Business Associations Charts

Professor Joo
Spring 2004

Partnership Form vs. Corporate Form.......................................................................................2

Formation....................................................................................................................................2
Overview of Shareholder Powers................................................................................................3
SEC Rule 14a-8...........................................................................................................................3
Voting and Appraisal in Mergers – Delaware Approach...........................................................4
Shareholders’..............................................................................................................................4
Exceptions to ..............................................................................................................................4
Conflict of Interest and Self-Dealing Compared.........................................................................5
Directors’ Fiduciary Duty and the Business Judgment Rule: Review & Summary Under
Delaware Law.............................................................................................................................6
BREACHES OF FIDUCIARY DUTY..........................................................................................6
Demand Requirement Flowchart – Delaware.............................................................................7
Rule 10b-5 and Insider Trading..................................................................................................8
Overview: 10b-5 Private Cause of Action..................................................................................9
Rule 14a-3.................................................................................................................................10
Overview of Limited Liability Companies (LLCs).....................................................................10
Protecting Minority Owner from Majority Oppression............................................................11
“Piercing the Corporate Veil”..................................................................................................11
 Partnership Form vs. Corporate Form
Partnership
Formation • Informal
• Unlimited personal liability
• Traditional: Unlimited liability
for each partner; personal assets
Liability at risk
• Partnership can buy insurance
to insure partner against
personal losses
• Ownership is not transferable.
A partner could contract around
Transferability of
this, but that makes little sense
Ownership Interest
• In partnerships, the partners can
withdraw at will
• Partnership is done when the
partners say it is done
Continuity
• Today, a partnership can
continue beyond the partners
• No, unless agreed otherwise
(each partner has equal power
Centralized with all the other partners)
Management • Can agree to have an executive
committee or a managing
partner
Default Rules • Many
2
Corporation
• Formal; file with the secretary
of state
• Articles of Incorporation,
charter, bylaws
• Limited
• Shareholders get limited
liability because they have less
control
• All you lose is the extent of
your investment in the
corporation (shares may
become worthless)
• In certain situations, piercing
the corporate veil is permitted
• Ownership is transferable and
easier because you can sell
your shares and there is an
easily identifiable market for
them
• Indefinite; perpetual existence
unless limited in the charter
(default rule is forever)
• Yes – CEO, CFO, Secretary,
Board of Directors
• Definite managerial hierarchy
• Many; default rules are
changed through the charter or
bylaws
 Overview of Shareholder Powers
(Keep in mind the general presumption that state corporation law sees shareholders having
limited control in the company)
• Electing / Removing Directors

• Approving Amendments to the Articles

• Approve Fundamental Changes

o Amendment of Articles of Incorporation
o Dissolution
o Sale of All or Substantially All Assets
o Merger/Consolidation

• Make Nonbinding Suggestions

SEC Rule 14a-8

Management can exclude a shareholder proposal from the corporation’s proxy if the proposal:

• Is beyond shareholder power under state law (14a-8(i)(1))

• Would cause the corporation to violate the law (2)

• Relates to operations that account for less than 5% of total assets or net earnings and
gross sales, and is “not otherwise significantly related to business” (5)
o Lovenheim: ¶ is small shareholder who wants to offer non-binding resolution for
the corporation to stop engaging in practices that force feed geese (affects about
5% of business). Held: although it accounts for less than 5% of total assets, in
light of ethical/social concerns, ¶’s proposal may be “significantly related to
business”

• