Corporations Outline

Jerry Prettyman Corporations Outline 10/23/2010
I) Choice of Business Association.........................................................................................................7

A) Agency – Authority to Bind.........................................................................................................7
1) Agency Theory..........................................................................................................................7
2) Agency in Practice.....................................................................................................................7
B) Personal entities............................................................................................................................7
1) Proprietorship............................................................................................................................7
2) Partnerships/ LLP......................................................................................................................7
a) Factors – Sharing of profits, low scrutiny, proportional losses.............................................7
b) Limited Liability Partnership – passive = no liability...........................................................7
c) Formalities.............................................................................................................................8
d) Management & Rights – GP has all management capacity...................................................8
C) Close corporations........................................................................................................................8
1) Factors – Liability, Scrutiny, Liquidity, Taxation.....................................................................8
2) Formalities ................................................................................................................................8
3) Management & Rights...............................................................................................................8
D) Public corporations – liquidity, central mgmt, continuity, w/o liability.......................................8
1) Factors – limited liability, liquidity, high scrutiny, low taxes...................................................8
2) Formalities – records filed.........................................................................................................8
3) Centralized management & rights.............................................................................................8
4) S-Corporation – single class, <75, check the box.....................................................................9
5) C-Corporation, multiple class, >75...........................................................................................9
E) Limited Liability Corporations ....................................................................................................9
a) Management - manager-managed or member-managed.......................................................9
b) Liability – no member liability for LLC obligations ............................................................9
c) Pass-thru only if no continuity or transfer.............................................................................9
d) No continuity.........................................................................................................................9
F) Corporate Form & Where to incorporate......................................................................................9
1) Kintner characteristics of a pure corporation............................................................................9
2) “Corporate” characteristics (3 of 4)...........................................................................................9
3) Taxes – Check the box, LLP, LLC............................................................................................9
4) State laws.................................................................................................................................10
5) Delaware..................................................................................................................................10
II) Start-up & Financing.......................................................................................................................10
A) Partnership operating agreement ...............................................................................................10
1) Factors to address....................................................................................................................10
2) When the O/A is silent.............................................................................................................10
B) Corporation ................................................................................................................................10
1) Promotion................................................................................................................................10
2) Filing of Articles of Incorporation...........................................................................................10
3) Organizational Meeting...........................................................................................................10
a) People - Naming of directors & officers; ............................................................................10
b) Paper - Adoption of bylaws, share value, & certificate issue;.............................................10
c) Things - Adoption of corporate seal, minute book & financial institution;.........................11
4) Board Meetings........................................................................................................................11
C) Financing a Company.................................................................................................................11
1) Investment Contracts (Smith – worm farming).......................................................................11
2) Equity Capital – 3 elements.....................................................................................................11
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a) Start-up capital.....................................................................................................................11
b) Equity securities – See SEC §12 & Reg. D.........................................................................11
c) Retained earnings.................................................................................................................11
3) Debt Financing........................................................................................................................11
a) Instruments (bonds & debentures).......................................................................................11
b) Leverage Buy-outs (LBO)...................................................................................................11
4) Balance Sheet..........................................................................................................................11
a) Generally; Assets – Liabilities = Equity..............................................................................11
b) Capital categories................................................................................................................12
III) Stock Offerings..............................................................................................................................12
A) SEC §12 Registration of Securities............................................................................................12
1) 15 USC §78l(a) SEC Registration...........................................................................................12
2) 15 USC §78l(g) Exceptions.....................................................................................................12
3) Intrastate Resident Exemption ................................................................................................12
4) Regulation D Exception, Rules 501, 502(c), 504, 505, & 506................................................12
a) Rule 501 - Accredited investor............................................................................................12
b) Rule 502(c) – No general media advertising.......................................................................12
c) Rule 504 – nonpublic corporation in ‘blue sky law’ state...................................................12
d) Rule 505 – non-reporting corporation.................................................................................12
e) Rule 506 ‘safe harbor’ private offering...............................................................................12
5) Resale of securities, Rule 144..................................................................................................13
6) Remedies for Securities Violations.........................................................................................13
B) Stock Transactions......................................................................................................................13
1) Stock Issuance.........................................................................................................................13
a) Preferred Stock....................................................................................................................13
b) Common Stock....................................................................................................................13
c) Par Value..............................................................................................................................13
d) Diluted stock........................................................................................................................13
e) Initial public offering – clean up & disclose........................................................................13
2) Share transfer restrictions........................................................................................................13
3) Conversion...............................................................................................................................14
4) Stock buyback as distribution..................................................................................................14
C) Shareholder Preemptive Rights - no dilution of equity..............................................................14
1) Inherent rights..........................................................................................................................14
2) Opt-in and opt-out rights, §6.30(a) opt-in...............................................................................14
3) Remedy for dilution.................................................................................................................14
IV) Management & Control.................................................................................................................14
A) Articles of Incorporation, Bylaws, Resolutions .........................................................................14
B) Duties of Directors & Officers....................................................................................................15
1) Promoters.................................................................................................................................15
2) Board of Directors/ Active Partners........................................................................................15
3) Officers and managers.............................................................................................................15
4) Removal and election of parties..............................................................................................15
a) Directors...............................................................................................................................15
b) Officers................................................................................................................................15
c) Shareholders.........................................................................................................................15
5) Management and Control of Meetings....................................................................................15
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a) Assembly of owners.............................................................................................................15
b) Voting rules.........................................................................................................................15
c) Recordation..........................................................................................................................16
C) Distributions................................................................................................................................16
1) Dividends.................................................................................................................................16
a) Permissible Distribution, MBCA §6.40, insolvency & balance tests..................................16
b) Non-MBCA, retained earnings & impairment tests............................................................16
2) Compensation & Bonuses.......................................................................................................16
3) Distribution of capital surplus, MBCA §46.............................................................................16
4) Capital asset use for distributions............................................................................................16
D) Rights of passive investors (shareholders & partners)...............................................................16
1) Approval of board actions.......................................................................................................16
2) Proxy service – see VIII B. Statutory §14(a)...........................................................................17
3) Right of inspection - reasonably related..................................................................................17
4) Proposal rights.........................................................................................................................17
a) The shareholder, $2000 or 1%, > 1 year, <500 words, in advance.....................................17
b) Relate to > 5% of business & a power of the company.......................................................17
c) No violations or conflicts.....................................................................................................17
5) Shareholder agreements – voting blocks & voting trusts........................................................17
a) Agreements to elect board members ...................................................................................17
b) Particular person in key job agreement ..............................................................................17
c) Share-transfer restrictions....................................................................................................18
6) Shareholder rights plans..........................................................................................................18
E) Common Law Duty.....................................................................................................................18
1) Duty of Care – Reasoned investigation, information, & decision ..........................................18
a) Duty of Care – monitor, inquire, but clairvoyance not required..........................................18
b) Breach of Duty of Care........................................................................................................18
c) Defense to Duty of Care......................................................................................................18
d) Remedy for Breach of Duty of Care....................................................................................19
2) Duty of Loyalty - No conflict of interest, Equal Opportunity.................................................19
a) Duty of Loyalty by Management.........................................................................................19
b) Limited Duty of Loyalty by Shareholders – fair opportunity, not equal.............................19
c) Breach of Duty of Loyalty by Management – Waste & Freeze-out....................................19
d) Breach of Duty of Loyalty in a Close corporation - equal opportunity...............................19
e) Defense to Breach of Duty of Loyalty ................................................................................20
f) Remedies for Breach of Duty of Loyalty.............................................................................20
3) Fiduciary Duty - Agency.........................................................................................................20
a) Fiduciary Duty.....................................................................................................................20
b) Breach of fiduciary duty – improper bind, freeze-out.........................................................21
c) Defense to breach of fiduciary duty.....................................................................................21
d) Remedies for breach of fiduciary duty................................................................................21
4) Corporate Opportunity Doctrine..............................................................................................21
a) Requirements – Guth line of business, ALI disclosure.......................................................21
b) Defense to the Corporate Opportunity Doctrine..................................................................22
c) Remedies for Breach of the Corporate Opportunity Doctrine.............................................22
F) Assumption of duty.....................................................................................................................22
V) Statutory Federal Actions...............................................................................................................22
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A) Disclosure Requirements............................................................................................................22
1) Materiality...............................................................................................................................22
2) Reliance...................................................................................................................................22
3) Selective Disclosure – Regulation FD.....................................................................................22
a) Any statements regarding the earnings report are material.................................................22
b) Failure to disclose is not 10b-5 actionable..........................................................................22
4) Forward-looking statements – Regulation S-K......................................................................22
5) Consolidated report..................................................................................................................23
6) Omissions................................................................................................................................23
B) SEC §14(a) Proxy solicitations...................................................................................................23
1) Proxy solicitation requirements...............................................................................................23
a) Any request, express or implied, for a proxy.......................................................................23
b) Filing with the SEC 10 days before.....................................................................................23
c) Bold-face type, dating, identification of the matter, solicitations & proponents.................23
d) Prohibition of false or misleading statements......................................................................23
2) Requirements for prosecution..................................................................................................24
a) Any requirement failure.......................................................................................................24
b) Misleading failures..............................................................................................................24
3) Remedies.................................................................................................................................24
C) SEC §14(e)-3a Misappropriation................................................................................................24
1) Elements..................................................................................................................................24
2) Presumption of fraudulent acquisition.....................................................................................24
D) SEC §10b Illegal Transactions...................................................................................................24
1) §10b-1 Manipulative or deceptive devices..............................................................................24
2) SEC §10b-5 Insider trading ....................................................................................................25
3) Strict liability with a small scienter element...........................................................................25
a) Elements...............................................................................................................................25
b) Traditional vs. misappropriation theories............................................................................25
c) Private right of action..........................................................................................................25
d) Statute of Limitation............................................................................................................25
4) Remedies - Civil penalties for insider trading.........................................................................26
a) Section 21A, 15 USC §78u-1..............................................................................................26
b) Section 20A– Liability to Contemporaneous Traders for Insider Trading..........................26
c) Statute of limitations............................................................................................................26
d) Private rights of action based on contemporaneous trading................................................26
E) SEC §16b Short-swing profits – public/private..........................................................................26
1) Requirements for prosecution..................................................................................................26
2) Employee compensation exceptions........................................................................................26
3) Remedies.................................................................................................................................26
F) PSLRA & SLUSA '98 Limitations..............................................................................................26
1) PSLRA '95...............................................................................................................................27
a) Certification.........................................................................................................................27
b) PSLRA Safe Harbor............................................................................................................27
c) Aftermath.............................................................................................................................27
2) SLUSA '98...............................................................................................................................27
3) Delaware “carve-out,...............................................................................................................27
G) Sarbanes-Oxley (SOX) Provisions.............................................................................................28
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1) Corporate Disclosure and CEO/CFO Certification.................................................................28

2) Maintenance of Internal Controls for Monitoring. 404...........................................................28
3) Creation of the Public Company Accounting Oversight Board..............................................28
4) Audit Committees of Corporate Boards of Directors..............................................................28
5) Exec. Compensation, Loans & Disgorgement of Incentive-based Compensation, 304..........28
6) Professional Standards for Attorneys, §307............................................................................28
7) Whistleblower Provisions, 806................................................................................................28
8) Barring people from serving as officers or directors of public companies.............................28
9) Securities analysts....................................................................................................................28
10) Qualified Legal Compliance Committee (QLCC).................................................................28
VI) Breach of Duty & Causes of Action..............................................................................................29
A) Attempts to bind the company or pierce the corporate fiction...................................................29
1) By act without fraud................................................................................................................29
2) By error without fraud – de facto incorporation......................................................................29
3) By fraud – the act was in bad faith, breach of duty of care, loyalty, or fiduciary duty...........29
4) Evidence of alter ego operations.............................................................................................29
5) Successor Liability..................................................................................................................29
B) Shareholder suits ........................................................................................................................29
1) Direct suits...............................................................................................................................29
a) Voting, dividends, fraud, inspection....................................................................................29
b) Oppression...........................................................................................................................29
c) Remedy for the shareholder ................................................................................................30
2) Derivative Suits.......................................................................................................................30
a) Breach of care or loyalty......................................................................................................30
b) Contemporaneous ownership & Demand by the shareholder.............................................30
c) Board dismissal – reasonable good faith, & independence.................................................30
d) Remedy for the corporation.................................................................................................30
3) Liability by failure to stop a wrongful act...............................................................................30
VII) Defense, Indemnification & Insurance........................................................................................30
A) Business Judgment Rule ............................................................................................................30
1) Good faith required..................................................................................................................30
a) Fulfill basic duties................................................................................................................30
b) Evidence of good faith to duty of care, duty of loyalty, and fiduciary duty........................31
c) Reasonable act to the purpose of the corporation................................................................31
2) Confluence of Articles of Incorporation and Bylaws (Ultra Vires)........................................31
a) Permitted Acts......................................................................................................................31
b) Prohibited Acts....................................................................................................................31
3) Indefensible Acts.....................................................................................................................31
4) Enron.......................................................................................................................................31
B) Indemnification...........................................................................................................................31
1) Requirements of indemnification............................................................................................31
2) Eligibility for Indemnification, MBCA §8.51.........................................................................31
3) When indemnification occurs, MBCA §§8.52, 8.53...............................................................32
C) Directors and Officers Insurance................................................................................................32
1) Types of policies – “claims,” “occurrence,” & “tail”..............................................................32
2) Cancellation, notice coverage, material misrep = void ab initio.............................................32
3) Exclusions................................................................................................................................32
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VIII) Takeover- Merger & Acquisition, Valuation, Appraisal............................................................33

A) Williams Act...............................................................................................................................33
1) Requirements...........................................................................................................................33
2) State law controls and is not preempted..................................................................................33
B) Valuation - Efficient Capital Market Theory..............................................................................33
1) Uncertainty..............................................................................................................................33
2) Fair Value, §13.01(4)...............................................................................................................33
3) The Efficient Capital Market Theory......................................................................................33
4) Right of appraisal limited to voting rights, MBCA §13.02.....................................................33
5) Market Exception to Appraisal Rights ...................................................................................33
C) Evaluation of Tender Offers.......................................................................................................34
1) Three types of threats – Unitrin (share repurchase)................................................................34
a) Opportunity loss...................................................................................................................34
b) Structural coercion...............................................................................................................34
c) Substantive coercion............................................................................................................34
2) Seven reasons to avoid a tender offer/ public bid....................................................................34
3) § 12.02 Shareholder 25% Safe Harbor Vote...........................................................................34
D) Takeover Defenses - Poison Pills...............................................................................................34
1) Reasonable in Scope & Duration.............................................................................................34
2) ‘Flavors’ of poison pills...........................................................................................................34
a) Shareholder based: flip-over, flip-in, back-end...................................................................34
b) Director based: dead-hand, no-hand....................................................................................34
3) Other defenses to hostile takeover...........................................................................................35
a) Requiring majority shareholder approval............................................................................35
b) Not requiring majority shareholder approval......................................................................35
c) The All Holders Rule, 14d-10, all holders in class..............................................................35
d) Ways around poison pills: friends, court, proxy contest.....................................................35
4) Proportional to the threat (Unocal)..........................................................................................35
a) Selective Stock Repurchase (Unocal-Mesa exclusion).......................................................35
b) Lockups - Revlon.................................................................................................................35
E) Evaluation of Board’s Response.................................................................................................36
1) Enhanced Judicial Scrutiny.....................................................................................................36
2) Rational Business Purpose Defense........................................................................................36
3) Plaintiff’s POE Burden – Unitrin............................................................................................36
a) Share repurchase – perpetuation?........................................................................................36
b) Preclusion of further bids - Unitrin......................................................................................36
c) Inevitable Sale or Breakup - Revlon....................................................................................36
IX) Dissolution & Wind-up.................................................................................................................36
A) Retirement, death, deadlock, oppression, fraud, waste...............................................................36
B) Problems & alternatives & to dissolution...................................................................................36
C) Procedure (UPA 29-40)..............................................................................................................37
X) Interactivity Table...........................................................................................................................37
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I) Choice of Business Association

A) Agency – Authority to Bind
1) Agency Theory
Actual Authority – granted by the charter (operating agreement, articles of incorporation or bylaws)
Apparent authority– Title of the person (president, board chairman) implicitly grants authority
Inherent - The power of an agent which is derived not from actual authority, apparent authority or
estoppel, but solely from the agency relation and exists for the protection of persons harmed by or
dealing with a servant or other agent.
Implied & Incidental – The authority to do incidental acts that are reasonably necessary to
accomplish an actually authorized transaction, or that usually accompany it.
Ratification by the board – Where the principal, with knowledge of the material facts, either (1)
affirms the agent's conduct by manifesting an intention to treat the agent's conduct as authorized, or (2)
engages in conduct that is justifiable only if he has such an intention.
Lack of Authority - Shareholders can not bind a corporation, An extraordinary action taken by the
person which would facially appear invalid (granting self an outgoing pension)
2) Agency in Practice
A corporation is bound by its guaranty where the corporation provides a certified copy of a board of
directors resolution purporting to grant such authority even if the corporate officer who executed the
guaranty had no authority to do so. Drive –In Development.
Absent express authority from the board, the president of a corporation does not have the power to
buy, sell, or contract for the corporation, nor to control its property, funds, or management.
Black/Harrison Homes
Apparent authority is a question of fact. It depends not only on the nature of the contract, but the
officer negotiating it, the corporation’s “ordinary” manner of business, the size of the corporation, and
the number of stockholders. Lee/Jenkins.
Voting trusts are agreement in agency.
B) Personal entities
1) Proprietorship
Good - Sole management duty & benefits, limited record keeping, easy to sell & liquidate, low
public scrutiny, all P/L the owners, self-interest & commingling OK (but not recommended).
Bad – Usually personal tax rates, and complete liability
How - Get a business license & hold yourself out as a business
Tax – check the box for pass-through personal tax & passive investment, or a corporate tax structure.
2) Partnerships/ LLP
a) Factors – Sharing of profits, low scrutiny, proportional losses
Good – Mixed assets of money and labor to a common purpose; low public scrutiny, equal sharing
of profits; losses shared in proportion to contributions.
Bad – All partners are fully liable in general partnership.
Partnerships are inalienable (illiquid), and dissolve on a partner’s/ owner’s death or retirement unless
the OA expressly provisions procedures for transfer.
Tax – check the box for pass-through personal tax & passive investment, or a corporate tax structure.
b) Limited Liability Partnership – passive = no liability
The general partner(s) has complete (joint & several) liability in an LLP; although a limited partner
becomes liable as a general partner when he takes part in the control of the business (ULPA 7).
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LLP partners are only liable for their own negligence/ wrongful acts/ misconduct to the full extent of
their wealth.
c) Formalities
Draft operating agreement to do business, act like a business; open separate bank account.
To get LLP status, the GP must file the O/A with Sec. State.
d) Management & Rights – GP has all management capacity
General partnership - active management by all partners with binding capacity of other partners
LLP – Only general partner has power to bind; passive investors have no management rights,
Partners has voting rights & reasonable right of accounting.
C) Close corporations
1) Factors – Liability, Scrutiny, Liquidity, Taxation
Good - low public scrutiny
Bad - No self-interest for Directors and Officers, - care, loyalty & fiduciary duty to others; Illiquid,
difficult to sell individual ownership; personal guarantee liability for shareholders; annual meeting &
record keeping requirements.
Taxes – income is taxed at low corporate rate, distributions taxed at personal income rates.
A Close corporation is typified by: (1) a small number of stockholders; (2) no ready market for the
corporate stock; and (3) substantial majority stockholder participation in the management, direction and
operations of the corporation. Donahue v. Rodd Electrotype.
2) Formalities
Raise money & people, draft articles of incorporation, file for incorporation /w fee, state approval,
act like a business, keep & maintain records, open separate bank account
In Cal file statutory certificate exemption.
3) Management & Rights
Close corporation boards have less limitations than public corporation boards because close
corporations do not have the wide SEC notice requirements, nor a large base of outside shareholders
with voting control. Shareholders hold rights of fair dealing
D) Public corporations – liquidity, central mgmt, continuity, w/o liability
1) Factors – limited liability, liquidity, high scrutiny, low taxes
Good - Liability limited to investment, public stock is a liquid asset so it’s easy to sell individual
ownership on national exchanges;
Bad – Corporations may have minimum capitalization requirements – loans to the corporation are
not capital! Annual meeting & record keeping requirements; Annual incorporation fees; Public scrutiny
Taxes - Income is taxed at low corporate rate, distributions taxed at personal income rates;
Corporation can retain operating/ development earnings; low corporate tax rate with double taxation on
pass through income.
2) Formalities – records filed
Raise money & people, draft articles of incorporation, file for incorporation /w fee, wait for state
approval, open separate bank account, act like a business, keep & maintain records.
3) Centralized management & rights
Centralized management of board of directors, who must pass resolutions to authorize or ratify all
acts of directors, officers, managers, etc. Centralized management survives death or retirement without
restructuring, and can issue, sell & buy stock over the public exchanges. Shareholders have limited
rights if coupled with an interest, but no rights without interest.
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4) S-Corporation – single class, <75, check the box

Single class of stock, up to 75 investors, check the box taxes.
A Subchapter S corporation can engage in mergers, stock-for-stock swaps, and other corporate
reorganizations on a tax-free basis, while LLCs cannot. If they want pass-through tax treatment,
businesses normally elect Subchapter S status rather than LLC status, p. 203.
5) C-Corporation, multiple class, >75
Multiple classes of stock and more than 75 investors
High public scrutiny
E) Limited Liability Corporations
a) Management - manager-managed or member-managed
All members have limited liability, and depending on organizational agreement, management may
be done by all members or just select officers. LLCs may be manager-managed rather than member-
managed, but an affirmative election to be manager-managed must be made in the articles of
incorporation. ULLCA § 203(a)(6).
b) Liability – no member liability for LLC obligations
All LLC statutes provide that LLC members are not liable for LLC obligations, but courts do apply
the veil-piercing doctrine to disregard limited liability. Except those states that waive it, most states
would apply duty of care and fiduciary duties through derivative actions.
c) Pass-thru only if no continuity or transfer
Pass-through tax status applies to limited liability companies only if they did not possess the
corporate characteristics of continuity of life and free transferability of interests.
d) No continuity
Any partner’s death, bankruptcy, or expulsion operates as a dissociation by that partner.
F) Corporate Form & Where to incorporate
1) Kintner characteristics of a pure corporation
“(i) associates, (ii) an objective to carry on a business and divide the gains, (iii) continuity of life,
(iv) centralization of management, (v) liability for corporate debts limited to corporate property, and (vi)
free transferability of interests.”
2) “Corporate” characteristics (3 of 4)
The IRS says that corporations have the following characteristics, (1) continuity of life; (2) free
transferability of interests; (3) centralization of management; and (4) unlimited liability. Because limited
liability companies offer limited liability as a matter of course, to ensure partnership tax status limited
liability companies must lack two of the three remaining characteristics. The IRS made clear that pass-
through tax status applies to limited liability companies only if they did not possess the corporate
characteristics of continuity of life and free transferability of interests.
3) Taxes – Check the box, LLP, LLC
Unincorporated business forms (proprietorship and partnership) may elect to be taxed under
Subchapter K, Subchapter S, or Subchapter C without regard to the type of unincorporated business
form selected.
An entity may not change its classification back within five years without permission of the
Commissioner. The conversion of an entity that is currently taxable as a corporation to a Partnership is
itself a taxable event, treated as though the corporation dissolved and reconstituted itself as a
partnership. The conversion in the opposite direction, i.e. from a partnership to a corporation will
usually (though not always) be tax-free.
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4) State laws
Different states follow different statute and case law. Tax rates vary between the states, as does the
experience of the state bureaucracy and court system with handling corporate issues. The rules for
distributions are also different.
5) Delaware
Streamlined application process (as short as 2 hours) but franchise tax hurts small corporations
Legislature which focuses on corporate law issues every year
Judicial branch very well versed in corporate law, with well-reasoned opinions
Legal environment favorable to flexibility in corporate governance issues
The Delaware Chancery Court is a specialized business court
II) Start-up & Financing
A) Partnership operating agreement
1) Factors to address
Written if lasting longer than 1 year (statute of limitations)
Initial contribution recorded
Sharing profits and losses - (1) Flat percentage; (2) Salary; (3) Ownership percentage; (4) Income
percentage; (5) Tiered percentage;
Proportioned sharing of taxes (equally, or unequally?)
Management compensation (named GP for LLP)
Voting rights
Disassociation and Dissolution provisions
2) When the O/A is silent
A partnership agreement to share profits equally does not automatically mean that the partners agree
to share the losses equally. Where the partnership agreement is silent on a matter, the Uniform
Partnership Act will be controlling. Richert. Partners are not fiduciaries of retired partners and are not
personally liable for a retirement plan. Bane.
B) Corporation
1) Promotion
Promoter contracts for capital, & place of business
2) Filing of Articles of Incorporation
Name and address of corporation, registered agent (for service of process), purpose clause, share
volume and class. Initial share volume is usually low since some state fees are chargeable according to
the number of shares issues. The initial share volume does not prevent the Board of Directors from later
declaring stock splits for later sales or IPO.
3) Organizational Meeting
a) People - Naming of directors & officers;
b) Paper - Adoption of bylaws, share value, & certificate issue;
Bylaws include listing the number of directors, procedures for handling vacancies on the board,
qualifications, term, and election schedule of directors, power and indemnification of directors, Place
and Notice of Meeting of Board, presence, quorum and voting rules (approval) of the board, and powers
of officers of the corporation.
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c) Things - Adoption of corporate seal, minute book & financial

institution;
4) Board Meetings
Adopt resolutions to present to the shareholders
Proxy regulation - periodic SEC proxy filings
Annual filings of Balance Sheet and Profit & Loss Statement
Annual shareholder meetings,
C) Financing a Company
Partners, Directors, and Officers may contribute cash and property (capital) to the start-up in return
for partial ownership. Labor contracts, promissory notes, and all forms of ownership granted in return
for future service are invalid. ‘Pay as you go’ contracts are valid. Loans (below) are NOT capital.
1) Investment Contracts (Smith – worm farming)
The conditions for an investment contract are whether the scheme involves (1) an investment of
money (2) in a common enterprise (3) with profits to come solely from the efforts of others.
2) Equity Capital – 3 elements
a) Start-up capital
Initial contributions by the original entrepreneurs. Initial directors and passive investors
(shareholders) contribute cash and property in return for share ownership. Valuable intangible property
may be accepted where proof of some value exists. The initial share volume does not prevent the Board
of Directors from later declaring stock splits for later sales or IPO.
b) Equity securities – See SEC §12 & Reg. D
Capital contributed by subsequent investors in exchange for ownership interests.
c) Retained earnings
Income earned but not yet spent or otherwise allocated. As the company grows, more assets can be
added (e.g., real property, accounts receivable.)
3) Debt Financing
Initial directors and passive investors (lenders) contribute cash as investment (12% limit in Cal.).
Debt financing is NOT counted as capitalization, but as a liability on the balance sheet. A THIN
CORPORATION is a company with debts that greatly outweigh its equity.
a) Instruments (bonds & debentures)
Bonds are the primary finance vehicle after initial capitalization because the corporation doesn't
want to sell more stock. Secured means the lender has a lien on corporate assets (check the title report!).
Unsecured means the lender does not have a lien on corporate assets. Bonds are secured and registered.
Zero coupon, a.k.a. junk bonds, are secured by less than investment-grade properties (already fully
mortgaged). Debentures are unsecured loans on the promise of the corporation to pay back the loan.
b) Leverage Buy-outs (LBO)
An LBO is premised on the belief that the corporation has the ability to squeeze out more profits,
and so can sustain a debt greater than its valuation. The debt structure allows investors who want to have
their investment characterized as a loan can have interest deducted. If the LBO payoff fails, bankruptcy
usually results.
4) Balance Sheet
a) Generally; Assets – Liabilities = Equity
Assets = Cash & Property; Capital, Income, & Accounts Receivable
Liabilities = Debts; Loans and Accounts Payable
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Equity = Difference (may be <0)

b) Capital categories
Stated capital = (par values of outstanding stock and no-par values (stated value))
Capital (paid-in) surplus = excess surplus when shares issued for > par/stated value
Revaluation surplus = generated by upward revaluation of corporation assets
Earned surplus (retained earnings) = holds $ earned but not yet paid to SH
III) Stock Offerings
A) SEC §12 Registration of Securities
A sole shareholder can’t avoid registration requirements by selling stock from his own portfolio.
Transactions by an issuer not involving any public offering (1933 Act §4(2) “public” offer need not be
open to the whole world, but the purchasers must be knowledgeable enough, such as Directors and
Officers. Line employees not fully informed of the risk (SEC v. Ralston-Purina).
1) 15 USC §78l(a) SEC Registration
SEC Rule 12(a) requires that all securities not exempted by Rule 12(g) for trading on the national
stock exchanges must be registered with the SEC before trading commences.
2) 15 USC §78l(g) Exceptions
SEC Rule 12g-1 clarifies the Rule 12(a) applies to companies with more that $1,000,000 in assets,
and more than 500 shareholders. Rule 12g-1 raises the assent requirement to $10,000,000.
SEC Rule 12g-4 permits de-registration of any company with either (i) less than 300 persons; or (ii)
if less than 500 persons, where the total assets of the issuer have not exceeded $10 million on the last
day of each of the issuer's most recent three fiscal years.
3) Intrastate Resident Exemption
1933 Act §3(a)(11) Familiarity & local community ties make it easy to conduct due diligence. An
employer cannot base employee stock sales as “exempt” for local sales from the employee’s plant, when
the corporation’s office is not just as local. (SEC v. Ralston-Purina). The exemption is the domicile, not
the place of the sale!
4) Regulation D Exception, Rules 501, 502(c), 504, 505, & 506
a) Rule 501 - Accredited investor
Any bank, S&L, insurance or investment company, directors or officer of an issuer, natural person
whose net worth exceeds $1,000,000, has income in excess of $200,000, or has joint income in excess of
$200,000; accredited investors & family residents are NOT counted in purchaser limits.
b) Rule 502(c) – No general media advertising
Except where ‘blue sky laws’ apply (Rule 504), non-registered entities may not advertise in general
media. This does not include issuer or representative (investment firm) contacts with persons in a
“preexisting relationship” to the issuer or representative.
c) Rule 504 – nonpublic corporation in ‘blue sky law’ state
$1MM per year, no investor limit, or restrictions on advertising.
d) Rule 505 – non-reporting corporation
$5MM per year, no advertising, disclosure & Q&A for non-accredited purchasers, non-accredited
purchaser limited of 35.
e) Rule 506 ‘safe harbor’ private offering
Unlimited securities, no advertising, knowledge or experience required for non-accredited investors,
non-accredited purchaser limit of 35.
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5) Resale of securities, Rule 144

Unless the sale would be exempted, the resale is not exempted. Even then, §4(1) does not allow
resale by the issuer, or anyone who buys from the issuer or a control (insider) person with a view to
further distribution. Rule 144 permits secondary public resale by control persons only after a public
information is available, any long-term hold requirements are met, sale through a non-soliciting, normal
commission broker, and subject to ‘trickle’ volumes. Rule 144 does not control sales between existing
shareholders.
6) Remedies for Securities Violations
A purchaser of a security may rescind the transaction and get her money back with damages with
interest, or recover damages if she has resold the stock, whenever the stock offer or sale violated §5.
B) Stock Transactions
1) Stock Issuance
a) Preferred Stock
Capital only – fixed value dividend with preferred payment over other capital returns. Preferred
stock has cumulative dividends, which are those unpaid distributions carried forward to until operating
funds are available to pay dividends. No growth value because the return never increases. In the event of
dissolution, preferred stockholders are bought off first. Various types of preferred stock.
Participating Preferred - entitled to original div + may share w/ common in any additional
distributions after common paid
Redeemable Preferred - redeemable by the corporation at a specified price so long as one
outstanding class of common shares with full voting powers.
Convertible Preferred - may be converted into common shares at a specified price or specified ratio
(usually established when class is created.
b) Common Stock
Voting rights and variable dividends when available. No cumulative dividends, so there is a risk of
no dividends – ever. Common stock is ‘growth’ stock. As the company’s value increases, so does the
value of the common stock.
c) Par Value
The nominal value (1-cent) is assigned to stock for which the corporation will pay on demand. No
par stock means just that. A corporation can sell stock at less than par value if the board authorizes it.
d) Diluted stock
Stock ‘sold’ for cash of less than par value is discount stock because it dilutes the voting and
distribution value of stock previously issues. If property is given instead, the stock is called, ‘watered.’ If
the stock is issued as a gift, then it is called ‘Bonus’ stock, but is void or voidable because of the absence
of valuable consideration. A corporation may also buy-back its stock, usually at market prices, which is
then held in the ‘treasury,’ until retired or re-issued.
e) Initial public offering – clean up & disclose
Clean up corporate records, employment contracts, supplier and client contracts, A/P & A/R.
Records must be ‘clean’ for about 3-years back. Underwriters, accountants, and lawyers help ($$$).
2) Share transfer restrictions
A corporation may restrict the transfer, or re-sale of its stock where (1) the restrictions are
reasonable (corporation has first right of refusal, but not a par value restriction), (2) the transfer
restriction must be conspicuously printed on the stock certification, and (3) the transfer restriction must
be in Bold letter and in ALL CAPS; (4) the restriction must be right above signature line. (Ling v.
Trinity Savings & Loan)
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3) Conversion
Forced shares are redeemed when the value of shares obtainable on conversion exceeds the
redemption price.
Downstream shares authorize preferred shareholders to convert shares into common shares,
Common shares are not convertible to preferred shares.
4) Stock buyback as distribution
A corporation may buy-back is stock as part of its capital or income distribution program.
Redemptions are supposed to be proportionate in class being redeemed. The corporation cannot
discriminate in that it must buyback shares in proportion to shareholder ownership. Repurchase
programs allows the corporation to negotiate for both the quantity of stock bought-back, and the price.
Both programs decrease the number of available shares, and increase the share price.
C) Shareholder Preemptive Rights - no dilution of equity
1) Inherent rights
Pre-emptive rights safeguard a stockholders right to protection against dilution of their equity
(recapitalization) in the corporation and protection against dilution of their proportionate voting control.
Katzowitz – recapitalization is invalid where it dilutes shareholder equity & voting rights. A stockholder
has an inherent right to a proportionate share of new stock issued for money, in some other equitable
way that will enable him to protect his interest by acting on his own judgment and using his own
resources.
2) Opt-in and opt-out rights, §6.30(a) opt-in
Under § 6.30(a), no preemptive right exists unless provision for it is expressly made. As a result, a
“plain vanilla” corporation whose articles of incorporation contain the statutory minima will not have
preemptive rights. As of 1998, nineteen states adopted an “opt out” rather than opt in provision.
A corporate executive owes a fiduciary duty to the shareholders, and cannot abrogate that duty
through stock manipulation, even for seemingly beneficial purposes, if the acts are inconsistent with that
fiduciary duty. Lacos – attempt rejected to force the board to issue super-voting stock to president.
3) Remedy for dilution
A shareholder can waive the right, but can’t have it taken away. Stokes – the remedy for dilution is
the difference between the purchase price and market value of the stock. The difference is not based on
par value.
IV) Management & Control
A) Articles of Incorporation, Bylaws, Resolutions
Ultra Vires (replaced by breach of duty) – The State (or shareholders if permitted by the A/I or
bylaws) seeks to cancel an act by the Board, directors, or officers who acted outside within the bounds
of the Article of Incorporation, Bylaws, and resolutions of the board of directors. A third party may not
sue a company under ultra vires.
Reverse Ultra Vires (not supported) – The Board, directors, or officers seek to cancel a transaction
because they acted outside within the bounds of the Article of Incorporation, Bylaws, and resolutions of
the board of directors.
Unless granted authority by the Articles of Incorporation, or Bylaws, the Board must seek
shareholder approval before executing any agreements reflecting on composition of the Board, or
ownership of the corporation.
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B) Duties of Directors & Officers

As agents of the company, all partners, directors, and officers owe the company the duties of care,
loyalty, and fiduciary duty.
1) Promoters
Raise initial capital, initial board of directors, and corporate office.
A promoter is personally liable unless (1) the acts of creditor show the creditor intended to hold only
the corporation liable, or (2) the corporation ratifies & receives the benefit of the promoters act. A
promise to ratify is invalid when the corporation does not yet exist.
A promoter may make a profit for her efforts, although her part in the corporation must be disclosed
in the records (such as the organizational meeting minutes) of the corporation. If the promoter takes
stock as her compensation, wholly or in part, the SEC rules of disclosure(§§10, 14, 16) &holding apply.
2) Board of Directors/ Active Partners
Authorize & direct agents of the company in acts binding to the company.
Draft and adopt changes to the charter & operating documents for approval by passive investors
Issue & buyback as authorized by the charter & operating documents any or all ownership
certificates
3) Officers and managers
Faithfully carryout the direction of the board of directors.
Timely notify the board of circumstances consequential to the company.
4) Removal and election of parties
a) Directors
Directors may be elected to the board by the board, or by shareholders.
Directors cannot remove another director unless the articles of incorporation of bylaws permit it.
Shareholders can remove a director for or absent cause.
b) Officers
Only directors may hire and appoint officers of the corporation.
Directors can remove an officer for or absent cause, but subject to any employment contract golden
parachutes.
c) Shareholders
Directors can buy back shares (thus ‘removing’ shareholders) in equal portions of ownership.
5) Management and Control of Meetings
a) Assembly of owners
(i) Notice of meeting
Adequate notice (10 to 50 days)
Must list topics
No discussion on off-topic items
Approval of notice is implicitly adopted if no objection
(ii) Permissible form presence
Physical, proxy or electronic
(iii) Quorum of all owners present
Accounting for vacancy or supermajority rules)
(iv) Majority of owners present voting
b) Voting rules
Straight or cumulative voting as determined by the bylaws and statute. Straight voting = 1 vote per
share; cumulative voting is 1 vote per share per director position up for voting.
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Bylaws determine adoption percentage (67, 50.1, or highest vote count)

c) Recordation
Records made
Records kept (all) or maintained (current only)
C) Distributions
Distributions may be made in the form of cash dividends, stock dividends (issuing stock instead of
cash) or redemption by the buying back of stock.
1) Dividends
Directors may not store earned income but non-specific purposes. While shareholders do not have a
right to dividends, where the corporation regularly pays a dividend, courts will presume reliance for
dividends. Dodge/Ford. The record date is the date on which persons recorded as owing stock on that
date will be paid the dividend on the distribution date. Preferred shareholders have a first right to
receiving dividends
a) Permissible Distribution, MBCA §6.40, insolvency & balance tests
A corporation may only a pay a distribution up to the permissible amount. Different states and
authorities prescribe different tests.
(i) Equity insolvency test, (§6.40(d))
A corporation may not pay a distribution of by paying out distributions, the corporation would be
become insolvent.
(ii) Balance sheet test §6.40(c)2 - GAAP
The balance sheet test prohibits distribution if the total assets are less than total liabilities. The
MBCA does not require Generally Accepted Accounting Principles (GAAP), but only that the
accounting practices and principles are reasonable.
b) Non-MBCA, retained earnings & impairment tests
(i) Pure Insolvency Test – “Earned surplus”
Distribution is allowed if there is enough money in retained earnings over and above costs.
(ii) Impairment of capital
Distribution is allowed if is there is enough retained capital to operate and pay bills
(iii) Distribution of Capital Statutes
2) Compensation & Bonuses
“Bonusing” out occurs when corporations pays out excess capital as deductible compensation at the
end of the year to avoid double taxation from both personal and corporate taxes. Corporate executive
justify these as a “retainer bonus,” that is, to keep good executives the corporation must pay them well.
3) Distribution of capital surplus, MBCA §46
Also known as a ‘partial liquidation.’ Distribution can be made out of capital surplus (of what’s left
at end of dissolution process) with proper authorization, typically a majority or 2/3rds of shareholders.
4) Capital asset use for distributions
Stated capital – never used
Capital (paid in) surplus – a few states allow it
Revaluation surplus – rarely used
Earned surplus – may always be used to pay cash/property
D) Rights of passive investors (shareholders & partners)
1) Approval of board actions
Approve changes to the charter/ operating documents
Elect or discharge directors
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2) Proxy service – see VIII B. Statutory §14(a)

Section 14 of the SEC rules, (17 CFR 240) provides shareholder rights for proxy service and voting.
Solicitation or mailing rights (minimum ownership required). See below.
3) Right of inspection - reasonably related
A shareholder may inspect the books of the corporation on presenting a valid reason, and proof that
the purpose is proper. Any secondary reason (even if invalid) is irrelevant. Thomas & Betts.
Valid reasons include to determine the return on investment, or to determine fraud. A shareholder
may access records of times prior to the shareholder’s interest in the corporation if the request is
reasonably related to the shareholder’s interest in the corporation. Saito. The request for inspection is
invalid if the purpose is to further goals unrelated to the ownership of the company’s stock.
NOBO List - A corporation does not have to create a record of beneficial owners as it keeps the
names of the recorded owners, who have the ability to disseminate to the beneficial owners. Parsons.
4) Proposal rights
a) The shareholder, $2000 or 1%, > 1 year, <500 words, in advance
Rule 14a-8 permits a shareholder to submit a proposal for inclusion with a proxy statement if the
shareholder meets certain requirements. First, the shareholder must have continuously held at least
$2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal at the
meeting for at least one year by the date she submits the proposal. She must also submit proof of
ownership, and she must continue to hold those securities through the date of the meeting. Second, the
proposal may not exceed 500 words. Third, she must submit the proposal sufficiently in advance of the
shareholder’s meeting. That date varies, but is stated in the prior year’s annual report. Fourth, the
shareholder or her agent must attend the meeting.
b) Relate to > 5% of business & a power of the company
c) No violations or conflicts
The proposal cannot violate any state, federal, or foreign law; be materially false or misleading; nor
relate to the redress of a personal claim or grievance against the company or any other person; nor
benefit or further a personal interest, which is not shared by the other shareholders at large; nor deal with
a matter relating to the company's ordinary (day to day) business operations; nor relate to an election for
membership on the company's board of directors; nor conflicts with one of the company's own
proposals at the same meeting.
5) Shareholder agreements – voting blocks & voting trusts
Voting block – breach of shareholder to the other shareholders of the agreement
Voting trust – breach by the trustee to the shareholders of the agreement (writing, 10 years max.)
Shareholder agreements are invalid if the act restricts the authority of the board, violates law, injures
minority shareholders, or injures the corporation’s creditors or public. A voting block has greater leeway
if all shareholders are members of the voting block, and all directors are shareholders (even though not
necessary all members of the voting block). Another notable exception (for Del.) is, as where again, all
shareholders are members of the voting block, the shareholders may approve and enforce an agreement
on the directors for minority approval of board acts. (Zion/Kurtz)
a) Agreements to elect board members
Agreements where all signers agree to vote to elect all the signers to the board are generally valid.
Where shares are conspicuously marked with voting agreement, later shareholders will be bound (buys
or gifts). Both the burden and benefit run with the stock.
b) Particular person in key job agreement
Agreement where a majority of the shareholders agree to put and keep a particular person into key
job cause injury to minority-holder plaintiff where the minority shareholder objects.
Page 17 of 37
c) Share-transfer restrictions
A purchaser without actual knowledge of pre-existing restrictions, will not be bound unless
restrictions were conspicuously noted. Right of first refusal by corporation or other shareholder,
restriction normally applies only if shares are sold, not gifted or as a bequest.
6) Shareholder rights plans
There is no exclusive authority granted boards of directors to create and implement shareholder
rights plans, where shareholder objection is brought and passed through official channels of corporate
governance. Shareholders may, through the proper channels of corporate governance (unless prohibited
by the articles of incorporation), restrict the board of directors authority to implement shareholder rights
plans. Teamsters.
E) Common Law Duty
1) Duty of Care – Reasoned investigation, information, & decision
a) Duty of Care – monitor, inquire, but clairvoyance not required
Reasonable investigation, reasonably informed, and a reasonable decision.
Monitor the corporation and other employees. Directors must inquire into corporate practices upon
receiving notice of impropriety.
Directors are personally liable for failing to prevent wrongdoings by other corporate officers, if (1)
they owed a duty to the victim, (2) they were negligent in monitoring the other officers, and (3) their
negligence was the proximate cause of the injury.
A trustee has a duty to the corporation of reasonable investigation and due care regarding the
background of a suspect buyer. The measure of damages is compensation for all the detriment causes,
i.e., the loss of assets, and the loss of earning power. DeBaun/FirstWestern
Directors, as trustees, stand in a fiduciary relationship with the corporation, and are liable for
negligence in the performance of their duties – but clairvoyance isn’t required. Accepting a contract
where the bank bore all the risk, and had no gain possible was negligence, but damages were limited to
that attributable to only the obligation they incurred. All directors and officers who participated in the
option vote are found liable here –even though the vote was only to ratify. Litwin v. Allen
b) Breach of Duty of Care
Under the duty of care, a director, officer, or controlling shareholder is under a duty to disclose, and
be aware of all relevant facts reasonably available. Thus, a directors, officers, or controlling shareholders
failure to present a report to the board, or read the report presented, containing information material to
the issue at hand is a breach of the duty of care. This breach extends to the circumstance where the
president brings a share pricing report to the board, and only reads to a single price from the report to the
board, without disclosing that the reports suggests a range to share prices. The president breaches his
duty by non-disclosure, while the board breached their duty by not asking to see and read the report for
themselves.
c) Defense to Duty of Care
On challenge to a person for violating the Duty of Care, the director must show that she made a
reasonable investigation, read and understood all material information from the investigation, and that
her decision was reasonably based on the information available to her at the time she made the decision.
In other cases, she would have to show that she did not owe a duty to the victim (corporation,
director, shareholder), or that she was not negligent in monitoring the officer, or her negligence was not
the proximate cause of the injury (other intervening or superceding factors applied.)
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d) Remedy for Breach of Duty of Care

Here, the court ordered the company to pay the shareholders the difference between the higher price,
that the president did not disclose, and which the board should have adopted, and the lower price that he
gave the board, which the board adopted. Punitive damages are unlikely unless provided for by contract
or statute.
2) Duty of Loyalty - No conflict of interest, Equal Opportunity
a) Duty of Loyalty by Management
The party must put the partner/ship/corporation ahead of their self-interest. The fiduciary duties a
manager owes to the limited liability company and to its members are those of a partner to a partnership
and to the partners of the partnership. Cal. Corp. Code §17153.
Minority shareholders in a close corporation must have the equal opportunity of the same offer to
purchase their shares as extended to a controlling shareholder. Donahue v. Rodd Electrotype.
b) Limited Duty of Loyalty by Shareholders – fair opportunity, not equal
(i) Public corporation
A controlling shareholder has the right to sell their stocks, but must act fairly for the other
shareholders when the sale includes corporate control with unusual profit to the fiduciary at the
detriment to the other shareholders. Perlman/Feldmann
A CONTROLLING shareholder (i.e., selling control of the corporation) does not have a fiduciary
duty to all other shareholders to secure the same buyout price for them. Zetlin/Hanson.
N.B. The duty of price equity is on the directors- not the shareholders!
(ii) Close Corporation
Close Corporations are a special circumstance in that the shares are not liquid – there is not a ready
market for a shareholder to sell out. The majority rule is that a controlling shareholder cannot use her
power to the detriment of minority shareholders. [See equal opportunity by management, above.]
c) Breach of Duty of Loyalty by Management – Waste & Freeze-out
(i) Business transactions
Under the duty of loyalty, a director or officer is to give preference to the company and not engage
in self-serving acts against the company. Such an act would be where (1) without prior disclosure by the
benefited person, plus (2) approval by the board, the corporation transacts business with a director,
officer of the corporation, or a related member, and (3) the transaction was unfair to the company. Thus,
even if without disclosure, or no approval by the independent directors, if transaction was “fair,” as
viewed at the time it was made, the duty of loyalty is not breached.
(ii) Waste
A director or officer may also breach the duty of loyalty by securing excessive compensation for
himself, or for another person. (1) If the corporation is not receiving some benefit from compensation
scheme, then possibly waste unless approved in advance by disinterested directors (i.e., immunized). (2)
Stock options are ordinarily acceptable, as long as they are not clearly excessive. (3) Retirement
benefits, if awarded at moment of retirement may be waste as there is no consideration.
d) Breach of Duty of Loyalty in a Close corporation - equal opportunity
(i) Preferential repurchase - equal opportunity doctrine
A preferential share buyback in a close corporation favoring a majority shareholder over minority
shareholders is a breach of loyalty to all shareholders for depleting corporate assets. The corporation
cannot selectively purchase her shares unless the corporation equally offers the same opportunity and
price to the minority shareholders. Donahue/Rodd
(ii) Freeze-out by majority shareholder
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A freeze-out occurs where a majority shareholder uses her control in a close corporation to the
detriment of the minority shareholders. The goal is usually to force minority shareholders to sellout at a
lower price than the minority shareholders want for the their stock. Freeze-out tactics drive down the
worth of the corporation, as by executing over-priced transactions or salaries, or removing employees, or
officers from the corporation.
The squeezers (those who employ the freeze-out techniques) may refuse to declare dividends; they
may drain off the corporation's earnings in the form of exorbitant salaries and bonuses to the majority
shareholder-officers and perhaps to their relatives, or in the form of high rent by the corporation for
property leased from majority shareholders; they may deprive minority shareholders of corporate offices
and of employment by the company; they may cause the corporation to sell its assets at an inadequate
price to the majority shareholders. Donahue v. Rodd Electrotype.
e) Defense to Breach of Duty of Loyalty
(i) Business Judgment Rule
On challenge to a Director or Officer for violating the Duty of Loyalty, the defendant need only
show that the Business Judgment Rule applies, i.e., there was not gross negligence on her part.
(ii) Immunity
Alternatively, the director may assert “immunity,” by virtue that her act had approval of the
disinterested board of the directors, or disinterested shareholders. Immunity applies, if after disclosure, a
majority of disinterested directors or shareholders pre-approve the transaction, and the court won’t even
consider whether the transaction was fair since deciding corporate business is for the board to decide
(and the directors were disinterested and informed). Alternatively, there may have been ratification after
the fact where the disinterested directors or shareholders ratified the transaction after proper disclosure,
but pre-suit. Here, ratification would also immunize the transaction.
(iii) Shareholder Valid Business Purpose
Challenges to a majority shareholder come under the valid business purpose rational. If the
shareholder’s request, or act, had a valid business purpose, then the court will allow the transaction.
f) Remedies for Breach of Duty of Loyalty
(i) Public corporation
If a transaction was not fair to the corporation, and the board or shareholders did not approve, or
post-ratify the transaction, then the court may determine damages by (1) rescission, or reformation of the
contract in terms fair to the corporation, (2) with an accounting and disgorgement for the difference
between the fair price and the contract price, and (3) the salary earned. Punitive damages are unlikely
unless provided for by contract or statute.
(ii) Close corporation
If a transaction in a close corporation was not fair to minority shareholders, regardless of board
approval, the court may enjoin the board and award damages. As the minority shareholders would likely
want out, with an accounting (by injunction) and award of losses is likely. Punitive damages are unlikely
unless provided for by contract or statute.
3) Fiduciary Duty - Agency
a) Fiduciary Duty
Under fiduciary duty, the agent acts on behalf of the principal and the principal wants the agent to
act on his behalf. Directors and offices of the corporation owe fiduciary duty to the corporation and the
shareholders. Fiduciary duty is met if the director/ partner/ actor reasonably believes that the judgment
she’s making in the best interests of corporation. A general partner owns fiduciary to the limited partners
(USA Cafe). An emerging view (with some statutory teeth) is that controlling shareholders have a duty
to minority shareholders to not unfairly profit in share transactions with the corporation.
Page 20 of 37
b) Breach of fiduciary duty – improper bind, freeze-out

(i) To the corporation
An officer breaches her fiduciary duty where (1) she commits an act either knowingly without
authorization or improperly binds the company, or (2) she violates her duty of care, AND (3) resulting in
economic damage to the corporation, directors, or shareholders.
(ii) Freeze-out of minority shareholders
In a freeze-out, directors and majority shareholders breach their fiduciary duty to minority
shareholder. A freeze-out cause of action may occur in a partnership or close corporation, where the
ownership is illiquid. A freeze-out cause of action is less likely in a public corporation since the minority
shareholders can sell to escape the freeze-out.
c) Defense to breach of fiduciary duty
On challenge to a person for violating fiduciary duty, the person must show either that (2) she did
not owe a fiduciary duty to the plaintiff, or (2) she did not breach that duty, or (3) her acts did not cause
economic damage to the plaintiff.
d) Remedies for breach of fiduciary duty
The remedies for breach of fiduciary duty are restitution of the economic damage. Punitive damages
are unlikely unless provided for by contract or statute.
4) Corporate Opportunity Doctrine
The Corporate Opportunity Doctrine is a duty of loyalty rule that requires directors and officers (but
not shareholders) to not accept a related business opportunity without offering it to the corporation first.
a) Requirements – Guth line of business, ALI disclosure
(i) Guth Line of Business Test
Under the prior “Guth Line of Business Test,” liability rested on whether the opportunity "was so
closely associated with the existing business activities ... as to bring the transaction within that class of
cases where the acquisition of the property would throw the corporate officer purchasing it into
competition with his company."
(ii) ALI §5.05 – Corporate Opportunity Unoffered
The ALI Principle of Corporate Governance Section 5.05, broadly defines a corporate opportunity as
one which a director (1) becomes aware of in his corporate capacity, or (2) uses corporate information or
property to acquire, or (3) is closely related to a business in which the corporation is engaged or expects
to engage. The director cannot then take the corporate opportunity unless (1) the director fully discloses
and offers it to the corporation, and (2) the board rejects the opportunity, and (3) the rejection is ratified/
approved by either (a) a disinterested majority of the directors, or (b) a disinterested majority of the
shareholders. If these tests are met, then the burden of proof is on the challenger to show that the
transaction was unfair to the corporation.
(iii) Fairness and Feasibility
The Durfee court used the fairness test, that is simply, was taking the opportunity fair to the
corporation. In this context, fairness also rests with feasibility, in that a corporation might ‘want’ an
opportunity, but be inadequate in resources, or experience to take the opportunity and use it, without
breaching its duty of care to the shareholders.
(iv) Harris
Thus, in Harris, she failed to offer the condominium opportunity to the board. Has she offered the
opportunity, but it was not ratified by a majority of disinterested directors or shareholders, then the
burden of proof is on her to prove that it was fair to the corporation for her to take the opportunity.
Page 21 of 37
b) Defense to the Corporate Opportunity Doctrine

On challenge to a person for violating the Corporate Opportunity Doctrine, s/he must prove that
while she did not follow these rules, the opportunity was not one either (1 of 4) (1) closely rated to
corporation’s existing or prospective activities, or (2) essential to corporation’s well being-special or
unique opportunity, or (3) the Corporation did not had a reasonable expectation that the opportunity was
a corporate one, or (4) the corporation did not have the financial resources to take advantage of the
opportunity, AND (5) by taking advantage, the opportunity did not place the director in a position
adverse to the corporation.
c) Remedies for Breach of the Corporate Opportunity Doctrine
See Remedies for Breach of Duty of Loyalty
F) Assumption of duty
RULPA 303(b) case law makes corporate officers/limited partners liable when they (1) act as
partnership managers, (2) commingle assets, or (3) Keep the corporation undercapitalized.
V) Statutory Federal Actions
A) Disclosure Requirements
1) Materiality
A fact is material if there is a substantial likelihood that a reasonable investor would consider it as
altering the “total mix” of information in deciding whether to buy or sell. Levinson. An omitted fact is
material if there is a substantial likelihood that a reasonable SH would consider it important in deciding
how to vote” (TSC Indus/Northway)
2) Reliance
A court will presume a trader relied on the misrepresented information if the information (1) was not
disclosed or misrepresented to the public, and (2) the information was material and (3) the information
was related to the plaintiff’s securities traded in an open market. Levinson.
3) Selective Disclosure – Regulation FD
a) Any statements regarding the earnings report are material
Regulation FD provides that a company selectively disclosing (as to market professions, etc.)
material and not previously available information, under circumstances in which it is reasonably
foreseeable that the security holder will trade on the basis of the information, must thereafter publicly
disclose that information. Public disclosure must be simultaneous if the selective disclosure is
intentional, or promptly if the disclosure was unintentional. Since statements regarding the earnings
report are material, a previously undisclosed fact that conditions have not changed must be disclosed.
b) Failure to disclose is not 10b-5 actionable
Failure to make a required disclosure is not per se securities fraud under Rule 10b-5, so a plaintiff
may not rely on a failure to make a required Reg. FD disclosure to sue under Rule 10b-5.
4) Forward-looking statements – Regulation S-K
The SEC permits management discussion & analysis reports to contain “forward-looking
statements.” These statement include projections of financial data and management decisions, along
with the assumptions underlying these projections. While Regulation S-K requires that all variables in
those forward-looking statements be fully and honestly disclosed, the “safe harbor” rule clarifies that
forward–looking statements are not misleading unless the were written in bad faith or have no basis for
projections. All the assumptions must be justified by sound accounting.
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5) Consolidated report
A “consolidated report” include information from all of the corporation’s subsidiaries. While the
assumption is that all companies are operating under the same circumstance, sometimes unique
circumstances have impact on the overall prospective financial status of the company. In that case, the
‘forward-looking’ statements do not have a basis for the projections they portend. These unique
circumstances also put the corporation on notice for the need to break that division’s activity report out
of the consolidated report. Thus, Caterpillar’s General counsel erred by knowing about the unique
situation in Brazil, but the MD&A did not disclose those conditions.
6) Omissions
An omission is actionable only where there is a duty of disclosure. There is a duty of disclosure only
where (1) the undisclosed information makes previous statements (i.e., forward-looking statements)
misleading, or (2) the corporation has (or would have) a reasonable belief that people are trading on
reliance of undisclosed information, or (3) incorrect rumors are attributed the issuer.
B) SEC §14(a) Proxy solicitations
1) Proxy solicitation requirements
a) Any request, express or implied, for a proxy
SEC Rule 14a-1 (17 CFR 240.14(a)-1) requires that a party’s solicitation of a shareholder’s proxy (to
vote her shares) must be first filed with the SEC (subject to the other requirements of the section) if the
solicitation is (i) any request for a proxy whether or not accompanied by or included in a form of proxy;
(ii) any request to execute or not to execute, or to revoke, a proxy; or (iii) the furnishing of a form of
proxy or other communication to security holders under circumstances reasonably calculated to result in
the procurement, withholding or revocation of a proxy. SEC Rule 14a-2(a) exempts solicitation
otherwise than on behalf of the registrant where the total number of persons solicited is not more than
ten. A request for the stockholders list gives a presumption that there is a continuous plan for a proxy
solicitation. (Gittlin).
b) Filing with the SEC 10 days before
SEC Rules 14a-3 and 14a-6 require that before making a solicitation, the solicitor file a proper proxy
statement with the SEC at least 10 days before soliciting shareholders, and provide the proxy statement
to all persons solicited with or before the solicitation.
c) Bold-face type, dating, identification of the matter, solicitations &
proponents
SEC Rules 14a-4 require that the solicitation, (1) indicate in bold-face type on whose behalf the
solicitation is made; (2) provide a specifically designated blank space for dating the proxy card; (3)
identify clearly and impartially each separate matter intended to be acted upon, regardless if related to or
conditioned on the approval of other matters, and (4) whether the solicitation was proposed by the
registrant or by shareholders. Undated or post-dated proxies are prohibited under Rule 14-10.
d) Prohibition of false or misleading statements
(i) Director and shareholder proposals
SEC Rule 14-9 prohibits 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. Required disclosures include
conflicts of interest, the compensation given to the five highest-paid officers, and details of any major
change being voted upon.
(ii) Buy-out of minority shareholders in a public corporation is inactionable
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Minority shareholders do not have a cause of action where a supermajority shareholder executes a
buy-out with the approval of a disinterested board. While Rule 14a-9 is intended to prevent knowingly
false statements in proxy statements, disbelief of conclusory statements in a proxy solicitation is
inactionable where the shareholder’s position is insufficient to have mattered. Virginia Bankshares.
2) Requirements for prosecution
a) Any requirement failure
Any failure of a party under SEC Rule 14a is subject to prosecution. This could a failure to file when
required; a failure to timely file when required; a failure to include the proxy statement with or before
the proxy solicitation; a failure to properly, clearly, and impartially indicate the required information on
the solicitation; failure to provide for dating, or post-date a solicitation; or provide false, or misleading
material, or to omit material information.
b) Misleading failures
Rule 14a-9 provides examples of what, depending upon particular facts and circumstances, may be
misleading within the meaning of this section. (a) Predictions as to specific future market values; (b)
Material that directly or indirectly impugns character, integrity or personal reputation, or directly or
indirectly makes charges concerning improper, illegal or immoral conduct or associations, without
factual foundation; (c) Failure to so identify a proxy statement, form of proxy and other soliciting
material as to clearly distinguish it from the soliciting material of any other person or persons soliciting
for the same meeting or subject matter; (d) Claims made prior to a meeting regarding the results of a
solicitation.
3) Remedies
§27 (15 U.S.C.A. §§ 78n(a), 78aa) allows a shareholder a private cause of action under §14(a) with
remedies of injunction, rescission, and damages. Generally no attorney fees.
C) SEC §14(e)-3a Misappropriation
1) Elements
Misappropriation occurs when (1) a tender offer is in progress, (2) another person has information
material to the tender offer, (3) s/he know the material information is nonpublic, (4) s/he knows the
information came from a insider, and (5) s/he buys or sells any of the securities involved.
2) Presumption of fraudulent acquisition
As insiders have a duty under 10b-5 to abstain from disclosure while in possession of material,
nonpublic information obtained in a fiduciary relationship, courts presume that the third party
fraudulently acquired the information.
A fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities,
in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that
information. (O’Hagan)
D) SEC §10b Illegal Transactions
1) §10b-1 Manipulative or deceptive devices
Section 10b-1 prohibits the use of manipulative or deceptive activities relating to the sale or
purchase or securities. The key phrases are, “by the use of any means or instrumentality,” “in connection
with the purchase of sale of any security,” “any manipulative or deceptive device,” and “in the public
interest to for the protection of investors.” Not stating what has to be said is as serious as fraudulent
disclosures. A mere breach of fiduciary duty by a majority shareholder, without any deception,
misrepresentation, or nondisclosure, does not violate 10b.
The information must be material – Basic Inc. v. Levinson. The information must be truly non-
public, a substantial number of members of public must not know. Sec. 10b also applies to public sales
Page 24 of 37
of non-publicly traded stock. The is an implied private right of action under federal law can be brought
by harmed private person shareholder or corporation (must have bought/sold stock during the
approximate time), for civil damages.
An omitted fact is material if there is a substantial likelihood that a reasonable SH would consider it
important in deciding how to vote” (TSC Indus/Northway).
2) SEC §10b-5 Insider trading
Under the “equal access to the market theory,” all persons, insiders and outsiders, are statutorily and
strictly bound to not trade “on the basis” of information they would reasonably believe is derived from
insider knowledge. Section 10b-5 is a federal claim limited to publicly traded companies on national
exchanges, but is not limited to fraudulent disclosures. Rule 10b-5 is preemptive in that it eliminated
state laws relating to insider trading of multi-state corporations. A fraud under Rule 14 may lead to a
Rule 10b-5 violation
3) Strict liability with a small scienter element
a) Elements
The purpose of §10b is to catch fraud, not the mere possession of nonpublic market information
without a duty to disclose. A corporate insider’s duty arises “from (i) the existence of a relationship
affording access to inside information intended to be available only for a corporate purpose, and (ii) the
unfairness of allowing a corporate insider to take advantage of that information by trading without
disclosure.” Chiarella
Strictly, all that is necessary is that (1) the information came from, or derived from an insider of the
firm, and (2) a recipient (tippee) traded on that information. Thus, the source (director or officer), and
intermediaries (all tippers) who knew or should have known that tipper was breaching a fiduciary
obligation, are also guilty of passing the information. For the purposes of 10b-5, insiders are considered
to be persons who are directors, officers, or employees of the issuer, or is a person affiliated, and in a
confidential duty to the issuer, such as lawyers, bankers, CPA’s. One who stumbles upon the
information without having a fiduciary duty to the issuer is not liable.
b) Traditional vs. misappropriation theories
Under the traditional theory, a tipper can be liable even if he doesn’t personally benefit. All that is
necessary is if he intends to make a pecuniary gift to tippee. Under the misappropriation theory, an
outsider is liable if he steals the information and trades on it, or passes it on. The scienter element then
enters on such derivative actions. The tippee’s liability is derivative, so if the tipper is not guilty the
tippee not guilty. However, if the tipper is liable, the tippee won’t be liable he knew or should have
known that tipper was breaching a fiduciary obligation. A reckless disregard of the truth is interpretable
as scienter but aiding and abetting a person is not.
c) Private right of action
Birnbaum held that private plaintiffs in Rule 10b-5 cases are limited to actual purchasers or sellers of
the securities. The "fraud on the market" theory is rebuttable presumption that the actor is liable per se
for the misleading or deceitful, but the defendant can rebut the presumption by proving the have bought
or sold anyway, the statement was immaterial, or the statement did not have an impact on the market
price of the stock.
d) Statute of Limitation
Two years after discovery of facts constituting the violation, or five years after the violation.
The SOX version is that a complaint must be filed within 1 year after the discovery of the facts
constituting the cause of action and within 3 yrs after the cause of action occurred.
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4) Remedies - Civil penalties for insider trading

a) Section 21A, 15 USC §78u-1
(i) Trader
Disgorgement of profits resulting from the trade(s), PLUS up to 3X that amount as penalty (judges
discretion). In a case of multiple defendants, the remedy is limited to proportionate liability (right of
contribution), not joint and several liability.
(ii) Controller
The person who "controls" the transaction, such as the insider, tipper, or manager, is also liable for
up to the greater of $1MM or 3x profit or loss avoided.
(iii) Whistleblower
§(e) provides 10% of penalty as bounty as an incentive for whistleblowers.
b) Section 20A– Liability to Contemporaneous Traders for Insider
Trading
Section 20 A has not led to many successful actions because of the ambiguity in the definition of
“contemporaneous” and how particularized the allegations must be to show that the defendants
possessed material nonpublic information at the time of trading.
c) Statute of limitations
No action may be brought under this section more than 5 years after the date of the purchase or sale.
d) Private rights of action based on contemporaneous trading
Any person who violates any provision by purchasing or selling a security while in possession of
material, nonpublic information shall be liable to any person who, contemporaneously purchased or sold
the same class of securities. The total amount of damages imposed shall not exceed the profit gained or
loss avoided in the transaction(s).
E) SEC §16b Short-swing profits – public/private
A publicly traded corporation or shareholder may recover profits made by a director, officer, or 10%
+ shareholder resulting from the purchase and sale, or the sale and purchase, of stock within a 6 month
period, if both transactions were made while the person was a director, employee, or shareholder of
more than 10% of the stock.
1) Requirements for prosecution
(1) The person was in an “insider” or 10%+ shareholder at both transactions, (2) the transactions
were a purchase and a sale (not 2 sales or 2 purchases), in either order, and (3) both transactions
occurred in less than 6-months and a day.
SEC 16b is a strict liability statute. The trader is not required to be acting on insider information, but
simply must have made both a purchase and a sale, in either order, during the 6 month period. The
purchase that lifts the buyer over 10% does not count for 16b purposes.
2) Employee compensation exceptions
Employee benefit plans with stock appreciation rights; the exercise of long-term options.
3) Remedies
Relief is limited to the theoretical profits made by trader by calculating the stocks lowest purchase
price against the highest sale price, so as to maximize the corporation’s recovery.
F) PSLRA & SLUSA '98 Limitations
Private causes of action based on SEC violations are now limited (1) to federal court, (2) without
allegations of fraud. Consequently, a complaint based on fraud is dismissed since the federal court does
not have jurisdiction where the cause of action is solely a state issue.
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1) PSLRA '95
a) Certification
PSLRA required lead plaintiffs to file sworn certifications stating that (1) they have reviewed the
complaints, (2) they did not purchase stock at the direction of counsel in order to qualify as class
representatives, and (3) that they will not accept any payment for serving as class representatives.
Lead attorney's fees are capped at a "reasonable percentage" of the amount of damages and interest
actually paid to the class. PSLRA was intended to stem perceived damage from “strike suits,” i.e., class
actions filed not on merits of case, but by plaintiffs and counsel filing suit after a significant change in
stock price.
b) PSLRA Safe Harbor
Statements that qualify for the safe harbor cannot give rise to private liability if either of two tests is
met. First, no private liability may be imposed for forward-looking statements made without actual
knowledge that the statements were false or misleading. Second, no private liability may be imposed if
the forward-looking statement is identified as such when made and is accompanied by meaningful
cautionary language identifying important factors that could prevent the statement from becoming
accurate.
c) Aftermath
After PSLRA, plaintiffs filed parallel suits in state and federal courts, which doubled issuer’s
problems, rather than reducing as Congress intended PLSRA to do.
2) SLUSA '98
SLUSA preempts any state claim that meets four prerequisites. The lawsuit must be: (1) a "covered
class action"; (2) based on state law; (3) in which the plaintiff has alleged either a "misrepresentation or
omission of a material fact" or "any manipulative or deceptive device or contrivance;" (4) "in connection
with the purchase or sale of a covered security." If the complaint does not allege misrepresentation,
fraud, or omission of a material fact, then SLUSA does not apply. (MDCM) Nor would SLUSA apply
where suit is filed in the issuer’s home state, since local federal courts have jurisdiction where the issue
is (1) federal law (SMJ), and (2) in the defendant’s home state (PJ).
3) Delaware “carve-out,
[SEA §16(d)(1), 15 U.S.C. §§ 77p(d)(1), 78bb(f)(3)(A)]
The Delaware carve-out exception only requires that the case be filed in the state of incorporation of
the corporation. (Gibson). The Delaware “carve-out,” contains two prongs.
Subsection (A) preserves state jurisdiction for breach of fiduciary duty claims arising from
transactions taking place between the issuer and its security holders. These include: (i) repurchases of
securities by the issuer from its security holders, i.e., "buy-backs"; (ii) reorganizations, such as the
exchange by the issuer of one class of securities for another; and (iii) offerings of additional securities
solely to existing shareholders, i.e., "rights offerings."
Subsection (B) preserves state jurisdiction for breach of fiduciary duty claims arising from an
issuer's recommendation, position, or other communication concerning three other types of corporate
transactions: (i) mergers and other corporate transactions requiring shareholder approval; (ii) tender
offers; and (iii) situations where majority shareholders force minority shareholders to relinquish their
shares, i.e., "freeze-outs."
Both prongs extend to misstatements made by affiliates, so issuers cannot insulate themselves from
liability by directing misleading disclosure through its parent, subsidiary, controlling shareholder, or an
underwriter. Both provisions are limited to actions "based upon the statutory or common law of the State
in which the issuer is incorporated or organized."
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G) Sarbanes-Oxley (SOX) Provisions

1) Corporate Disclosure and CEO/CFO Certification
CEO and CFO to certify annual reports. Liability if information is not accurate. 302
Quarterly and annual reports must disclose all material off-balance-sheet transactions. 401
CEO and CFO need to certify that they have disclosed any fraud to outside auditors.
CEO and CFO can be personally liable if information is not incorrect. 906
2) Maintenance of Internal Controls for Monitoring. 404
Develop internal control system.
Annual report needs to contain internal control report
3) Creation of the Public Company Accounting Oversight Board
Public accounting companies must register and submit annual reports to this board
Must submit detailed application and agree to cooperate with board investigation
Lead audit partner must rotate every 5 years, 203
Large firms get audit by this board every year, 104
4) Audit Committees of Corporate Boards of Directors
Must be made up of independent directors §301(3) and they can’t accept any consulting, advisory or
any compensatory fees (can’t get paid a consulting fee; must be truly independent)
Don’t all have to be financial experts, but if they are, it has to be disclosed
Establish procedures for getting info from whistleblowers, internal reports, confidential submissions
Make it easy for employees to bring in information and blow whistle
5) Exec. Compensation, Loans & Disgorgement of Incentive-based
Compensation, 304
Strict liability clause: When a restatement occurs to show a lower amount and executive gets a
bonus, executive has to disgorge bonus; No more loans because they take $ directly off bottom line of
company
6) Professional Standards for Attorneys, §307
Attorneys must report evidence of material breaches of securities law “up the ladder” – to the board
if necessary
7) Whistleblower Provisions, 806
Makes it easier to blow whistle; 10 years in prison for harming a whistleblower. 1107
8) Barring people from serving as officers or directors of public
companies
If conduct is unfitting of a CEO (e.g., Martha Stewart)
9) Securities analysts
New Rules for Corporate Counsel and Accountants
Accountants have to refrain from practice of management consulting and auditing being dome at the
same firm – this has resulted in some firms splitting up
Separation of the consulting and audit functions prevents audit results compelled by financial factors
Attorneys now have “up the ladder” requirements.
10) Qualified Legal Compliance Committee (QLCC)
Outside committee set up to review compliance with SOX (this fulfills the ladder requirement)
Page 28 of 37
VI) Breach of Duty & Causes of Action

A) Attempts to bind the company or pierce the corporate fiction
1) By act without fraud
The act violated company or personal authority, but the company benefited from the act (estoppel)
2) By error without fraud – de facto incorporation
Corporate liability exists only if (1) the corporation was defectively incorporated under the statute,
(2) the act was a reasonable business act (“colorable compliance”), and (3) the creditor agreed to look
only to the corporation (estoppel). As directors of a corporation are responsible to ensure de jure
incorporation, they are liable if all three conditions of de facto incorporation are not met.
3) By fraud – the act was in bad faith, breach of duty of care,
loyalty, or fiduciary duty
Piercing the corporate veil - personal liability attaches for under-capitalization, misrepresentation,
where the actors took actions for personal gain, or without company formalities that did not benefit the
company.
4) Evidence of alter ego operations
The alter ego doctrine provides that when directors are operating, and using a business for their own
benefit, the corporate veil may be pierced on a showing by the plaintiff that the defendant used the
company as their own alter ego. Evidence of alter ego operations are shifting of funds unrelated to
business operations, commingling of funds, use of company assets for private use, failure to maintain
required business records, hold periodic meeting, or perform associated filings.
Besides the above parent corporations may fall into alter ego status by the involvement in the day-to-
day operations of the subsidiary, drawing checks from subsidiary’s accounts, having payments sent to
the parent, or both firms banking with same bank under the same account numbers.
5) Successor Liability
Successor companies are generally no liable for the acts of the predecessor company. Express
indications of the absence of liability are (1) a purchase agreement for the assets of the company, in
conjunction with (2) a Bulk Sales Transaction notice, which provides constructive and actual notice to
creditors, who must make any claims before the sale takes place. The effective act is due diligence by
the buyer.
Successor companies are liable for the acts of the predecessor company where (1) there was an
express or implied agreement to do so, (2) there was a consolidation or merger of the firms (buying lock,
stock & barrel), and (3) the successor entity is a mere continuation or reincarnation of the predecessor as
by a showing of fraud, bad faith, or lack of sufficient consideration.
B) Shareholder suits
1) Direct suits
a) Voting, dividends, fraud, inspection
Shareholders may file suit directly against the corporation, or the directors where the injury is
directly on a right of the shareholders. Such suits would be to (1) enforce shareholder voting rights; (2)
compel payments of dividends (Dodge v. Ford); (3) prevent oppression of or fraud on minority
shareholders (Davis); or (4) compel inspection of the corporation’s books or records (Saito).
b) Oppression
Oppression only occurs when an action defeats expectations that when objectively viewed were both
reasonable under the circumstances and were central to the petitioners decision to join the venture; or (2)
the conduct of the board or majority shareholder is burdensome, harsh, or wrongful. [MBCA §14.30(2)]
Page 29 of 37
c) Remedy for the shareholder

The remedy in direct suits is a court order for the requested action (injunctive relief), or monetary
damages as restitution to the shareholder for the harm they suffered.
2) Derivative Suits
a) Breach of care or loyalty
Shareholders may file derivation suits as the exclusive remedy where the alleged harm is done
primarily to the corporation, rather than to the individual shareholder. Such suits would include a cause
of action for breach of the duty of care, or breach of the duty of loyalty (i.e. self dealing).
b) Contemporaneous ownership & Demand by the shareholder
The plaintiff of a derivative suit must normally have contemporaneous ownership, that is, the
plaintiff must have owned his shares at the time of the transaction of which he complains. The two
exceptions are (1) the “continuing wrong exception” for when the wrong began before the plaintiff
owned the shares, but the wrong continued after the plaintiff bought the share; and (2) the operation of
law exception for when the plaintiff’ predecessor owned shares before the wrongdoing, and the plaintiff
acquired the shares through inheritance.
Prior to filing suit, the plaintiff must also make a demand on the directors to cure improper action.
The two exceptions here are for futility, as when the president is the alleged wrongdoer, and controls the
board of directors, or if all or a majority of board are the alleged with the breach of duty or loyalty in the
cause of action.
c) Board dismissal – reasonable good faith, & independence
As a derivative suit is filed on behalf of the corporation, the Board may move to dismiss or motion
for summary judgment. A court reviewing such motions shall evaluate whether Board made the motions
in reasonable good faith, with reasonable & independent business judgment. The Board should have the
burden of proof, not a presumption, to show the reasonable good faith & independence of the Board.
d) Remedy for the corporation
The remedy in direct suits is a court order for the requested action (injunctive relief), or monetary
damages as restitution to the corporation for the harm it suffered.
3) Liability by failure to stop a wrongful act.
Absent, non-voting or dissent voting directors are held to same standard as majority board members.
They are still held responsible for the result from the outcome of vote. If a director reasonably believes
that the board’s act are wrongful, as by when board doesn’t make an adequate investigation before
commitment of large sums of money, to avoid liability, the director MUST step down from the board,
and give notice as to their reason for stepping down.
VII) Defense, Indemnification & Insurance
A) Business Judgment Rule
“If the conditions for the business judgment rule are met, the court will find that the board satisfied
its duty of care even though the transaction turned out badly or seems to the court to have been
substantively unwise.”
1) Good faith required
a) Fulfill basic duties
To apply the Business Judgment Rule, the court must first determine that the director(s)/ officer/
partner fulfilled their duty of care, duty of loyalty, and fiduciary duty. As long as the actor’s belief is not
wholly irrationally that the action was in the corporation’s interest, these duties will be deemed satisfied,
even if a financial loss results.
Page 30 of 37
b) Evidence of good faith to duty of care, duty of loyalty, and fiduciary

duty.
Reasonable reliance on the opinion’s of others, such as the CPA or counsel, even if those opinions
were wrong.
c) Reasonable act to the purpose of the corporation
Corporations are risk-taking entities because risk is inherent to business. A decision is not wrong
because the act entailed risk (i.e., holding or speculating in foreign currency in an import/ export
business). An act may also have intangible results and still be acceptable, as by developing goodwill
through charitable donations.
2) Confluence of Articles of Incorporation and Bylaws (Ultra Vires)
a) Permitted Acts
Was the act expressly permitted by the Articles of Incorporation and Bylaws? If yes, there was not a
breach of duty. The doctrine of ultra vires is no longer accepted as limiting companies to acts within a
defined business purpose. Thus, the absence of an act as permissible in the Articles of Incorporation and
Bylaws is irrelevant.
b) Prohibited Acts
Was the act expressly prohibited by the Articles of Incorporation and Bylaws? If yes, look for intent
in good or bad faith by the actors as determinative of breach of duty.
3) Indefensible Acts
Gross negligence, unreasonableness, oppressiveness, statutory violations, deceit, misrepresentation
or a breach of contract.
These acts are not defensible under the business judgment rule because they violate one or more of
the basic duties that partners, directors, and officers, owe to the company.
4) Enron
Company hired attorneys to create “special purpose entities” (independent spin-offs) which ‘bought’
Enron’s debt and transferred their ‘assets’ to Enron. The SPE then ‘wrote-off’ the debt, leaving Enron to
appear financially better. Anderson Accounting allowed the SPE’s to continue in deference to Enron’s
millions in fees. The scheme collapsed when an SEC audit of one of the SPE’s showed insufficient
outside equity, and required Enron to consolidate (restate) the SPE’s debts into its books, and the true
picture emerged. The collapse of Enron led to investor and employees who had their entire retirement
wiped out. Congress passed the Sarbanes-Oxley bill with several provisions to prevent future, similar
problems.
B) Indemnification
1) Requirements of indemnification
Indemnification is the payment by a corporation of the fees and costs necessary to defend its
corporate agents. While indemnification is not statutorily required, few corporate directors and officers
are willing to put their personal assets at risk in defense of their corporate acts.
A corporation is required to indemnify its directors where corporate bylaws provide for director
indemnification without regard to the cause of action. (Public Service Company of New Mexico). A
company is not required to indemnify its directors against allegations relating to their work that prove
dereliction of duty. (Merritt-Chapman & Scott)
2) Eligibility for Indemnification, MBCA §8.51
Good faith on the part of the person seeking indemnity.
Reasonable belief on the part of the person seeking indemnity
That his conduct met the requisite standard or conduct, and was not unlawful.
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N.B. Indemnification is weighted in favor of granting indemnification, not denying it.

3) When indemnification occurs, MBCA §§8.52, 8.53
A corporation is required to indemnify for reasonable expenses a Director who was wholly
successful on the merits or otherwise in the defense of any proceeding against him for because he was a
director of the corporation.
A director may request advance funds for indemnification, in writing, of his good faith belief, that he
met the relevant standard of conduct, and of his repayment if either he is not entitled to mandatory
indemnification, or his conduct did not meet the relevant standard of conduct.
A director’s right to receive the costs of defense in advance does not depend on the merits of the
claims against them, and is separate and distinct from any right of indemnification they may be later able
to establish. A corporation may advance expenses on condition of repayment if ultimately the director or
officer was not entitled to indemnification by the corporation. Del. 8-1-§145. Indemnification is made
after disposition of the underlying claims.
C) Directors and Officers Insurance
1) Types of policies – “claims,” “occurrence,” & “tail”
A claims made policy provides coverage for claims first made against an insured during the policy
period. Thus, an insured is only protected for claims arising and asserted during the policy period. If the
insured retires, or changes employers, or insurers, the insured will not have coverage for earlier arising
claims.
An occurrence policy provides coverage for injuries that take place during the policy period
regardless of when the claim is asserted. Thus a later insurer is liable for events occurring before
coverage started.
‘Tail’ or “extended reporting” policies provide gap insurance for claims asserted after the initial
coverage period, but provide no coverage for claims from acts arising during the coverage period.
2) Cancellation, notice coverage, material misrep = void ab initio
A D&O insurer may cancel a policy, although an insured can cause coverage to extend beyond the
date of termination by providing notice to the insurer of a “specific wrongful acts,” The notice to the
insurer must state the particular subsidiary involved, the particular agents, officers, or directors involved,
the time period during which the events occurred, the identity of potential claimants, and the specific
unsound practices made the basis of the order. McCullough.
An insurer may rescind a policy as void ab initio for Material Misrepresentations where the director
or officer has knowledge of facts or circumstances that might subsequently give rise to a claim, and does
not disclose that information to the insurer. Alternatively, the insurer may simple exclude all coverage
for causes of actions arising from (or derived from) those facts or circumstances.
3) Exclusions
“Conduct” exclusions seek to eliminate coverage for certain conduct deemed as sufficiently self-
serving or egregious for which insurance protection is inappropriate. Examples are personal profit,
dishonesty, remuneration, and §16(b) violations (short-swing profit).
“Other insurance coverage” exclusions apply where the director’s and officer’s acts would be
covered by other types of insurance. Examples are bodily injury/ property damage, ERISA, libel and
slander, pollution, and prior policy notice.
“Laser” exclusions address specific risks unique to the insured corporation that the insurer identifies
as inconsistent with its underwriting principles.
Page 32 of 37
VIII) Takeover- Merger & Acquisition, Valuation, Appraisal

