds of facts will help shareholder overcome BJR presumption?
 Conflict of interest among directors
• 9 of 10 directors were owners of company that breached contract
o Question board’s decision to refuse demand
• Evaluating the decision to litigate only – refusal wrongful
 Failure to investigate demand fully and thoroughly – breach of
duty of care
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 o If demand not accepted, hard to get around BJR presumption
• 2. Shareholder doesn’t make demand
o Shareholder sues to make corp enforce the breach
o Corp – will respond and say demand wasn’t made and bond wasn’t posted,
argue therefore case should be dismissed
o Shareholder – will argue that demand didn’t have to be made that demand
was excused/futile – show 1 of 3 things (DE Test – Grimes)
 1. Majority of board interested in transaction
• If this is true, very likely that 3 is also true
 2. Board controlled by people who have interest in the transaction
• Board incapable of acting independently
• If 2 true, 3 probably true
 3. Decisions could not have been the product of valid business judgment
o If show any of these 3 requirements then demand excused & lawsuit proceeds
on the merits
o Worst case scenario – demand not made and excusal not found, case
dismissed but can be brought again (usually need demand)
• Well-advised P’s – advised not to make demand

• Aronson v. Lewis (1984)

- Aronson introduces the concept of “reasonable doubt” into this analysis. The case creates a test for trial
courts to see if the failure to make a demand was justified by using discretion to determine whether the
particularized facts alleged in the complaint create a reasonable doubt that:
o The directors are disinterested and independent for purposes of responding to the demand;
OR
 [Aronson court says and, but acts like it’s or; and the NY courts in Marx specifically
interpret the branches of this test as “disjunctive”]
o The challenged transaction was otherwise the product of a valid exercise of business
judgment.
- Self interest, for these purposes, is defined in terms of direct financial interest in the challenged transaction;
- The fact that a majority of directors voted to approve the transaction – and therefore are named as
defendants – does not constitute self-interest and will not excuse demand.

To Summarize:
- If demand is required and made, it will invariably be refused;
- Then BJR applies to the decision to dismiss the lawsuit and plaintiff loses.
- Demand may be excused if plaintiff’s allegations raise reasonable doubt about self interest or the protection
of the business judgment rule, but then the directors can appoint a special litigation committee as in Zapata
[footnote 13]
o Where demand is excused, the corporation may still move to dismiss the suit as not in the best
interests of the corporation.
NEW YORK STANDARD:
• Marx v. Akers (pg. 250) RULE: A plaintiff establishing that a demand on a company’s board would have
been futile must show either that the measure furthered the board’s self-interest, that the directors did not
fully inform themselves about the challenged transaction, or that the challenged transaction was so egregious
on its face that it could not have been the product of the directors’ sound business judgment. Aka: THE
PLAINTIFF MUST PROVIDE MORE THAN CONCLUSORY STATEMENTS TO ESTABLISH THAT A
DEMAND WOULD BE FUTILE.
- New York standard for demand excusal/futility
Facts: Shareholder alleges that directors had engaged in self-dealing by awarding excessive compensation
to themselves.
- Shareholder does NOT make a demand (Grimes plaintiff had made the demand but argued that refusal was
wrong); BIGGEST FACTUAL DIFFERENCE between Grimes and Marx
What is the court’s view on derivative actions in general?
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 - “By their very nature, shareholder derivative actions infringe upon the managerial discretion of corporate
boards… Consequently, we have historically been reluctant to permit shareholder derivative suits, noting
that the power of the courts to direct the management of the corporation’s affairs should be ‘exercised with
restraint.’”
- “the object is for the court to chart the course for the corporation which the directors should have selected,
and which it is presumed that they would have chosen if they had not been actuated by fraud or bad faith.
Due to their misconduct, the court substitutes its judgment ad hoc for that of the directors in the conduct of
its business.”
Is this a bad thing?
- NO – this gives shareholders a mechanism to hold management’s feet to the fire [as court’s are reluctant to
get into the internal workings of a corporation]

- When a corporation’s board is judicially determined to be “disabled by conflict” the court will
step in and do what the board should have.
- The only way to get to the merits of a bad contract is if the plaintiff can prove that the decision to
reject demand was thoroughly researched.

Rule of law: under NYBCL § 626(c), plaintiff has to “set forth with particularity the efforts of the
plaintiff to secure the initiation of such action by the board, or the reasons for not making such effort.”

Three prong disjunctive standard:

(1) Majority of board of directors interested in challenged transaction (“Duty of Loyalty”)
(2) Directors failed to inform themselves to degree reasonably appropriate (“Duty of Care”)
(3) Challenged transaction so egregious that it could not have been the product of sound
business judgment of the directors
- We will take away the demand requirement where we are concerned with board of director’s decision to
make valid business judgments.
- Court decides whether or not the shareholder is able to bring his case to the court from here

Difference between inside and outside directors?

- Inside directors have an interest AND a position in the company
- Outside directors only have an interest (could be more impartial than are inside directors)

Back to facts of Marx:

- 18 members on the board, only 3 of which are inside directors.
- Argument sates that their compensation was excessive (WASTE)
o Paying too much and therefore breached the duty of care (thus demand could be excused)
What would you need to show a breach of a duty of care?
- Comparable circumstances at another firm (can’t just abstractly claim that they breached the duty of care)
- 3 out of 18 is NOT a majority of the board
Holding: Claim is dismissed for failure to make a demand
- For demand refusal, the court needs to see one of those 3 elements proven – the court will thus not give the
plaintiff the benefit of not having to make a demand because he failed to meet the standards outlined
- Majority of the board did not have an interest here (only 3 out of 18) as to setting executive compensation.
*If you DO make a demand, the court evaluates the response
- If you refuse to make a demand you have to show that making a demand would be futile because the board
would be unable to discharge their duties due to conflict of interest.
How does the Marx court view plaintiff’s allegations concerning the compensation paid to IBM’s outside directors?
- 15 out of 18 outside directors voted for their compensation (This tends to favor demand futility)
Does that help plaintiff in the long run?
- NO because he failed to state a cause of action
- On this claim the court finds that 15 out of 18 satisfies demand futility but is unable to show that
compensation is excessive
- SO: Plaintiff gets past the procedural issue but loses on the merits as to outside director compensation.
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** SEE Derivative Litigation Decision Tree (See D Slides 82 & 83, pg. 14)**
Derivative Litigation on Exam:
• Questions to ask, analysis to follow
• 1. Is lawsuit direct or derivative?
o Direct – go straight to litigation
 If P wins, P gets money
o Derivative – need to look at whether demand is required
 Demand required – demand not futile, demand is required
• If demand was required, was it made?
• If no, case dismissed w/leave to amend, must now make demand
• If yes, look to see if BJR protected board’s decision to refuse
demand
• Demand if refused – was refusal wrongful?
o If yes – P sues
o If no – lawsuit ends, can’t be brought again
o Standard – BJR as applied to decision to refuse demand
only (not on the merits of underlying claim)
 Demand excused/futile – demand was excused, P sues on merits
• Standard – Board disabled by some conflict, but board can regain
control any way via special ligation committee (SLC)
• If P wins, corp gets the money
• 2. How to determine if demand was futile?
o NY – Marx
o DE – Grimes
o Need to prove any of the 3 factors from either
• What must be true for BOD to get protection?
o BOD must’ve behaved properly in order to get BJR protection
o 1. Honor duty of care – directors need to be prepared, read stuff, have access,
show up to meetings
 Minimum level of diligence looking for from directors
 Ex. van Gorkom – didn’t due diligence
 Standard – what reasonable directors would do, examine in context
o 2. Honor Duty of Loyalty – conflicts
 Must be able to show entire fairness
The Task – Special Litigation Committee
- SLC’s are an artificial construct that boards can use to further their neutrality
Must balance:
- “preserving the discretion of directors to manage a corporation without undue intereference.” –
Marx v. Akers, against “permitting shareholders to bring claims on behalf of the corporation when
it is evident that directors will wrongfully refuse to bring such claims.” – Marx
Needed: A filter to separate cases in which the board is disabled by conflicts of interest from making an
independent decision in good faith.
Special Litigation Committees (SLC’s)
• Role of SLC – artificial construct that board’s can use to try and further their
neutrality
o Try to allow someone not involved in underlying act to make decision on
whether or not to go forward w/litigation
• Purpose – try to preserve the discretion of the directors to run the business
o Trying to show that the board is not disabled by conflict

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 • Balance – shareholders input and ability to bring claims on behalf of corp when it is
evident that directors will wrongfully refuse to bring such claims VS. preserving the
discretion of the directors and board to run the business w/o interference (Marx)
• Why SLC’s needed – a filter to separate cases in which the board is disabled by
conflicts of interests from making an independent decision in good faith
o Situations in which the board is so disabled by conflict that we question
whether the decision about whether to proceed on lawsuit is impartial
• When this gets brought up? - What effect should a court give to any board decision
not to sue, especially in demand excusal cases?
o Should the courts defer under the BJR? Or should they instead
reexamine the BOD or committee decision?

• The Demand Requirement as a Filter – see B slide 85

New York Standard:
- Majority of directors interested; or,
- Directors failed to inform themselves; or
- Challenged transaction could not have been the product of sound business judgment
Delaware Standard:
- Reasonable doubt as to:
o Majority of board has a material interest; or
o Majority of the board lacks independence; or
o Challenged transaction not product of valid exercise of business judgment

• Auerbach v. Bennett: Special Litigation Committee (pg. 256) RULE: A special litigation committee’s
determination forecloses further inquiry into a matter, provided the committee’s investigation is bona fide
(good faith). Aka: A BOD MAY GRANT AUTHORITY TO A SPECIAL COMMITTEE TO MAKE
RECOMMENDATIONS ON A DERIVATIVE CLAIM.
What did the SLC do in the scope of their review?
- Special Committee found evidence that the corporation was engaging in bribery. They bring this
information to the attention of the Board who takes it to the Audit Committee – finds that there was some,
but not much bribery
- Plaintiff immediately files suit against the corporation’s directors, Arthur Anderson & Co., and the
corporation
- The Board chooses to preserve its protection under the Business Judgment Rule and give the matter of
demand to a more impartial SLC
SLC sets out the scope of their review:
- SLC hires new, impartial special counsel
- Went through all transcripts
- Interview all directors present at the time
→ They choose to refuse the plaintiff’s demand after investigating
Issue1: May a board appoint a special committee to investigate the allegations contained in a derivative suit and
to determine whether the lawsuit should be dismissed? YES.
Issue2: How much deference should a court accord a Special Litigation Committee recommendation to dismiss
a suit?
- “we confront a special instance of the application of the BJR and inquire whether it applies in its full vigor
to shield from judicial scrutiny the decision of a three person minority committee of the board acting on
behalf of the full board not to prosecute a shareholder’s derivative action.”
Was SLC interested in the outcome?
- NO
Were they independent?
- Yes – but plaintiff argues that anyone chosen by the tainted board to serve on the SLC is NEVER
independent
Relevance of BJR?

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 - “As all parties and both courts below recognize, the disposition of this case on the merits turns on the
proper application of the business judgment doctrine, in particular to the decision of a specially appointed
committee of disinterested directors acting on behalf of the board to terminate a shareholders’ derivative
action…. In this instance our inquiry, to the limited extent to which it may be pursued, has a two-tiered
aspect.”

Two Tiers:
1) Bad Act
2) What litigation committee did to move forward
a. If can show demand refusal was valid, insulates and stops exploration into underlying act
(then lawsuit is over and cannot be brought again)
b. Corp won’t make decision about whether or not to refuse demand, but SLC that is
impartial will be allowed to recommend to refuse demand and this will be valid
- When refusal is made by a Special Litigation Committee, there is a difference
- They won’t necessarily insulate the bad act from the decision because the Special Litigation
Committee says so
*The Board may have artificially created presumption of independence
Holding: Ultimate decision covered by Business Judgment Rule, but judicial inquiry (NOTE:
JUDICIAL INQUIRY ON PROCESS OF DECISION, NOT ON THE MERITS!) is permitted with
respect to:
- Disinterested representation (duty of loyalty concern) – want disinterested people on the
committee
o How do you maximize disinterested independence?
 No financial interest
 Someone who understands the business (expertise)
 Disconnected from the events (new to the company)
• This includes new corporate counsel, etc. (No prior affiliations)
- Adequacy of investigation
o Marx court says decision was made that does not violate fiduciary duties so it will not
make a judgment as to whether decision was correct
o Must evaluate what they did, entire process
o Did they hire help, how did they come to make a decision, what was it based on? Etc
Burden of Proof?
- On plaintiff to show problem with committee
o Factors:
 Independence of committee
 Adequacy of investigation
• “While the court may properly inquire as to the adequacy and appropriateness of the committee’s
investigative procedures and methodologies, it may not under the guise of consideration of such factors
trespass in the domain of business judgment.”

- NOTE: This whole section not discussing the merits of the decision but the process

The Task: SLC

• Downside of the Special Litigation Committee:
- They are appointed by the Board of Directors (wrongdoers)

Auerbach v. Bennett: Demand Really Excused?

o Case in NY so use Marx test
 1. Majority of BOD interested? – not satisfied

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  2. BOD failed to inform itself? – no, did a lot
 3. Transaction egregious on its ace that couldn’t have been product of
sound business judgment? – not a way to excused demand, officers and
directors didn’t vote about performing bad act
• No decision by board to evaluate
 Doesn’t look like demand should have been excused
o Court looks at SLC’s decision to refuse the lawsuit – same as corp refusing
demand
 Don’t need formal language of making demand, can get to same
place when lawsuit filed
Why no discussion of demand under Marx?
- Demand was not waived but why is there no discussion?
o If plaintiff doesn’t make a demand and files a complaint the corporation can either:
1) Request demand, or
2) Get right into the lawsuit and claim failure to make a demand
• SLC in Auerbach made the decision to move to dismiss the lawsuit (*Here you don’t need the formal demand
step)

ONLY USE THIS CASE FOR SLC’S IN DE, NO WHERE ELSE – DE’S STANDARD FOR
REVIEWING SLC RECOMMENDATIONS:
• Zapata Corp. v. Maldonado (pg. 261) RULE: While a majority of a board may lack the independence to
evailuate a derivative claim, the taint of self-interest is not necessarily sufficient to prevent the board from
delegating the evaluation to an independent committee comprised of disinterested board members who
may recommend dismissal of a shareholder’s action. Aka: INTERESTED BOARD MEMBERS MAY
APPOINT A DISINTERESTED COMMITTEE TO INVESTIGATE LITIGATION
- No demand in this case because the plaintiff says all directors are named as defendants (he says demand
would be futile)
So what does the corporation do about this – what are its options?
- They can create a special committee to evaluate his claims; or they can wait until he files the lawsuit, and
defend with his failure to make a demand.
o They choose to allow an SC to evaluate… independent investigation committee determines that the
suit should be dismissed in the best interest of the corporation
Does the BJR create authority? Directors have authority under 141(a) to run the corporation [BJR is a
rebuttable defense that may be raised by officers and directors when they’re sued]
How does the BJR apply to this case? Here, the evaluation of the BOD/Committee decision not to sue only
becomes relevant when the plaintiff protests it. The BJR then is raised as a defense to the attack on the decision.
The court views the case as having 3 focuses:
1) Whether the lower court was right in finding that the shareholder had an individual right to
maintain the derivative action.
- Board has authority to validate or deny a demand
o They get to decide what to do with the lawsuit
o Corporation is entitled to make decision but it is subject to judicial scrutiny
2) What is the corporate power under Delaware Law of an authorized board committee to cause the
dismissal of litigation instituted on behalf of the corporation.
- 141(c) – Anything the board can do a committee can do
3) What is the role of the Court of Chancery in resolving conflicts between stockholders and SLCs?
- Rule of Law: Delaware standard for reviewing SLC recommendations is a 2-step approach:
o Step 1: Inquiry into the independence and good faith of the committee
 Inquire into the bases supporting the committee’s recommendations
 The corporation has the burden of proving independence, good faith, and a reasonable
investigation
o Step 2: Court may go on to apply its own business judgment as to whether the case is to be
dismissed
 The court will undertake an independent inquiry into whether the suit should be dismissed.
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  The court can consider matters of law and public policy in addition to the corporation’s
best interests.
What is the function of step #2?
- It allows meritorious suits to go forward, and helps account for structural bias problem
How is step #2 different from Auerbach?
- Court decides whether there was a reasonable basis for the decision

→ In this respect Zapata is far more intrusive judicial review than usual. Why?
- Context: Demand was excused because board disabled from acting due to conflicted interests
- Committee appointed by the disabled board
- Potential for structural bias – “there but for the grace of God go I”
o New directors appointed to SLC will be subject to the ire of defendant directors should
they choose in favor of plaintiffs [Thus Delaware’s desire to regulate these more carefully]

• BJR does not evaluate the merits of a decision, it evaluates the procedure of that decision.

Zapata disrupts the acceptable BJR case law…

- Cases like Zapata try to fit SLC cases into established body of law
- Courts in Delaware say in this particular case that they will double check decision by an SLC on
the merits using their own business judgment
o Court may have overstepped its bounds

Practical result of Zapata?

- The Special Litigation Committee has lost its usefulness [no one will choose to construct SLC’s to
decide derivative suits anymore]
- Case may have been designed to pull back on the use of SLC so that they don’t eat up derivative
suits

LIMITED LIABILITY COMPANIES

- Cross between a partnership and a corporation
- Tax Advantages
o Partnership – not taxable entity
 Not taxed at partnership level
 Only taxed to partners and individual income
 Disadvantages – complete personal liability
 Advantage - taxes
o Corporation – earnings are taxable income
 When give money to shareholders – dividends – shareholders pay taxes
on it and it was already taxed at corporate level
 Disadvantages – taxes
 Advantage – limited liability
o LLC – a way to combine the advantages of both entities w/o the disadvantages:
 Has the limited liability of a Corp
 None of the restrictions (e.g., number and type of shareholders) applicable to S
corporations
• Allows a corporation to elect to be taxed as a partnership but MANY restrictions
and regulations
• Sometimes favorable tax status is outweighed by restrictions on S corporations
History
- LLC is the first new legal business concept since the S corp (1950s)
- LLC’s introduced in Wyoming in 1977
- Created as a vehicle for ownership of real estate and development of oil, gas and other mineral rights
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Tax Treatment of LLCs
- The IRS initial position [pre-1988] was that LLCs should not be treated as a partnership
- In 1988, IRS rules that LLC could qualify for partnership-like tax treatment
- In 1997, IRS further liberalized with “check the box” regulations
o Check-the-Box Regulations give unincorporated associations the ability to choose their tax status
without regard to the entity’s nontax legal characteristics

Why are LLCs so popular – Major Advantages:

1. They provide a standard form contract that incorporates many of the most attractive
features of partnerships and corporations.
2. The LLC is an unincorporated business organization that can provide its members with
3. Pass through tax treatment (see below: “LLC Tax Consequences”)
4. Limited Liability, and
5. The ability to actively participate in firm management.

LLC Funding – owners of LLC’s are called members

o Members typically contribute capital
o Contribution may be cash, property, services, etc
o Form of Contribution for LLC’s – ULLCA – 401

LLC Limited Liability – member liable only for the amount of his or her capital
contribution, even if the member actively participates in the business
o Members stand to lose capital contributions, but their personal
assets are not subject to attachment
o Biggest difference w/partnership, advantage over partnership
o Personal assets are not subject to attachment
 Unless corporate veil pierced
o No personal liability solely b/c of your role as being member or
manager of LLC
 Not liable just b/c members
 Have to do something else that will hold them personally
responsible (piercing)
 No member or manager of LLC is obligated personally for any
debt, obligation, or liability of the LLC solely by reason of being a
member of acting as a manager of the LLC
- ULLCA Section 303: No member or manager of a limited liability company is obligated
personally for any debt, obligation, or liability of the limited liability company solely by reason
of being a member or acting as a manager of the limited liability company

Limited Partnership vs. LLC

- General Partners
- Limited Partners (Liability capped at their investment in the partnership but they are not
allowed to control the enterprise – PASSIVE INVESTMENT)
- LLCs give you the BIG 3:
1) Pass through taxation
2) Limited Liability

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 3) Ability to Participate in Firm Management

LLC Tax Consequences

- Income and losses pass through to members
- LLC does not pay taxes at the entity level, so profits are not subject to double taxation
- Capital gains flow through to owners and retain their tax attributes (i.e., are subject to lower rates)

LLC Financial Interests

- Profit and Loss Sharing
o Absent contrary agreement, most LLC statutes allocate profits and losses on the basis
of the value of members’ contributions
o Compare partnership law’s equal division default rule
- Withdrawal
o Member may withdraw and demand payment of his/her interest upon giving the
notice specified in the statute of the LLC’s operating agreement.

Assignment of LLC Interest

- Unless otherwise provided in the LLC’s operating agreement, a member may assign his financial
interest in the LLC
o An assignee of a financial interest in an LLC may acquire other rights only by being admitted as a
member of the company if all the remaining members consent or the operating agreement so
provides. See ULLCA § 501-503.
- Analogous to partnership rules

LLC Management Rights

- Absent contrary agmt, each member has equal rights in the management of the LLC; ULLCA § 404(a)
(1)
o Most matters decided by majority vote, see ULLCA § 404(a)(2)
o Significant matters require unanimous consent, ULLCA § 404(a)(3)
 E.g., merger, admission of new member, dissolution, etc…
- Manager-managed LLC option available. See ULLCA § 404(b)
o A member or members gets elevated status
 Owners, but also run day-to-day
 The manager of a manger-managed LLC has a duty of care and loyalty
• Usually, members of a manager-managed LLC have no duties to the LLC or its
members by reason of being members
• Only if manager do you pick up fiduciary duties
- Member-managed LLC is the other choice. See ULLCA § 404(a)
o Everyone runs the LLC
o All members have a duty of care and loyalty
o Duties are owed to the LLC but not to the other owners

Derivative Actions – can sue LLC derivately

- Member may bring an action on behalf of the LLC to recover a judgment in its favor if the members with
authority to bring the action refuse to do so

LLC Formation
- File articles of organization at designated state office. ULLCA § 202(a)
o Required and optional contents set forth in ULLCA § 203
o Filing fees plus $800 minimum franchise tax
- Other formation tasks:

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 o Choose and register name: LLC statutes generally require the name of the LLC to include the
words limited liability company, the abbreviation LLC, or similar phrases. ULLCA § 105.
 Effect of, see Water, Waste & Land v. Lanham
o Designate office and agent for service of process (ULLCA 108)
o Draft operating agreement – the basic contract governing the affairs of a limited liability company
and stating the various rights and duties of the members
 Similar role as partnership agmt
 Understanding of the members
 Explains how business will work
• E.g. can have arbitration clause
 LLC is Bound – LLC is itself bound by the operating agmt, even if only the members,
and not the LLC itself, signed the agreement
• This means that if one member sues the LLC, the operating agmt will control
on matters with which it deals
Default Rules for LLCs
- Typical LLC statutes provide default rules, but with flexibility
- The default rule is comparable to the general partnership form:
(1) vesting management in the LLC’s members
(2) except that the number of votes cast by each member while voting is determined by
their proportional share in the book value of the membership interests.
o In general, both of these rules are subject to any contrary provisions of the articles of
organization and operating agreement. The LLC thus provides substantial flexibility in
structuring the firm’s decision-making process.

• Water, Waste & Land, Inc. d/b/a Westec v. Lanham (pg. 300) RULE: If a limited liability company’s agent
fails to inform a third party that he is acting as the company’s agent, the LLC Act’s notice provision does not
relieve the agent of liability to the third party. Aka: IF A THIRD PARTY IS NOT AWARE THAN AN
AGENT IS ACTING FOR A PRICIPAL, THE AGENT MAY BE LIABLE TO THE THIRD PARTY.
Facts: Clark and Lanham want to construct a Taco Cabana
- Clark’s business card used the letters P.I.I. after its name
o Letters P.I.I. used in accordance with Colorado statutory requirements
- Clark interacting with Westec who decides to perform the services before being paid [Clark tells Westec to
send proposal to Lanham]
- Water, Waste & Land sends a written proposal to Lanham. They hear nothing back from him but still
perform the construction.
o Agency relationship [or apparent authority] between Clark and Lanham should have put WWL on
notice of something
- WWL never gets paid and sues Clark, Lanham, and Westec
- The ONLY binding agreement between the parties is the oral contract that has been partially performed
Issue1: Is a member of an LLC personally liable under a K if the other party to the K was not aware that the
member was negotiating on behalf of an LLC? YES.
Issue2: Who is responsible for the breach?
- Clark, Lanham, or PII?
- PII admits liability but they have no assets
o County Court finds that Clark is an agent for Lanham and PII and should not have liability
o Thus Lanham and PII are responsible for the judgment
o District Court reverses Lanham’s liability
 You need to require LLC to have LLC in their name and to use it at all times
The Colorado SC Holds: “the statutory notice provision applies only where a 3rd Party seeks to impose
liability on an LLC’s members or managers, simply due to their status as members or managers of the LLC.
When a 3rd party sues a manager or a member of an LLC under an agency theory, the principles of agency
law apply notwithstanding the LLC Act’s statutory notice rules.”
How do these facts work out under standard agency law?
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 - Under common law agency rules, an Agent has liability on a partially disclosed agency – to avoid liability,
Agent must fully disclose both the agency and the identity of principle.
How is this a partially disclosed agency?
- It sounds undisclosed – and both Clark and Lanham are agents for the undisclosed LLC!
- The court tells us that the partially disclosed agency exists because Clark and Lanham failed to disclose the
existence OR identity of the LLC. Does this make sense?
o Yikes. This sounds much more like an undisclosed agency. The court seems a little mixed up on
the definition of partially disclosed agency, as evidenced by this language from the full opinion:
 “For these reasons, we conclude that where an agent fails to disclose either the fact that he
is acting on behalf of a principal or the identity of the principle, the notice provision of our
LLC Act, section 7-80-208, cannot relieve the agent of liability to a third party.
 When a third party deals with an agent acting on behalf of a limited liability company, the
existence and identity of which has been disclosed, the third party is conclusively
presumed to know that the entity is a limited liability company and not a partnership or
some other type of business organization.
 Where the third party does not know the identity of the principal entity, however, the
situation is fundamentally different because the third party is without notice and the law
does not contemplate that he has any way of finding the relevant records.”

Rule – LLC must Choose and register name: LLC statutes generally require the name of the
LLC to include the words limited liability company, LLC, or similar phrases – ULLCA 105 –
result of WWL v. Lanham
 When disclosed - When a 3rd party deals w/an agent acting on behalf of an LLC,
the existence and identity of which has been disclosed, the TP is conclusively
presumed to know (notice) that the entity is a LLC and not a partnership or some
other types of business organization
 Undisclosed – where the TP does not know the identity of the principal entity,
the situation is fundamentally different b/c the TP is w/o notice and the law does not
contemplate that he has any way of finding the relevant records

• Elf Atochem North America, Inc. v. Jaffari (pg. 305) RULE: An LLC is bound by the terms of an operating
agmt that is signed by some of its members and that defines the LLC’s governance and operation, even if the
LLC did not execute the agmt. Aka: AN LCC’S OPERATING AGMT GOVERNS IT’S MEMBERS ACTS
Facts: Jaffari is President of Malek and is approached by Elf to merge companies and make a solvent and
maskant.
- Merger discusses 3 separate agreements:
o Operating Agreement (looks like a partnership agreement)
o Distribution Agreement
o Employment Agreement
- Malek had a lot more marketability, etc.
- What choice of law provisions does the merger agreement provide?
o All disagreements between parties will be submitted to arbitration in San Francisco, Calif. [Only
based upon the big agreement – not separate distribution agreements]
 Arbitration has no precedential value
 You can decide who your judges are [Need an odd # if possible]
- Jaffari is accused of fraud, breach of contract, etc.
o Elf brings a lawsuit to compel LLC to enforce its rights in Delaware
In the Lower Court:
- Claims dismissed for lack of subject matter jurisdiction
- Elf says that the other 2 agreements with Jaffari don’t’ have an arbitration agreement (but Big Agreement
said ‘any controversy or dispute arising out of this agreement…’)
A Derivative Suit against Jaffari?
- An owner is bringing suit on behalf of an LLC (thus LLC is acting more like a corporation in this context)

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 o Partnerships don’t need derivative litigation because individual owners are personally liable for all
partnership debts
- Elf Atochem is created in Delaware but the operating agreement calls for all disputes to be arbitrated in
California
- Even though distribution agreement and employment agreement don’t have this language, they seem to
arise out of the operating agreement (and so California should be the site of all arbitration)
Why California?
- Malik LLC from California and they must have dominated the agreement
*There are limitations on the parties’ ability to contract freely
- Presumably this stipulation afforded Elf some monetary compensation [FREEDOM OF CONTRACT]
- Elf, however, hopes to get around the arbitration agreement through the operating and employment
agreements
• What about plaintiff’s argument that the Delaware Chancery Court somehow still has “special
jurisdiction over this matter since it involves a Delaware LLC?
- Default Rule – LLC statute applies in Delaware unless the parties provide otherwise
o *The parties DID provide otherwise [Arbitration]
o New York and Delaware heavily favor arbitration (quicker, more solid results)

Piercing the LLC Veil

• PCV [in the corporate context]: we typically need:
(1) A total disregard for the separate existence of the corporation
(2) Most of the cases and commentators state that there is a second element that must be proved: injustice or
some such concept.
→ Piercing the LLC veil works similar to piercing the corporate liability veil
- When conduct on the part of shareholders causes them to lose the protection afforded by limited liability
For PLLCV, We look to:
1) Unity of Interest (total disregard for personal character of corporation/LLC)
a. Commingling of funds
b. Lack of corporate formalities (must honor statutory requirements of corporations) – Unlikely that
this is the only transgression
2) Injustice

§ 302. Limited Liability Company liable for member’s or manager’s actionable conduct:
- A limited liability company is liable for loss or injury caused to a person, or for a penalty
incurred, as a result of a wrongful act or omission, or other actionable conduct, of a member or
manager acting in the ordinary course of business of the company or with authority of the
company.
- Debts of the LLC are solely debts of the LLC

§ 303. Liability of Members and Managers

(a) Except as otherwise provided in subsection (c), 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.
(b) The failure of a limited liability company to observe the usual company formalities or
requirements relating to the exercise of its company powers or management of its business is
not a ground for imposing personal liability on the members or managers for liabilities of
the company.
(c) All or specified members of a limited liability company are liable in their capacity as
members for all or specified debts, obligations, or liabilities of the company if:
(1) A provision to that effect is contained in the articles of organization; and

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 (2) A member so liable has consented in writing to the adoption of the provision or to be
bound by the provision.
• Kaycee Land and Livestock v. Flahive (pg. 312) RULE: The common law doctrine of piercing the corporate
veil is not abrogated by the LLC Act and may be used against LLC members in appropriate cases. Aka A
COURT MAY PIERCE THE CORP VEIL OF AN LLC
Facts: Limited Liability Company with no money (hence why plaintiffs wish to pierce the veil)
Issue: “In the absence of fraud, is a claim to pierce the LL entity veil or disregard the LLC entity in the same
manner as a court would pierce the corporate veil,… an available remedy against a Wyoming LLC…”
- Defendant says that there is nothing in the LLC statute that says you can pierce the veil but it IS in the
corporate statute
Wyoming Law: Section 17-15113
- “Neither the members of a limited liability company nor the managers of a limited liability company
managed by a manager or managers are liable under a judgment, decree or order of a court, or in any other
manner, for a debt, obligation or liability of the limited liability company.” [Premised on MBCA § 6.22]
ULLCA § 303(a): “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.”
Cf.: MBCA§ 6.22(b): “… a shareholder of a corporation is not personally liable for the acts or debts of the
corporation except that he may become personally liable by reason of his own acts or conduct”
Minn. Stat. § 322B.303(2)
- “case law that states the conditions and circumstances under which the corporate veil of a corporation may
be pierced under Minnesota law also applies to limited liability companies.”
→ If legislature put the agreement in the corporate statute they could have put it in the LLC statute (no intent for
this ability to be extended to the LLC)
- Defendant says please say that there are no circumstances where LLC veil can be pierced
Holding: LLC statute does not preclude court from disallowing a corporate veil to be pierced

Are there good reasons to consider an LLC to have elements of both partnership and corp.?

• McConnell v. Hunt Sports Enterprises (pg. 317) RULE: LLC members are bound by the terms of their
operating agmt, and if the agmt expressly allows them to engage in “any other business venture of any
nature,” they are not prohibited from participating in a competing venture.
Facts: Investors formed an LLC to bring an NHL franchise to Columbus [Hunt and McConnell are members]
- They need an arena but don’t want to invest in it
- Hunt finds an offer from Nationwide Insurance Enterprise unacceptable
- McConnell is approached by Nationwide. McConnell says that if the deal won’t work out with the LLC he
will form a separate contract with Nationwide. McConnell eventually takes the self deal.
o The fact that McConnell is approached by Nationwide shows that perhaps there is no tortious
interference
- Hunt sues McConnell
Is § 3.3 of the Agreement “Manifestly Unreasonable”?
• ULLCA § 103(b)(2): operating agreement may not “eliminate the duty of loyalty” but may “identify
specific types or categories of activities that do not violate the duty of loyalty, if not manifestly
unreasonable ….”
• Section 3.3 of the Agreement: “Members May Compete. Members shall not in any way be prohibited from or
restricting in engaging or owning an interest in any other business venture of any nature, including any venture
which might be competitive with the business of the Company.”
- i.e. We will allow parties to contract out of certain responsibilities UP TO A LIMIT; *Tension between
freedom of contract and duty of loyalty

What is manifestly unreasonable?

- The LLC had an opportunity to take the deal initially but the smart members went ahead and took
the opportunity
- The question is not whether § 3.3 is manifestly unreasonable but whether it permits CONDUCT
that is manifestly unreasonable
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Can we limit the fiduciary duties of owners in an LLC?
- YES, just as we could with partnerships but the limitation can’t be manifestly unreasonable
Holding: Court says that the agreement wasn’t manifestly unreasonable because it probably factored in
to the price of the deal
- The agreement is therefore found not to permit activities that are manifestly unreasonable
- *Duties that managers owe to LLC looks more like a partnership [so we have
corporate/partnership aspects of an LLC]

Why would the parties agree to this clause?

- Members all had interests in conflict with LLC so they agreed to permit one another to engage in
other ventures.

LLC Dissolution
• By Operation of Law:
- Upon the happening of any event specified in LLC operating agreement
- Vote of members (as specified in operating agreement)
- It becomes unlawful to carry on the business
• Upon Court Order:
- Economic purpose frustrated
o i.e. No way the LLC can continue running and make profit
o Usually need a court order for this situation because 1 or more people refuse to end the
LLC bc they think it may turn around
- Misconduct by members

• New Horizons Supply Cooperative v. Haack (pg. 323) RULE: An LLC member may be responsible for the
company’s debts if the members fails to take the appropriate steps to dissolve the company when it winds up
its operations. (Wisconsin Case)
Facts: Ms. Haack claims that articles of organization were filed but she can’t produce them
- Haack’s company, Kickapoo…, owes New Horizons $1,000.
- Haack signed checks without any designation that she was acting on behalf of Kickapoo (mistake #1)
o She had claimed that Kickapoo would pay $100/month
o She defaults on the 2nd month
- New Horizons sues for remaining debt
- Kickapoo’s remaining assets are:
o Truck, Pallet Jack, Accounts receivable (Held by Haack)
LLC can be dissolved by:
- Articles of Dissolution; or
- Letting your creditors know (creditors should start lining up at this time)
* Both of these will put creditors on notice
o Trial court says that they found a partnership and assessed liability on the
remaining partners [Even though the limited liability agreement decimated the partnership]
• This corporation is an LLC – Trial Court is wrong
Test:
Assets that she has vs. Her share of the debt
- She must pay whatever is less
• What this is saying is, “We’re going to hold you responsible for the amt you took up to your share of the debt”
- If you don’t take any assets from the LLC your responsibility is $0.
o Assets should be taken back for shareholders up to a limit that is fair if they were not put on notice
Unsecured Creditors – Creditors who have not been backed up by collateral
- Benefit from this rule

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 - Tears away some limited liability but Court never dips into managers personal assets – just those
belonging to the LLC

DUTY OF CARE & THE BUSINESS JUDGMENT RULE

Two Ways of Thinking about the Business Judgment Rule:

1) As a standard of liability to measure Director & Officer conduct [Director’s POV]
- No liability for negligence
- Instead liability based on things like:
o Fraud
o Illegal conduct
o Self-dealing
- A rebuttable presumption if plaintiffs can show that the director’s decision cannot stand (by
showing the they breached some duty – care, loyalty, etc.)
2) As an abstention doctrine for the courts [Court’s POV]
- Court will not review Board of Directors’ decision if:
- Preconditions:
o No fraud
o No illegality
o No self-dealing

Purpose of the BJR – to allow directors and board to run business without fear that they will be held
responsible for potential bad deals

What is the duty of care?

- MBCA § 8. 30(a): “Each member of the board of directors, when discharging the duties of the
directors, shall act:
(1) in good faith, and
(2) in a manner the director reasonably believes to be in the best interests of the corporation”
What is the duty of loyalty?
- Directors and officers have a fiduciary duty to put the interests of the corporation ahead of their
own.

Breaches of DOC & DOL are procedural prerequisites – to uphold presumption and be entitled to
defense, need to show neither was breached and thus entitled to BJR presumption and protection

Why doesn’t BJR offer protection for an uninformed decision?

- The defense doesn’t work if there is a breach of the duty of care and duty of loyalty
- Duty of care is triggered by an uninformed decision
*We need BJR because directors are in the best position to make decisions on behalf of the corp.

Who has the burden of proof on this issue?

- Always on the plaintiff (who is attacking the Board’s decision)
- Director’s must avail themselves of all reasonable information (see, e.g., Smith v. Van
Gorkam)
P Must prove – breach of duty of care (uninformed directors)
 Directors must avail themselves of all reasonably material available info (Smith v.
Van Gorkom) – high standards (controversial) i.e. Director didn’t read merger document
given to him before voting
 Question – what is enough to say reasonably availed yourself? – not sure

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 o Burden shift – when demonstrate breach of fiduciary duties, burden then
shifts to defendant (BOD, officer, or director)
 However, just b/c someone is on 2 sides of a transaction (interested)
doesn’t automatically make it a bad deal, but b/c of this, courts will take
a closer look at this
• Will have to show entire fairness
- Defense – BJR is a rebuttable presumption officers and directors raise when they are
sued
o Defense directors and officers can raise when they have been sued
 Entitled to presumption as long as haven’t violated duty of care or
loyalty
- Presumption – decision of board or director/officer will stand unless show reason
why it shouldn’t
o Rebuttable – if can show decision shouldn’t stand
 If duties have been breached
o Board can make decision that turn out to be bad as long as didn’t discharge
duties when making those decisions
 Won’t 2nd guess these decisions as long as there was rationale business
reasons made at time made decision

• Kamin v. American Express Company (pg. 328) RULE: A complaint alleging that some course of action
other than that taken by the board would have been more advantageous does not give rise to a cause of
action for damages. Aka A CORPORATION’S DIRECTORS ARE NOT LIABLE MERELY BECAUSE A
BETTER COURSE OF ACTION EXISTED
Facts: Plaintiffs sue on a theory of corporate waste (breach of a duty of care) – amount that corporation is
paying in exchange for what it is getting is so disparate that it can’t be the result of good business judgment
- Complaint alleges that American Express invested $29.9 million in DLJ stocks that were worth only $4
million
o If the company had sold the stock it would have recognized a $26 million tax loss that could have
been offset against its taxable income [as a tax shelter]
 When it instead issued the DLJ stock as a dividend [dividends can be distributed as cash,
stocks, or property], it lost that tax benefit
 The shareholders recognized dividend income equal to the fair market value ($4 million) of
the DLJ stock, and got a basis in the DLJ stock equal to that amount
o Plaintiff’s calculated the cost of the company’s scheme at $8 million.
- The shareholders were upset that the company didn’t take the tax benefits for its lost investments
[moreover, shareholders were forced to pay taxes on this dividend]
- This is a derivative suit because the shareholders are injured by way of the injury to the company [this
would be a direct suit if dividends had been paid to all other shareholders except plaintiff]
- Plaintiff seeks to reverse the dividend payment [harder to do than stopping something before it starts]
Duty of Loyalty Issue?
i.e. Is there evidence of self-interest here?
- If the directors compensation is tied to the success of the corporation, it is in the director’s interest to
increase profitability of the corporation [Thus, there is probably no duty of loyalty issue here because there
was no financial benefit conferred by their decision]
Duty of Care Issue?
- Directors investigated the demand in a special meeting
- Choose their course of action because they thought that taking the investment hit would harm the price of
AMEX’s own shares (they wanted to keep this quiet)
What standard does the court adopt for the DOC of directors?
- BJR invoked and standard articulated by the Court:
o “The Court will not interfere unless a clear case is made out of fraud, oppression, arbitrary
action, or breach of trust.”

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 o “The Court will not interfere unless the powers have been illegally or unconscientiously executed;
or unless it be made to appear that the acts were fraudulent or collusive, and destructive of the
rights of stockholders.”
o “Mere errors of judgment are not sufficient grounds for equity interference, for the powers of those
entrusted with corporate management are largely discretionary.”
o Directors did not totally overlook facts called to their attention
Holding: Defendant’s motion for summary judgment granted under the BJR

When can you declare a dividend open to debate?

- Solvency tests in every state statute – you can’t bankrupt a company when you declare a dividend
[Must have a certain amount of assets left when you are done]

Two ways that shareholders can get value:

1) Dividends -when you receive a percentage of the stock that you own after a year. i.e. if you are
a preferred stockholder, and you put in $1,000, and the shares are 3$ apiece, you’d get $3,000
at the end of the year
a. This decision is always within the discretion of Board
b. Never open to SH discussion
2) Appreciation – only realized after you sell your stock (which has become more valuable)

Should a board declare a dividend? Its ALWAYS a BJR for the BOARD to decide!!
- Decided on a case by case basis by some companies
- Dividends are always paid by some companies, never paid by others
- Is the decision of a board to pay or not to pay dividends open to shareholder debate?
o NO – this would be a usurpation of the Board’s authority (Always within the discretion of
the board to declare a dividend)
 *DEFINITION OF BUSINESS JUDGMENT
Kamin Court states:
“The minutes of the special meeting indicate that the defendants were fully aware that a
sale rather than a distribution of the DLJ shares might result in the realization of a
substantial income tax saving. Nevertheless, they concluded that there were
countervailing considerations primarily with respect to the adverse effect of such a sale,
realizing a loss of $25 million, would have on the net income figures in the American
Express financial statement. Such a reduction of net income would have a serious effect
on the market value of the publicly traded American Express stock.”

Strong Abstention Version of BJR

Court says: “A complaint which alleges merely that some course of action other than that pursued by the
Board of Directors would have been more advantageous gives rise to no cognizable cause of action.
Courts have more than enough to do in adjudicating legal rights and devising remedies for wrongs. The
directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business
questions which will have an impact on profits, market prices, competitive situations, or tax advantages.”

• Most objective observers would probably conclude that what the directors of AMEX did was dumb so
why no cause of action?
- A bad decision can still be protected by the BJR (otherwise no one would serve on a Board of
Directors)

The Deal: Legal Structure – see F Slide#15 pg. 3

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• Smith v. Van Gorkom (pg. 332) (DELAWARE CASE) – RULE: The BJR presumes that, when making
business decisions, directors act on an informed basis, in good faith, and in the company’s best interests.
*Seminal case for breach of the duty of care
Facts: Van Gorkom: CEO of Trans Union, a holding company for a rail car leasing business
- Van Gorkom is a lawyer and an accountant (nearing retirement) [Duty of Loyalty Issue? Constructing a
merger for a company in which he owns a lot of stock]
- Trans Union has investment tax credits that they could have offset against a certain kind of income that
they DO NOT HAVE – they need someone to come in with income to match [So, Company has a potential
to up their stock value]
o The current trading price of their stock reflects company with tax savings that they can’t use – if
they merge with a company who can use those credits stock value will rise
Timeline
• TU Stock - $38
- Sept. 5: Chief Financial Officer Roman runs a feasibility study – not a valuation study – difference?
o Feasibility Study takes, as an assumption, a number and then tests out whether this would work in
the market (looks at the viability of a particular price to do a deal – can be run with MANY
different numbers). Valuation Study simply comes up with that number (a process whose end
result is a price or range of prices of value for the stock).
o Where does $55 come from?
 Created by Van Gorkom out of his imagination (Conflict of interest? He was leaving soon
and wanted to “cash out”)
- Before Sept. 13: Van Gorkom meets with TU controller Carl Peterson
- Sept. 13-19: Van Gorkom approaches Pritzker
- Sept. 20: BOD meeting
o Court says historic price range was $30-$40. They believe V.C. should have contracted for a
valuation study.
 BOD reaction is wildly negative (as was senior management)
 20 minute presentation to Board [with an assumption that $55 is a reasonable price]
 Copies of proposed merger agreement were not available at meeting with BOD (not even a
written summary of terms of merger)
 Agreement never produced by the defendant even after directors requested it (It probably
never existed)
 BOD deliberated for 2 hours – woefully inadequate without papers or experts
• Duration of meeting is not dispositive but it is a fact you must work around
• Van Gorkom did not disclose the method by which he came up with the $55 value
(he made it up but it satisfied feasibility test)
- Oct. 1: First public wrinkle: within 10 days of the press release, key executive officers threatened to resign.
o Van Gorkom meets with Pritzker who agrees to some modifications as long as VG could convince
the dissidents to stay on the TU payroll for 6 months after the deal closed
 Pritzker gets the right to buy TU shares at $38
• Saying to bidder, “We’re gonna give you a chunk of the shares at the current
market price to lock you in to the deal”
• Gives bidder protection is he is outbid (can sell his interests for a profit between
the $38 and the actual purchase price)
• Why didn’t TU get any higher offers?
o Couldn’t provide anything other than public information to potential
buyers – Also, they couldn’t seek out these buyers (*Thus, the market
valuation was defective)
o If TU is allowed to hear offers that are higher, they can gauge the $55 price according to the free
market (a market valuation)
- Oct. 8: TU Board of Directors approves revised deal
o VG gets the senior management team calmed down and back in favor of the deal; they agree to hire
Salmon Bros. to solicit other offers for TU, and they approved the proposed amendments to the
Merger Agreement which had not yet even been drafted.
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 - Oct. 10: amendment to merger agreement delivered to VG and signed by VG, apparently without reading
them
- Dec. 19: this litigation was filed, and within 4 weeks, 8 of the 10 BOD were deposed
- Jan. 26: BOD has “lengthy” meeting and votes to proceed with the merger
- Jan. 27: BOD approves supplement to proxy statement detailing the merger
- Feb. 10: TU shareholders approve merger by 69.9% to 7.25% (22.85% abstained)

What Happened to the Old Trans Union Shareholders?

• DGCL § 251(b)(5):
The plan of merger shall specify “the manner of converting the shares of each of the constituent
corporations into … cash … securities of any other corporation or entity which the holders of such
shares are to receive in exchange for [their] shares.”
→ Everything that the old company owned now belongs to the merging company ($38 in stock became $55 in cash
for old shareholders)

This case is shocking to the legal profession because of the extreme breach of care by the Board
- Sign amendments to merger without even reading it

What does the court look at first?

• The application of the BJR to the 9/20 BOD meeting
- Was the business judgment made by the BOD “informed”?
o NO – the BJR is rebutted because of the Board of Director’s breach of the duty of care (Never even
saw the merger agreement)
 VG’s role forcing the sale and creating the share price;
 The intrinsic value of TU – the company they sat on the board of, some for many years
- How do you make shareholders whole?
o Reach the conclusion the board would have reached if they had been informed and give
shareholders the difference between $55 and that number

What factors helped the Court reach this decision?

- No valuation study (only feasibility study), no expert analysis to support price (only lawyer who gave bad
advice), 2 hour meeting, market valuation test made no difference
What relevance, if any, does the court find for the fact that the shareholders approved the board action?
- Approval without all of the facts, so this fact is irrelevant

What about defendants’ arguments?

• What about defendants’ argument that the substantial premium over the market price makes their decision an
informed decision?
- $55 is a better deal than $38 but it is not the highest available (it is a premium but everyone knew market
value was low)
• What about the defendants’ argument that their business savvy should be sufficient to save them from liability?
- Probably not ever a winner – needs a backup argument

• The application of the BJR to the BOD conduct after the 9/20 BOD meeting
- Was their conduct [in approving the amendments] informed and not so grossly negligent; and if so, could it
cure the 9/20 violations of the business judgment rule?
o The amendments didn’t cure the 9/20 meeting because they didn’t have them at the time

What about § 141(e)?

- A member of the BOD or a member of any committee designated by the BOD shall in the performance of
such member’s duties be fully protected in relying in good faith upon the records of the corporation and
upon such information, opinions, reports, or statements presented to the corporation by any of the
corporation’s officers or employees, or committees of the BOD, or by any other person as to matters that
the person reasonably believes are within such other person’s professional or expert competence and who
has been selected with reasonable care by or on behalf of the corporation.
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How does § 141(e) figure into all this?
- Allows you to rely on experts
- Directors need to make sure that they are informed [this might require use of experts]
o You can rely on records of corporation, reports and statements of committee, information from
“experts,” etc.
- Feasibility study, etc. from Van Gorkom CANNOT be relied upon by the B.O.D. [B.O.D. has no § 141
defense]
o One very serious problem is that Van Gorkom himself was uninformed. Suppose that instead of
himself briefing the board of directors, Van Gorkom had the corporation’s lawyer brief the board.
What if it was a lawyer who the B.O.D. relied upon?
- Must opine in the area of expertise, so lawyer is not a § 141(e) expert concerning valuation study, etc.

Legal Standard from Smith v. Van Gorkom

What do B.O.D. need to show to be informed?
- Directors must gather all information “reasonably available” to them:
o The reasonably available standard requires an in-depth study:
 Valuation study
 Discussion of course of the negotiations
 Review of actual contract
 Information about the terms of the offer and their fairness

ALI Principle’s of Corporate Governance § 4.01(c)(2):

- The ALI standard only requires directors to be informed to the extent that they reasonably believe
to be appropriate under the circumstances
How does ALI standard differ from the court’s standard?
- The ALI approach permits directors to make decisions on less than all reasonably available
information, if they reasonably believe doing so is appropriate given the situation.
o Gives directors more subjective view, but still need to make a showing they did at least
something

Would it make sense to apply ALI standard to Smith v. Van Gorkom?

- NO → the level of misconduct by board was bad enough even to satisfy the ALI’s less stringent
subjective standard

Pg. 344 (Question 2)

• If $55 per share was good enough for Van Gorkom, who held 75,000 shares, why was it not good
enough for the rest of the shareholders? Did Van Gorkom’s interests or goals differ from those of a
typical shareholder?
- Van Gorkom was not a representative shareholder because of his age and the fact that he was
considering retirement

Does the board have to get the highest price or just a fair price?
- TRICK QUESTION – the only fair price is the highest price
- By definition, fair price must be the highest price bc the duty is on the Board to mazimize the
interests of the SHs

When shareholders find out a company is merging they can

1) Attempt to stop it by injunction
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 2) Sue to rescind
3) Opt out individually (go to a judge to have your shares valued –aka invoke your appraisal
rights)
a. • Appraisal Rights – statutory rights that SHs have that allow them to go to a judge
and say that they are not getting a good deal and the judge can value the shares and
cash out.

Cinerama, Inc. v. Technicolor, Inc. (pg. 342)

Facts:
- Plaintiffs were shareholders who opposed the merger of Technicolor into a subsidiary of MacAndrews and
Forbes, and perfected their appraisal rights. While they were pursuing their appraisal remedy, they learned
facts that led them to file for rescission.
- They were ultimately unsuccessful – lower court held that since the price was fair, there was no harm, no
foul. Up and down on appeal, ultimately affirmed – and we get an example of the “entire fairness”
doctrine.
- In Cinerama the court said even though bad things were happening, you got a fair price in your opt out
(Beginning of the “ENTIRE FAIRNESS DOCTRINE”)
Distinctions between Cinerama case & Van Gorkom – F Slide #47, pg, 8

Doctrine of Entire Fairness (from Cinerama) – standard used to evaluate certain types of conflicted
transactions that are still fair transactions
o “No harm, no foul”
o Purpose – opportunity for Ds to cleanse the taint of breach of
loyalty
Factors to be considered in analyzing the Entire Fairness of a transaction:
- Timing
- Initiation
- Negotiation
- Structure of the transaction
o Did some get more than others
- Disclosure to and approval by BOD
- Disclosure to and approval by the shareholders

Technicolor gave us an explanation of how to rebut the Business Judgment Rule:

- “To rebut the rule, a shareholder plaintiff assumes the burden of providing evidence that
directors, in reaching their challenged decision, breached any one of the triads of their
fiduciary duty—good faith, loyalty or due care. If a shareholder plaintiff fails to meet this
evidentiary burden, the business judgment rule attaches to protect corporate officers and
directors and the decisions they make, and our courts will not second-guess these business
judgments. If the rule is rebutted, the burden shifts to the defendant directors, the proponents of
the challenged transaction, to prove to the trier of fact the “entire fairness” of the transaction to
the shareholder plaintiff.”

Entire Fairness Recap

• If P can’t show breach of duty of care or loyalty, then case goes away
• If can show breach of either – BJR is rebutted, and the burden shifts to D who must
now show entire fairness
o Burden initially on P to rebut the BJR
• If P rebuts BJR and can show breach, then burden shifts to the defendant directors to
show that even though there was/is a breach, that the transaction is still fair
o Show that there are no damages b/c shareholders got a fair deal

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• Francis v. United Jersey Bank (pg. 356) RULE: Directors have the duty to act honestly and in food faith and
with the same degree of diligence, care, and skills that a reasonably prudent person would use in similar
circumstances. Aka: DIRECTORS MUST DILIGENTLY DISCHARGE THEIR DUTIES
The Players:
- Lilian Pritchard:
o Widow of Pritchard & Baird’s (a reinsurance company) founder
o Director of the company but:
 Inactive
 “Listless”
 Drank “rather heavily”
- Pritchard boys: Charles Jr. and William
o Sons of Founder
o Active in management; dominant figures
o Systematically embezzled large sums in form of nominal “loans”
Facts: Francis is a trustee of creditors and United Jersey Bank represents widow’s estate
- Husband passes away and widow inherits his 48% interest in the company
o She is a director now with duty of care and loyalty to the shareholders
o She doesn’t do much with her duties – “Business is complicated; I don’t know nothing about
reinsurance.”
- All the while sons are embezzling large sums of money; calling them “loans”
o This throws off the company’s balance sheet (loans are still considered company assets… assets
that they do not have when the brothers do not pay back the loan)
- So, the estate of Widow Pritchard is being sued for breach of fiduciary duties [Sons who are the
wrongdoers are not good targets – judgment proof]
o She breached her duty of care
o What did Court Expert? Directors have a duty to be informed!:
 “Obligation of basic knowledge and supervision”
 Read and understand financial statements
 Object to misconduct and, if necessary, resign
• A statutory responsibility to manage the corporation
• A director can’t give a proxy (right to vote) to someone because they must
discharge their own duty of care
Holding: Because she did not discharge her duty, Pritchard is found liable to the creditors
**SEE F SLIDES 53-56 – pgs 10-11 for Sample Balance Sheets

New Federal Legislation – The Sarbanes-Oxley Act:

• Post-Enron scandal Congress passes Sarbanes-Oxley Act, which:
- Makes it easier to prosecute securities fraud, particularly financial fraud
- Imposes greater responsibility on senior management and directors, particularly independent
directors and audit committee members, by requiring them to take a substantially more proactive
role in overseeing and reporting the financial reporting process, including disclosure and reporting
systems and internal controls
- A push at independent directors:
o Codifies duties of directors (consistent with case law) and adds statutory penalties
→ Important to remember the distinction between inside/outside directors
- Does not purport to change the common law duty of care, but increases civil and criminal
enforcement authority over the conduct of corporate officers and directors,
o No question that potential civil liability for directors will be greater after Sarbanes-Oxley

S-O Audit Committee Requirements

- § 301 orders SEC to adopt rules mandating that:
o At least one member of audit committee must be a financial expert

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 o The audit committee shall receive reports from the independent auditors regarding critical
accounting practices and policies, discussions that have taken place with management regarding
alternative treatments of financial information under GAAP, and any accounting disagreements and
other material written communications between the auditors and management
o The audit committee must establish procedures to receive and address complaints regarding
accounting, internal control and audit issues, and to provide company employees an opportunity to
make confidential, anonymous submissions regarding accounting and auditing matters

DUTY OF LOYALTY: Interested Directors and Corporate Opportunities

Interested Directors – people on both sides of a transaction (fairly common in business world), i.e.
when two people who are on the boards of different companies do a deal together

Two Common Fact Patterns for DOL breaches:

- Director or Officer enters into a contract with the corporation;
- Director or Officer learns of a business opportunity that may be of use to the corporation, but they
take it for themselves (Corporate Opportunities Doctrine)
*Corporate Opportunities Doctrine is a subset of the Duty of Loyalty Doctrine

Conflict of Interests Transactions

- History: In the late 19th century, any shareholder could void ANY contract between a director and the
firm, regardless of the fairness of the contract or ratification.
- It didn’t matter if it was a good deal for the corporation or not, and it didn’t matter if the interested director
approved the transaction or not.
- Benefits of the Old Rule: simplicity and easy to apply; shareholders faced smaller risks that directors
would defraud the corporation
- Drawbacks to Old Rule: corporation often lost advantageous deals they could otherwise have made with a
director.
FOR EXAM: explain that there was an old rule but discuss new approach (entire fairness)
Protect board by saying deal was fair for both sides, if entire fairness then no breach of DOL

Why doesn’t the BJR apply to conflict of interest transactions?

- Board is in the best position to decide corporate matters
- BJR presumes that directors who honor the duty of care and duty of loyalty are making good
business decisions
- Conflicted directors are not those that we presume make good decisions [don’t get presumption of
BJR]
• BJR yields to the rule of undivided loyalty (protects decisions made without breach of duties)
- Plaintiff in Bayer v. Beran rebutted BJR because he demonstrated a breach of the duty of loyalty
(burden shifts to defendant)
- Although it was a breach of duty the defendant was able to show that the transaction satisfied the
Entire Fairness Doctrine

§ 402 of Sarbanes-Oxley
- Bars publically held corporations registered with the SEC from directly or indirectly lending or
arranging for the extension of credit to their own officers or directors.
o In addition, S-O § 406 requires a corporation to adopt a code of ethics applicable to its
CEO, CFO, controller, and chief accountant.
o If the company fails to do so, it must disclose that failure and explain its reasons for not
adopting the required code.
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 o In order to pass muster, the ethics code must provide for “the ethical handling of actual or
apparent conflicts of interest between personal and professional relationships.”

• Bayer v. Beran (pg. 374) SEE G SLIDE #7, pg. 2) RULE: A director does not breach his fiduciary duty by
approving a radio advertising program in which the wife of the corporate president, who was also member
of the BOD, was one of the featured performers. Aka: RULE REQUIRING DIRECTORS’ UNDIVIDED
LOYALTY AVOID POSSIBILITY OF FRAUD AND THE TEMPTATION OF SELF-INTEREST.
Opera Singer and Her CEO Husband Case
- When there is a breach of the duty of loyalty the burden shifts to the defendant to show that
there is ENTIRE FAIRNESS in transaction
o Look at the timing of the deal, who initiated the deal, how the negotiations unfolded, etc.
o If defendant can show entire fairness his breach of the duty of loyalty is irrelevant (cleanses the
taint of the breach)
- If plaintiff has shown a breach of the duty of loyalty, the burden shifts to the defendant-director to show
that the breach doesn’t matter because it satisfied the requisite fairness requirement [Entire Fairness
Doctrine]
o Despite breach the transaction is inherently fair to the corporation [There is still a breach but the
taint of the breach has been cleansed]
- How did the court find that there was entire fairness?
o Opera singer was paid the same as all other singers and was competent at her job
Facts: CEO is married to a professional singer and his corporation hires her to perform on their radio
show [Definitely a conflict of interest]
- Opera singer was not paid more, given no more exposure than the other performers, etc. [This contractual
relationship passed the Entire Fairness Doctrine]
o Need to make sure that the singer’s contract was identical and fair to the other performers (Make
sure it is an “arm’s length transaction”)
- All the decisions to hire the opera singers are protected by the BJR except as to her until they prove Entire
Fairness
Complaint: High-end artsy opera program
- Maybe plaintiff wants something that will appeal more to the masses
Standard of Review: BJR (as to the decision to employ the opera program and hire other singers)
Court focuses strongly on balancing authority and accountability: “To encourage freedom of action on
the part of directors, or tp put it another way, to discourage interference with the exercise of their free
and independent judgment, there has grown up what is known as the BJR. Indeed, although the
concept of responsibility is firmly fixed in the law, it is only in a most unusual and extraordinary case that
directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest.
The BJR, however, yields to the rule of undivided loyalty. This great rule of law is designed to avoid the
possibility of fraud and to avoid the temptation of self-interest.
See F Slides 9-10, pg. 2 – Answer Questions??

Was it a breach of the Duty of Loyalty for the corporation to hire Ms. Tennyson?
- Because of the conflict of interest, the business judgment rule does not apply. Hence, Dreyfus and the
other directors bore the burden of proof on the issue of the fairness of the transaction. THEY MET THIS
BURDEN.
Why no breach of DOL?
- Tennyson (wife) did not get unreasonable pay.
- The program was not designed to further her career.
- The company obtained its money’s worth from the radio campaign.
Corporate Formalities Issues
- The hirings did not issue from a resolution at a board meeting, but the court refused to impose liability on
directors because they did not come to a conclusion in this matter.
Plaintiffs argue that the transaction was ultra vires (illegal as beyond corporation’s power – exceeding its grant of
authority) because there was no formal board action.

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 - Drafting point for Articles of Incorporation is the purpose clause of the corporation [Should be drafted very
generally so as not to violate doctrine of ultravires]
Can one director bind the corporation? One director cannot, but a majority of directors can
- In the law of agency principles may give the agent the power to bind the company
- The board of directors can bind the corporation; Directors appoint officers [CEO, CFO, etc.], who act as
agents of the corporation
o A majority of directors can bind the corporation by authorizing the agents to execute what they
agree upon [i.e. Empower the officers to bind the corporation]
o Thus, only one director cannot bind the corporation [unless the B.O.D. is one guy]
- So in the opera case, the Curt says that the directors were kicking this around at the water cooler but the
result was fair [No formal ratification – court reads in an implied ratification because they did not oppose
radio program]
Advice to give Dreyfus?
- DISCLOSE AND ABSTAIN –let other directors know about conflict then leave room during the vote

Burden of proof w/duty of loyalty – initially on P to show there is a conflicted transaction

and if/when successful, burden shifts to defendant to show entire fairness
o In this case, P rebutted BJR by showing director was interested in transaction
b/c wife was on other side of transaction
o Now, D must demonstrate that although there is a breach that the deal is still
fair to the corp
o Breach shown, now D must show entire fairness
o For P to win – must not only show breach but D would have to not be able to
show entire fairness
Where director has conflict deal not automatically voided, but Courts will look at this
transaction much closer
o If no conflict, BJR is presumption Board has that they behaved properly
o If P has shown conflict of interest (breach of duty of loyalty) burden shifts to D
director to show why the transaction is still fair
 Remember – P doesn’t automatically win, but burden will shift
 Way for director to show conflict doesn’t matter is to show that the transaction
is completely fair to the corp despite the breach – entire fairness doctrine
• Breach of duty of loyalty – by definition any interested director transaction
automatically shows breach of duty of loyalty, however, the question is what does
this do?
o Still a breach, but the stench of the breach has been shown to be ok
o Courts will take a closer look at the transaction, and look at it through entire
fairness
 If entirely fair - P should have nothing to complain about, no damages

Variant: Quorum Issue [in the context of Delaware cases, ONLY]

Variation on Bayer:
• Assume a Delaware corporation with 5 directors: Dr. Dreyfus, plus Alice Adams, Bob Brown, Charlie
Connors, and Ed Edmond. There are 1 million outstanding shares; each director owns 5,000. At a
scheduled BOD meeting, only Dr. Dreyfus, Alice, and Ed show up to discuss and vote on the radio
advertising idea. Do they have a quorum?
- Simple majority is usually what the court requires to have a quorum (i.e. The minimum number
of directors needed to have a valid meeting); All corporate statutes require AT LEAST a majority
of directors
- If there are only 2 directors present at the meeting in this hypo it is NOT valid
o However, directors can participate in a meeting via telephone, etc. to satisfy quorum
o During the course of a meeting quorums may come and go
o On any given issue you must have a majority of the directors present to pass a resolution
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  e.g. On a 10 person board, 6 need to show up for the quorum; For an issue to pass among
those 6, 4 directors need to support it. *This requirement places a lot of emphasis on
notice – each director must be afforded adequate notice.
- DGCL § 141(b):
o “…A majority of the total number of directors shall constitute a quorum for the
transaction of business unless the certificate of incorporation or the bylaws require a
greater number…”
Does the fact that Dreyfus is one of the 3 directors present matter for quorum purposes?
- DGCL § 144(b):
o “Common or interested directors may be counted in determining the presence of a
quorum…”
o Kicks in when you have an interested director

Voting Statutes: Do You See the Difference?

- DGCL § 141(b): “The vote of the majority of the directors present at a meeting at which a
quorum is present shall be the act of the board of directors unless the certificate of incorporation or
the bylaws shall require a vote of a greater number.”
- DGCL § 144(a)(1): “ . . . the board or committee in good faith authorizes the contract or
transaction by the affirmative votes of a majority of the disinterested directors, even though the
disinterested directors be less than a quorum . . .”
o You need a majority of the total disinterested directors to say yes even if this is less than the total
majority; Every disinterested director that votes is subject to liability on that vote
o e.g. 10 person board: 5 interested, 5 disinterested
 We know we need 6 people in the room but we also need the affirmative vote of 3
disinterested directors

When you have an interested director vote you need to show 1 of 3 things:
(1) Need a majority of the total number of disinterested directors [At least 2 required by MBCA]
(2) Majority of shareholders can vote and cleanse a conflicted transaction [If shareholders who have
no financial stake in the business agree to the transaction they effectively cleanse taint of the
interested directors – Legislature DID NOT mention that it had to be a majority of disinterested
shareholders but they allowed the courts to define this requirement]
(3) A showing that the vote is fair

Hypothetical
- 5 total directors: 3 are interested; 2 disinterested
o All 5 show up to a meeting
o On the issue in which the 3 are interested, we need BOTH of the disinterested to say yes to approve
the transaction [when we’re talking about a conflict transaction something smaller than the
majority will suffice]
o We would still need only the customary simple majority to pass a non-conflict transaction
Steps:
- Make sure you have a 141(b) quorum; then go through the votes that the quorum will
consider
- If any of the votes are interested you need to discover the ratio between
interested/disinterested and get a majority of the disinterested

What is the effect of ratification per § 144(a)(1) or § 144(a)(2)?

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 - Takes an otherwise suspect transaction and validates it
- § 144(a): “No contract or transaction between a corporation and 1 or more of its directors or
officers ... shall be void or voidable solely for this reason, or solely because the director or officer
is present at or participates in the meeting of the board or committee which authorizes the contract
or transaction, or solely because any such director’s or officer’s votes are counted for such
purpose, if:
(1): approved by a majority of the disinterested directors
(2): approved by a majority of the shareholders

Why is it okay if a majority of the disinterested directors approve the transaction?

- If the folks who have no stake in the transaction are satisfied with the terms then they “cleanse the
taint”
o INCREDIBLE PRESSURE on disinterested directors; especially if we’re under the
Delaware Statute
 DGCL § 144(a)(1) allows only 1 disinterested director on the board to cleanse the
taint
 MBCA § 8.61(b) requires at least 2 disinterested directors

And what about § 144(a)(3)? What would be an example of a situation in which it would be relevant?
• It’s unlikely that (a)(1) or (a)(2) would be true and (a)(3) would not be
- So, if you can’t pass (a)(1) or (a)(2) this is your last resort, and it will be a long shot
- Issues:
o Hallmark of a Fair Transaction?
 Within the range of terms that parties bargaining at arms-length might reach
 Defects in disclosure highly relevant, however
• If undisclosed facts had been known, firm might have gotten a better deal
even if terms were in the range of fairness

§ 144(a)(3) Issues in Bayer

- Nothing to show that some other soprano would have enhanced the program
- No suggestion that the present program’s cost is disproportionate
- Tennyson’s contract was on a standard form, negotiated through her professional agent
- Her compensation was in conformity with that paid for comparable work
o She received less than any of the other artists on the program
- Although she appeared with greater regularity than any other, she received no undue prominence
- Subordinated to the advertisement of the company’s products

What’s the rule in NY on this?

- BCL § 713 adopts the common law rule and provides special rules for scrutiny of interested
transactions.
o § 713(b): the proponents must “establish affirmatively that the contract or transaction was
fair and reasonable as to the corporation at the time it was approved by the board.”

Disinterested directors in DE – 1 disinterested director (if he is only one) may

approve the transaction
Disinterested directors in MBCA – need at least 2 – 1 disinterested director
can never approve transaction alone - Have to find another way

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Lewis v. S.L. & E., Inc. (pg. 379/173) RULE: A transaction in which a director has an interest, other than as
the corp’s director, is automatically suspect and subject to further review. Aka: DIRECTORS MAY NOT
ENGAGE IN SELF-DEALING
Facts: SLE and LGT are owned by the same cast of characters
- One owns the land, one owns the tire store that operates on the land
- There was a shareholder agreement (a contractual arrangement that provides a “right of 1st refusal” to
other shareholder should you so choose to sell) that required shareholders at some point to sell their SLE
shares and buy LGT.
- When ownership interests change, the company who owns that land no longer received fair market value on
the lease → SLE’s income no longer even covered the taxes that they had to pay on the land (they were in
effect subsidizing LGT’s lease)
- Donald (brother) never purchased LGT shares and was losing money through SLE; he wants to see the
financial statements of LGT [he does not want to sell his shares based on book value “calculated” by LGT]
- Donald brings a waste claim for the assets of SLE against his brothers who are directors of both companies
(WASTE – amount being paid for something not possibly the product of a valid business judgment; 1st
claim we’ve seen for underpayment)
Procedural: Donald doesn’t win in lower court because he doesn’t assert damages (couldn’t show that he was
not getting appropriate price)
- On appeal bad brothers need to show fairness of transaction (because Donald shows conflict of interest
burden shifted to the interested directors)
- Defendants DO NOT satisfy burden of BCL § 713
Why did this case really happen?
- Ownership interests in the two companies hanged, where some brothers/sisters only owned SLE stocks and
are being ripped off by LGT
So what’s plaintiff’s remedy?
- Upwardly adjust the book value of SLE stock (court will make sure calculation is supportable)
What could Richard and Leon, Jr. have done to sanitize the lease transaction?
- 141(a)(1) requires disinterested directors
- 141(a)(2) requires shareholder approval [can we have disinterested/interested shareholders?]; the
Directors/Brothers are the majority shareholders as well → THEY ARE INTERESTED
SHAREHOLDERS and even though lawmakers don’t include “disinterested shareholders” the courts
have read this requirement in

REVIEW:
- In substance, Bayer seems to apply the rules that are stated or implicit in Lewis:
(a) Absent a conflict of interest, the plaintiff has the burden of proving a breach of fiduciary
duty, and will no doubt lose because of the business judgment rule,
(b) Given an unratified conflict of interest transaction, the defendant directors have the burden
of proving that the challenged transaction was fair and reasonable.
(c) Given a transaction with a conflict of interest but with ratification (by disinterested
shareholders or directors) under a provision such as New York’s § 713, the plaintiff again
has the burden of proof and must overcome the business judgment rule.

Ownership Interests in Companies

2 different corporate interests:
• Ownership Interests – stock
• Creditor Interests – bonds, debentures

Stock Terminology – common stock

- A type of stock that represents the RESIDUAL value of the corporation; common stock has no
special contract rights or preferences; so creditors and preferred shareholders must receive their
required interest and dividend payments before common stockholders get ANYTHING.

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 - Common stock has no fixed maturity date (date when the debt is done/due); if the corporation is
liquidated, the creditors and preferred stockholders are paid the value of their interests first, and
common stockholders are paid the value of their interests, if any, last. (Hierarchy of Payment: 1.
Creditors, 2. Preferred Stockholders, 3. Common Stockholders)
- Ordinarily, common stockholders have the exclusive right to elect the board of directors who
manage the corporation
- They may also get to vote on mergers and other important matters.
- In return for their investment, common stockholders receive DIVIDENDS declared by the board
of directors
- Common stock is frequently the only class of stock outstanding;
- It generally represents the greatest proportion of the corporation’s capital structure and bears the
greatest risk of loss should the enterprise fail
o But in return for this position of subordination, the common stockholders have an
exclusive claim to the corporate earnings and assets that exceed the claims of creditors and
other shareholders
o Therefore, the common stockholders bear the major risks of the corporate venture, yet
stand to profit the most if it is successful.
 They can benefit either from appreciation or cast/stock/property dividends

Stock terminology – preferred stock

- An equity security that is given certain preferences and rights with regard to assets or dividends
over common stock. They have contractual rights superior to those of common stock; it is
“preferred” to common stock – it takes priority over the common stock in some way, usually
either in terms of dividends or liquidation preferences or both.
Preferences:
1) Liquidation Preference
- The right to be paid before the common stockholders if the corporation is dissolved and liquidated.
The liquidation preference is usually stated in a dollar amount.
o Example: a corporation issues a stock that has a liquidation preference of $200. This
means that if the corporation is dissolved and liquidated, the holder of each preferred share
will receive at least $200 before the common stockholders will receive anything. Note that
since the corporation must pay its creditors first, there may be insufficient funds to pay
even this preference.
o Remember Order of Payment (Liquidation): 1) Outside Creditors; 2) Inside Creditors;
3) Preferred Stockholders; 4) Common Stockholders
2) Dividend Preference
- The right to receive a fixed dividend at set periods during the year, like every quarter. The
dividend rate is usually a set percentage of the initial offering price.
o Example: if a stockholder purchases $10,000 of a preferred stock that pays an 8 % annual
dividend. The stockholder has the right to receive $800 each year as a dividend on the
preferred stock.
- Common stockholders have NO RIGHT to a dividend; Contract right to a dividend for preferred
stockholders.
- cumulative dividend right: corporations must pay a preferred dividend if they have the earnings
to do so. Cumulative preferred stock provides that any missed dividend payments must be paid in
the future to the preferred stockholders before the common stockholders can receive any
dividends.
- non cumulative preferred: dividends do not cumulate; the corporation does not have to pay any
missed dividends. For these shares, only the current year’s dividends must be paid to preferred
shareholders prior to the payment of dividends to common shareholders.

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 o Preferred stockholders would choose to have cumulative dividends; common stockholders
would choose to have preferred stockholders get noncumulative dividends
3) Participation Preference
- allows the stockholder to participate in the profits of the corporation, along with the common
stockholders. Participation is in addition to the fixed dividend paid on preferred stock. The terms
of the participation can vary widely. Usually, the common stockholders must be paid a certain
amount of dividends before participation kicks in.
- Preferred stockholders share in common stockholder profits (Common stockholders HATE this
stipulation)
4) Conversion Right
- permits the stockholders to convert their shares into another security, typically, common stock.
The terms and exchange rate of the conversion are established when the shares are first issued.
The holders of the convertible preferred stock usually exercise this option if the corporation’s
stock increases significantly in value.
- A conversion ratio must be built in for these options (won’t convert if common stock is at or
below the price of the preferred stock)
- Source of discontent among common stockholders because this right has a dilution effect on
stocks
- A 1-Time Conversion
5) Redemption Right
- permits the corporation to redeem/buy back the preferred stock at some future date. The terms of
the redemption are established when the shares are first issued. Corporations usually redeem
shares when the current interest rate falls below the dividend rate on the preferred stock.
- As soon as the corporation has the contractual right to redeem stock it will
o *Only thing that makes preferred stock less valuable

BENIHANA Case – See ‘G’ Slides pg. 7!

Corporate Opportunities Doctrine

- Directors and Officers can’t take for themselves opportunities presented to them in their corporate
capacity that: (do not need all factors, but strongest case would include as many as possible)
1. The corporation is financially able to take advantage of;
 You aren’t taking something away from the corporation if they couldn’t take the
offer anyway.
2. are within the corporation’s line of business and is of practical advantage to it;
3. is one in which the corporation has an interest or expectancy; and
 Interest: something to which the firm has a better right
 Expectancy: takes something on which, in the ordinary course of things, would
come to the corporation
• If officer bought land to which the corporation had a contractual right, the
officer took an “interest”
• If the officer took the renewal rights to a lease the corporation had, the
officer took an expectancy
4. by embracing the opportunity the officer or director would create a conflict between his or her
self-interest and that of the corporation.

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 - An example of the breach of the duty of loyalty.

Does Director or Officer’s belief matter? YES VERY IMPORTANT

o Must be good faith belief that this was not a corporate opportunity
o If you believe based on these factors that the corporation is not entitled to this
corporate opportunity, you are entitled to take opportunity for yourself
o Remember: director or officer’s belief is CRITICAL!

• Broz v. Cellular Information Systems, Inc. (pg. 384) RULE: Under the doctrine of corp. opp. A corp.
fiduciary must place thecorp’s interests before his or her own interests in appropriate circumstances, but a
corp fiduciary does not breach his or her fiduciary duty by not considering the interests of another corp
proposing to acquire the corp in deciding to make a corporate purcase.
Facts: Broz is creditor and sole shareholder of RFB Cellular
- Broz also a member of board of directors of CIS
- He is surely an expert in the field, but he has a huge conflict of interest
- RFB and CIS discover that a 3rd license (Michigan-2) has become available for purchase
- Broz claims that he learns of this offer in his RFB capacity [Not CIS]
o Broz believes that CIS is not a viable purchaser so he buys the license of RFB
- CIS had NO interest in the Michigan-2 license (would not have bought it for anything)
o They were having a financial crisis & attempting to get out of debt → moving out of cell industry
o Every member of CIS says we couldn’t have taken this & wouldn’t have taken it even if we could
o Broz never formally presents offer to the board
- FN 17: CIS was selling all licenses except 5 – none in the Midwest
- PriCellular is tendering an offer for CIS
o Tender Offer – A public offering sale; NOT a purchase
o PriCellular was bidding on Michigan-2 against Broz
 PriCellular was offered right of first refusal unless someone offered at least $500,000 more
 Broz pay $500,000 extra
• But, Broz owes NOTHING to PriCellular
- PriCellular sues for taking a corporate opportunity
o Brox takes an offer for himself that could have gone to CIS/PriCellular
Holding: Court rules that Broz did not breach his duty of loyalty

Court Provides the “Classic Statement” of the doctrine:

“if there is presented to a corporate officer or director a business opportunity which
the corporation is
1)
financially able to undertake, is, from its nature
2)
in the line of the corporation’s business and is of practical advantage to it
3)
is one in which the corporation has an interest or a reasonable expectancy, and,
4)
by embracing the opportunity, the self-interest of the officer or director will be
brought into conflict with that of the corporation, the law will not permit him to seize
the opportunity himself.”

Are these factors or elements?

- It’s not entirely clear; the test uses “and.” The court calls them factors but then implies that
absence of any one is enough to avoid liability.
- NO SINGLE FACTOR IS DISPOSITIVE BUT INSTEAD THE COURT MUST BALANCE
ALL FACTORS AS THEY APPLY TO A PARTICULAR CASE

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Under Broz, when can a Director or Officer take an opportunity for himself?
- “If the director or officer believes, based on one of the factors articulated above, that the
corporation is not entitled to the opportunity, then he may take it for himself.”
- The D or O’s belief is CRITICAL!!

What about the fact that he was competing with PriCellular, who was about to buy CIS?
- None – Pricellular proffered a tender offer which doesn’t always go through.
Why didn’t PriCellular just outbid RFBC?
- They couldn’t

• In re eBay, Inc. Shareholders Litigation (pg. 389/177) RULE: The fiduciary duty of loyalty requires
directors and officers to offer investment opportunities derived from corporate business to the corporation
before acting on them individually
Facts: Goldman Sachs is an investment banker that helps companies by conducting public offerings
- IPO [Initial Public Offering] – the time when a non-public company becomes a public company → value of
share initially rises when it becomes public
- The idea of spinning comes from when an investment bank gives preferential treatment to certain clients
(want to try and stay in their good graces)
o Goldman Sachs gave eBay at least 40 public offerings and eBay CEO sold them for a lot of money
- Plaintiff alleges that directors of eBay usurped a corporate opportunity
o When Goldman came to directors, they should have said thank you on behalf of eBay, not
themselves
o Goldman came to directors in their corporate capacity; Goldman Sachs works for eBay, not the
individual directors
- Uncanny coincidence that the rich people that Goldman Sachs came to were directors of their biggest and
best client?
o Absolutely not… this is defendant’s argument and it is absurd
Is this a corporate opportunity under Delaware law?
1) Can corporation take advantage of the opportunity financially?
- Court says yes
- eBay invests a lot of its excess capital in a lot of other companies, new divisions, etc.
2) Within their line of business?
- How should we determine whether something is in a company’s line of business?
o The broader we read corporate opportunity the more conflict we’re going to stir up [and thus
narrow what directors can do, discouraging people to be directors]
o Court looks at financial assets of eBay and investment is a large portion of eBay profits → line of
business is read broadly here
 Concept of line of business is designed to help us determine a conflict and through
financial records show what a corporation is actually doing
3) 3rd Prong Not Discussed
4) Self-interest of director in conflict with eBay
- YES – Goldman Sachs giving these opportunities to directors to entice them to keep Goldman Sachs on (a
definite conflict of interest)
Holding: THIS IS FOUND TO BE A CORPORATE OPPORTUNITY

Under what circumstances will directors be entitled to preferential treatment w/o incurring
liability?
- Something that is unconnected to the opportunity of continuing business (e.g. a shareholder offers
this to directors)
- Courts shut down spinning by making directors liable to shareholders

• In Beam ex rel. Martha Stewart Living Omnimedia v. Stewart (pg. 392)

Facts: Stewart owns stock in company and sells 3,000,000 shares to ValueAct.

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 - Investor wanted to give money for Martha shares. For Martha to sell her own shares instead of permitting
the company to raise capital by selling its stocks took away a corporate opportunity (according to plaintiff)
- “4 Factor test must be balanced – NO FACTOR IS DISPOSITIVE” according to court
Which of the 4 factors did the court rely on to conclude that there was no usurpation?
1) Court says corporation is able to take advantage financially
2) Within line of business?
- Investing and selling stocks is NOT within Martha Stewart Omnimedia’s line of business
o eBay bought and sold stock in other countries for income
- When you sell ownership interest in your company you are RAISING CAPITAL – you aren’t generating
income – NO REVENUE
- Martha sells her shares to new shareholders and doesn’t further dilute current stockholder shares
Chancellor Chandler held that:
(a) the corporation is financially able to exploit the opportunity prong: should be analyzed in this context by
asking whether MSO had enough authorized but unissued stock to satisfy the investor, which it did.
(b) within the corporation’s line of business prong: an opportunity is within the corporation’s line of business if
it is “an activity as to which [the corporation] has fundamental knowledge, practical experience and ability
to pursue.”
a. Chandler held: “Simply stated, selling stock is not the same line of business as selling advice to
homemakers. Further, I would presume that a company’s ‘line of business’ is one that is intended
to be profitable. By definition, a company’s issuance of its stock does not generate income.”
(c) Interest and expectancy prong: Chandler held that for MSO to have an interest or expectancy in the
transaction there must be “some tie between that property and the nature of the corporate business.”
a. In Beam, “plaintiff does not allege any facts that would imply that MSO was in need of additional
capital, seeking additional capital, or even remotely interested in finding new investors.” [If there
was such an indication Stewart’s interests would have been in direct conflict with her company –
Breach of Duty of Loyalty issue]
- In contrast, eBay apparently was looking for investments in marketable securities
(d) conflict of interest prong: The fourth prong of Broz asks whether, by taking the opportunity for his own, the
corporate fiduciary will thereby be placed in a position inimical to his duties to the corporation.
a. In Beam, Chandler held that “Delaware courts have recognized a policy that allows officers and
directors of corporations to buy and sell shares of that corporation at will so long as they act in
good faith.”
Holding: No Corporate Opportunity, she can sell her stock
o Would be different if company needed money but they don’t
o If Martha Stewart was only SHs, not D or O, then CO not a problem

How is this different than the situation in the eBay litigation?

- Here the contrast to eBay is particularly significant. In contrast to the sale of stock at issue in
Beam, eBay apparently did intend to make a profit from investing in marketable securities.

Are the holdings in eBay and Martha consistent?

- Yes… if owner of eBay had sold off some of his shares to someone the case wouldn’t have
satisfied line of business prong either [Instead he invested in another company with potential
company assets]

Suppose the independent members of eBay’s BOD had authorized the defendants to accept the
allocated shares. What result on those facts?
- Decision of BOD must still pass BJR
- There will probably be duty of loyalty issues, etc.
- Broz makes clear that rejection of a corporate opportunity by the independent board creates a safe
harbor. Presumably, by analogy to the case law under DGCL § 144(a)(1), within this safe harbor,
the standard of review is the business judgment rule and plaintiff must show that the rejection
constituted waste.

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Dominant Directors & Dominant Shareholders

Is every SH who holds significant stock in both companies in a proposed merger disqualified from
voting, absent disclosure? Of course not – given that many investors hold large stock portfolios, such a
rule would be completely unworkable.

Dominant Director – someone on the Board with an extreme amount of

control
Dominant Shareholder: when a SH picks up enough stock, gets fiduciary duties
• A controlling shareholder, whether an individual or a parent corp, has
sufficient voting shares to determine the outcome of a shareholders
vote
o Owner will always have controlling interest in the vote
o Ex. Parent-subsidiary dealings
• Shareholders owns a lot of stock, pick up fiduciary-like duties
o If you own enough stock so that you can control the board (by
being able to elect directors), the minority shareholders may
have no incentive to vote or do anything b/c their votes may not
matter
o Rule – when you own enough stock so that you are deemed to
control the board, you pick up board-like responsibilities
• Nonetheless, courts do impose some fiduciary duties on some shareholders,
for 2 closely related reasons:
1. Controlling shareholders can control the board
 B/c such a board will not act as an independent institution, courts
may impose the board’s fiduciary duties directly on the
shareholders
 So controlling shareholders owe fiduciary duties to the minority
2. Some corporate actions require direct shareholder vote
 Where a controlling shareholder uses that vote in a manner the
court considers unfair, a court may hold that the shareholders
violated fiduciary duties to the other shareholders

IBM Example
- Suppose IBM enters into a merger agreement with Apple
- Is every shareholder who holds significant stock in both companies disqualified from voting, absent
disclosure?
o Of course not – given that many investors hold large stock portfolios, such a rule would be
completely unworkable.
- Shareholders don’t have the conflicts that directors have

For the most part, shareholders don’t owe fiduciary duties to anyone. Why do directors?
- They are elected and act on behalf of the company and have legal and ethical obligations
Can a shareholder sell land to a company in which it owns shares?
- It could → if land is not valuable they would be ripping themselves off [Investors are
typically self-interested]

Intrinsic Fairness (same as Entire Fairness test used for interested director transactions)
- In general, transactions between a controlling shareholder and the corporation are subject to an
intrinsic fairness/entire fairness test. Under it, the controlling shareholder has the burden of
proving that the transaction was fair to the corporation.
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 - Nonetheless, the test applies only when a potential for self-dealing inheres in the
arrangement – when the controlling shareholder can receive something at the expense of the
corporation (or the minority shareholders)

Duty of Complete Disclosure – when a controlling SH or group deals with the non-controlling SHs, it owes the
latter a duty of complete disclosure with respect to the transaction

• Sinclair Oil Corp. v. Levien (pg. 394/179) RULE: If, in a transaction involving a parent company and its
subsidiary, the parent company controls the transaction and fixes the terms, the transaction must meet the
intrinsic fairness test.
Facts: Sinclair owns a lot of subsidiaries in several different countries Why?
o Corporations are either foreign or domestic [home states favor corps. That are incorporated within
their borders]
o Subsidiaries in different countries get the benefit of home country patronage
- Sinclair owns 97% of Sinven stock (they control everything) → plaintiff in this case is a member of the 3%
minority
- Complaint alleges that: (i) Sinven is dividending too much money (decision to declare a dividend is within
the Business Judgment of directors as long as you have a certain level of solvency)
o Plaintiff is not alleging that he isn’t getting his share. Rather, that NOONE should be receiving this
money.
o Sinven declare more in dividends than they had earned in a year [company not bankrupt → it’s
savings are just being spent]
o Plaintiff says Sinven directors did this to finance Sinclair ventures
- (ii) Sinclair usurped Sinven’s corporate opportunities [denial to Sinven of industrial development], and
- (iii) Sinclair allowed another Sinclair subsidiary, Sinclair Int’l, to breach various contracts with Sinven
What two standards does the court identify?
- Business Judgment Rule: Burden of Proof on plaintiff to rebut the BJR
- Intrinsic Fairness: Burden of Proof on defendants to show transaction was fair to Sinven
How does the court select standard of review?
- Intrinsic fairness is used when parent has received a benefit to the exclusion of the minority
shareholders of the subsidiary and at the expense of the minority shareholders of the
subsidiary
o When a parent controls the transaction and fixes the terms, intrinsic fairness is
triggered, and the burden shifts to the parent.
o The test to apply intrinsic fairness is when Parent has received a benefit to the
exclusion and at the expense of the Subsidiary… this amounts to self-dealing [Parent
on both sides of the transaction]
- So, the Sinclair court uses the Business Judgment Rule because dividends were divided
evenly: There was no breach of the duty of care or the duty of loyalty
Holding: Plaintiff is unable to rebut the Business Judgment Rule on the dividends issue

Plaintiff’s 2nd Argument: Corporate Opportunities Doctrine

- Plaintiff argues that Sinclair took an opportunity to create new business in Venezuela
What standard should we use here?
- No evidence of a breach of loyalty, so BJR
- In order to trigger heightened scrutiny, plaintiff MUST SHOW a breach (not just allege)
- BJR used because decision as to where to invest is a business judgment

Plaintiff’s 3rd Argument: Breach of Contract Claim

- Sinven agrees to sell all of its oil to Sinclair International, another subsidiary of Sinclair (with
minimums/maximums set out for quantities and prices)

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 - There are late payments and breaches by Sinclair on this contract but 97% of Sinven
shareholders/directors say it’s ok.
o This disadvantages the 3% minority (*SELF-DEALING)
- Thus, the burden shifts to Sinclair, who is unable to show that the transaction was fair (they are
thus liable on the breach of contract claim)
o They favored Sinclar by not enforcing Sinven’s rights against them

3 Ways to Avoid Liability

• 144(a)(1) – disinterested directors (i.e. no personal gain)
o Need a critical mass of disinterested directors – they are all interested in the above case
• 144(a)(2) – disinterested shareholders
o [Must be an informed vote, 3% probably not enough to carry a
transaction]
• 144(a)(3) – is transaction entirely fair?
*No way to save Sinclair because majority of 3% disinterested shareholders is not enough to bind
corporation – ONLY way he could win is if he owned 100% of Sinven

• Zahn v. Transamerica Corporation (pg. 399) RULE: If a stockholder who is also a dreictor is voting as a
director, he or she represents all stockholders in the capacity of a trustee and cannot use the director’s
position for his or her personal benefit to the stockholders’ detriment. Aka: A STOCKHOLDER VOTING
AS A DIRECTOR MUST VOTE IN ALL SHAREHOLDERS’ BEST INTERESTS.
Facts: Transamerica began acquiring Class A (2/3) and Class B Stocks (80%) of Axton-Fisher Shares
- Dividend preference: Class A was entitled to a cumulative annual dividend of $3.20, then the Class B was
entitled to $1.60 and then the two classes shared equally any excess dividend.
- Redemption/conversion preference: company could call the Class A shares for redemption upon 60 days’
notice at $60 per share plus accumulated dividends, but Class A shareholders could convert each Class A
share into one share of Class B instead. The B shares are not convertible or callable.
- Liquidation preference: upon liquidation, the division of assets was 2:1 in favor of the Class A.
- Voting rights: All the votes were in the class B except when dividends had not been paid for four
successive quarters, then the classes of stock with the defaulted dividends pick up voting rights like class B
(not an issue in the case).
- Plaintiff is a Class A stockholder – company called (‘redeemed’) A shares and all of the stockholders took
the money due to an impending liquidation
o Company is liquidated shortly thereafter with assets on the company’s books that are grossly
undervalued (B shareholder knew of this discrepancy)
- A shareholders say that if you had told them of the real value of the tobacco they would have taken B
stocks rather than “cash out”
o A stock before redemption would have received twice as much as B stocks in the impending
liquidation
Playing with the Numbers:
- Assume that there is only one A share and one B share and that the amount available on liquidation
is $60. What result?
o In the absence of conversion, because the liquidation preference for division of assets is 2:1 in
favor of the A share, the A share gets $40 and the B share gets $20.
- Now assume that the amount available on liquidation is $240. What result?
o In the absence of conversion, the A share would get $160 and the B share would get $80.
- What happens if the corporation seeks to redeem the A share for $60?
o If the directors issue the notice of redemption for the A share for $60 and the holder decides to a B
share instead, each will receive $120.
- What is the purpose of this redemption provision?
o The redemption provision was included to benefit the B shareholders in situations in which the
value of the company had risen to the point where redemption would force conversion.

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 - Assume there are 100 A shares and 100 B shares, but no preferred. The company has $6000 in cash
and nothing else. Suppose the company liquidates. What will the A shares and B shares get?
o The liquidation ratio is 2:1 in favor of the A shares, so the A shares will get $40 per share and the B
shares will get $20 per share.
- Do the B shares have an incentive to cause the firm to redeem the A shares at $60 before liquidating?
o No. Redeeming the 100 A shares for $60 would leave nothing for the B shares.
- So when will the B shares have an incentive to redeem the A shares?
o When the company is doing well – and has more than the $6000 cash on hand
- Still assume there are 100 A shares and 100 B shares, but no preferred. If the company has cash of
$30,000. What will the A shares and B shares get upon liquidation if the company does not redeem
the A shares?
o The A shares will get $200/share and the B shares get $100.
- Do the B shares now have an incentive to redeem the A shares?
o Absolutely. If the company redeems the A shares for $60, the firm will be left with $30,000 - ($60)
(100) = $24,000, yielding $240 per B share. This is a short-hand account of what apparently
happened in the case.
- But if the company calls the A shares for redemption and the A shares know that the company has
$30,000, what will they do?
o Using their 60-day notice period, they’ll convert to B shares. Hence, there will be no A shares, 200
B shares, and each will get $150.
So, why didn’t the A shares in Zahn convert?
- They weren’t made aware of the gross undervaluation of company assets

B Shareholders did 2 things wrong and paid for it:

1) Controlled the timing
2) Did not disclose the value of the tobacco assets
* Material Omission (we will look at this in a couple classes) – this is a big deal

See examples on G Slides 78-79, page 13-14

• In re Wheelabrator Technologies, Inc. Shareholders Litigation (pg. 408) RULE: An interested

transaction between a corporation and its directors is not voidable if it is approved in good faith by
a majority of fully informed, disinterested stockholders. Aka: STOCKHOLDERS MUST BE FULY
INFORMED WHEN THEY RATIFY AN INTERESTED TRANSACTION
Facts: Companies in a joint venture decide upon a merger
- Waste Management, Inc. directors leave the merger meeting
- 7 disinterested directors approve deal, then interested directors come in and also approve
- Majority of shareholders approve
- Complaint: Dissident shareholders sued claiming:
(i) That the proxy disclosure was inadequate
(ii) That the directors violated their duty of care
(iii) That the directors violated their duty of loyalty
- Court says this doesn’t matter because meeting had experts, ample information, and a 2 year
working relationship
Holding: Court grants summary judgment because duration of meeting is not dispositive

Reasoning:
(i) Disclosure. The plaintiffs argued that the proxy material was materially misleading because it
didn’t disclose that the board meeting lasted only three hours.
a. Court said it was fine, brought in experts, looked at documents, had history of working
together, did due diligence (length of meeting was not important)

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 (ii) Duty of Care. Even if (hypothetically) the board didn’t exercise due care, the shareholders
ratified the merger after full disclosure. That’s enough to kill the claim that they violated the
duty of care.
(iii)Duty of Loyalty. Even if (hypothetically) the board violated its duty of loyalty in voting for the
merger, ratification changed the burden of proof. But nothing is simple here. The court sets
out a two-part standard:
o Does it matter whether the shareholders are interested or not? And what about the
language of § 144(a)(2) -- does it require DISINTERESTED shareholders?
 No. The section provides that an interested transaction is not void if (a) there is full
disclosure and the disinterested directors ratify it, (b) there is full disclosure and the
shareholder ratify it, or (c) it is fair. The drafters inserted a requirement of
disinterest in (a) but not in (b).
 Accordingly, ratification ought to be effective to shift the burden of proof of
unfairness to the plaintiffs (under § 144(a)), even if the shareholders are not
disinterested;
 Courts have held otherwise.
 Although perhaps not faithful to the statutory language the decision does appeal to
common sense.
**144(a)(2)b – should shareholder vote involve only DISINTERESTED
SHAREHOLDERS?
• Even though statute only says majority of shareholders, case law and
most courts indicate and read into it that the majority must be
majority of disinterested shareholders**
o Common law fills in deficiency of statute
§144(a)(2) – Disinterested shareholders only?
- This case affirms that this statute is read to imply a majority of the disinterested shareholders

DUTY OF GOOD FAITH

What’s the big deal with good faith?

o Only directors who act in “good faith” are entitled to indemnification for legal
expenses under DEL Section 145
o Only directors who rely in good faith on corporate records and experts can be
relieved of liability under DEL Section 141(e)
o Only disinterested director and/or SH approval of interested director
transactions can insulate director transactions from judicial review
o And § 102(b)(7) only exculpates directors from monetary liability for breaches
of the Duty of Care, but not for conduct that is not good faith or breaches the Duty of Loyalty.

• Brehm v. Eisner (pg. 345) RULE: In order to constitute waste, an exchange must be so one-sided that no
person of a reasonable mind would have entered into it. Aka THE “WASTE TEST” IS VERY STRINGENT
Facts: Mike Ovitz hired as president of Disney; he is a friend of Disney CEO Michael Eisner
- Disney needs a 2nd in command because Eisner’s health is questionable
- Ovitz lacks experience working as a president but he has been sought after by other large corporations
- The Board was not excited about this employment but they eventually came around (a little fishy)
- Board approves an extremely lucrative 5-year contract for Ovitz
o Salary of $1 million + A Bonus
o He has a stock option – option to buy stock (if it is less than the market price)
 A Class options that vest in 3 years (vest – available to be acted on) → Why might you
want stock options to vest later? Encourage them to stay on, give stock time to mature and
become worth more.
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  B Class stocks will become available if Ovitz stays on after 5 years
- Old Board had information on the contract and had hired Graef Crystal, a compensation expert
- Beginnings of a 141(e) defense; the board hired someone to run the numbers and this employee did not
discharge his duty
3 Options to End Ovitz’s appointment:
Option 1: Initial term expires, no renewl offered: If Ovitz works through 5 years and leaves he will receive
$10 million termination payment
- Why does he get $10 million when his contract isn’t renewed?
o Compensation for harm to reputation
- Ovitz does NOT LAST for the 5 years [Only 14 months] → Thus he would not receive $10 mil.
Option 2: Prior to expiration of the initial term, Disney could terminate Obitz for “good cause” [gross
negligence or malfeasance] If he is fired for good cause he gets nothing!
Option 3: Ovitz could resign [without cause] – this triggers payment of the PV of his remaining salary
through the first 5 year term, plus $7.5 million for each fiscal year remaining under the agmt,
and the immediate vesting of the A options.
- Why would he get so much?
o This is what the market would bear to have people work for Eisner
Complaint: The Old Board is charged with violating the duty of care and waste (for signing contract in the first
place)
- The New Board is charged with choosing Option 3 rather than Option 2; also alleges that the New Board
was not independent
Why wasn’t Ovitz fired for cause?
- Disney says what he did didn’t rise to the level of cause
What duty does waste tie in to?
- Duty of Care
When is something waste?
- When it is so disproportionate to reasonable costs that it could not be the product of a valid duty of care [If
Disney had fired Ovitz for cause the plaintiff in this case would have not sued Disney on the contract
because there would have been no damages]
- A transaction “that is so one sided that no person of ordinary, sound judgment could conclude that the
corporation has received adequate consideration”
Issues:
How do we define the issue with respect to the Old Board?
- Did the decision of the Old Board to approve the Ovitz contract amount to “waste” (and thus outside the
protection of the BJR)?
- If not, was the decision an informed one free of self-dealing, etc.? If so, covered by BJR.
o “The board is responsible for considering only material facts that are reasonably available, not
those that are immaterial or out of the board’s reasonable reach.”
- If not, is there a § 141(e) defense?
o The Board relied upon a compensation expert’s report
o Crystal said compensation had been “shocking”
 *Inquiry is NOT whether the board made a good choice but only whether the process by
which they arrived at their decision had merit
o Crystal should have evaluated the clauses but did not
 Should this be dispositive that no one totaled up the various termination clauses?
• 141(e): Must select your expert with reasonable care, in good faith, and they opine
their area of expertise
o Plaintiff claims that the board should have run the numbers:
 The board says 141(e) obviates their duty to do so because they carefully picked Crystal
Holding: Court finds that § 141(e) provides the board with a defense; Delaware Supreme Court finds for the Board
of Directors (no breach of fiduciary duty)
The issue is NOT whether the Board made the right decision:

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 - “The inquiry here is not whether we would disdain the composition, behavior and decisions of Disney’s
Old Board or New Board as alleged in the Complaint if we were Disney stockholders. In the absence of a
legislative mandate, that determination is not for the courts.”
- That decision is for the stockholders to make in voting for directors, urging other stockholders to reform or
oust the board, or in making individual buy-sell decisions involving Disney securities.
• Was the BOD entitled to, and did they in fact rely in good faith on the expert? In other words, what
does plaintiff need to show to defeat the BOD’s reliance on § 141(e)?
- 141(e) is NOT a bullet proof exemption if you can show:
o The BOD did not in fact rely on the expert;
o Their reliance was not in good faith
o They didn’t reasonably believe the expert’s advice was within his professional
competence;
o The expert was not selected with reasonable care by the corporation; and the faulty
selection goes back to BOD;
o The subject matter [in this case, the gross calculations] was so obvious that BOD’s
failure to consider it was grossly negligent, regardless of the expert; or
o BOD decision was so unconscionable as to be waste or fraud.
Role of Disney Compensation Committee
- Compensation Committee had very little role in all of this [received only a summary of the deal’s terms and
conditions]
o No draft employments were presented to the committee for review before the September 26, 1995
meetings.
o The compensation committee met for less than an hour on September 26, 1995, and spent most of
its time on two other topics.
o No questions were asked about the employment agreement
o No time was taken to review the documents for approval
- The rest of the board can claim that they relied on the subcommittee [the compensation committee]
- In order to rely on a committee report do you have to know that the committee knows what it’s doing?
o NO – committees are held to a much lesser standard than are experts under 141(e)
No Committee Report = No Protection Under § 141(e)
- No presentations made to the Board regarding the terms of the draft agreement
- No questions were raised, at least so far as the minutes reflect
- At the end of the meeting, the Old Board authorized Ovitz’s hiring as Disney’s president

Does conduct that admittedly falls below “best practices” necessarily constitute a breach of duty?
o If measured in terms of the documentation that would have been generated if “best
practices” had been followed, the record leaves much to be desired. The Chancellor acknowledged
that, and so do we. [YIKES]
o But, the Chancellor also found that despite its imperfections, the evidentiary record was
sufficient to support the conclusion that the compensation committee had adequately informed itself
of the potential magnitude of the entire severance package including the options, that Ovitz would
receive in the event of an early NFT.

So is good faith a predicate for BJR protection? And what are the categories of “bad faith”?
o Subjective bad faith – conduct motivated by actual intent to do harm which clearly
constituted the bad faith
o Lack of due care – does this rise to the level of bad faith? It’s gross negligence
without malevolent intent. This is NOT bad faith.
o Intentional dereliction of duty— a conscious disregard for your responsibilities – this
is a non-exculpable nonindemnifiable violation of the fiduciary duty to act in good faith, so it’s bad
faith.

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Waste -A plaintiff who fails to rebut the BJR presumptions is not entitled to any remedy unless the
transaction constitutes waste…
o If the exchange was so one-sided that no business person of ordinary, sound judgment
could conclude that the corporation has received adequate consideration
 The court tells us that the “payment” of a contractually obligated amount cannot
constitute waste, unless the contractual obligation itself is wasteful”

Oversight
o A rudimentary understanding of the firm’s business and how it
works
o To stay informed about the firm’s activities
o To engage in general monitoring of corporate affairs
o Attend BOD meetings regularly
o Routinely review financial statements

Classic “Caremark” Claim: When a director liability claim is predicated on ignorance of liability-
creating activities within the corporation, only a sustained or systemic failure of the BOD to exercise
oversight will establish the lack of good faith needed for liability.
o Example: an utter failure to attempt to assure a reasonable information and
reporting system exists
 Graham: absent cause for suspicion, there is not duty on the BOD to install and operate a corporate
system of espionage to ferret out wrongdoing which they have no reason to suspect exists
 Caremark: absent grounds to suspect deception, neither corporate boards nor senior officers can be
charged with wrongdoing simply for assuming the integrity of employees and the honesty of their
dealings on the company’s behalf.

Why does this standard for demand futility fare poorly with respect to the important class of cases
in which plaintiff alleges that the board failed to exercise proper oversight?
o BJR is inapplicable where the board did not exercise business judgment

Does acting in bad faith trigger an independent basis of liability under Delaware corporate law?
o No, “although good faith may be described colloquially as part of a ‘triad’ of
fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith
does not establish an independent fiduciary duty that stands on the same footing as the duties of
care and loyalty. Only the latter two duties, where violated, may directly result in liability,
whereas a failure to act in good faith may do so, but indirectly.

FEDERAL SECURITIES LAW

THRESHOLD QUESTION: Is the interest in question a “security”? (i.e. any note, stock, bond,
debenture, investment, contract.. etc)
- The definition of a ‘security” is the threshold question for the rest of the semester (Does what
we’re talking about fall within the definition of a security?) EXAM*REMEMBER THIS

Primary and Secondary Markets:

- primary markets/issuer transactions: sale of securities to investors by issuers seeking to raise
capital for their businesses. Private placements are the most common form of transaction. But
these sales can be in public markets or through private placements in negotiated transactions.
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 o Sale of securities to investors by issuers (Company to investor)
o “Private Placement” – when you sell a share not in a public offering
- secondary markets/trading transactions: buy-sale transactions among investors of already-
issued securities. (Investor to Investor)

Function of Securities Markets:

(1)capital formation: bringing together investors and businesses through the issuance of equity
(owners) and debt (creditors);
a. SEC doesn’t interfere, as long as their standards are met, don’t look at the quality of a
transaction
(2)liquidity: the ability to readily sell and investment instrument – providing an “exit strategy;”
(3)risk management: permits diversification and hedging of investments (allows people to buy into
different kinds of companies with different kinds of risk).
→ The public market has so much info that hypothetically investors know what they’re getting in to.

Participants in the securities markets:

- investors: seek a return on their investment; they own securities, either directly or indirectly; the
trend has been towards indirect ownership of securities by institutional investors.
- issuers of securities: make a financial commitment to provide a return in the form of:
(1) dividends
(2) interest payments,
(3) appreciation (company doesn’t give dividends but it becomes more valuable – as do your
ownership holdings) and/or
(4) liquidation rights;
-Creditor first, preferred stock holders, then common stockholders have residual rights
- Financial intermediaries: bring issuers and investors together (middle men); they come in
various forms:
o Dealer: when a firm buys and sells securities for its own account, taking title itself.
o Broker: when a firm buys and sells as an intermediary for a customer. This is a
middleman, do not own in their own name
o Market maker: a dealer who keeps an inventory of a particular company’s securities and
holds itself open as a willing buyer and seller of those securities. i.e. “I promise to hold
enough of this stock to provide investors a market.”
 Ensures there is a market for certain types of stock
o Underwriter: when a firm helps a company sell securities through an offering registered
under the 1933 Act (the company that takes you public – orchestrates entrance into the
public market). Remember Goldman Sachs: IPO – Initial Public Offering
 Helps company sell stock to the public
 Going to a Public Market: Downside/Upside of Public Market – Owners give
up some control (have to answers to SHs) but gain a lot of money

Overview of securities law – state and federal

- Securities regulation is designed to protect investors, whether they are buying securities from an
issuer, trading in the securities markets, exercising their voting rights or selling in a tender offer.
• For the most part, sec. regulation in the United States is a matter of federal law, based on the idea that:
(1) Mandatory disclosure [Make sure that investors have all the information they need to make
informed decisions] and
- Federal law has a laundry list of information that must be disclosed before a company can sell
securities on the public market

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 - e.g. Who’s running the company, profits/losses, asset/liability ratio, salaries [the who, the what,
the where, etc.]?
(2) Anti fraud liability will equip securities investors and securities markets with the information to
move capital to its optimal uses.
- Penalties if disclosure is fraudulent -How can disclosure be fraudulent?
o Can be materially misleading or a material omission (the BIG 2) – GRAY AREAv
→ So the laws have an affirmative component, through disclosure obligations on issuers and insiders;
and a negative component, with prohibitions via the anti fraud rules – no material misrepresentations
or omissions in connection with the sale of securities.
- “Materiality” – is the omission, etc. important? – VERY important question.
o There is MUCH case law dealing with this concept
o i.e. misstatements aren’t always bad but material misstatements are

Seven Statutes: Only 2 are important for this class

• Securities Act of 1933: regulates the sale of securities to the public-private market
- Hustled out quickly by the legislature and left out several key protections
- Governs all public-primary sales
• Securities Exchange Act of 1934: establishes the SEC to administer the securities laws and to regulate
practices in the purchase and sale of securities – secondary market
→ There are contradictions between the 2 statutes

SEC
- The 1934 Act establishes the SEC to administer the securities laws and to regulate practices in the
purchase and sale of securities – secondary market
o Independent agency
o Enforce the securities laws
o Promulgate rules and regulations to implement those laws more effectively
o Congress appoints members of the SEC

State Securities Scheme: “Blue Sky Laws”

- The states had already begun to legislate in this area, before the market crash in 1929, with the
first state blue sky law in 1911.
- The blue sky laws are named because they protect the investors from having nothing standing
behind their investment besides water or blue sky.
- All Blue Sky Laws vary but each contain 3 key ideas:
1) anti fraud provisions: the state’s attorney general is empowered under the statute
to investigate fraud in the advertisement, purchase or sale of a “security” and has the
authority to undertake criminal prosecutions and get injunctive relief. Individual investors
are entitled to sue civilly as well.
2) disclosure provisions: the statutes require pre-approval of the offering circular or
prospectus, all advertising and any other information in connection with the sale or
purchase of securities
3) licensing and registration provisions for securities and brokers and dealers of
securities: the laws provide for the registration of securities offered for sale in that state,
and for all persons selling securities (*Unique to the states)

back to the THRESHOLD QUESTION – if what you are selling is NOT a security then DO NOT
have to register it. EXAM: first step of evaluation is whether or not it is a security…
Is the interest in question a “security” for purposes of the ’33 or ’34 Act?
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 - Definition of a Security § 2(a)(1): “The term ‘security’ means any note, stock, ... bond,
debenture, ... investment contract ... or, in general, any interest or instrument commonly known as
a ‘security’.”
 “unsecured” as opposed to a “secured” bond:
• “secured” – company is pledging assets in addition to its promise to pay
o lower interest rate
• unsecured – no assets, company just promises to pay back
e.g. a mortgage (secured) v. credit card (unsecured); interest on mortgages is
much lower than on credit cards because there is much more risk on credit card
payments
o Investment contract – not defined by Congress in the statute
- Why does this definition matter?
o In order to come within the registration requirements of §5 of the 33 Act, the offer or sale
of a property interest must constitute the offer or sale of a “security.” And once you have a
class of securities registered under § 5, you must provide the SEC and the market with
continuous disclosure under the periodic disclosure system of the 1934 Act.
o If you’re selling a security (under §2(a)(1)) you either need to register it or find an
exception
o If the item in question is NOT a security as defined in §2(1) of the 33 Act, then the
registration requirements of § 5 are not applicable.
o So your first line of inquiry is to see if you are dealing with a security.
o If so, look to see if there are any exemptions from the registration requirements available.

• Both the 1933 and 1934 Act definitions have a laundry list of examples and categories, plus a catch-all
at the end. The purpose of this two-part test is to include in the definition all of the many types of
instruments that in our commercial world fall within the ordinary concept of a security.
• Both sections start with “unless the context otherwise requires” which allows instruments that would
otherwise fall within the definitions to be carved out, if the context otherwise requires.

The ’33 Act defines 3 kinds of securities:

(1) any interest or instrument commonly known as a security: things like bonds, stock, notes,
debentures and warrants
(2) types of securities specifically mentioned in the Act: things like pre-organization subscriptions;
fractional, undivided interests in oil, gas or other mineral rights
(3) investment contracts and certificates of participation: the two most important clauses in §2(1)
are its broad, catch-all phrases “investment contract” and “certificates of interest or participation in
any profit-sharing agreement.” The SEC and the courts have applied these phrases to include
many financial schemes not specifically mentioned by the Act as “securities.”

- Most of the case law has arisen in connection with the phrase “investment contract” and, to a
lesser extent, to the phrase “unless the context otherwise requires”.
o A broad concept that covers a lot of interests that we wouldn’t normally characterize as
securities
- The courts have fleshed out the concept of the investment contract to cover any investment
scheme that triggers the investor’s need for the protection of the federal securities laws.

Is a LLC or Partnership Membership Interest an investment contract and thus a security?

- Securities Act § 2(a)(1): “The term ‘security’ means any note, stock, ... bond, debenture, ...
investment contract ... or, in general, any interest or instrument commonly known as a
‘security’.”
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• Robinson v. Glynn (pg. 415) RULE: Federal Securities law applies to transactions in which the investor
relinquishes meaningful control over investments that are both called and carry the common characteristics of
“stock.” Aka. ORDINARY BUSINESS TRANSACTIONS ARE NOT SUSCEPTIBLE TO FEDERAL
SECURITIES LAWS.
Facts: Glynn has developed a fundamental access system and wants Robinson to fund it
- Robinson initially gives $1 million
- He is performing tests to prove his theory and Robinson promises to pledge an additional $24 million if the
tests are favorable
o Glynn tells Robinson that tests were a success (when they weren’t even performed). Robinson
provides the promised funds.
- There is now a LLC formed
- When Robinson learns that the tests were frauded, he seeks to recover his money under §10b and §10b-5
(securities fraud)
o If what you’re dealing with is not a security, you don’t get to use 10b
o If Robinson doesn’t get to use §10b he’s not done with his suit but it will be messier
- Robinson claims ownership interest in LLC is a security
- Robinson wants court to declare LLC interest a security (company argues against this)
Court sums up the issue thusly:
- “The parties have vigorously urged us to rule broadly in this case, asking that we generally classify
interests in LLCs as investment contracts (Robinson’s view) or non-securities (Glynn’s view).”

Reasoning: The court consults:

SEC v. Howey (1946) for definition of an investment contract:
- The Howey test seeks to identify transactions in which investors are counting on others to manage
the enterprise that will produce financial returns on their investments.
- The definition isolates transactions in which ownership is separated from control, suggesting the
importance of mandatory disclosure and higher liability standards to ensure that investors allocate
capital to its highest-valued uses.
Facts of Howey: Orange grove interests are sold without being registered
- S.C. holds this a sale of unregistered securities (an investment contract)
According to Howey, what is an investment contract?
(1) “A contract, transaction or scheme whereby a person invests money,
(2) In a common enterprise,
(3) And is led to expect profits
(4) Solely from the efforts of the promoter or third party.”

1. Investment of Money: the investment can be cash or non cash consideration, like checks or
money orders or credit. The investment part is satisfied if you put out consideration with the hope
of some financial return -- producing income or profit. This excludes the purchase of a
consumable commodity or service.
a. Anything constituting legal consideration for purposes of contract law should satisfy the
first prong of the Howey test
2. Commonality/common enterprise: This prong focuses on the question of the extent to which the
success of the investor’s interest rises and falls with others involved in the enterprise. Courts have
developed two tests, depending on the circuit:
a. horizontal commonality [relationship between investors]: looks to the relationship
between the individual investor and the other investors who put money into the scheme.
Requires investors share the risk of the enterprise, usually through a pooling of their funds;
e.g., shareholders of a corporation.

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 i. Multiple investors have interrelated interests in a common scheme - they must
share in a single pool of assets; the investors’ fortunes are interwoven - they pool
resources, share profits and share losses pro rata.
b. vertical commonality [relationship between an investor and the promoter]: looks to
the relationship between the investor and the promoter of the scheme. Requires the
promoter and at least one investor share the risk; a single investor has a common interest
with the manager of his investment;
i. this requires a profit sharing arrangement between the promoter and each investor
-- the investor’s fortunes are inextricably interwoven with and dependent on the
fortunes of the promoter/manager of the enterprise.
3. Expectation of profit from the efforts of others: the expected return must come from earnings
of the enterprise, not merely additional contributions, and this return must be the principle
motivation for the investment.
a. Howey says that the profits must be SOLELY from the efforts of others; lower courts
wrestle with whether “solely” means only or predominantly or substantially. There is a
split in the circuits about whether to go with the more flexible interpretation.
b. MOST LITIGATED ISSUE. Court looks at who the plaintiff is – if investment is totally
out of plaintiffs hand they need more protection than if profits are a result of your own
labor. “Solely” is too high a standard so most case law says “predominantly form the
effort of others.”
What is the test – how much effort must the promoter put into the project, as opposed to the
investor’s efforts, in order for the expectation of profits test to be met?
- The critical inquiry is “whether the efforts made by those other than the investor are the
undeniably significant ones, those essential managerial efforts which affect the failure of success
of the enterprise”
According to the 4th Circuit:
- The “Supreme Court has endorsed relaxation of the requirement that an investor rely only on
others’ efforts, by omitting the word “solely” from its restatement of the Howey test. And neither
our court nor our sister circuits have required that an investor like Robinson expect profits “solely”
from the efforts of others.
- Requiring investors to rely wholly on the efforts of others would exclude from the protection of
the securities laws any agreement that involved even slight effort from investors themselves. It
would also exclude any agreement that offered investors control in theory, but denied it to them in
fact. Agreements do not annul the securities laws by retaining nominal powers for investors
unable to exercise them…”
- Courts are split but most use horizontal commonality

Robinson argues:
- Argument #1: His lack of technical expertise, relative to Glynn, prevented him from
meaningfully exercising his rights.
o Prong 3 of Howey:
 Court says if they allowed this argument to go forward, it would open a flood of
litigation on the stupidity argument
o Specific facts?
 Robinson was a director and the treasurer of Glynn’s company (court lists his
extensive duties)
 Potential profits from this enterprise were entirely in Robinson’s hands (fingers on
the pulse of this company)
- Supreme court says definition of investment contract is flexible rather than static [it allows the
court to decide whether plaintiff is someone the court wants to protect]

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 - “Economic reality” of the investment scheme?
o If you boil it down, this guy was calling a lot of the shots
 Robinson had a huge stake in the profits he would take from this enterprise
(exercised meaningful control over his investment)
- Holding: This is not an investment contract and thus not a security under Robinson’s first
argument
- Argument #2: Language of agreement characterizes investment as a security
- Holding: “just because you call them shares doesn’t mean it’s a security”
- Argument #3: his membership interests were investment contracts and also stock.
Court discusses Landreth Timber Co. v. Landreth:
Issue: Whether something that is stock has to be considered an investment contract
- Landreth Timber Co. v. Landreth holds that real stock is always a security: Landreth deals with
whether a single individual who buys all the stock of a company and has the power to actively
manage it could state a claim for fraud in his purchase.
- The 9th Circuit used the Howey test to support its holding that when he purchased all the stock, he
was really buying a business, and the “economic reality” of the transaction was that he was buying
a business and not an investment in a security.
Holding: The Supreme Court reversed, holding that it would be burdensome to apply the Howey test to
traditional stock. If something is called stock, and has the 5 common elements from Forman, it’s
stock and there is no need to get into the investment contract analysis.
• So, a nice rule is: STOCK IS ALWAYS A SECURITY unless it’s not really a stock (doesn’t extend to
bonds) [i.e. You says it’s stock but it doesn’t satisfy all 5 elements (In this case it still may be a security
if it is an investment contract)]
- *Howey test is unnecessary if your interest is a stock

What if GeoPhone had still been a corporation when Robinson bought in? Same result?
- NO. He would have bought stock, which is automatically a security (we don’t have to address the
investment contract issue).
What if GeoPhone organized as a partnership? Same result?
- YES. Same result because 3rd prong of Howey Test would not be satisfied.
- In general, partnership owners and managers are the same
o This would not be considered a security

Things to remember
o 1. Just because call something “stock” or “partnership” doesn’t make it so
 Need to demonstrate something is a tock, or partnership, or investment
contract, can’t just say it is
 Look at intent of parties (did they intend for this to be what they call
it)
 Just b/c call something a security doesn’t make it so
o 2. Typical test for stock – 5 elements (Forman) – see SLIDE I-30, pg. 5
 A. Right to receive dividends – if profits are given out, you get your
share
• Not entitled to or have right to dividends, but if they are given out
you will get your share
 B. Negotiability – must be freely negotiable
• Ex. If sale are subject to right of first refusal not freely negotiable
 C. Ability to be pledged
 D. Confers voting rights
 E. Capacity to appreciate in value

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  Rule – if something is called stock and has the 5 common elements of
stock, it’s stock and there is no need to get into Howey
 Stock is always a security
o On test – won’t be tested about the 5 characteristic of stock BUT if unsure
couldn’t hurt to go through analysis
 However – if Albert says something is a stock on the test, then it is a
stock (don’t need Howey to see if it is an investment contract)
• Answer what is asked
• If doesn’t say anything just describes it, then most likely have
to do test to determine if it is a security (most likely will
do Howey and see if it is an investment contract)

Selling Securities under the Securities Act of 1933

- 2 ways to sell securities on the secondary market
o Private Placement – more streamlined, less expensive way to sell securities
o Public Offering – securities sold in a public offering must be registered (usually the bigger
the offering the more likely the offering is to be public)
• 3 Periods of Time – SEE SLIDE I-35, pg 6
1) Time before registration statement filed with SEC
a. NO SELLING ACTIVITY
2) Time when you wait – After filing but not effective
a. Offers permitted but NO sales
b. SEC review: adequacy of disclosure, not merits
3) Time when registration goes into effect
a. Sales allowed
b. Prospectus must be delivered
Remember: Registration is required by § 5
- §5 prohibits the offer and sale of “securities” through the mail or via interstate commerce without
filing a disclosure document called a registration statement with the SEC;
- § 5 requires that the securities can’t be sold until the registration statement is declared effective by
the SEC; and
- § 5 requires the delivery of a prospectus to everyone who actually buys the securities, as well as to
anyone just offered the securities.
- Because the registration process is costly in financial and time terms, we try to avoid it if possible.
There are two primary ways:
o to sell an exempt security -- that by its nature not subject to registration OR
o to sell a security that would otherwise have to be registered in an exempt transaction (the
way you sell the security is exempt – ONLY a 1-time deal).

§3: Exempt Securities: ALWAYS exempt from registration, both when issued and later when traded.
- These securities were thought to be inappropriate subjects of regulation either because they were
already regulated by some other governmental authority or because of the intrinsic nature of the
securities themselves.
- Anti-fraud provisions still apply though (exemption only applies to registration); Exempt offerings
remain subject to the anti fraud provisions of the securities laws; so the SEC can take action
against any seller of securities under §17 - the general anti fraud provisions for the offer and sale
of securities, primarily used by the SEC and the US Justice Department in criminal actions.
- Just because a security is exempt under FEDERAL registration requirements doesn’t necessarily
mean it is exempt from state blue sky registration, and state anti fraud rules and liabilities.
- Burden of proving exemption: is on the person claiming the exemption; if the burden is not met,
the exemption is lost, and if they were counting on the exemption, they have probably now
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 violated §5 which requires registration with automatic liability for selling unregistered securities
under §12(a)(1).
Exempt Securities Include:
- Government securities: those issued or guaranteed by governmental organizations under §3(a)
(2) like U.S. and state notes and bonds
- Commercial paper: short term commercial paper [with a maturity of less than 9 months] is
exempt –they tend to be high quality, negotiable notes issued for current business operations and
typically purchased by banks and other institutional sophisticated institutional investors, not the
general public.
- Securities subject to non- SEC regulation: some securities are exempted on the theory that other
regulation offers adequate protection to investors, including:
o §3(a)(2): securities issued by banks;
o §3(a)(5): securities issued by federally or state-regulated S&Ls;
o §3(a)(2): insurance policies and annuity contracts issued by state-regulated insurance
companies
- Securities issued by not for profit issuers: available to organizations that operate for religious,
educational, benevolent, fraternal, charitable or reformatory purposes.

§ 4: Exempt transactions: these are one-time exemptions based on the type of transaction -- the way
you sell the security. So on resale, the security may need to be registered, absent some exemption.
- § 4(1): market trading exemption: exemption for persons other than an issuer, underwriter or
dealer for ordinary trading transactions like on stock exchanges or between investors. [You and
Me on NYSE, etc.]
- § 4(2): “private placement exemption” exempts from registration any offering “by an issuer not
involving a public offering” – of course the laws don’t define “public offering.”
o An offering to sophisticated private investors more easily passes muster than does a public
offering to anyone
o Under SEC v. Ralston Purina, the court holds that the application of this exemption turns
on whether the particular class of persons affected needed the protection of the Act. An
offering to those who are shown to be able to fend for themselves is a transaction “not
involving any public offering.”
o Relevant definitions:
 Accredited investors – not counted among the regular people [there is a limit to the
number of regular people that can purchase]. Examples include institutional
investors; big organizations, key insiders [directors, executive officers and general
partners of the issuer], millionaires [net worth, with spouse, of more than $1
million]; fat cats [annual income of at least $200,000 alone or $300,000 with
spouse], venture capital firms
Regulation D:
- Deals with Private Placements [Note: this section does not deal with the question of whether the
investment is a security or not. We are confident that this is a security but seeking to invoke the
private placement exemption]
- Really 3 separate exemptions [Rules 504, 505 and 506] for private and small offerings. The
exemptions are available only to the issuer who files an informational notice called a Form D with
the SEC within 15 days of the first sale.
- Which rule you use turns on (1) the dollar amount of the offering; (2) the number and kind of
investors [NOT OFFEREES]; (3) whether the Reg. D offering is part of some other larger
offering; (4) the kind of advertising used; (5) the kind of information provided to investors.
- Reg. D offerings have a prohibition on “general solicitation” and “general advertising”: no
newspapers, magazines, television or radio ads, open seminars or investment meetings are

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 permitted for a private placement, because since people could just walk in off the street, the issuer
wouldn’t be able to show that everyone who attended satisfied the sliding scale of sophistication.
- Reg. D offerings have resale restrictions: investors who purchase in a private placement
purchase “restricted securities” -- they cannot resell these securities to “unqualified” investors
without registration or another exemption. Such resales would transform the whole offering into a
public distribution, and the reselling investors would become statutory underwriters.
- Funds need to be very careful to identify any restricted securities in their record keeping systems,
and place blocks or liens on their securities in their trading systems so that their traders don’t
inadvertently sell them.