A) Williams Act
1) Requirements
The Williams Act requires (1) anyone who purchases more than 5% of the stock of a publicly held
company to disclose that fact promptly to the SEC; (2) complete disclosure of the offeror's background
and identity; the source and amount of the funds to be used in making the purchase; the purpose of the
purchase, including any plans to liquidate the company or make major changes in its corporate structure;
and the extent of the offeror's holdings in the target company; (3) cash tender offers remain open for 20
business days, (4) the tendering shareholder has the right to withdraw the offer, (5) all tendering
shareholders receive the highest price offered, and (6) if over-subscribed, all shareholders may have a
pro-rata purchase of their shares in proportion to the number of shares they offered.
2) State law controls and is not preempted
Generally, the law of the state of incorporation controls the internal affairs of a corporation. The
Williams Act does not preempt state securities laws.
B) Valuation - Efficient Capital Market Theory
1) Uncertainty
Valuation of stock in a buyout remedy situation is thorny. What if depressed due to conduct of
majority shareholder causing the dispute?
2) Fair Value, §13.01(4)
The value of the corporation’s shares determined (i) immediately before the effectuation of the
corporate action to which the shareholder objects; (ii) using customary and current valuation concepts
and techniques generally employed for similar businesses in the context of the transaction requiring
appraisal; and (iii) without discounting for lack of marketability or minority status except, if appropriate,
for amendments to the articles pursuant to §13.02(a)(5).
3) The Efficient Capital Market Theory
The concept here is that the stock market will flush out the true status of most companies, and that
status will then be reflected in the company’s stock price. This theory advances a defense to ‘fraud on
the market,’ where the defendant shows that the market did not rely on his fraud, or, his fraud did not
have an effect on the market. Either way, the defendant’s fraud did not case harm to the market, so the
plaintiff was not damaged by the defendant’s actions.
4) Right of appraisal limited to voting rights, MBCA §13.02
Right of appraisal only applies for (1) a fundamental change to shares and (2) when fair value of the
shares is so uncertain as to cause reasonable difference in fairness. Appraisal rights are available only if
the shareholder has voting rights on the transaction. So, if no voting rights - no appraisal rights.
Holders of shares exchanged on National Exchanges, or in companies with more than 2000
shareholders and a market value more $20 million only have appraisal rights if the transaction requires
the holder to accept something other than cash, or shares (i.e., debt equity.)
5) Market Exception to Appraisal Rights
§13.02(b) eliminates appraisal rights are required when a liquid and reliable exists for shareholders
to sell their shares. Liquidity exists when the class or series is either listed on the NYSE, AMEX, or
other inter-dealer national market security system. §13.02(a).
Page 33 of 37
C) Evaluation of Tender Offers

1) Three types of threats – Unitrin (share repurchase)
a) Opportunity loss
Where a hostile offer might deprive target shareholders of the opportunity to select a superior
alternative offered by target management or, we would add, offered by another bidder.
b) Structural coercion
The risk that disparate treatment of non-tendering shareholders might distort shareholders' tender
decisions.
c) Substantive coercion
The risk that shareholders will mistakenly accept an under priced offer because they disbelieve
management's representations of intrinsic value.
2) Seven reasons to avoid a tender offer/ public bid
(1) price too low; (2) poor fiscal reputation; (3) overwhelming debt obligations; (4) “just say no” is
best long-run interest; (5) long-range plans protected by business judgment rule; (6) violation of the
antitrust laws/ statute; or (7) coercing shareholders.
3) § 12.02 Shareholder 25% Safe Harbor Vote
A shareholder vote is required if the transaction would leave the corporation without a “significant
continuing business activity” which is at least 25% of the total assets and 25% of either income form
continuing operations before income taxes or revenues from continuing operations. The “all or
substantially all” test is still on the books in virtually all states.
D) Takeover Defenses - Poison Pills
1) Reasonable in Scope & Duration
Poison pills are resolutions adopted by companies to make hostile merger unpalatable for the
acquiring company. Poison pills rest on the power of the directors to issue securities for corporation,
which though designed to raise capital became the tool to block undesired acquisitions. Poison pill
provisions and by-law amendments must be reasonable in scope and duration, which is not the case
where one is redundant, or inconsistent to the other, and together compound reasonableness (3-months?)
into unreasonableness (9-months!) (Mentor).
2) ‘Flavors’ of poison pills
a) Shareholder based: flip-over, flip-in, back-end
“Flip-over” rights allow the holders to purchase shares in the acquiring company under certain
circumstances.
“Flip-in” rights allow the holders to purchase shares of the target company.
“Back-end” rights entitle the holders to acquire debt securities or other assets.
b) Director based: dead-hand, no-hand
“Dead hand” poison pills provide that the rights may be withdrawn only by the directors who
authorized the pill, or persons nominated by those persons (thus creating two classes of directors.). New
York invalidated the dead hand provision as an improper intrusion on director’s abilities to manage the
company, and director attempts to improperly control future boards. Georgia however, has codified and
upheld such a plan. The dead-hand provision is functionally indistinguishable from poison pill debt
security provisions.
“No hand,” a.k.a. “slow hand” poison pills provide that only “continuing directors” would be
empowered to redeem the rights to facilitate an acquisition by a hostile bidder. Mentor/Quickturn
essentially invalidates no-hand provisions in Delaware corporations.
Page 34 of 37
3) Other defenses to hostile takeover

a) Requiring majority shareholder approval
1) Supermajority shareholder approval.
2) Majority approval by disinterested shareholders.
3) Virtual unanimous shareholder approval (95%) unless the offer meets bylaw standards for price
and terms.
4) Anti-greenmail provisions prohibiting premium price stock acquisition without shareholder
majority approval.
5) Cumulative voting.
b) Not requiring majority shareholder approval
1) Staggered board of directors
2) Fair price equivalent consideration for all shareholder
3) State takeover legislation
4) Minority redemption at bylaw prices in the event of majority acquisition or increase
5) Preferred share approval of certain transactions (probably invalid on the exchanges now, see
former Rule 19c-4)
c) The All Holders Rule, 14d-10, all holders in class
Rule 14d-10 requires an offer be open to all security holders in the same class.
d) Ways around poison pills: friends, court, proxy contest
Friendly takeover, Court order to redeem the rights, or proxy contest.
4) Proportional to the threat (Unocal)
a) Selective Stock Repurchase (Unocal-Mesa exclusion)
A defensive measure must be reasonably related to the threat perceived within the ambit of the
business judgment rule. This entails an analysis by the directors of the nature of the takeover bid and its
effect on the corporate enterprise. Examples of such concerns may include: inadequacy of the price
offered, nature and timing of the offer, questions of illegality, the impact on "constituencies" other than
shareholders (i.e., creditors, customers, employees, and perhaps even the community generally), the risk
of nonconsummation, and the quality of securities being offered in the exchange. Unocal/ Mesa.
b) Lockups - Revlon
(i) Definition – compensate prospective acquirer, threaten costs
Lock- ups are promises by a target company's board of directors to compensate the prospective
acquirer if the target breaches or does not consummate the merger agreement. Lock-ups are designed to
protect the negotiated deal by (1) compensating the prospective acquirer and by (2) imposing the threat
of additional costs on other competitors who might decide to make offers.
(ii) Types – stock, assets, topping fee, reimburse, break $
The acquirer may ask the target's board of directors to grant a number of lock-up provisions
including: (1) an irrevocable stock option (grants the acquirer the right to purchase ten to twenty percent
of the target's stock at a favorable price), (2) an asset option (grants the acquirer the option to purchase a
particularly desirable asset of the target at a negotiated price), (3) a "topping" fee (the target must pay a
fee to the initial bidder if the target accepts another bidder's offer), (4) an expense reimbursement
provision (the target reimburses the initial prospective acquirer for any costs incurred during the initial
merger effort), and (5) a termination or "break-up" fee (the target pays the acquirer as much as three
percent of the value of the transaction).
Page 35 of 37
E) Evaluation of Board’s Response

1) Enhanced Judicial Scrutiny
Boards have the power and duty, on reasonable investigation, to protect shareholders from threats of
inadequate takeovers. The duty of the court is to first decide if the Board’s response was (1) proportional
to the threat (Unocal) and (2) not coercive or preclusive under the Business Judgment Rule.
2) Rational Business Purpose Defense
Where the transaction would cause a change of control, then the issue is whether the poison pill
provides value to shareholders. If not then the act is preclusive and should be enjoined. Where the
transaction would not cause a change of control then the issue is whether the poison pill provides a
balanced response to threat.
3) Plaintiff’s POE Burden – Unitrin
If the Board’s response meets these requirements, then the burden shifts to the plaintiff to show by a
preponderance of the evidence that the Board’s response was (1) for perpetuation of the Board, or (2) a
breach of fiduciary duty by fraud, overreaching, bad faith, or (3) a breach of the duty of care
(unreasonable investigation, or being uninformed.)
a) Share repurchase – perpetuation?
Because stock buyback programs (redemption and repurchase) decrease the number of available
shares, share prices usually rise, which would make tender offers more expensive, and possibly benefit
shareholders to get a better price. However, the higher price could also deter a tender offer, so the
purpose of the board’s buyback program is significant. If the board buys back stock (using corporate
money, of course) to protect the corporation from those who would hurt it, then the purpose is allowed.
If however, the purpose is entrench the board members (as for personal gain) then the buyback is not
allowable.
b) Preclusion of further bids - Unitrin
Preclusive is an act of the board that effectively precludes further bids from providing a higher value
to shareholders. If a defensive measure is preclusive or coercive, the proportionality test is not met.
c) Inevitable Sale or Breakup - Revlon.
Once a sale or breakup becomes inevitable, (as by an act of the board) the board must seek to obtain
the highest possible price for shareholders and may not consider the interests of other constituencies.
IX) Dissolution & Wind-up
A) Retirement, death, deadlock, oppression, fraud, waste
Dissolution may be invoked by or automatic dissolution on the death or retirement of a partner, or a
court may order dissolution to where deadlock prevents any operation of the company.
Director, or shareholder deadlock
Directors or controlling shareholders oppress or defraud a minority shareholder
Waste of the corporate assets
Partnerships in California must dissolve if 50% or more of the partners leave.
B) Problems & alternatives & to dissolution
Personal liability of partners continues until dissolution/wind-up.
What if the depressed share price is due to the majority shareholder’s conduct causing the deadlock?
There is difference between privity of K and privity and estate for subsequent partners.
Provisional director with limits others director regarding corporate governance (Abreu v. Unica).
Page 36 of 37
C) Procedure (UPA 29-40)

Follow court order, or the charter provisions for disassociation of partner who dies, or retires.
Notice to owners, creditors, lenders, registration bodies, etc.
Valuation (various methods) - Inventory value = FMV on date of dissolution
Pay taxes, creditors, pay loans, return capital [pay shareholders]
X) Interactivity Table
Party & Holdings Relation to Act Duty Private SEC – Not
(In what & How person of Company for private
much) interest company
President, Director/ Non-Disclosure, Sale, Duty of Care, Duty
Partner, or Officer or Purchase, Poison of Loyalty,
Pill, Fraud Fiduciary Duty,
Statutory
Acct/ Counsel Disclosure, Sale, or Sarbanes-Oxley
Purchase, Fraud
Manager, Disclosure, Sale, or Fiduciary Duty
Employee, Spouse Purchase Statutory
Shareholder Sale or Purchase Statutory
Public Sale or Purchase Statutory NA (Locked Only on sale
out) or purchase
Tippee Disclosure Statutory
Tipper Profited Statutory
Page 37 of 37

Corporations Outline

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Corporations Outline

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Jerry Prettyman Corporations Outline 10/23/2010

I) Choice of Business Association.........................................................................................................7

1) Corporate Disclosure and CEO/CFO Certification.................................................................28

VIII) Takeover- Merger & Acquisition, Valuation, Appraisal............................................................33

I) Choice of Business Association

4) S-Corporation – single class, <75, check the box

c) Things - Adoption of corporate seal, minute book & financial

Equity = Difference (may be <0)

5) Resale of securities, Rule 144

B) Duties of Directors & Officers

Bylaws determine adoption percentage (67, 50.1, or highest vote count)

2) Proxy service – see VIII B. Statutory §14(a)

d) Remedy for Breach of Duty of Care

b) Breach of fiduciary duty – improper bind, freeze-out

b) Defense to the Corporate Opportunity Doctrine

4) Remedies - Civil penalties for insider trading

G) Sarbanes-Oxley (SOX) Provisions

VI) Breach of Duty & Causes of Action

c) Remedy for the shareholder

b) Evidence of good faith to duty of care, duty of loyalty, and fiduciary

N.B. Indemnification is weighted in favor of granting indemnification, not denying it.

VIII) Takeover- Merger & Acquisition, Valuation, Appraisal

C) Evaluation of Tender Offers

3) Other defenses to hostile takeover

E) Evaluation of Board’s Response

C) Procedure (UPA 29-40)

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