Need to Know Rules 504-06 but NOT IN DEPTH

- Rule 504: small offerings registered or exempt under state blue sky laws: § 3(b) exemption:
$1 million limit on aggregate offering price with almost no conditions, in order to assist small
businesses in their efforts to raise funds. No limit on the number or kind of investors. The SEC
figured that the blue sky laws would take care of these small offerings…
- Rule 505: medium sized offerings subject to SEC conditions: § 3(b) exemption for issuers that
are not investment companies and no “bad boys” under Reg. A. $5 million limit in any 12 month
period, plus no more than 35 “non accredited” purchasers.
o No limitation on the nature of purchasers; informational requirements for non-accredited
investors. Bad boy disqualification provisions of Rule 262 apply [make it unavailable if
the participant in an offering has been bad- subject to SEC disciplinary action or convicted
of violating certain laws within the prior 5 years]. Rule 505 stock becomes restricted.
- Rule 506: private offerings subject to SEC safe harbor conditions: § 4(2) exemption is called a
safe harbor. There is no dollar amount limitation; general advertising and solicitation is not
permitted, and the offering is limited to 35 unaccredited purchasers. Plus, all the unaccredited
purchasers must be knowledgeable, sophisticated and able to evaluate and bear the risks of the
prospective investment.

• Regulation D requires issuers to take “reasonable care” to prevent unregistered, non exempt
resales, by:
(1) having purchasers sign letters of investment intent;
(2) disclosing the securities’ restricted nature;
(3) legending the securities as restricted;
(4) establishing stop order procedures with transfer agents; and
(5) requiring opinions of counsel for transfer.

Rule 144: provides a safe harbor system for selling restricted stock, with procedures including holding
periods and limits on how much stock you can sell at once- you have to dribble it out.

Liabilities under the 1933 Act:

- Before the 1933 act, defrauded investors had to prove the elements of common law fraud: material
misrepresentation, scienter, causation, reliance and injury. This was hard to do if the
misrepresentation was an omission not an affirmative misstatement.
- Also, causation can be hard to demonstrate – how much of the loss was from the misstatement,
and how much from other factors, such as general market conditions?

Important Civil Liabilities

- 1933 Act § 11
- 1933 Act § 12(a)(1)
- 1933 Act § 12(a)(2)
- Implied private rights of action
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 o 1934 Act § 10(b) and SEC Rule 10b-5
o 1934 Act § 14(a) and proxy rules
- 1933 Act § 11: Provides private rights of action for investors who bought under a materially
misleading registration statement (affirmative misrepresentation OR material omission)
- §11 creates an express right of action for securities purchasers when a registration statement
contains untrue statements of material facts or omissions of material facts. So this is a remedy for
someone who purchased a registered security either in the offering or on a post offering trading
market as long as they can show the securities were part of the block sold in the offering.
- Possible defendants: this section imposes express liability on everyone who prepares or signs
the registration statement [§6 tells us who has to sign] -- [issuer, CEO, CFO, chief accounting
officer]; all directors [even those who didn’t sign the registration statement]; underwriters, and
experts like lawyers, accountants, investment bankers who have consented to be named as experts
– their liability is limited to the information prepared or certified by them, and certainly, most
of them would prefer not to have any liability.
o Expert opinions are included in the registration statement (Can only sue experts in their
capacity as experts when preparing the document)
What might lawyer say with respect to a registration statement?
- “I have read everything about this deal. It is my opinion that these securities are legally enforceable…”
- Can only opine as to matters of law
And an accountant?
- Give an audit opinion (based on clients financial statements he believes that they are an adequate
representation of corporations financial status)
Underwriters (investment bankers)?
- Fairness Opinion (opine on price of stock)

• § 11 liability is broader than a common law fraud action. All a purchaser has to do to succeed on a § 11
action is to show
(1) That he bought the security in the offering; and
(2) That there was a material misrepresentation in the registration statement.
→ The plaintiff does NOT have to show scienter, causation or reliance on the misstatement.

• Damages are limited to the total amount of the offering, even if the plaintiff’s damages are bigger.
- § 11(e) then specifies the damages recoverable (roughly, the difference between the original price
of the security and its present price). It adds that the defendant may reduce those damages by
showing that part of the damages resulted, not from the misstatements in the document, but rather
from other causes.

Defenses
- We should think of the registration statement as having two parts (the parts prepared by certified
experts, and everything else), and the potential defendants as constituting two groups (the experts,
and everyone else). The defenses available for a misleading registration statement vary according
to those two variables.
- Issuers (corporation itself) are strictly liable unless they can show one of these affirmative
defenses:
o (1) the purchaser knew of the untruth or omission when they bought the security (in effect
“bought a lawsuit”); OR
o (2) the untruth or omission is not material; OR
o (3) the statute of limitations has run.
- For non issuers, there are 3 additional affirmative defenses [their standard is essentially a
negligence standard but they must show they were NOT negligent]:

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 o (1) resign or take steps to resign and tell the issuer and the SEC in writing that they have
done so, and disclaiming all responsibility for the relevant sections of the registration
statement;
o (2) if the registration statement has already gone effective, written notice to the SEC and
reasonable public notice; and
o (3) due diligence/reasonable investigation defense -- absolves defendants from liability if
they had reasonable grounds for believing and did believe that there was no omission or
material misstatement.
 § 11(c) gives, as a test for reasonable investigation and reasonable belief, the level
of care that a prudent person would exercise if his or her own money were at stake.
 The due diligence defense is popular, but not always successful. The court will
look at the defendant’s knowledge, expertise and status with regard to the
issuer, its affiliates and underwriters, and the degree of participation by the
defendant in the actual registration process and preparation of the materials. (This
is similar to § 141(a))
Why does the statute require reasonable grounds for believing AND actual belief?
- We’re going to hold you liable if you’re a moron; but if someone smart tells you that you have
reason to believe the adequacy we’ll protect you

Section 12: “The Gun Jumping Statute”

§ 12(a)(1): Strict liability for illegal offers and sales; rescission remedy – situation where you
purchase securities that were unregistered
- § 12(a)(1) imposes civil liability on those who sell securities in violation of § 5; the purchaser just
has to show that he bought the security from the defendant and that it was unregistered, and he
wins.
o Plaintiff gets his money back, with interest or recovers rescissionary damages if he has
resold the stock. The securities sales contract is rescinded. This simple and powerful
private remedy enforces the registration and gun jumping requirements of §5.
- Purchasers can only recover if there is a direct link with the seller-- privity requirement. Even
though the purpose of this section is to promote full disclosure in offerings, there is no proof of
any misrepresentation required.
- This section operates like a “put” back to the seller within one year after the alleged §5 violation.
Plus, any action has to be brought within 3 years after the security was first offered to the public,
to give sellers some final date to relax after.

§ 12(a)(2): Fraud in a prospectus or oral sales communication

- This section picks up where § 11 ends; this is an express private remedy for purchaser against
seller of a security for material misstatement or omission in connection with the offer and sale.
- Plaintiff must show:
(1) sale of security;
(2) through the jurisdictional means [interstate commerce or the US mail];
(3) via a prospectus or oral communication;
(4) containing a material misstatement or omission;
(5) by a defendant who offered or sold the security [privity required]; and
(6) defendant knew or should have known of the untrue statement [so there is the possibility of a
due diligence-like defense here too]
- Defendant is liable to the purchaser for recission or damages. Again, a privity requirement. But
no need to prove reliance.

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 - Plaintiff must not have known about the misstatement or omission when he bought the security.
There is a one year statute of limitations, starting from the date of actual discovery or when
discovery should have been made.
- Scienter – D knew or should have known there was an untrue statement

• Doran v. Petroleum Management Co. (pg. 422) RULE: In determining whether an offer to participate in a
limited parternship was a private offer, the court must consider the number of offerees and their
relationship to each other and to the issuer, and the number of units offered, the offering’s size, and the
manner of the offering. Aka. THE STATUS OF PRIVATE OFFERINGS RESTS ON THE OFFEREE’S
KNOWLEDGE
Facts: Doran agrees to become a special participant in a Wyoming Corporation
- He agrees to take on a debt (note) that PMC owed to Mid-Continent Supply Company
- Doran has a petroleum engineering degree (sophistication is a relevant inquiry)
o But, sophistication is not measured in a vacuum – measured on a case by case basis
- 8 offers were made and Doran was the only one to accept (He agrees to assume one of the firm’s debts and
is liable for $113,000)
- Corporation had been doing well when the offer was made because they were overproducing. They were
shut down by the government shortly thereafter, however, due to their overproduction.
o Corporation defaults on the note that Doran guaranteed.
- Doran sues under § 5 because he alleges that the corporation sold him unregistered securities. Seeks
rescission.
Threshold Inquiry: Is this a security?
• Howey Test
1) Investment of $ - Yes. Doran invested.
2) Common Enterprise – Horizontal Commonality? There were others in the partnership.
3) Profits derived primarily from the efforts of others.
→ The District Court found that the interest WAS a security (although 2nd prong a bit weak)

Private Placement or Public Offering?

1) # of offerings and relationship to the issuer
- 8 offerings is too many
- # of offerees is not dispositive (as long as you’re within the statutory limit); an offering to
a small number of offerees can be public, just as an offering to many can be private
2) Relationship between offerees and issuer
- Passive investor who is new to the company needs MORE PROTECTION
3) # of units offered
4) Size of the offering
- There are dollar amounts that will be too big
* The most critical factor is # of offerees and relationship to the issuer (but 1st is most important)

What is so special about the number of offerees?

- It allows the court to ascertain the magnitude of the offering and to determine the characteristics
and knowledge of the persons identified.
Why does the test focus on offerees and not just on those who actually purchased the stock?
- To be a private placement, the entire process must have been a private affair – not just the ultimate
sales.
Why do the offerees have to be sophisticated?
- The theory is that sophisticated parties are in less need of the protections of the securities laws.
Sophistication in terms of business knowledge.
Why should the court care about the offerees’ relationship to the issuer?
- The relationship can help us understand what kind of information was available to the offerees as a
result of the relationship.

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Holding: Court finds transaction to be a public offering
- Remand to find out whether offerees would have had information necessary to evaluate
partnership interests
- District Court erred in finding a private placement

• Escott v. BarChris Construction (pg. 432); “Bowling Alley Case” RULE: If false statements made in
registration statement or omitted facts that should have been included are material, the registration
statement is misleading. Aka FALSE STATEMENTS MUST BE MATERIAL FOR A REGISTRATION
STATEMENT TO BE MISLEADING
Facts: BarChris would build a bowling alley and finance it by entering into a contract with customers (who gave a
small down payment) and then collect the costs after finishing.
- Front loaded their expenses (forked over a lot of their own $ before getting paid)
- 1st issued common stock, etc. and DEFAULTED and files for bankruptcy
o Convertible subordinated debentures?
 Unsubordinated debt instruments that can be converted into something else –
presumably common stock. They are subordinated, meaning they are not in a
priority position – there is some other debt ahead of them.
Under what statute are they suing? And who are they suing?
- The debenture holders brought this class action under § 11 of the 1933 Act. They sued:
o (i) the signors of the registration statement, including the issuer BarChris and its 9 directors
and the controller,
o What is the background of these defendants?
 (ii) the underwriters (Drexel), and
 (iii) the accountants (Peat Marwick).
- Under § 11, the following parties are liable if the registration statement is materially misleading:
those who sign the registration statement, directors, experts, and underwriters (§ 11(a)).
o The issuer is liable because it must sign the registration statement; it has no defenses.
o The other parties may have the so-called due-diligence defenses of § 11(b).
• Did the registration statement contain false statements of fact or omit to state facts necessary to prevent
it from being misleading?
- Registration statement DID contain false statements that were material
o Misstatement of earnings is probably material.
Court Looks at Each Individual Defendant
- Vitolo (President) and Pugliese (VP) – directors
o Argument: Claim ignorance/stupidity
 This argument is irrelevant for a due diligence defense (not an element)
- Kircher (Treasurer) – director
- Birnbaum – director
o Didn’t investigate the accuracy of the registration statement so he can’t invoke the due
diligence defense (no reasonable basis to believe)
- Auslander – director
o Admits that he never read registration statement
- Grant (outside counsel) – director
- Peat, Marwick – outside auditors
o Supposedly experts but they send a new accountant who takes everyone at their word
→ All defendants found responsible

What about damages?

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 - The court notes that the defendants may lower their liability by showing that the losses were
attributable to events other than the misstatements. It tables the issue, however, for hearings on
each plaintiff’s individual claims.
- Arguably, the issue is common to all. To the extent that the misstatements were material, they
affected the price of the securities: i.e., people paid more for the debentures than they would have
paid had the statements been true. That premium attributable to the misstatements should not have
varied across plaintiffs. If so, the court should have dealt with the issue in this opinion.

Integrated Disclosure System

- Both the 1933 and the 1934 Acts require disclosure; the 1933 Act requires disclosure with respect
to a particular transaction. Thereafter, the 1934 Act requires disclosure about a particular issuer,
on a continual basis.
- Every quarter you file a form 10(q)
- On last quarter you file a yearly 10(k)
o Keeps company info current
- 8(k) form is ALSO on TWEN

What is a registration statement? What forms are available to what issuers?

- Form S-1: info on the registrant and the transaction; this form contains the most detailed set of
instructions and must be used by companies that do not qualify to use another form, typically
companies making an IPO.
- In practice, this form is used by issuers that have not previously filed periodic reports under the
1934 Act. Form S-1 has been the basic 1933 Act registration form for many years and requires a
full description of the business and finances of the issuer.
o Registration form that you use for a public offering
o Very burdensome form to fill out
o Tells the market everything about the public offering
- Form S-2: this second tier registration form is not used very often; this form is available to
“seasoned” companies that have been filing periodic reports with the SEC [“reporting
companies”] for at least 3 years, must be free of defaults on debt and not in arrears on its
preferred stock dividends. The form permits incorporation by reference of the information in the
company’s Form 10-K and other periodic SEC filings.
o Not used very often
o Don’t require as much information as the S-1 forms because company has been actively
registering for 3 years since it’s IPO
- Form S-3: info on just the transaction; this form is available to large, seasoned US companies
that have been reporting companies for at least one year
- Form 10: Once the Form S-1 is filed and effective, the issuer has to register the particular class of
securities with the SEC on Form 10.
- Form 10-K: I put the form and the information sheet for this form on TWEN; it’s the annual
report containing audited financial statements, Management’s discussion and analysis [MD&A]
and incorporates the glossy annual report to shareholders.
- Form 10-Q: also on TWEN; quarterly report for the first 3 quarters of the year, containing
unaudited financial statements, and management’s report on any material developments.
- Form 8-K: also on TWEN; to be filed when certain important events happen, within 15 days.

Section 10(b): Federal Anti-Fraud Statute

It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce or of the mails, or of any facility of any national
securities exchange.—

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 (b) To use or employ, in connection with the purchase or sale of any security
registered on a national securities exchange or any security not so registered, any
manipulative or deceptive device or contrivance in contravention of such rules
and regulations as the Commission may prescribe as necessary or appropriate in the
public interest or for the protection of investors.
- Covers PUBLIC AND PRIVATE exchanges

Rule 10(b)-5
It shall be unlawful for any person, directly or indirectly, by the 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 statements made, in the light of
the circumstances under which they were 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 with the purchase or sale of any security.

Elements
- Jurisdictional Nexus
o It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any
national securities exchange,
 Highly unlikely that you could buy or sell securities that don’t pass through
interstate commerce

- Transactional Nexus
o Bad behavior “in connection with the purchase or sale of any security.”
- Material misrepresentation or omission
o (b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under
which they were made, not misleading,
 Materiality standard can’t be set too high or too low
 Must find a balance with materiality (we now have a balancing test for it)
- Reliance
o Connection between defendant’s misrepresentation and plaintiff’s injury
o Traditionally, Court bifurcated reliance test
 If the case involved an affirmative misrepresentation, courts required the plaintiff to
show that he relied on the misrepresentation.
 If it involved a failure to disclose, they adopted a rebuttable presumption: absent
proof by the defendant to the contrary, they presumed that the plaintiff relied.
o How can this reliance be demonstrated?
 One way is to show a breach of a duty to disclose material information; the SC has
held that the necessary nexus between plaintiff’s injury and defendant’s wrongful
conduct is established due to the breach.
o What is the “fraud on the market” theory?
 A rebuttable presumption
 A misrepresentation out on the market that effects the price of the security/stock (if
everyone knew about the misstatement the price would go down)
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  We presume that the buyer relied on the integrity of the of market price (and thus
the misstatement that effected the market price)
o When is the theory invoked?
 When we have 1) an efficient market, and 2) a material misrepresentation
o How can a defendant rebut the fraud on the market presumption?
 Defendant needs to sever the link between the misrep and either the price of the
stock paid to/received by plaintiff or the decision to trade at the fair market price.
1) Market not deceived: the market wasn’t affected by the misstatements and
the plaintiff paid the right price
2) Corrective statements: after corrective statement there is no fraud on the
market BUT this remedy doesn’t cover purchases made before the statement
(not a complete defense)
3) Specific plaintiffs would have sold anyway: Decision not
effected/determined by erroneous market price (e.g. Daughter was getting
married and needed $, etc.)
- Causation
o Plaintiff must show that the misstatement caused the damage. If the corporation issued an
overly optimistic press release, for example, the plaintiff must show that the statement
raised the price of the security.
o The defendant could then try to rebut the claim with evidence that the misstatement
nonetheless did not contribute to the plaintiff’s loss.
- Scienter
o Plaintiff must show that the defendant acted with an intent to deceive, manipulate, or
defraud. Reckless disregard of falsity of statement will satisfy this requirement too.
o Negligence does not suffice, though numerous subsequent lower court decisions cases hold
that recklessness does

• Basic Inc. v. Levinson (pg. 450) RULE: An omitted fact is material is there is a substantial likelihood that the
average, reasonable SH would have considered it important knowledge to have before deciding how to vote. Aka
SHs DETERMINE WHICH OMITTED FACTS ARE MATERIAL
Facts: Combustion had been negotiating a merger with Basic for 2 years
- Rumors consistently circulated about the deal, but Basic denies them on 3 separate occasions (public
dissemination of a misstatement or omission). The rumors effect the New York Stock Exchange, however
(volume of trading is abnormally high for Combustion/Basic)
o Denial 1: October 21, 1977 (stock price at $20)
o Denial 2: September 25, 1978
o Denial 3: November 6, 1978
- Merger announced December 19, 1978 – priced at $46.
Who are the plaintiffs?
- Anyone who bought/sold shares the day after the denial of the merger plans up until December 18
- Plaintiffs claim they would have gotten higher cost for their shares if Basic hadn’t denied rumors of the
merger
Why did Basic deny the rumors?
- FYI: Basic and Combustion agreed to keep the deal secret at least until an agmt in principle was reached
- But Why?
o To prevent competitive bidders from getting wind of the deal at an early stage
o Discourage 3rd party interference (Worried that talks of a merger might jump the price of stock)
o Also, preliminary merger discussions are just that: PRELIMINARY. Deal might fall apart and
market might react to this.
Issues: Whether failure to disclose preliminary merger talks is material.
- Is this a proper class action, when proof of reliance is an issue?
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Procedural:
- District Court certifies the class, adopting the fraud on the market theory, but does not believe that the
denials were material
- 6th Circuit reverses and remands
o Believes that plaintiffs relied on the material misrepresentation
o If you have a duty to speak, you better speak truthfully
o Defendants here had no duty to speak but they did so untruthfully
What tests can assist the court?
- Agreement in principle
- Basic materiality

Materiality
- General Standard?
o “whether there is a substantial likelihood that a reasonable shareholder would consider the
fact important” – TSC Indus., Inc. v. Northway Inc. (1976)
 But how do we apply when faced with uncertain and contingent facts?
• This is where the balancing test comes in to play
- Basic standard?
o The Supreme Court takes “a highly fact-dependent probability/magnitude balancing
approach” – Little precedential value
o based on the 2nd circuit rule in SEC v. Texas Gulf Sulphur [the materiality of speculative
events will depend at any given time upon a balancing of both the indicated probability
that the event will occur and the anticipated magnitude of the event in light of the totality
of the company activity.]
- Side-issue
o Where 10b-5 liability is premised on an omission of material fact, liability can only arise
where the defendant had a duty to disclose
o Basic may not have had a duty to disclose on these facts
 Footnote 17
 Issue not decided

What’s the Agreement in Principle Test?

- Test for materiality
- An agreement in principle test states that when negotiations are a certain point along they must be
disclosed
- How did the 3rd Circuit justify agreement in principle test?
1) Don’t want to overwhelm investors with tentative negotiations, etc.
2) Security and secrecy will always take a back seat to materiality
3) It’s a bright line test
- Scrapped by the 6th Circuit in Levinson – the test is not so precise as 3rd Circuit alleged
What’s critical?
- Purchase price
- Payment method and time period for payments
o *If we don’t have these we don’t have an agreement in principle

The Supreme Court acknowledges a reasonable investor standard

- The Balancing Test – a test to determine materiality (alternative to the agreement in principle
test). Applied only for speculative events
o Used for contingent events (like preliminary merger); used when there is an element of
UNCERTAINTY
- What is balanced?
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 1) Probability magnitude test – what’s the probability that a contingent event will happen (pg. 454
Part C)
- When we look at preliminary merger negotiations we have to look at the probability that
this particular deal is going to close
- The more probable it is to occur the more likely it is to be material
2) The magnitude of the event to the company (How big a deal is this going to be for the company?)
→ Both factors must be balanced to determine materiality

• So we’re evaluating the decision of a board of directors to withhold certain facts

- Company says it’s not material
- If the fact that they’re talking about is contingent or uncertain, we need to use the balancing test
(only applies to uncertainties)

Does the board have an obligation to speak?

- They might not have but when they chose to speak they had to speak truthfully
Do you have an obligation to disclose preliminary merger negotiations?
- Unclear whether they had an obligation
- There’s only an issue of materiality because the board decided to open their mouths and lie
o “Absent a duty to disclose silence is not misleading”

What about the Court’s discussion of fraud on the market?

- Basic says fraud on the market test includes reliance and so should 10b-5
o 10b-5 does not say anything about reliance (you only need to show that there was a
material misstatement)
Holding (Basic): Supreme Court remands and adopts the fraud on the market theory and presumes
reliance [All Fraud on the Market does is shift burden to defendants to rebut reliance]

What’s Justice White’s problem?

- He agrees that TSC is the right standard for materiality but he doesn’t believe that fraud-on-the-
market should be used
- Says he doesn’t know anything about economics and doesn’t feel comfortable adopting the
standard

What do we take away from Basic?

- Reasonable Investor
- Fraud-on-the-Market – people trade based on these statements
o 10b-5 needs to show:
1) Material misrepresentation
2) Reliance (Fraud-on-the-Market Theory makes this a rebuttable presumption
because information is out there and effects price)
3) Scienter
- Plaintiffs want to be in Federal Court rather than State Court on a 10-b action because you don’t
have to prove reliance
Were Basic’s statements calculated to mislead?
- Yes – they were saying something to settle the stock market BUT it doesn’t have to be shown that
anyone really was deceived
o NOTE: The market reacted as if people knew a merger was pending (This is irrelevant,
however)
What about a shareholder who sells her shares to pay medical bills?
- She can be included even though she didn’t rely because you don’t have to prove reliance (a bit of an
inefficiency in the statute)
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 o So, the court says that a corporation can shut her out if they prove that she didn’t rely
Who pays for damages?
- Corporation – current shareholders are writing a check for the old shareholders
o The class is composed of those who sold stock after 1st misstatement or those who bought stock at
too high a price

• West v. Prudential Securities, Inc. (pg. 463)

Facts: Hofman told people that Jefferson Savings was going to be acquired at a big premium
- Even if this tip is true he’s going to have an insider trading problem. But here we’re dealing with a
material misstatement (a 10b-5 issue).
- He relays false information to 11 customers
- Plaintiffs are anyone who bought stock during the time that he was making misstatements
Issue: Can just the 11 sue or anyone?
- The 11 have a nice cause of action even for common law fraud (they satisfy reliance requirement)
Can this be a class action for everyone (Not just the 11)?
- Yes – if they can use fraud on the market theory (integrity of the market price)
The difference with the Basic case is that the misstatement was NOT PUBLIC:
- So, you CAN’T use fraud-on-the-market; based only on a public misstatement that effects price
- Class cannot be certified because plaintiffs can’t show direct common law fraud and they can’t show fraud-
on-the-market
Holding: So, only the 11 have standing to sue

Options for Disgruntled Shareholders unhappy with Mergers

1. Statutory right of dissent & appraisal: any minority SH dissatisfied with terms of the offer can:
(1) reject the terms;
(2) obtain an independent judicial appraisal of the value of her shares;
(3) receive that value in cash instead of the consideration offered in the cash merger
transaction.
- “market out” exception: no appraisal rights in a stock for stock merger if the corporation’s
shares are traded on a public market before and after the merger; the disgruntled shareholders
can cash out on their own, assuming the market price is a good approximation of “fair value”
o SHs can cash out on their own, no judge needed
2. Injunction: before the consummation of the deal, a dissenting shareholder can bring a lawsuit,
seeking to have the transaction halted. Grounds include lack of authority [shareholder vote], lack
of compliance with statutory requirements, fraud and/or abuse of power, violation of mandatory
disclosure provisions under applicable federal securities laws. Can Bring in DOC, DOL claims
3. Rescission: after the deal has been consummated, a dissenting shareholder can bring a lawsuit for
rescission. The transaction must be voidable due to lack of authority, fraud or abuse of power. Or
under §12, there is a one year put back to the seller for fraud in the sale of securities.

Short-form Merger
- A streamlined process where a majority parent company owning at least 90% of stock can merge the 10%
sub-interest without minority shareholder approval (can merge into itself)
o No shareholder approval needed
o Board of parent corporation approves
o Copy of articles of merger filed with Secretary of State and mailed to each shareholder of
subsidiary corporation
o Parent must own at least 90% of each class of stock of the subsidiary corporation
o Give notice within 10 days of the effective date of merger
o Shareholders can seek statutory appraisal rights

• Santa Fe Indus. v. Green (pg. 468) RULE: Under the short rom merger statute, a parent company may
merge itself with its subsidiary if the parent owns at least 90% of the subsidiary’s stock and if the parent
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company’s board of directors approves the action. Aka PARENT MAY MERGE ITSELF WITH ITS
SUBSIDIARY IN SOME CASES.
Facts: Santa Fe Industries held 95 percent of the stock of Kirby Lumber Corp.
- Santa Fe buys out the remaining 5% interest at $150/share using Delaware short-form merger statute
o Shareholders claim the fair price of each stock is $772 (if you consider all of Kirby’s assets)
- Morgan Stanley said shares were worth $125 each
- Shareholders were fully informed of Kirby value, etc.
- Shareholder also claim violation of 10b-5 because:
o Merger was effected without prior notice to the minority shareholders and was done without any
legitimate business purpose
 They claim no prior notice [But they aren’t legally entitled to this]
 No business purpose – Santa Fe did this only to get rid of the minority shareholders [Yet
Court finds this to be a valid business purpose]
o Their shares had been unfairly undervalued
o What they’re really saying is that directors violated duty of care/loyalty… Fiduciary breach claims
attempting to be dressed up as 10b-5 claims
 *There is no material misrepresentation! Shareholders are trying to bootstrap state law
claims into federal court
- Trial Court dismisses for failure to state a claim
- Appellate Court wrongfully reverses:
o Court says you don’t need a misrepresentation or omission to satisfy 10b-5; They try to Federalize
State Common Law!
 This would circumvent the fiduciary duties of state law and pull them into federal court
 “…neither misrepresentation nor nondisclosure was a necessary element of a rule 10b-5
action…”
Holding: Supreme Court reverses
- Inadequate compensation is not a 10b-5 claim unless the appraisal was fraudulent

Manipulation
What is manipulation?
- Practices that artificially affect market activity for the purpose of misleading investors
Examples:
- Wash Sales – buy and sell your own stuff
o Manipulator enters a purchase order and a sale order at the same time through the same
stockbroker
 Ownership of the stock does not change but creates the appearance of activity in a
security
- Matched Orders/Sales – buy and sell friends stuff and clam profit/sale when there is none
o Manipulator enters a purchase order with one stockbroker and a sale order, at the same
time and at the same price, with a different broker
 Sometimes involves multiple manipulators acting together (so called “cross sales”)
 Matched purchase and sale transactions create the false appearance of active
trading

No “Federal Fiduciary Principle”

- What was the Congressional Intent?
o Congress’ purpose for the 1934 Act was to assure full disclosure
o Once full and fair disclosure is made, the fairness of the transaction is a non-issue under
federal law
o Creating a federal cause of action here thus would not serve any of the central purposes of
the act
- Implied Private Right of Action
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 o Courts generally should not create an implied federal cause of action where the matter is
one traditionally relegated to state law
o Here the conduct in question was a breach of fiduciary duty, a matter clearly the subject of
state corporate law
- Federalism
o Allowing Rule 10b-5 to reach “transactions which constitute no more than internal
corporate mismanagement” would displace state law
o Corporations are creatures of state law
o Courts should not use Rule 10b-5 to preempt state corporate law
 2nd Circuit decision enlarged 10b-5 so much that it would have undercut the
relevant state law
 Fiduciary Duty principle is firmly embedded in state law jurisprudence and has no
basis in Federal law

Was there deception in Santa Fe?

- Were plaintiffs deceived?
o No omission or misstatement in merger documentation
o Plaintiffs are not claiming that they were lied to; rather, they are claiming a breach of duty
because the transaction was unfair
 Breach of fiduciary duty without fraud not a violation of Rule 10b-5
→ If all Santa Fe facts remain the same except that there was improper notice the shareholders have a
viable 10b-5 claim

Terminology:
Call Option – right to buy specified # of stock at particular price
- A right to buy stock: call option gives the owner the right, but not the obligation, to buy a
specified number of shares at a specified price
o A contract with someone who either does own stock or will own stock on a particular day.
o You can opt to either exercise your option or not
Put Option – right to sell stock (not obligation)
- A right to sell stock: put option gives the owner the right, but not the obligation, to sell a specified
number of shares at a specified price

Option premium – The price paid to purchase an option (not the stock price)
Strike or exercise Price
- The price specified in the option contract at which the underlying stock can be bought or sold
- The issuer of the option need not be the issuer or even a holder of the stock itself

Stock prices influence option prices – for example:

- Put: Suppose you have the right to sell stock at $25 on June 1 and you don’t own the stock. You
have a “naked” put.
- You make money if the market price goes to $20, since you could then buy at the market price and
immediately resell under the put and pocket a $5 gain. If the market price is above $25 on June 1,
you lose the amount you paid for the put.
- If you own the stock, the put merely protects you from a decline in the value of the stock below
$25. It is like an insurance policy [Lock in a price at an earlier date]
- Call: Suppose you have the right to buy stock at $25 on June 1. You make money if the market
price goes to $30, since you could then buy under the call and immediately resell at the market
price and pocket a $5 gain. If the market price is under $25 on June 1, you lose the amount you
paid for the call.
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• Deutschman v. Beneficial Corp. (pg. 474)
Facts: Deutschman buys call option in Beneficial but never buys stock
- NOTE: Calls are considered securities in the Federal definition
- Trial Court tells Deutschman that he can’t sue under 10b-5 because options aren’t securities
- Managers made public misstatements to keep price of Beneficial stock up
- Don’t have to own stock to sue under 10b-5
o He had no state law claims because there were no fiduciary duties owed him

REVIEW OF SECTION  REMEMBER! :

ALWAYS START WITH THRESHOLD QUESTION – IS IT SECURITY?
Materiality Test – what is the standard court’s use?
• A. TSC, then
• B. Balancing
• A. TSC – all issues of materiality (general standard of materiality)
o Test – whether there is a substantial likelihood that a reasonable shareholders
would consider the fact important
 Must show that a reasonable investor would consider this fact or
omission to be important
 What a reasonable shareholder would think is important
• Did it have an impact or effect on whether or not you bought the
security, and if it did, did it also affect how much you were willing
to pay
o Something that would’ve mattered to shareholder when making a vote or
when deciding to sell or buy or not
 Always use TSC when dealing w/materiality
 Then decide if balancing test needs to be used later
• Don’t always need to use Basic balancing test
 When use balancing test – only use balancing test when there
are uncertain or contingent facts
• Ex. Preliminary merger discussions (something may or may not
happen)
• Always use TSC first
o Ex. If give public wrong income number, don’t need balancing test b/c not a
contingent fact,
just a material misstatement

• B. Balancing Test – Basic

o Deals w/uncertain or contingent facts – how to factor something in that
may happen?
o Not measured under sophisticated investor but under reasonable investor
standard
o Balancing Probability and Magnitude - highly fact-dependent
 Probability and magnitude balanced
 Look at how likely this contingent event is to happen
 Basic – preliminary merger agreement
• Not all preliminary merger agreements are at the same point,
must get into the specific agreement at issue (subjective)
o Probability that this particular merger will happen
• Closer to closing, more likely deal will go through

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  1. Probability contingent event will happen – more probably, more likely
to be material
• Less likely, less material
 Balance against this
 2. Magnitude – if it happened, how big of a deal would it be to this
company
• Bigger magnitude, more likely to be material
• Less magnitude, less material
 Balance these 2 actors
 So – take particular event and see:
• 1. How likely it is to happen?
• 2. If it happens, how big of a deal would this be?
 If unlikely and not a big deal, not material
 If likely to happen and would be a big deal – material
• Then balance other possible situations (very likely, but small
magnitude)
o Balancing test – 2nd test we use to help inform TSC when talking about
uncertain and contingent facts
 Very fact dependent
• Not whether a big deal to companies in general, just to that
particular company in the circumstances
• All Issues of Materiality – always use TSC – whether there is a substantial
likelihood that a reasonable shareholders would consider this fact important
o When looking at uncertain and contingent acts, use balancing test in addition
to TSC
o Balancing test helps inform TSC test, by helping us figure out whether a
reasonable shareholders would consider this important
 Only use balancing test for uncertain and contingent facts
• Always use TSC, then decide on balancing test later
o Ex. If give public wrong income number, don’t need balancing test b/c not a
contingent fact, just a material misstatement
o If something uncertain (contingent), in order to flesh out the TSC standard, and
help the Court see if reasonable investor would think the fact was important,
must put that contingent info in context, and balance it to see if significant and
likely to happen
Materiality Recap
o TSC test – general test for materiality in securities cases
 Standard – would reasonable investor have considered the info
important
• If no, not material
• If yes = material
• If no contingent event, just use this test
• Contingent event – anything preliminary
o Basic balancing – look at in addition if there is a contingent or speculative
event
 Figure out whether reasonable investor though important
o Anything that has happened = TSC
o Anything about to happen – TSC and Basic
• On test – start w/TSC, then if contingent go to Basic

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INSIDER TRADING
- Insider trading is simply trading on non-public information by someone with a duty not to trade.
The insider can exploit his advantage whether the information is good or bad.
o Example: Exxon stock prices are down because of the environmental claims against the company.
o Suppose that an entrepreneur with a get-tough attitude toward environmentalists—say, Donald
Trump—determines that he could raise that stock price by fighting off the environmentalists.
o He decides to buy up Exxon stock at the present (low) price, beat the environmental claims, sell off
the Exxon stock at the new (higher) price, and live happily ever after with his fifth wife and new
son.
o How will this work?
o Exxon stock sells at $100/share. Trump will announce a tender offer at $120, conditional on
receiving at least 51 percent of the stock. Offers a “premium.”
o Exxon stock will now rise to a price between $100 and $120, depending on how likely investors
think Trump’s tender offer is to succeed. Moreover, much of the stock will fall into the hands of
the arbitrageurs who buy something in one place and sell it in another place at the same time in
order to make a profit from the difference in price in the two places.
 ENTER THE INSIDE TRADER
o Let’s say a guy named Ivan cheated by buying information about tender offers from Dennis
Levine, who works at Drexel Burnham Lambert. In the case of the DT tender offer, Levine would
have learned about the offer if Trump went to Drexel to raise funds.
o In the real world, Ivan’s ties to Drexel apparently gave him two advantages: (a) sometimes he knew
about forthcoming tender offers in advance and could buy stock before its price rose, and (b)
sometimes he had inside information about whether a tender offer in the works was going to
succeed or fail and could beat the other arbs into or out of the market.
o Target Shareholders Lose
 The gain from the tender offer run-up in price is finite, and to the extent Ivan captures it,
someone else loses it. If the tender offer raises the 1 million outstanding shares of E stock
from $100 to $120, then SHs will make $20 million.
 To the extent IB makes a greater share of that profit through his inside information, other
SHs lose.

What’s the harm?

- If someone buys stock with knowledge of the tender offer before it is announced, those selling to
the insider are disadvantaged
- People who bought for too much are also disadvantaged
- Lastly, the integrity of the stock market is also damaged

Purpose of having these rules – concerned about people putting their own interestes first to the detriment
of the company
o Measure inside trading by gains you shouldn’t have gotten or losses that you shoud’ve
suffered but avoided.

Insider Trading is a 10-b5 Violation – bc it is DECEPTIVE

o Triggers deceptive device for 10(b) and the disclose or abstain rule
o 10-b5 gives 10b its teeth
o Doesn’t say “insider” explicitly, but applies to any person
o Insider trading is subset of 10b5
o Standing – need to be purchaser or seller if you are PLAINTIFF
o Rule: No insider trading if there is NO TRADE!
o Remedy – if found guilty of insider trading, ust give back profits you gained or losses you
did not incur (+ criminal remedies)
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Two Primary Forms of Insider Trading:

1) Classical Insider Trading [§16 of ’34 Act]

- Typically, a corporate insider trades [buys or sells] shares of his corporation, using material, non
public information obtained through his position as an insider [Officer, Director, or more than
10% Shareholder; also applies to Temporary Fiduciaries (Dirks FN 14].
- The insider exploits his informational advantage [which is a corporate asset] at the expense of the
corporation’s shareholders.
o This constitutes a deceptive device for §10(b) and triggers the disclose or abstain rule
The classical theory applies to traditional insiders (directors, officers, 10% SHs) AND to temporary
fiduciaries as described in FN14 in Dirks (later in outline)
- A de minimus standard but it’s enough shares that you are on the company’s radar [pretty
invested in the company]
Temporary Fiduciaries?
- Folks who have a role in the corporation on a limited basis (introduced for a finite period of time)
o e.g. Lawyers, accountants: don’t have standard fiduciary duties to corporations but they
have this temporary fiduciary status imposed upon them for insider trading purposes

2) Misappropriation/Outsider Trading
o M/O Trading prohibitions target the trading based on non-public information by someone in
breach of the duty he owed to the source of his information
o An insider can also exploit an informational advantage by trading in other companies’ stocks when
he learns that his firm [or a related firm] will do something that affects the value of another company’s
stock, and trades on this material non public information.
o The insider “misappropriates” the information at the expense of his firm, through a breach of trust
or confidence.
o When you learn of something in your capacity as an insider and use this information to trade in
someone else’s stock
o The crux of this application centers not on a fiduciary relatinship between the insider and the
purchaser or seller of the security, but on the fiduciary-turned-trader’s deception of the folks who
entrusted him with the information in the fist place.
o The fiduciary’s disclosed, self-serving use of a principal’s information to buy or sell securities, in
breach of his duty of loyalty and confidentiality owed to his principal, defrauds the principal of
exclusive use of that information.
See pg. 481 Problems:
1. Rose is agent, takes care of land for Martha
 Martha comes to believe there is oil, hires geologist
 Rose tells her Martha’s cousin owns land nearby, she buys him out w/o
discussing her belief about the oil, turns out there is oil
 Question – has Martha done anything wrong legally? – no, as no legal
obligation to George
 Anything special or inside about the info? – no, George could’ve found out
same info as Martha
• Absent fiduciary relationship, she has done nothing illegal
 What if? – Martha makes possibly misleading comments
• George asks her if she knows anything about the oil and she says “how would I
know anything more than what you know? – is this material misrep
• Probably no liability, just getting close

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  If says – “there is no oil on the land” – then probably a misleading
misstatement
 Absent a relationship between person w/insider info and the company or the
asset connected to the company, there is no liability
Insider in company can’t trade on info b/c violates fiduciary duty
2. Partners – one hires geologist who finds there is oil, buys out partner w/o disclosing info
 Problem, partners owe fiduciary duties to on another
 Partner entitled to the profits b/c fiduciary duty was violated
3. If person was just a shareholder – owes no fiduciary duty
• Securities & Exchange Commission (SEC) v. Texas Gulf Sulphur Co. (pg. 482) RULE: A person who is
trading a corporation’s securities for his own benefit and who has access to information intended to be
available for business use only, may not take advantage of the information, knowing it is not available to
those with whom he is dealing. Aka. INSIDERS MAY NOT USE BUSINESS INFO FOR PERS TRADING
SLIDSE for this case: J pgs. 3-7
Facts: Texas Gulf begins drilling in eastern Canada to test for ore deposits
o Making predictions based on whatever data they can collect
- They decide that there is stuff on site that they want
o The corporation begins to buy up all of the land surrounding the test site (very discrete – not visible
who is buying land from corporate standpoint)
o Directors also begin buying up all stock and call options in the company
- President commands secrecy among officers so cost of land stays low
o TGS insiders being acquiring shares (7,100) and call options (12,300)
o The company is entitled to keep the information quiet
o The timing of material disclosure is a matter of business judgment: “We do not suggest that
material facts must be disclosed immediately; the timing of disclosure is a matter for the business
judgment of the corporate officers entrusted with the management of the corporation within the
affirmative disclosure requirements promulgated by the exchanges and by the SEC.” – FN 12 (pg.
488)
 So, the company had no duty to disclose the information prior to its public statement
on April 16, 1964.
What valid business reason could support the decision to delay disclosure?
- Didn’t want to drive up the price of land and stocks
If TGS wanted the information kept confidential, did insiders have a right to disclose it?
- Agency Restatement § 395: Unless otherwise agreed, an agent is subject to a duty to the principal
not to use ... information confidentially given him by the principal or acquired by him during the
course of or on account of his agency or in violation of his duties as agent, in competition with or
to the injury of the principal, on his own account or on behalf of another ....”
Given that the corporation had no duty to disclose, and had decided not to disclose the information,
what options did they insiders have if they wanted to trade?
- Disclose or Abstain Rule
o You either have to disclose your material information or abstain from trading (In many
cases you aren’t allowed to disclose information so you HAVE to abstain from trading)
o In this case, the insiders had to simply abstain from trading
When does the duty to disclose or abstain end?
- When the information being traded upon becomes public
When is information considered “public?”
- “It must be effectively disclosed in a manner sufficient to ensure its availability to the investing
public.”
o i.e. Until your informational advantage is made worthless
o Insiders can start trading again when the news hits the wires
What happened to the stock price while the drilling was going on?
- It shot up
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 o Probably because 7,100 shares were bought, etc.
 The market is seeing increased activity in the stock and responding accordingly
As a factual matter, was the 4/12 press release (pg. 483) false?
- The press release said: “The work done to date has not been sufficient to reach definite conclusions and
any statements as to size and grade of ore would be premature and possibly misleading.”
o The information offered is definitely correct BUT ONLY IF you construe the statement super
narrowly. The statement was really designed to mislead.
o The fact that insiders were trading on the information proves that it was material.

Who is suing whom?

- The SEC, seeking an injunction and other remedies, sued the company for issuing a misleading
press release and the officers for insider trading.
o Experts testify for both sides:
 SEC estimates 8.3 million tons of ore to be extracted
 Texas Gulf says they’re unsure of the extent of mineral deposits
- TGS is being sued under 10b-5
o In order to sue under 10b-5 you need to be either a seller or purchaser (TGS is neither
a purchaser nor a seller but they are defendants)
o The SEC can ALWAYS be a 10b-5 plaintiff but buyers and sellers can also be plaintiffs
 Buyer and seller requirement only applies to plaintiffs

Is the issuance of this press release “in connection with the purchase or sale of a security” to satisfy
10b-5?
- “In connection with” prong is satisfied if the press release “would cause reasonable investors to
rely thereon” and “cause [such investors] to purchase or sell a corporation’s securities”
- We don’t have a direct link to a purchase or sale but we have a press release that people will rely
on when selling or purchasing
o SO, when a public statement is out there you get credit as a plaintiff for the purposes of
your suit
How did the 2nd circuit come to that conclusion? Where is the sale or the purchase?
- The language of Rule 10b-5 suggests that the drafters intended it to apply to fraud committed by
someone who was buying or selling a security.
Here the company was doing neither, right?
- According to the court, that did not matter: a company issues a press release in connection with a
purchase or sale as long as it issues a press release upon which a reasonable investor would rely in
deciding whether to buy or sell.
o T.G.S. thus broadens the scope of 10(b) and the connected required between transactions
and information on the market
The court looks to the dominant congressional purposes underlying the ’34 Act:
- to promote free and open public securities markets, and to protect the investing public from
suffering inequities in trading, including, specifically, inequities that follow from trading that has
been stimulated by the publication of false or misleading corporate information releases.

→ The trial court defined materiality quite narrowly, in the fear that to do otherwise would prohibit
insiders from trading and would thus deplete the ranks of capable corporate managers. The 2nd Circuit
doesn’t buy this and promotes favoring shareholders in close cases like this.
How do we know when a fact is material?
- This is the case that started the balancing test- this is the language that the SC picked up in crafting
its balancing test for Basic.

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What standard does the court use to determine materiality here?
- The court applies the balancing test [the indicate probability that the event will occur and the
anticipated magnitude of the event, in light of the totality of the company activity] and find that
the results were material.
o The middle ground is where this becomes difficult/uncertain
- The court announced a reasonable investor standard for materiality: information is material if a
reasonable investor would consider it important. Such an investor will consider information
important if it might affect the value of the stock.
o Direct from TSC
o Balancing Test in this case:

How do we know when a fact is material? – Basic balancing test

o This is speculative event, exploratory drilling
o Test
 1. Probability event will occur
 2. Magnitude if it will occur
 Here – probability high, would be a big deal
o Reasonable investor standard – info material if a reasonable investor would
consider it important (TSC)
 Investor will consider info important if it might affect the value of the
stock
• Problem for D&O’s – hard for them to say info was not material since they bought
their shares based on this info
What is the result of this standard on insiders?
- Under this materiality standard, insiders will seldom be able to defend their trades by arguing that
information is immaterial.
- According to the court, the fact that insiders trade on a piece of information itself
demonstrates its materiality. This result makes intuitive sense, but also effectively eliminates the
materiality requirement in insider trading cases: no one files an insider trading case unless an
insider has traded, yet the fact that an insider traded will itself be evidence of the materiality of
that information.
What factors did the court look to in undertaking this probability/magnitude balancing?
• Probability – there appeared a great chance that the drilling would reap vast quantities of ore
• Magnitude – such a finding would be hugely lucrative for the company
→ So, the information was material because the drilling would probably reap great gains

Relevance of Texas Gulf:

- Before this case we would need a shareholder to read the press release and rely upon it when
buying and selling.
- Now all we need is to have the press release out there for shareholders to have standing
(similar to fraud on the market)

Big question: what can insiders do or not do with the stock of their firm, and when can they do it?
- First question- who are insiders? The court refers to § 16(b)- what is that all about?
§ 16 of the 1934 Act restricts the conduct of officers, directors and 10% shareholders. §16(b) deals with
short swing profits, a concept we will come back to.
- Are insiders always prohibited from investing in their own company, because of their access
to inside information?
o Of course not. The court is very clear on this: insiders duty to abstain or disclose ONLY arises “in
situations which are essentially extraordinary in nature and which are reasonably certain to have
substantial effect on the market price of the security if [the extraordinary situation is] disclosed.”

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 - Does an insider have to share the benefit of her superior financial or expert analysis by
disclosing her guesses or predictions?
o Of course not- the courts are not aiming to entirely level the playing field.
- When can an insider trade on inside information?
o Insiders must wait to trade until the information has been effectively disseminated, until
the information is effectively disclosed in a manner sufficient to insure its availability to
the investing public. Thus, those who traded before the April 16th announcement violated
Rule 10b-5.
- But what of TGS director Coates, who placed his orders immediately after the public
announcement?
o He waited until after the announcement but he didn’t wait long enough for the information
to disseminate
o Lower court lets him off the hook but appellate court reverses

Insider Defendants
What was the legal rule announced in this case?
- Where an insider has material nonpublic information the insider must either disclose such
information before trading or abstain from trading until the information has been disclosed
Rationale for the Rule?
- “The Rule is based in policy on the justifiable expectation of the securities marketplace that all
investors trading on impersonal exchanges have relatively equal access to material information.”
- “The essence of the Rule is that anyone who … has “access, directly or indirectly, to information
intended to be available only for a corporate purpose and not for the personal benefit of anyone”
may not take “advantage of such information knowing it is unavailable to those with whom he is
dealing,” i.e., the investing public.”
- So: if a company decides not to disclose (so that, for example, it can purchase land cheaply), the
insiders must not buy stock
- Where an insider has material nonpublic information the insider must either disclose such
information before trading or abstain from trading until the information has been disclosed

Theories for Regulating Insider Trading

Why do we regulate?
1) Fairness: We’re worried that managers will get their personal agendas into the mix
a. Information Parity
b. Integrity of the trading markets
c. Operational concerns
Remedies:
1. SEC injunctions
2. Disgorgement
3. Civil penalties
4. Criminal Sanctions

• Chiarella v. U.S. (pg. 493); precursor to O’Hagan’s misappropriation ruling.

SEE SLIDE J-45 pg. 8
Facts: Chiarella works for a printer and discovers a document that proposes a tender offer in stock from a client.
- He trades in this stock that the client had proposed to buy
o It is stock of the target company – NOT the company that he works for
 He therefore has no connection to the target
So who did he breach a duty to?
- His own company and his company’s client (who had no expectation that someone would trade on the basis
of their tender offer)
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 - If he had traded in the client firm’s stock this would have been classical insider trading
Holding: Supreme Court holds that Chiarella owed no duty to the target and thus did not violate classical insider
trading
o SC reversed Ct of Appeals and found no 10b-5 violation since Chiarella was not an insider of the
target
o Since there was no relationship at all, let alone a relationship of trust between the target’s SHs and
Chiarella, the target’s employee, he had no duty to abstain or disclose
o “Not every instance of financial unfairness constitutes fraudulent activity under Section 10(b)
- But, the SEC argues that Chiarella engaged in misappropriation.
o In response to the Court’s holding in this case, therefore, the SEC enacts 14(e)(3): a no fraud
statutory prohibition of this kind of conduct.
o 14(e)(3) only deals with tender offers – this is pretty much just in waiting for O’Hagan Court
– gets you to same result
Foreshadowing of O’Hagan: Gov’t argued the idea of misppropriation – that he had violated a duty to the
acquiror by misappropriating the info. Court declined to hear that issue since it was not submitted to jury.

Overview of Players
• Insiders
- These folks obtain material non public information because of their role in the corporation
[officer, director, employee, controlling shareholder]
- They have a 10b-5 duty not to trade [abstain or disclose…]
• Constructive/Temporary Insiders
- From Dirks footnote 14; these folks are temporary [or constructive] insiders, and they are
prohibited temporarily from trading in the company stock where they are temporary insiders.
o Certain professionals become fiduciaries of the SHs because of the special confidential
relationship, and bc of their access to information
- Lower courts have put a quasi temporary insider status on family members in situations where
there are expectations of confidentiality
- They become FN14 insiders (Temporary Insiders) when they (from DIRKS):
(1) obtain material nonpublic information from the issuer with
(2) an expectation on the part of the corporation that the outsider will keep the
disclosed information confidential, and
(3) the relationship at least implies such a duty
• Outsiders
- Outsiders [no relationship to the corporation] under O’Hagan have an abstain or disclose duty
when they are aware of material nonpublic info they got from a relationship of trust or confidence.
- These outsiders’ breach of confidence to the source of that information is, as a matter of law, a
deception occurring “in connection with” the purchase/sale of securities
• Tippers
- Both inside and outside traders who have this confidentiality duty can be liable as participants in
illegal trading if they knowingly make improper tips.
- What makes a tip “improper” is if the tipper anticipates a reciprocal benefit [selling the tip,
giving it to family/friends, expects the tippee to return the favor etc.]
- The tipper is liable even though he/she didn’t trade his/herself, as long as the tippee does.
• Tippees
- Folks with no other duty of confidentiality pick up a 10b-5 duty to abstain or disclose when they
knowingly trade on improper tips.
- So tippees are liable for trading after obtaining material, non public information that he/she knows
or has reason to know came from someone who breached a duty of confidentiality.
• Everybody Else
- Strangers with no relationship to the source of the material non public information have no 10b-5
duty to abstain or disclose.
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 - Doesn’t matter whether they overhear the material non public information or develop it
themselves.
.What is tipping and why is it wrong?
o Can’t use a tippee to do what you are not legally permitted to do yourself
o Folks with no other duty of confidentiality pick up a 10b-5 duty to abstain or disclose
when they knowingly trade on improper tips.
o Both inside and outside traders who have this confidentiality duty can be liable as
participants in illegal trading if they knowingly make improper tips.
o So tippees are liable for trading after obtaining material, non public information that
he/she knows or has reason to know came from someone who breached a duty of confidentiality
o In general, the tippee’s liability is derivative of the tipper’s, “arising from his role as a
participant after the fact in the insider’s breach of a fiduciary duty.”
o What makes a tip “improper” is if the tipper anticipates a reciprocal benefit [selling the tip,
giving it to family/friends, expects the tippee to return the favor etc.]
o The tipper is liable even though he/she didn’t trade his/herself, as long as the tippee does.

Tipper/tippee issues: what are the possible approaches for the Supreme Court in tipper/tippee
cases?
- Problems from the Chiarella holding: it’s hard to police tipees who trade on inside information,
since the tipee has no independent fiduciary duty to the corporation
- SEC Response: a tipee inherits the fiduciary obligation to the SHs whenever he receives inside
info from an insider. BUT SC takes diff approach (see below)
- Tipper or Tippee liability is a difficult area of insider trading
o Insider can’t trade himself so he tells a tippee to trade [Courts hold that you can’t do this
either]
o Once the tippee trades you hold both responsible – tippee takes on insider’s duties
- Anyone who obtains information from an insider picks up the insider’s duty – this was typically
the SEC’s argument.
- SC rejects SEC view that anyone who obtains information from an insider picks up the insider’s
duty
- The Supreme Court instead divided outsiders who receive inside information into 3 categories:
o 1) Temporary FN 14 [to Dirks] Insiders: lawyers and accountants who enter into
confidential relationships with corporations and are given access to inside information for
corporate purposes. Those who are in a confidential relationship with insiders for a finite
period of time.
o 2) Tippees [one who gets a tip from a tipper who expects that the tippee will buy/sell
based on that information]: who receive information in breach of the insider’s duty to
refrain from profiting on undisclosed information
3) Non-temporary insiders, non-tippees: they can trade freely. e.g. Someone overhearing a trade
discussion on a train, etc. NO LIABILITY

• Dirks v. Securities Exchange Commission (pg. 494); Tippers and Tippees. RULE: A tippee does not
inherit a duty to disclose material non-public information merely bc he knowingly received the
information. Aka. TIPPEES DO NOT AUTOMATICALLY HAVE A DUTY TO DISCLOSE
Facts: Dirks is an investment professional
- Secrist is a former officer of Equity Funding of America
○ He leaves because he alleges massive fraud in the company

- Secrist asks Dirks to investigate – he does so and begins telling people of his findings
- Some of Dirks’ clients sell their shares in Equity Funding and give him some of the proceeds (all told $16
million shares are sold off)
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 - SEC sues Dirks
Issue: Did Dirks violate the antifraud provisions of the federal securities laws by disclosing material nonpublic
information he got from insiders to investors who traded on the information? IS HE LIABLE AS A
TIPPER?
Does an individual, who is not a fiduciary and was not in confident with a securities’ seller always
have a duty to disclose material nonpublic information of which he has knowledge. NO.
What did the trial court decide?
- at the first hearing, the administrative law judge found that Dirks had aided and abetted violations
of § 10 - where tipees -- regardless of their motivation or occupation – come into possession of
material corporate information that they know is confidential and know or should know came
from a corporate insider, they have to abstain or disclose.
- But since Dirks played such a huge role in uncovering the fraud, the SEC only censured him.
SEC’s position:
- Dirks breached a duty that he had assumed as a result of knowingly receiving confidential
information from EF insiders.
- The insider himself could bring the fraud to light, but Dirk, standing in their shoes, breached a
fiduciary duty when he passed the information on to traders. So he could have reported the fraud,
no problem. But since he told folks who traded on the information, he somehow assumes this
duty.
o i.e. SEC wants him to be characterized as someone who has benefitted from the
information of an insider and should thus be sanctioned (this is too broad – will effect
integrity of the market)
If the SEC won, and a duty to disclose or abstain was imposed on everyone who knowingly received
material nonpublic info from an insider and trades on it, what might happen?
- This would have an inhibiting influence on the role of the market analyst – they would no longer
try to sniff out information.
- Anytime anyone got inside information they would be liable

→ What we really need is an insider who breaches their fiduciary duty in disclosing information. The
tippee must also have reason to know of this breach of duty.
- Secrist did not breach a duty. He was attempting to expose fraud.
1) He wasn’t an employee anymore
2) Even if he was, this was information that he had an obligation to disclose
- For a tipper to breach a duty, it must reap a personal benefit
o Tipper is only liable under 10b-5 if they have this personal benefit
 “Personal Benefit” is read broadly by the courts
o Tippee is liable if he knew that tipper has breached a duty and still trades
- So, for Dirks to have liability as a tipper, he would have to give information with the intent to have
someone trade and give him a benefit.
- Absent some personal gain, there is no breach of duty.
o Looking at objective criteria, the courts must determine whether the insider personally will
benefit, directly or indirectly, from his disclosure
o Examples of personal gain: tippee pays for the tip; 2 insiders at different firms trade tips;
gift; Pecuniary gain; enhanced reputation that will translate into future profits; or gifts
- And absent a breach of duty by the insider, there is no derivative breach.
Holding:
- In general, the tippee’s liability is derivative of the tipper’s, “arising from his role as a
participant after the fact in the insider’s breach of a fiduciary duty.”
- A tippee therefore can be held liable only when:
o The tipper breached a fiduciary duty by disclosing information to the tippee, and
o The tippee knows or has reason to know of the breach of duty
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 - A fiduciary-duty breach occurs only where a tipper earns a personal benefit from the tip.
- Absent some personal gain, there is no breach of duty.
o Looking at objective criteria, the courts must determine whether the insider will personally
benefit, directly or indirectly, from his disclosure.
o Examples of personal gain:
 Tippee pays for the tip
 2 insiders at diff firms trade tips
 Gift
 Pecuniary gain
- And absent a breach of duty by the insider, there is no derivative breach.
- Thus, Dirks is liable only if Secrist breached a fiduciary duty to EF shareholders in telling Dirks,
and Dirks knew (or should have known) of that breach. Because Secrist was trying to stop fraud,
he breached no fiduciary duty.

Analysis Questions on Page 500

1. Why did the court absolve Secrist of liability?
- The Court views § 10(b) as an anti-fraud provision, not as a provision designed more broadly to
ensure that all participants in the market have equal access to information or that there is a level
playing field.
o There is no fraud, says the Court, because Secrist violated no fiduciary duty in tipping.
o He violated no fiduciary duty because he received no personal benefit (NOTE: some courts
have even found revenge to be enough to satisfy personal benefit aspect)
o Whistle blowers are not held as liable tippers
2. What is the scope of the Court’s doctrine on breaches of fiduciary duty?
- The Court requires some personal benefit to Secrist (presumably a tangible benefit—that is,
something other than that he feels good about what he did).
o If Secrist and Dirks routinely exchanged stock tips, their exchange would violate Rule
10b-5 since the tipper would be receiving a benefit (future information).
o If Secrist tipped Dirks out of revenge, whether S would have received a benefit (and
therefore violated a fiduciary duty) is less clear.
o If S carelessly discussed the fraud in the elevator, that would not constitute a fiduciary
duty breach under Dirks.
3. What if Secrist disclosed inside information when Dirks bribed him, and then Dirks tipped
his clients in violation of 10b-5? Did his clients also violate 10b-5?
- Whether Dirks’ clients violated 10b-5 would depend on whether they knew (or had reason to
know) that Dirks received his information through a fiduciary duty breach.
- All this would do is to extend the scope of the tipper/tippee relationship if Dirks’ clients knew that
the info they received was obtained pursuant to a breach of the fiduciary duty.
* You cannot use someone else to accomplish what you cannot as an insider

The Doctrine of Tipper/Tippee has evolved to account for a misappropriation theory

• 14e-3, enacted by the SEC after Chiarella, is a statutory band-aid that become irrelevant after O’Hagan
Rule 14e-3. Transactions in securities on the basis of material, nonpublic information in the context of
tender offers
(a) If any person has taken a substantial step or steps to commence, or has commenced, a tender offer (the
“offering person”), it shall constitute 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
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 a. The offering person,
b. The issuer of the securities sought or to be sought by such tender offer,
c. Any officer, director, partner or employee or any other person acting on behalf of the offering
person or such issuer…
Historical background: Chiarella and Dirks created significant gaps in the insider trading prohibition’s coverage.
- Rule 14e-3 dealing with tender offers was the SEC’s immediate response to Chiarella, but the rule’s scope
is very limited. It is not triggered until the offeror has taken substantial steps towards making the offer and,
more important, is limited to information relating to a tender offer.
- As a result, most types of inside information remained subject to the duty-based analysis of Chiarella and
its progeny.
- The misappropriation theory filled part of the gap, although it too is limited in that it requires a breach of
fiduciary duty before trading on inside information becomes unlawful.
- It is not unlawful, for example, to trade on the basis of inadvertently overheard information, as in SEC v.
Switzer which we talked about earlier.
How can we change facts in Dirks to make him liable?
- If Secrist still works for Equity (breaches a duty to his corporation); BUT, he would still need to expect a
benefit (which can be satisfied in a number of ways, remember – BENEFIT TO THE TIPPER CAN BE
CONSTRUED EXTREMELY BROADLY; we’d like to see a monetary benefit for test purposes,
however)
• You can have insider liability on a chain of trading communications:
- If tippee never trades neither party has insider trading liability (but tipper may still have duty of loyalty and
duty of care liability)
o BUT, there is no way that a tippee can be liable for insider trading if the tipper is not also liable and
vice versa. THEY EITHER BOTH OF LIABILITY OR NEITHER OF THEM DO.
Quick Recap
• Trading on material, non-public info – insider trading and misappropriation
o What makes it illegal – trading in breach of fiduciary duty (duty of confidentiality, DOL)
• Courts wrestle w/materiality (what is material)
o Loose definition of material – what a reasonable shareholders would think is
important
o If have non-material, non-public info, then can trade on it
o Why is this legal? – won’t affect trading
• If info publicly available – then trading is fine, no unfair advantage, no inside info
• Ways to get out of insider trading liability
o 1. Show info is non-material (reasonable investor would not think important)
 However, if insider trades on info, Court’s will presume info is likely just based
on fact insider’s traded on the info
o 2. Show info was public
• 2 types of bad conduct
o 1. Trading on material, non-public info of your company – classical insider trading
o 2. Trading on material, non-public info in breach of duty of confidentiality (duty not to
do anything or tell anyone) in someone else’s company/stock – misappropriation
• Must be material, non-public info and must trade on it in breach of a duty
• Non-insiders – 3 categories
o 1. Temporary Insiders – accountant, lawyer, etc
o 2. Tippees – people who get info from insiders and trade on it (buy or sell)
o 3. Everyone else
• Insiders – directors, officers, 10% shareholders, employees – abstain or disclose – have 10b-
5 obligation not to trade
• Rule – must be a trade for there to be insider trading
• Tippers – can get in trouble even if they don’t trade themselves, have someone else trade for
them – both are liable
o Illegal Tipper
 1. Tipper must anticipate personal benefit – get something for info
• Expect tippee will give them something (info, money, gift, etc)

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 • Benefit can be seen broadly (most likely money)
• Tips but does not trade himself
 2. Tippee – trades on the info received from tipper
• Gets material, non-public info, and knows or has reason to know that the
info comes from someone in breach of a duty, will pick up liability
• Want to prevent tipper from accomplishing what couldn’t do himself
• Liable derivatively b/c of tipper’s breach
o Either both liable or neither
 Need tipper to tip and tippee to trade
o If tip people and they don’t trade, insider trading not triggered
• Liability based on inside tips about your company (classical) and the corp your company is
dealing with (misappropriation)
• Cases
o Dirks – tippers v. tippees situation
 No violating of duty, Dirks or Secrist not an insider
 Secrist received no personal benefit
 Duty to disclose illegal actions
o Chiarella – foreshadowing misappropriation
 Traded in company’s target
 Misappropriated (stole) info he got due to confidential relationship
 Why not liable? – would be today, but at the time no law against
misappropriation
 SEC creates 14(e)(3) – only applies to tender offers
• Securities Exchange Act (1934) 14(e)(3) (pg 321) – Chiarella Statute
o Waiting for O’Hagan court creates 14(e)(3), gets you to same place as O’Hagan
o 14(e)(3) only deals w/tender offers
o Any person in possession of material info, knows or should’ve known info was non-
public (names crossed off)
 Not allowed to purchase or sell based on this info (Chiarella did)
 Abstain or disclose duty – can only trade if info becomes public or is public
• United States v. O’Hagan (pg. 501) RULE: An attorney who, based on inside information he acquired as an
attorney representing an offeror, purchased stock in a target corporation before the corporation was purchased
in a tender offer is guilty of securities fraud in violation of Rule 10b-5 under the misappropriation theory. Aka.
Atty breaches his dol is he uses nonpublic info to trade securities
SEE SLIDE J-74 pg. 13
Facts: O’Hagan is a partner at a law firm representing Grand Metro regarding a tender offer for common stock of
the Pillsbury Company
- O’Hagan is not working on the tender offer
- Grand Met and law firm are trying to keep the tender offer secret
o When tender offers are announced stock prices typically jump
- O’Hagan starts purchasing call options for Pillsbury stock (REMEMBER: Call Option – right to buy
stock on a given date at a certain price)
o You will only exercise this right if the stocks are valued higher than your call option
o He buys 2,500 call options and 5,000 shares of common stock and makes $4.3 million
- * This is not classical insider trading
o O’Hagan is a temporary insider for Grand Met. But he didn’t buy Grand Met. Stock! He only
bought Pillsbury stock.
o If he bought Grand Met. Stock he would be a Dirks FN14 candidate
- This is a 14e-3 problem: Substantial steps to commence a tender offer
Issue: Is a person who trades in securities for personal profit using confidential information misappropriated in
breach of fiduciary duty to the source of that information liable under Rule 10b-5 and § 10(b)?
- Also, did the SEC exceed its rulemaking authority under § 14(e) by adopting rule 14e3(a) which prohibits
trading on inside information in a tender offer, even absent a duty to disclose?
Holding: YES – the Supreme Court lays out the opinion in O’Hagan that establishes misappropriation
- The misappropriation theory is a valid basis on which to impose insider trading liability.
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 - A fiduciary’s undisclosed use of information belonging to his principal, without disclosure of
such use to the principal, for personal gain constitutes fraud in connection with the purchase or
sale of a security and thus violates Rule 10b-5.
- The SEC had authority to adopt Rule 14e-3 as a prophylactic measure against insider trading in
connection with a tender offer.
See Questions on Slide J-77 pg. 13
Who should O’Hagan have disclosed this information to to avoid liability?
- Under misappropriation if you use information you would have to disclose this fact to the
principles (Law Firm and Grand Met) who would need to approve your plans to trade on the
information
- REMEMBER: 10b-5 liability is premised on misrepresentations or fraud “in connection
with the purchase or sale of a security”
Misappropriation is designed to fill a gap:
- When classical insider trading doesn’t apply but you have used information inappropriately
Why isn’t 14e-3 enough?
- 14e-3 applies only to TENDER OFFERS ONLY – narrowly construed!
o It was enacted so that the SEC could act upon fraud in a tender offer (response to
Chiarella)
o 8th Circuit thought SEC made fraud too big in 14e-3.
- Misappropriation is much broader than this- O’Hagan now covers ALL situations of insider
trading
o All we need is deception in the buying or selling of securities.
Is this case distinguishable from Santa Fe?
- Short form merger saw plaintiffs who tried to take Federal 10b-5 claims
Did O’Hagan’s conduct satisfy the requirement of §10(b) that the deceptive use of information be "in
connection with the purchase or sale of a security?”
- Misappropriation works because he used information without disclosing intent to Grand Met.
- Meets the statutory requirement that there be deceptive conduct in connection in connection with
securities transactions.

So is O’Hagan an inside trader or an outside trader?

- O’Hagan is an outside trader in Pillsbury. He owed no duty to Pillsbury or its shareholders. But
he did owe a duty of trust and confidence to his law firm, and to the firm's client.
- So the court says this misappropriation is properly the subject of a 10(b) action since it
meets the statutory req’t that there be deceptive conduct in connection with securities
transactions.

• United States v. Chestman (pg. 508) – Not in Slides.

Facts: Insider trader uses sister o accomplish what e could not as a company president
- Can’t trade on this information until it is public
- Sister tells her daughter, who tells her husband.
o Each person tells the next in the chain to keep the information confidential.
- Husband tells broker who trades on the information.
Issue: Does the family relationship have a fiduciary duty?
Second Circuit holds:
- “A person violates Rule 10b-5 when he misappropriates material nonpublic information in breach of a
fiduciary duty OR similar relationship of trust and confidence and uses that information in a securities
transaction.”
- The Court further held that in the absence of any evidence that Keith regularly participated in confidential
business discussions, the familial relationship standing alone did not create a fiduciary relationship between
Keith and Susan or any member of her family.

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 The court found that there was no fiduciary relationship between the tippee daughter and her
o
husband, absent a showing that the husband regularly participated in confidential business decision
- the family relationship was insufficient to create a fiduciary relationship on its own. So since the
husband's actions didn't constitute a breach of fiduciary duty, his tippee was likewise not liable.
BOTTOM LINE: In the absence of a fiduciary relationship, no liability for misappropriation.

What is the statutory assistance provided by the SEC in determining when you are a fiduciary for
misappropriation theory purposes?
SEC addressed Chestman problem by adopting Rule 10b5-2:
- “A non-exclusive list of three situations in which a person has a duty of trust or confidence for purposes of
the ‘misappropriation’ theory . . . .”
1) Whenever someone agrees to maintain information in confidence;
2) Whenever the person communicating info and the person to whom it is communicated
have a history, pattern or practice of sharing confidences, such that the recipient of the
info knows or reasonably should know that the person communicating the info expects
the recipient to maintain confidentiality; or
3) When someone receives or obtains material nonpublic information from a spouse, parent,
child, or sibling UNLESS recipient shows that there was no expectation of
confidentiality (Chestman)

Can liability for insider trading be imposed solely on those who traded on the basis of material nonpublic
information, or can it be broadened to include anyone who trades WHILE IN POSSESSION of such
information?
- Is there a difference between trading on the basis of info or in possession of info?
o 10b5-1: the preliminary note tells us that this rule defines when a purchase or sale constitutes
trading “on the basis” of material nonpublic information.
o (a) tells us that the “manipulative and deceptive device” prong is satisfied by the purchase or sale
of a security on the basis of material non public information:
 in breach of a duty of trust or confidence that is owed DIRECTLY, INDIRECTLY, or
DERIVATIVELY to the issuer or shareholders or to the source of that material non public
information.
 mostly this is interpreted to mean you were aware of the information when you made the
trade.

So who are we talking about?

- Insiders [D&O, employees, controlling shareholders]
- Temporary insiders under Dirks Footnote 14 [accountants, lawyers, investment bankers]
- Outsiders WITH A DUTY TO THE SOURCE OF THE INFORMATION – the outsider’s breach of
confidence to the information source satisfies the deception in connection with the trade…
- Tippers: insiders/outsiders who knowingly make improper tips – meaning they anticipate reciprocal
benefits: sells tip, gives tip to family/friends, expects tippee to reciprocate with information
- Liability extends to sub tippers who know or should know the tip is confidential and came from someone
who tipped improperly
REMEMBER:
- Tippers can be liable EVEN IF THEY DON’T TRADE, as long as a tippee down the line
eventually trades.
- Tippees: those with no confidentially duty will INHERIT an abstain or disclose duty IF they
knowingly trade on improper tips. If tippee knows or should know the info came from a
person who breached a duty in sharing, tippee is liable for trading. Ditto for sub tippees.

Who are we NOT talking about?

- Strangers with no relationship to the source of the material, non public information – they have
NO duty to disclose or abstain and can freely trade.

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 - Okay, back to misappropriation: Under O’Hagan, we see that there can be no 10b-5 insider
trading liability if there is no breach of trust or confidence.
o If O’Hagan tells his firm and Grand Met. About his plans to trade and they approve then
they need to go public with the information so there is no market wrongdoing
o Misappropriation is a violation of a duty that you owe to the source of your information
 You can’t trade on information in breach of a fiduciary duty. If you get permission
to trade the info must be made public before doing so

Mark Cuban Case

o There are ways that you can from insider trading either by gaining profits or avoiding losses that you
shouldn’t have been able to.
o Cuban engages in insider trading for Mama.com
o He is an insider because he owns more than 10% of company stock
o There’s going to be a “pike”
 More stock is going to be issued and thus dilute the value of the company’s stock
o Is this information material under TSC?
 Yes
o Cuban learns of this before the price drop and trades on the information (avoids losses)
 This is a case of classical insider trading – he owns enough stock to be considered an insider and violates
10b-5
 With civil penalties you have to give back what you got (Here, Cuban would have to “give back” the money
he didn’t lose)
Now say that Cuban is not a controlling shareholder…
o He might be considered a tippee – but there is no benefit to the tipper in this case so this isn’t exactly
satisfied
o This could also be a case for misappropriation – but here Cuban has a connection to the company so it’s not
pure misappropriation

Overview: Insider Trading Liability

1) Insiders - Officers, Directors, More than 10% Shareholders, Employees
o Officers and Directors have fiduciary duties to shareholders
o 10% or more shareholders have enough pull in the company to pick up some fiduciary duties
o Employees (e.g. Chiarella)
- Undermine Market Integrity, Trading Advantage
2) Temporary Insiders
3) Tippees of Insiders and Temporary Insiders - Insiders and Temporary Insiders cannot avoid liability simply
by having someone trade for them
Trading on Basis of Info vs. Trading While in Possession of Info
• If have info, hard to prove that the reason you traded was not based on that info
• Only hold people liable who trade based on material, non-public info
• For 10b-5 liability – need breach of liability
• Certain groups of people are limited on what they can do based on info they have
that no one else has
o Classical insiders – have to make info public and then can trade freely
 Limits trades insiders can make if they don’t want to disclose
 If can’t disclose, then must abstain
o Tippers/tippees – can’t trade on info you got from an insiders
 Can’t do what tipper couldn’t do themselves
o Misappropriation – didn’t get info from your company, but got info from some
place and traded in another’s stock
 Took info and didn’t disclose to source
 Can’t use info you get as insider to trade in another’s stock
 Violates fiduciary duty to the source

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  Can’t trade on basis of material, non-public info in breach of fiduciary
duty w/o disclosing to the source of info you wish to use it
 10(b)(5)(2) – presumption that if get from family members it is
confidential
• Can get out of this if can prove there was no confidentiality
o Hard to prove

SHORT SWING PROFITS & INDEMNIFICATION

o Form of insider trading (smaller group of insiders)
§ 16(a) – if own more than 10% of any class of stock or are director or officer there are certain
limitations on when and how you can trade:
- “Every person who is directly or indirectly the beneficial owner of more than 10 per centum
of any class of any equity security . . . or who is a director or an officer of the issuer of such
security . . . within ten days after the close of each calendar month . . . shall file with the
Commission . . . a statement indicating his ownership at the close of the calendar month and such
changes in his ownership as have occurred during such calendar month”
o Policy – assume these people are most likely to have access to inside information
§ 16(b)
- “any profit realized by [such beneficial owner, director, or officer] from any purchase and sale, or
any sale and purchase, of any equity security of such issuer . . . within any period of less than six
months . . . shall inure to and be recoverable by the issuer”
o Limits the amount of profits that officers, directors, 10% shareholders will get to keep over
a 6-month period.
o *Not insider trading, this is just regulating trade by insiders
o Statute sets up an artificial measure of what a profit is. If an insider has a matchable
purchase and sale within 6 months of one another than reaps a profit they must give it back
to the corporation:
 So, what result if trade within 6-month period:
• Any recovery goes to the company
• SHs can sue derivatively, and a SH’s lawyer can get contingent fee out of any
recovery or settlement (so lawyers can make a living on 16(b) suits)
As a whole, § 16 is much narrower than 10b-5:
- The section applies only to officers, directors, or shareholders with more than 10% of ANY
class of stock.
- This is a smaller group of insiders than under Rule 10b-5. (which covers any “person”)
- The statute applies to officers and directors if they are officers or directors either during the
purchase or sale;
- it applies to a 10% shareholder only if he or she held more than 10% at both the purchase and the
sale [which we will come back to in the Foremost-McKesson case in a few minutes].
- No tipping liability, no misappropriation liability, no constructive insiders – only TRUE insider
Companies:
- The section applies only to firms that must register under the 1934 Act [Only public corporations].
- This, too, is a smaller group than under Rule 10b-5 which covers public and private companies -
covers all issuers
- § 12: companies must register under the 1934 Act...
o If they have a class of stock trading on a national exchange, or they have 500 or more
shareholders and assets of at least $10 million
o Under § 12(a), all securities traded on a national exchange need to be registered [which
triggers the periodic disclosure system, proxy regulation, insider trading, take over
regulation]

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Equity Securities:
- This section applies only to equity securities and convertible debt (e.g. Debentures)
o A debt instrument that has the ability to convert into equity stock is treated as that amount
of stock
- Again, this is narrower than under Rule 10b-5 which covers any security as defined in the statute,
including investment contracts.
More on § 16:
Sale and Purchase:
- The section applies whether the sale follows the purchase or vice versa.
- It thus does not require that the trader earn his or her gains from buying and selling specific shares
of stock. Instead, if the trader unloads 10 shares of stock and buys back 10 different shares of
stock in the same company at a cheaper price, he or she is liable.
Six-month period:
- The sale and purchase must be within a six-month period [An arbitrary number but statutorily
required].
Disgorgement:
- Any recovery goes to the company
- Shareholders can sue derivatively, and a shareholder's lawyer can get a contingent fee out of any
recovery or settlement. So the lawyers make their living on § 16(b) suits.
Maximize Gains:
- Courts interpret the statute to maximize the gains the company recovers - the court will match the
highest and the lowest trade.
- It is hard to explain this principle without doing specific problems (as we will soon do), but let's
keep this idea in mind anyway.
Form and Substance:
- Form almost always triumphs over substance in § 16(b) cases.
- § 16(b) may take the profit out of trades on inside information, though not very effectively, but
may also apply to innocent trades and thereby will discourage executives from the desirable action
of investing in the shares of their own companies. This is the downside of § 16(b)’s “protection.”
o Nothing significant about short swing profit – merely a penalty that you must pay

Short Swing Profits Liability, IN SHORT:

• Officers and Directors – statute applies to them if they are O&D at either the
purchase or sale
o Even if leave role as either director or officer, still subject to liability for 6
months after leave position
o Can’t just quit and make trades
• 10% Shareholders – applies if held more than 10% at both the purchase and the
sale
o Must determine insider status the second before the trade
• Section 12 1934 Act – must register securities if 2 things are true
o 1. Class of stock trading on registered exchange
o 2. Or looks like – certain amount of shareholders and assets
• 16(b) – only applies to tock and convertible debt
o Applies either sale then purchase or purchase then sale (doesn’t matter)
• How measure SSP – takes a 6-month window and looks and all the buying and
selling and figures out what the max profits insider could’ve made (considers only the
best case scenario) and that is what you are charged with (have to give back)
o Doesn’t matter if you actually didn’t receive profits or even if you lost money,
have to give the amount back under the best case scenario you could’ve made

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 • Big area of derivative lawsuits – when these insiders file their paperwork w/the SEC at
the ends of every month, try to figure out if there are any SSP’s
o If company won’t act, shareholders usually will
• Potential downside – catch some people didn’t want to, and let others go probably
wanted

• Reliance Electric Co. v. Emerson Electric Co. (pg. 511) RULE: A corp may recover the profits realized by an
owner of more than ten percent of its outstanding shares from a purchase and sale of its stock within any 6
month period, provided the owner held more than ten percent at the time of both the purchase and the sale. Aka.
PROFITS ARE NOT RECOVERABLE BY A SUCCESSOR UNDER INSIDER TRADING PROVISIONS
Facts: Emerson bought 13.2% of Dodge Man. Co. in a probable takeover attempt
- Purchase invokes § 16(b) insider liability
- Takeover hopes are dashed so they sell enough stock [3.24%] to fall under 10%
- They then sell their remaining 9.96% interest shortly thereafter
- Before acquiring the 13.2% interest Emerson is NOT an insider
- When they sell below 10% they are no longer insiders
- So, when they sell their 9.2% they are NOT insiders
- Reliance (who controls Dodge) sues for recovery of short swing profits
- Emerson counters that no transaction dealt with 10% of the stock except for the initial purchase of 13.2%
o In order to calculate short swing profits we need matchable purchase and a matchable sale within
the 6 month statutory window
- Emerson also argues that if the 1st buy that take them over 10% DOES count as a matchable purchase, it
should only be matched to the 1st sale because this took them below 10% [This argument turns out to be
unnecessary because the court finds that the 1st purchase DOES NOT count]
How many matches do we have?
- None
- Purchase that takes them over 10% is not matchable (Foremost)
Holding – no liability b/c weren’t an insider when bought stock and weren’t insiders when
made 2nd sale (nothing to match up w/the 1 insider trade)
 Only 1 sale made when insider & never made another sale or purchase within
6 mos as an insider
 Did this in bad faith to circumvent 16(b), but not illegal
- Look at each trade made and try to figure out whether purchaser or seller
was an insider at the time of the trade
o Can only match within the 6-month window
- Matchable – need matchable buy and sell (need buy and sell within 6 month period
to match)

• Foremost-McKesson, Inc. v. Provident Securities Company (pg. 514) RULE: A corp may capture for itself
the profits realized on a purchase and sale of its securities within 6 months by a director, officer, or
beneficial owner, but a beneficial owner is accountable to the issuer only if it was a beneficial owner before
the purchase. Aka BENEFICIAL OWNERS HAVE NO LIABILITY FOR SHORT-TERM PROFITS IF
THEIR STATUS EXISTED BOTH BEFORE AND AFTER THE SALE
Facts: Company is liquidating and as part of their liquidation they sell some debentures (convertible debt) to
Foremost
- Convertible debt can be turned into equitable securities
- The bonds bought by Foremost would account for more than 10% of company stock
- 10/20: Provident acquires debentures convertible into > 10% of Foremost stock
- 10/24 Provident distributes some debentures to SHs
- 10/28: Provident sells remaining debentures.
Issue: Whether a person whose purchase of securities puts his holdings over 10% is a benefitical owner for
§12(b) at time of such purchase [triggering § 16(b) liability on profits on the sale of these securities wi 6 months]
Easier way to state the issue: does "at the time of purchase" mean before the purchase or
immediately after the purchase?
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Can we match 10/20 acquisition with 10/24 disposition? Is that 10/20 a matchable transaction?
Holding: The court chooses to determine insider status the second before the trade
- So, the second before the trade Foremost is not an insider so you can’t count the first transaction
o You have to be a 10% owner at the time of the sale and purchase (that fall within 6 months
of one another) for them to be matched
- In a purchase-sale sequence, the transaction by which the shareholder crosses the 10% threshold is
not a matchable purchase
- Only purchases effected after one becomes a 10% shareholder are matchable
Statutory Issue: “This subsection shall not be construed to cover any transaction where such
beneficial owner was not such both at the time of the purchase and sale, or the sale and
purchase, of the security involved”

Why does this issue matter?

- It is critical to owners like Provident who sell within six months of the acquisition that made him a
10% shareholder in the first place.

Short Swing Profits Checklist

- Publicly traded stock or registered under ’34 Act
- Match over 6 month period highest price sold at against lowest price bought at
- Officers and directors need only be officers and directors for 1 purchase/transaction.
o When they resign/lose officer or directorship status they still have insider liability for
the next 6 months following a sale/purchase.

Ask: Was insider an insider the second before the first trade?
- If yes the transaction is matchable
- If you get a matchable purchase and a matchable sale you can collect any profits derived
therefrom on behalf of the corporation
o Just because one transaction is matchable doesn’t mean you will be liable (you need it
to be matched against a sale/purchase)
- *It doesn’t matter whether you buy first and sell or sell first and buy
- However, you can only match the same classes of stock with one another [e.g. You can’t match
an A stock with a B stock]

Why do we have § 16 on the books?

- It forces insiders NOT to curb their conduct to facilitate a short gain on their investments

Hypo:
- Officer buys 200,000 shares on January 1
- Sells 110,000 shares May 1
- Sells 90,000 shares May 2
o Liable for both sales (as an officer)
To calculate profits:
- Start with the sale at the highest price and match these against as many purchases as you can
- Take any lower priced sales and match these up with the remaining purchases
- *This maximizes the traders liability
→ Thus, you can have a case where the defendant loses a substantial amount of money in their actual trades but
will still be liable for a large amount of money when short swing profits are calculated

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Indemnification -When make someone whole for their liability
• Saying a director is not liable for X gets you to the same place as saying that
the director is liable for X but that the corporation will indemnify the director
against X.
• Saying a director is not liable for X likewise gets you to the same place as
buying insurance against the liability.
• If director gets sued, corp would pay back any liability incurred if done within
the scope of agency or duty of corp

Liability Limitation Statutes

o DGCL §102(b)(7) provides that a corporation’s articles of incorporation may (but need
not) contain:
• A provision elimination or limiting the personal liability of a director to the corporation or
its stockholders for monetary damages for beach of fiduciary duty as director…
o provided that such provision shall not eliminate or limit the liability of a
director:
(i) for any breach of the director’s duty of loyalty to the corporation or its
stockholders;
(ii) for acts or omissions not in good faith or which involve intentional misconduct or
a knowing violation of law;
(iii) under §174 of this title [relating to liability for unlawful dividends]; OR
(iv) for any transaction from which the director derived an improper personal benefit
o NOTE: ONLY applies to directors
o Although officers also are subject to a duty of care, they are denied exculpation by charter
provision
o Arnold v. Society Savings Bancorp, Inc. (DELAWARE): As to a defendant who is
both a director and an officer, a §102(b)(7) provision applies only to actions taken
solely in his capacity as a director.
o Limits ONLY the monetary liability of directors – equitable remedies are still
available
o A §102(b)(7) provision is an affirmative defense for a suit of breach of duty

DELAWARE LAW:
Mandatory versus Permissive Indemnification
o Under §145(c), the corporation must indemnify a director of officer who “has been
successful on the merits or otherwise.”
Advancement of Expenses
o Under §145(e), the corporation may advance expenses to the officer or director
provided the latter undertakes to repay any such amount if it turns out he is not entitled to
indemnification

PROXY VOTING & PROXY FIGHTS

Shareholder Meetings:
• Annual: at a time and place proscribed in the bylaws; the shareholders vote on matters such as electing
directors. Most corporate statutes require that a corporation hold a shareholders meeting at least annually.
o MBCA § 7.01
• Special: outside the ordinary schedule of meetings [not annual].
o MBCA § 7.02
Voting Lists: prepared by the corporation prior to each shareholders’ meeting.
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Record Date: cutoff date for ownership determination
o e.g. Wednesday at 5pm; if you sell your shares on Thursday you will STILL be permitted
to vote at the upcoming meeting
Notice: written announcement that is sent a reasonable length of time [by statute] prior to the date of the
meeting.
- Notice of the special meetings must include a statement of the purpose of the meeting; business
transacted is limited to the stated purpose.
Resolutions:
- corporate business matters are presented in the form of resolutions, which shareholders vote to
approve or disapprove.
o Practical reality: action without a meeting (everyone can sign a written consent that
permits action in lieu of a meeting)

Typical Annual Meeting

- Nominating committee of the incumbent board [board that is in power now] of directors
nominates a slate of directors to be elected at next annual meeting
- Incumbent board identifies other issues to be put to vote
- At company expense:
o Management prepares proxy statement and card
o Management solicits shareholder votes (typically with aid of proxy solicitor)
- Common stock is valuable because it gives you a right to elect a board

Voting at Annual (or Special) Meetings

- Most matters require a majority of shares present at a meeting at which there is a quorum
- quorum: the minimum number of shares required to transact business. This is usually satisfied by
the presence, in person or by proxy, of 50% of the outstanding shares present, either in person or
by proxy.
- simple v. super majority: at times, more than a simple majority will be required either by statute
or by the corporate charter. Typical examples include mergers and dissolution and charter
amendments.

Types of Voting:
Plurality – means you have the highest # of votes (not necessarily a majority)
Straight Voting – each director’s seat is a separate election. Minority never wins
Cumulative Voting:
- a method of voting designed to allow minority shareholders representation on the board of
directors. When cumulative voting is permitted or required, the number of members of the board
of directors to be elected is multiplied by the total number of voting shares.
- The result equals the number of votes a shareholder has and this total can be cast for one or more
nominees for directors. All nominees stand for election at the same time. When cumulative
voting is not required either by statute or under the articles of incorporation, the entire board can
be elected by a majority of shares at a shareholders’ meeting.
 Type of voting is determined in the articles of incorporation
If want cumulative, must specifiy it
Default is straight voting!

Example:
- Corp has 10,000 shares issued and outstanding. The minority SHs hold only 3,000 shares, and the majority
SHs hold the other 7,000 shares. Three members of the board are to be elected. The majority SHs’
nominees are Allan, Burns and Caleb. The minority SHs’ nominee is Davis.
- Can Davis be elected to the board by the minority shareholders?
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 o If cumulative voting is not allowed, the answer is no.
o If cumulative voting is allowed, the answer is yes. The minority SHs have 9,000 votes among
them [the number of directors to be elected X the number of shares = 3 X 3,000 which totals 9,000
votes].
o All of these votes can be cast to elect Davis. The majority shareholders have 21,000 votes [3 times
7,000 = 21,000 votes], but these votes have to be distributed among their three nominees.
o If straight voting is used, the majority will win 7:3 EVERY TIME; Thus, cumulative voting can be
a powerful thing
- The principle of cumulative voting is that no matter how the majority SHs cast their votes, they will
not be able to elect all 3 directors if the minority shareholders cast all of their 9,000 votes for Davis.
o i.e. The majority cannot block the minority on ALL voting under this system

Proxies: a shareholder (as principal) can appoint someone else (as agent) to vote on his or her behalf at
the shareholders’ meeting. Because it is not usually practical for owners of only a few shares of stock to
attend shareholders meetings, such shareholders normally give third parties written authorization to vote
their shares at the meeting.
- As a practical matter, they are necessary to insure a quorum.

Proxy Voting:
- Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her shares at the meeting
- Appointment effected by means of a proxy (a.k.a. proxy card)
o Can specify how shares to be voted or give agent discretion
o Revocable

A validly executed proxy is the same as if a shareholder has shown up to the meeting
- Permitting someone to vote your shares in your stead
- Proxy votes are ALWAYS revocable [you can show up to the meeting and vote on your own
behalf if you don’t wish to be represented by your proxy]

Why do we have the idea of a proxy?

- Corporation pays a proxy solicitor a lot of money to get shareholders to fill out proxy cards in
their favor
o You need a quorum at shareholder meetings (if you don’t have proxies you would NEVER
have the statutory minimum number of shares in the room to pass anything at these
meetings)
 Not enough shareholders would actually show up to a meeting to have a quorum
NOTE: NO PROXIES SOLICITED AT DIRECTORS’ MEETINGS
- Directors have a duty of care – can’t delegate their job to others via proxy

• When statute/bylaws don’t require more than a simple majority all you need is 50.1% of shares present

Proxy Contests
- A shareholder (a.k.a. the insurgent) solicits votes in opposition to the incumbent board of directors
o Electoral contests: Insurgent runs a slate of directors in opposition to slate nominated by
incumbent board
o Issue contests: Shareholder solicits votes against some proposal

Proxy contests are relatively rare – why?

- Shareholders are apathetic
- Proxy contests cost a lot of money

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 o Example: you own 10% of a firm worth $8 million that you think is badly managed. You
think you can increase the value of the firm by 20% [$1.6 million] by replacing the BOD.
o You can make a tender offer for all the shares or wage a proxy fight:
 Tender: you need $7.2 million to buy the remaining 90% of the stock of an $8
million firm; you will then capture all the gains from the increase in value.
 You could also just tender for another 41% and become a majority shareholder, and
get 51% of the gains from the increase in value.
 Proxy fight: if you can replace the BOD, and the value does in fact increase by
20%, your holdings too will increase by 20%. And when you are successful, the
firm may reimburse you for your reasonable expenses. If you are NOT successful,
you pay the whole ticket.
• You don’t gain ownership rights but you’ve spent less and the value of your
stock has increased by 20%.
• ALSO, successful insurgents will sometimes have their expenses covered

Securities Exchange Act § 14(a)

“It shall be unlawful for any person, by use of the mails or by any means or instrumentality
of interstate commerce or of any facility of a national securities exchange or otherwise, in
contravention of such rules and regulations as the Commission may prescribe as necessary
or appropriate in the public interest or for the protection of investors, to solicit … any
proxy … in respect of any security … registered pursuant to Section 12 of this title”

SEC Proxy Rules

- 14a-3: Incumbent directors must provide annual report before soliciting proxies for annual
meetings
- Anyone who “solicits” a proxy must provide a written proxy statement BEFORE soliciting the
proxy.

What is a solicitation?
- “Solicit” includes not only “direct requests to furnish, revoke or withhold proxies, but also ...
communications which may indirectly accomplish such a result or constitute a step in a chain of
communications designed ultimately to accomplish such a result.”—Long Island Lighting Co. v.
Barbash, 779 F.2d 793, 796 (2d Cir.1985).
- E.g. Newspaper ad, television interview, etc. (can be read very broadly by the court)
What is NOT a Solicitation?
o Rule 14a-1(l)(2)(iv) exempts public statements of how the shareholder intends to vote and
its reasons for doing so
o Rule 14a-2(b)(1), subject to numerous exceptions, exempts persons who do not seek "the
power to act as proxy for a security holder" and do not furnish or solicit "a form of revocation,
abstention, consent or authorization”
 Consequently, for example, a newspaper editorial advising a vote against incumbent
managers is now definitively exempted
o Rule 14a-2(b)(2) exempts solicitations of 10 or fewer persons
o Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice by someone with whom
the shareholder has a business relationship

Proxy Statement: document in which the solicitor discloses information that may be relevant to the
decision the shareholder must make: annual report; disclosure of conflict of interests; issues that solicitor
plans to raise at the meeting

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What goes into a proxy statement?
- Information about the meeting
- Background information directly related to issues to be voted on
o Biographical information about candidates for director vacancies
o Financial data about merger partners (if any)

Other Proxy Statement Rules

- Rule 14a-6(b) re filing with SEC: solicitors must file proxy materials with the SEC
- Rule 14a-7 re mailing: management gets a choice: mail the materials for the solicitor, at solicitor’s
cost, or provide a list of shareholders.
- Rule 14a-9 re fraud

Cost of Soliciting Proxies:

- Uncontested meeting: Because corporate statutes require firms to hold meetings of shareholders,
the law allows managers to charge the firm (and thus the shareholders) for the cost of acquiring
the proxies necessary to ensure a quorum at an uncontested meeting.
o Less Expensive
- Contested meeting: Under current law, incumbent managers also may charge the costs to the
firm when an insurgent group contests their control.

• Levin v. Metro-Goldwyn-Mayer, Inc. (pg. 535) RULE: Incumbent mgmt may make reasonable use of corp
assets to inform shareholders of its position in a proxy content involving corporate policy issues. Aka CORP
MGMT MAY USE CORP ASSETS TO PROVIDE SHs W/INFO THAT IS RELEVANT TO A VOTE
Facts: Conflict for control between 2 sets of managers
- Levin is a stockholder AND a member of the board – his group owns only 11% of the shares [Must go
public and solicit proxies to get enough votes to be a force]
- Levin group seeks an injunction against “O’Brien” group’s method of solicitation [spent $125,000 on
newspaper publications, special counsel, and 4 proxy solicitation firms]
o 4 is overkill – hired in various capacities to block out any of them working for Levin
o “O’Brien” has every right to hire special counsel but with their own funds
Issue: Are illegal or unfair means being used to solicit proxies?
- Whether illegal or unfair means of communication such as demand judicial intervention, are being
employed by the present management?
Holding: Court says NO - $125,000 is not a lot to a company like MGM
o Court does not even address whether hiring the solicitors and special counsel with corporate funds
is inappropriate

Is it necessary or even appropriate to get into the defendants’ arguments that they have done a
swell job in managing the firm?
- NO – court says that it is up to the shareholders to decide whether management’s conduct is
permissible
- Remember: Management decisions are covered by the BJR
o Court says it will not unnecessarily exercise injunctive power so as to unduly influence
shareholder proxy decisions.
o Wants to permit shareholder to make their own decisions

Takeaway Point (Levin):

- Court will not step in where fees are not excessive and where actions are not illegal or unfair
(Reasonable expenses are ALWAYS permitted – we realize that proxy expenses are acceptable to
gain a quorum)

• Rosenfeld v. Fairchild Engine and Airplane Corp. (pg. 537)

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Facts: Ward had a nice contract with pension benefits
- Insurgents believe that they will save a lot of money by terminating this contract
- 3 separate sets of payment in the ensuing proxy battle:
o Old Board gets $106,000 for their own proxy solicitations [this payment is approved]
o When insurgents win, they reimburse old board $25,000
o When insurgents become incumbents they pay themselves $127,000 with shareholder approval
 These are all reimbursements for the proxy fight that had occurred between the two camps
- Shareholders ratify the $127,000 reimbursement payment 16:1 [ratify after the fact]
- Payments to the Old Board were not ratified; they don’t have to be – only payments to incumbent board
need be ratified [reimbursement for expenses from company funds that occurred BEFORE board becomes
connected to company need to be ratified]
o Insurgents were not entitled to anything when they were just insurgents [So shareholders must
approve these expenses before they are paid out]
o Old board doesn’t need shareholder approval because their actions were covered by the BJR
Does the court differentiate between a contested and uncontested proxy solicitation?
- Uncontested meetings: the court says that due to stockholder indifference, and the difficulty of
procuring a quorum, the corporation has to incur reasonable and proper expenses in soliciting
proxies, or there would be no valid UNCONTESTED meetings.
- Contested meetings: in event of a fight, if the BOD can’t use corporate funds to defend their
actions, they would be at the mercy of the insurgents who might be loaded with cash.

What test does the court set out?

- When the BOD act in good faith in a contest over policy [as opposed to a “purely personal power
contest”], they can incur reasonable and proper expenses to solicit proxies and defend their
corporate policies and don’t have to sit idly by.
o This test is REALLY hard to apply because policy goes hand in hand with power
struggles.

Proxy Contests: Reimbursement of Expenses:

Concept of the “Gracious Winner”

- Pays back the loser (who was the incumbent). Loser could have reimbursed themselves so the
New Board does not need shareholder approval to do this.
Can management use corporate funds to pay for expenses they incur in conducting their proxy
solicitation?
- Yes, as long as the amounts are “reasonable” and the contest involves “policy” questions rather
than just a “purely personal power struggle”—Rosenfeld

What would be a “reasonable expense?”

- Disclosure statements to shareholders
- Telephone solicitations
- In person visits to major shareholders
o Wining and dining said shareholders
o Private jet to bring major shareholders to company HQ

What about reimbursement of expenses? Can the insurgent use corporate funds to pay for
expenses it incurs in conducting their proxy solicitation?
- Only if approved by the shareholders—Rosenfeld
o Because insurgents were not connected to the firm at the time
- Unsuccessful insurgents get NOTHING
o This would promote far too many proxy contests (no risk for insurgents)
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What rules do we take away from Levin and Rosenfeld?
- the corporation may not reimburse either party unless the dispute concerns questions of
policy [NOT PERSONNEL – no pure power struggles]
- the firm may reimburse only reasonable and proper expenses.
- the firm may reimburse incumbents whether they win or lose without shareholder approval,
and presumably their action is protected by the business judgment rule—as long as there is a
dispute over policy.
- the firm may reimburse insurgents for their reasonable expenses only if they win, and only if
shareholders ratify the payment.
o Why do the insurgents warrant reimbursement?
 The theory is that they benefited the corporation and the other shareholders; but to
make the reimbursement invulnerable to attack they must obtain shareholder
approval after full disclosure. BUT, you can have a situation where winning
insurgents do NOT get reimbursed

What problems come up from these rules?

- The distinction between policy and personnel is largely a charade. All proxy disputes involve
personnel questions, and almost all involve questions of policy.
- More to the point, if the allocation of several hundred thousand dollars depends on a policy
disagreement, the parties will generally find one.
- the rule against reimbursing either party in a personnel dispute could (hypothetically) have
onerous consequences for the incumbents.
o Suppose existing managers are doing a fine job. Suppose further that (for whatever reason)
a group of insurgents decides to take their place—but raises no policy quarrels.
o If so, then the incumbents have no reimbursement. In theory, the law seems to grant the
incumbents reimbursement if the parties raise policy issues, but to deny incumbents the
reimbursement if the insurgents admit that the incumbents are doing a fine job but fight to
take over the company anyway.

Proxy Litigation: Fraud

- Rule 14a-9 under 1934 Act § 14(a) prohibits misrepresentations or omissions of a material fact in
proxy materials
o “No solicitation subject to this regulation shall be made by means of any proxy statement
… or other communication, written or oral, containing any statement which, at the time
and in the light of the circumstances under which it is made, is false or misleading with
respect to any material fact, or which omits to state any material fact necessary in order to
make the statements therein not false or misleading or necessary to correct any statement in
any earlier communication with respect to the solicitation of a proxy for the same meeting
or subject matter which has become false or misleading”

Proxy Litigation: Other Violations

- Soliciting without providing proxy statement
- Failing to file proxy materials w/ SEC
- Company soliciting proxies without first providing annual report

Who can sue?

- SEC
- U.S. Justice Department
- Private Cause of Action for Shareholders? [Yes after Borak and Mills]

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 - The company itself (typically against an insurgent)
o Odd, but the company not sue itself
o When a company sues it is claiming that the insurgent’s proxy statement is missing
something

Purpose of §14(a)? – Section has a “broad remedial purpose” to prevent management [or anyone else]
from obtaining authorization for any corporate action via deceptive or inadequate disclosure in a proxy
solicitation (see below case)

• J.I. Case Co. v. Borak (pg. 544) RULE: It is unlawful to solicit a poxy or consent authorization using false
and misleading statements, and, in such event, a court may enforce a private right of action for rescission or
damages. Aka PROXY MATERIALS CONTAINING FALSE & MISLEADING STATEMENTS GIVES
RISE TO A PRIVATE RIGHT OF ACTION
- Identifies and validates a private right of action for shareholders suing on an improper proxy statement
Facts: P claims that the proxy statement failed to disclose unlawful market manipulation of the stock of ATC
- He says if you had given actual information in the proxy statement the merger between Case and ATC
wouldn’t have been approved.
o Does this make the information important under TSC standard?
What does Case argue?
- There’s absolutely no private right of action under § 14(a)
o They’re right that 14(a) makes no specific reference to this
- If they’re wrong, it still shouldn’t apply because it only applies to derivative suits
Holding: Even though the statute itself does not specifically reference a private right of action, since
a chief purpose of the statute is to protect investors, the court finds an implication that it can
provide judicial relief where necessary to achieve the protection of investors.
o The section has a “broad remedial purpose” to prevent management [or anyone else]
from obtaining authorization for any corporate action via deceptive or inadequate
disclosure in a proxy solicitation.
o “It appears clear that private parties have a right under § 27 to bring suit for
violation of § 14(a) of the Act. Indeed, this section specifically grants the appropriate
District Courts jurisdiction over “all suits in equity and actions at law brought to
enforce any liability or duty created” under the Act.”
o In order to further this legislative intent the court finds an implied private right of action.
→ So, this case says shareholders have a private right of action for misleading proxy statements

What about Case’s claim that the merger can only be judicially dissolved if it was fraudulent or
non-beneficial, issues that the proxy statement would not have dealt with?
- Courts says that there is a connection between what makes something material and the proxy
statement (but they won’t get in to this until Mills)
o i.e. If you need the votes that the proxy statement solicits, this will be enough to satisfy
14(a) materiality – BUT IF YOU DON’T NEED VOTES, proxy statement is less material

What about Case’s claim that the remedies available for violations of § 14(a) via § 27 are limited to
prospective relief?
- No sir. If this were the case, victims of deceptive proxy statements would be stuck in state court
and the SC says that’s a problem- the whole purpose of § 14(a) might be frustrated if the laws of a
particular state didn’t appropriately legislate in this area.

Is the shareholder’s claim direct or derivative, and does it matter in this case?

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 - The SC says his claim is derivative – it flows from the damage done to the corporation via the
merger, and NOT to any damage directly inflicted upon this shareholder.
- But these cases are typically treated as BOTH direct [via class actions] and derivative [on behalf
of the corporation] so it really doesn’t matter since the court finds a private right of action under §
14(a) for direct AND derivative claims.
o Can bring claims on your own OR on behalf of the company
o Material misstatements and omissions in a proxy statement are actionable under 14(a) and
14a-9.

• Mills v. Electric Auto-Lite Co. (pg. 547) SEE SLIDE L-48 pg. 3. RULE: To establish a cause of action under
§14 of the Sec Exchange Act, a P need only show the misttaement’s or omission’s materiality and its ability
to influence a SH’s vote
Facts: Shareholder of Auto-Lite is a minority shareholder and gets merged out
- He seeks to enjoin the voting because there is a problem with the proxy statement
o He alleges that statement didn’t say that 11 of Auto-Lite’s directors are under the control and
domination of rival company Mergenthaler (owns about 50% of Auto-Lite’s stock
- Plaintiff sues derivatively
Elements Necessary to Establish 14(a) claim:
1) Materiality (misstatement or omission MUST be material)
- How defined in Mills?
o Information “might have been considered important by a reasonable shareholder who was
in the process of deciding how to vote”;
 in other words, the statement or omission must have “a significant propensity to
affect the voting process.”
- Modern definition?
o “[O]mitted fact is material if there is a substantial likelihood that a reasonable shareholder
would consider it important in deciding how to vote.” TSC Industries v. Northway (U.S.
1976)
2) Causation: How is it proven?
- Defect material?
o If so, was proxy solicitation itself, rather than the particular defect in the solicitation
materials, an essential link in the accomplishment of the transaction?
- In Mills, the proxy solicitation was necessary to get enough votes to approve the merger
o Footnote 7 left open issue of what happens if majority shareholder could approve deal by
its votes alone
 In Virginia Bankshares, Inc. v. Sandberg, VBI owned 85% of a subsidiary bank.
The two merged. Under Virginia law, the merger required a supermajority vote (2/3
of outstanding shares). Because VBI owned 85%, it could approve deal even if all
other shareholders voted no. Solicited proxies anyway.
 Supreme Court: Even if there was a misleading statement in the proxy material,
plaintiff can’t show causation between the misleading statement and the approval
of the merger, because deal would have been approved without soliciting proxies
• No causation if deal would have gone through anyway.
3) Reliance?
- As with Rule 10b-5, bifurcated but presumed where dealing with omission
- As for misrepresentations, circuit split on whether affirmative proof of reliance is required
4) Scienter?
- Most courts say negligence suffices

What is the result of the 7th Circuit approach?

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 - If the company could show by a preponderance of probabilities that the merger would have passed
even if the statement were not misleading, petitioners get no relief.
- What does this sound like?
o It sounds like a common law fraud test of whether the injured party relied on the misrep.
How on earth can you determine reliance by this many shareholders?
- The 7th Circuit declined to inquire into the reliance or lack thereof by thousands of stockholders,
and instead decided the issue based on a proof of fairness of the terms of the merger. [Forget
about the proxy statement – looks just at fairness and not the causal connection]
- Because the merger was fair, the court reasoned, the shareholders would have approved it anyway.
o This rule would undercut all 14(a) jurisprudence

So what is the 7th Circuit Test?

- All liability is foreclosed IF the court finds the merger was fair.
- Plaintiffs appeal, claiming that the 7th Circuit has interpreted Borak in a way that frustrates the
statute’s policy of enforcement thru private litigation.

Where does the requirement that the defect needs to have a significant propensity to affect the
voting come from?
- The express terms of rule 14a-9 require that the defect have a significant propensity to affect the
voting process – which is designed to make sure that a cause of action can’t be established by
proof of a trivial defect, or an unrelated defect.
Why wasn’t this enough for the 7th circuit – a showing that the defect was material
o 7th Circuit added the req’t that plaintiff prove that the defect had a decisive effect on
voting. (Albert: “good luck with that”)

What causal relationship has to be shown between a merger and a proxy statement?
- If we need voters solicited by a proxy statement to approve a deal we will have a causal
connection
- If we don’t need votes then causal connection is not satisfied and plaintiffs have no standing

What rule can we take from Mills?

- The objective rule that: “Where there has been a finding of materiality, a shareholder has made a
sufficient showing of causal relationship between the violation and the injury for which he seeks
redress if, as here, he proves that the proxy solicitation itself, rather than the particular defect in
the solicitation materials, was an essential link in the accomplishment of the transaction.”
o You don’t have to show that you relied on misleading words. Rather, you need only show
that the solicitor needed the votes gained by proxy.
o In Mills, Mergenthaler had 54% of shares; they need 66% of the vote
 So, proxy statement was necessary to approve the transaction and causation is
proven
 Rationale: Ps show causation if they show that the defect has a significant propensity to
affect the voting process. The issue thus becomes one of materiality, as long as the proxy
solicitation itself, rather than the particular defect in the solicitation materials, was an essential link
in the accomplishment of the transaction.
• That is, if the defect is material, and if the proxy solicitation was essential, P has
satisfied the requirement of proof of causation.

Remedies
- Prospective
o Injunction… corrective disclosure
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 - Retrospective
o Damages
 Must be a monetary injury
o Rescission
 Where deal is long-since done?
 Monetary equivalent

MILLS ON REMAND: The plaintiffs’ victory turned out to be hollow: The Supreme Court explicitly noted that
the merger’s fairness bore on the issue of damages, and on remand the Seventh Circuit dutifully held that the
plaintiffs had shown causation but not damages. See Mills v. Electric Auto-Like Co., 552 F.2d 1239 (7th Cir.), cert.
denied, 434 U.S. 922 (1977).

SHAREHOLDER PROPOSALS & INSPECTION RIGHTS

RULE 14a-8: SHAREHOLDER PROPOSALS

- Allows qualifying shareholders to put a proposal before their fellow shareholders
o And have proxies solicited in favor of them in the company’s proxy statement
o Expense thus borne by the company
- Tells us when shareholders are permitted to put their proposal in a proxy statement
o Statute mostly designed to give companies a way to exclude proposals

Popular Shareholder Proposals:

- In recent years, with the increasing activism of institutional shareholders, the following have
become popular shareholder proposals:
o to remove of poison pills;
o to require annual election of directors;
o to require secret balloting;
o to require that directors hold a specified minimum amount of corporate shares;
o to adopt cumulative voting;
o to prevent the same person from being both CEO and chair of the board; and
o to prohibit greenmail.
- Other proposals worth mentioning are:
o to require that a majority of the board and of all key committees be independent directors;
o to provide a ballot for the election of directors with more nominees than there are seats, so
shareholders have a choice;
o to link director pay to corporate performance;
o to require that the compensation committee be composed entirely of independent directors,
with its own compensation consultant; and
o to create a committee of shareholders to advise the directors.

Process for Excluding a Proposal:

1. First you need grounds to exclude the proposal:
o PERSON: Proponent fails to satisfy the eligibility standards of 14a-8(b)
o SUBJECT MATTER: The proposal violates one of the substantive provisions of rule
14a-8(i)
2. Management files a notice of intent to exclude with the SEC.
o Accompanied by an opinion of counsel
o Under rule 14a-8(f), management must notify the shareholder-proponent of remediable
deficiencies in the proposal and provide an opportunity for them to be cured.

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SEC Response
Staff Level Action:
- Excludable? Issue a no-action letter [If SEC agrees to the exclusion]
o No precedential value (can’t rely on someone else’s no action letter but you can use
previous grants of not action to support your request)
- Must be included? Notify the issuer of possible enforcement action if the proposal is excluded
- Not sure? Proposal not includible in present form, but can be cured
- Review by SEC Commissioner:
o If SEC recommends “no action”, proponent can file for preliminary injunction (e.g.,
Lovenheim)

Eligibility: Timing
- The proposal must be submitted to the corporation at least 120 days before the date on which
proxy materials were mailed for the previous year's annual shareholder's meeting.
- E.g., if the firm mailed its proxy materials on May 1, 2005, you count back 120 days from May 1
to determine when a proposal must be submitted to be included in the 2006 proxy statement,
which works out to about January 2, 2006.
- SEC is surprisingly strict in enforcing this requirement.

Eligibility: Holdings
- 14a-8(b)(1):
- Proponent must have owned at least 1% or $2,000 (whichever is less) of the issuer's securities for
at least one year prior to the date on which the proposal is submitted.
- Aggregation allowed for $ amount but not for holding period.
o A, owned $700 in stock for 2 years; B, owned $400 in stock for 18 months; and C, owned
$1000 in stock for 13 months.
 Okay.
o D has owned $1200 in stock for two years; E has owned $1200 in stock for two months.
 Not okay.

Eligibility: Length
- 14a-8(d):
- Proposal plus supporting statement cannot exceed 500 words
o References to websites with more information okay, but website is subject to proxy rules
o Why not an improper solicitation of proxies?
 Rule 14a-2(l)(2)(iv) permits a proponent to make public announcements about how
it intends to vote and the reasons behind the voting decision, so long as proponent
does not explicitly urge others to vote the same way

Eligibility: Submitting Proposals

- 14a-8(c): Only one proposal per corporation per year
o No limit on how many companies a proponent can submit proposals to
- 14a-8(h):
o Must show up at the meeting to present the proposal in person
 OR
o Ineligible to use the rule for the following two years

Substantive grounds for exclusion:

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1. The proposal does not concern a proper subject for action by shareholders ((i)(1)).
o A common example of this would be a proposal concerning the ordinary business
operations of the company—a point that illustrates the overlap among these rules. These kinds
of decisions are, as a matter of state law, left to the BOD and not open for shareholder
approval
o It must be an action which it is proper for shareholders to initiate
o Look to state law to decide that question
 E.g., DGCL 141(a): “The business and affairs of every corporation . . . shall be
managed by or under the direction of a board of directors . . . .”
 So we can’t tell the BOD what to do
o If shareholders not allowed to initiate, still ok if phrased as proposal
Why do we need precatory phrasing?
- Rule 14a-8(i)(1): “If the proposal is not a proper subject of action for shareholders under the laws
of the jurisdiction of the company’s organization” it can be excluded
What happens if precatory [referring to a wish or advisory suggestion which does not have the
force of a demand or a request which under the law must be obeyed] proposal passes and board
refuses to act?
- BJR (aka nothing)
2. The proposal is illegal ((i)(2))
- Crack cocaine, etc.
3. The proposal violates the proxy rules ((i)(3)).
- The classic example of this is a misleading proposal, since Rule 14a-9 prohibits misleading proxy
material.
4. The proposal concerns a personal grievance or benefit ((i)(4)).
5. The proposal relates to less than 5% of the assets, net earnings or gross sales “and is not
otherwise significantly related to the company’s business” ((i)(5).
- Rule 14a-8(i)(5): the proposal can be excluded if it relates to operations which account for:
o less than 5 percent of the company’s total assets at the end of its most recent fiscal year
o and for less than 5 percent of its net earnings and gross sales for its most recent fiscal
year
o and is not otherwise significantly related to the company’s business
6. The proposal concerns a matter beyond the power of the firm to effectuate ((i)(6)).
- We will see in Dole that if the proponents argued that Dole should work for a national health
insurance system (probably the proposal they really wanted to include), Dole could have excluded
their proposal under this exception.
7. The proposal relates to a company’s ordinary business operations ((i)(7).
- This exception is taken up in both Dole and Austin
8. The proposal relates to BOD elections ((i)(8).
9. The proposal conflicts with a company proposal ((i)(9) –
- the company then is required to specify the points of conflict, so no need for shareholder proposal.
10. The proposal has already been substantially implemented ((i)(10).
11. The proposal is duplicative of another proposal going into the same proxy statement ((i)(11).
12. The proposal has been submitted in the past and has not obtained much support ((i)(12)).
- The issue in these shareholder proposal fights is never whether the proponents will win. They
never do. The issue is instead whether they will obtain enough support to resubmit the proposal
the next year
13. The proposal relates to the specific amount of dividends ((i)(13).

Eligibility: Repeat Proposals

- Per Rule 14a-8(i)(12) a proposal can be excluded if it (or a substantially similar one) was submitted

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 o once during the preceding 5 years and got less than 3% of the vote
o twice in the preceding 5 years and got less than 6% of the vote the last time it was submitted
o 3 times in the preceding 5 years and got less than 10% of the vote the last time it was submitted
The proposal relates to the specific amount of dividends ((i)(13).

• Lovenheim v. Iroquois Brands, Ltd. (pg. 559/233); Duck Pate Case. RULE: SHs MAY INCLUDE
SIGNIFICANTLY RELATED MATERIAL WITH A COMPANY’S PROXY STATEMENTS
Facts: Iroquois company – way less than 5% of its revenue comes from pate (< .05% actually)
- Lovenheim claims that the practice of making pate bears on the ethical significance of the corporation
o Force feeding: Not very pleasant
- Plaintiff argues:
o the last phrase in the exception in rule 14a-8(i)(5): “and is not otherwise significantly
related to the issuer’s business” saves him- he does not dispute that his proposed
resolution relates to a matter of little economic significance to the corporation. But he is
parsing the rule to say that the “and otherwise language” saves him and prohibits the
company from excluding his proposal.
o His view is that “or otherwise” indicates that the drafters of the rule intended that
other non-economic tests of significance be used.
- Defendant argues:
o Plaintiff will lose since he can’t show a likelihood of prevailing on the merits with regard
to the issue of whether his proposal is “otherwise significantly related” to the issuer’s
business.
o Plaintiff will not suffer irreparable injury without a preliminary injunction, since his
proposal would likely not pass anyway
o Granting this injunction would have a distinctly adverse effect on the company since
investors react negatively to litigation and injunctions
o Granting the injunction may lead investors to conclude that the firm is mistreating animals.
o Granting the injunction would be contrary to public interest in allowing business to
function free from harassment, and in preventing proxy statements from being cluttered
- Court says that defendant hasn’t shown that plaintiff won’t prevail on the merits and even if they
can’t win you can’t exclude proposal only for that reason
Holding: Motion for preliminary injunction is granted

Takeaway Point:
- Courts have room to interpret the “otherwise” language in sub-5 of Rule 14a-8.

Shareholder Inspection rights: Shareholders may need certain information in order to be able to sue
derivatively or figure out if proxy statement is correct or not
• Policy Concerns:
o SHs have a legitimate interest in using the proxy system to hold the board accountable
o Nobody wants a junk mail distributor to get access to the shareholder list or a competitor to
get access to the corporation’s trade secrets and other proprietary information

When there is a proxy contest, insurgent has two choices:

1. Get list from company, which company will never do
2. Give material to company and they will send them for you and will charge you for it

Why would a shareholder want to inspect?

- Proxy contests; SEC Rule 14a-7: in a proxy contest, incumbent management must either:
o Mail the insurgent’s proxy materials for it

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 o Provide insurgent with a copy of the stockholder list
- Which would management prefer?
o Management would prefer to mail the insurgent’s proxy materials for it. They don’t want
to give out the shareholder list.
- Which would the insurgent prefer?
o Probably shareholder list
- Why would a shareholder want to inspect?
o Shareholder litigation – remember Grimes?
o Want to use the proxy system to hold the board accountable for bad decisions
o Want to get into the corporate books because they are typically unhappy with the running
of the corporation

DGCL § 220(b) – DELAWARE SH Inspection Right

- Right to inspect for any proper purpose, and to make copies and extracts from:
o the corporation's stock ledger, a list of its stockholders, and its other books and records…
- Plus a limited right for subsidiary records
- What “other books and records” are we talking about here?
o Bare minimum:
 Articles of incorporation
 Bylaws
 Minutes of board and shareholder meetings
 Board or shareholder actions by written consent
 SEC filings and other public records
What about contracts, correspondence, and the like?
- The Delaware supreme court has held that a request to access such records must be very narrowly
tailored: “A Section 220 proceeding should result in an order circumscribed with rifled precision.”
Security First Corp. v. U.S. Die Casting and Development Co, 687 A.2d 563 (Del.1997).
- Section 220(b):
o Shareholder must make a written demand setting forth a “proper purpose”
o A “proper purpose” is one “reasonably related to such person’s interest as a stockholder”
- Section 220(c):
o If shareholder only seeks access to the shareholder list, Burden of Proof on the corporation
to show that shareholder doing so for an improper reason
o If shareholder seeks access to other corporate records, Burden of Proof on shareholder to
prove requisite proper purpose.
Purposes:
- Proper Business purpose
o Investigate alleged corporate mismanagement
o Collecting information relevant to valuing shares
o Communicating with fellow shareholders in connection with a planned proxy contest
o Looking to oust board
o File derivative suit
o Seeking to take over company
- Improper
o Attempting to discover proprietary business information for the benefit of a competitor
o Secure prospects for personal business
o Institute strike suits

• Crane Co. v. Anaconda Co. – NEW YORK

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 - New York case dealing with the issue of a proper purpose
Facts: Crane requests shareholder list and Anaconda says no
- Crane owns no Anaconda stock at the time this request is made
o They had made a tender offer for A stock and they say they have a duty to inform A shareholders
of the tender offer.
- Anaconda’s first denial was proper – no duty to give shareholder list to Crane
- Once Crane buys stock they request list again.
o Anaconda believes they want list for reasons outside of its business
What does the statute require in order to get the stockholder list?
- If you are a resident of NY, and a shareholder of record for over 6 months, or a resident holding at
least 5% of a class of stock of a foreign corporation doing business in NY, you must furnish an
affidavit that your inspection is “not desired for a purpose which is in the interest of a business or
object other than the business of the foreign corporation” and that you have not sold or helped
anyone sell any such shareholder list within the past 5 years.
Defendant argues: Anaconda argued that corp control – seeking a SH list to convince the shareholders
to sell their stock – did NOT involve the business of the corporation.
Court says re D’s arg: Not everything affecting the SHs will affect the corp, but eberything that
affects the corp will affect the SHs. Court liberally construes the Statute.

Where are these corporations incorporated?

- Crane was incorporated in Illinois and this suit is brought in New York, where it is a foreign
corporation doing business there. And Anaconda was a Montana corporation.
Holding: Court says “Not everything that affects shareholders affects corporation but everything that
affects corporation affects shareholders.” The court liberally construes the statute.

Bottom line: An insurgent who hopes to organize a proxy fight must be able to communicate with other
shareholders. The proxy rules under § 14 of the 1934 Act provide for and control that communication.
- The incumbents must either mail the insurgents’ material for them, or give them a copy of the
shareholder list. If the incumbents choose to do the mailing, then they may charge the insurgents
for their expenses. Because incumbents seldom want to part with the shareholder list, they
generally choose to mail the material themselves.

Is this protection sufficient?

- For the insurgents, § 14 is often unsatisfactory.
- First, not all firms are subject to § 14. Rather, the provision applies only to firms registered under
the 1934 Act—the same limited group subject to the § 16(b) rules.
- Second, the insurgents may want to communicate directly with some of the major shareholders.
For that, they will need the shareholder list itself. And third, the insurgents may need access to
corporate records other than shareholder lists. Section 14 does not provide that access.

So if the federal law is insufficient, what choice do these poor insurgents have?
- They can still sue in state court
State law options:
o DGCL § 220(b) allows inspection for any purpose “reasonably related to such person's
interest as a stockholder”
o NY statute limited to purposes relevant to “the business” of the corporation
o Is a tender offer related to the business of the company?
o ALL STATE STATUTES REQUIRE INSURGENTS TO HAVE SHAREHOLDINGS

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• Pillsbury v. Honeywell, Inc. RULE: A stockholder who purchased stock for the sole purpose of
rbinging suit to compel production of corp books and records, who was motivated by his belief that the
corp should not be manufacturing ammo to be used in Vietnam, and who had no concern for the
corp’s economic well-bring, cannot compel production of the corp’s SH lists or business records.
Facts: Plaintiff belongs to an anti-war group trying to stop Honeywell from producing anti-personnel
fragmentation bombs for the military
- Plaintiff buys into company knowing that this is what they do
Holding: Court says plaintiff lacks proper business purpose (he admitted that he only wanted to further
political/social views)
- Purpose based solely on Pillsbury’s pre-existing social and political views rather than any economic
interest
What is plaintiff’s argument?
- A stockholder who disagrees with management has an absolute right to inspect corporate records
for purposes of soliciting proxies – this is a per se proper purpose.
What does Honeywell say about that?
- They argue that a proper purpose contemplates concern with investment return.
What would be the effect of ruling in plaintiff’s favor?
- If court accepted plaintiff’s argument ANYONE could receive the shareholder list for ANY
purpose

Fed Securities laws better -Provides quickest, most streamlined access to the company’s shareholder list

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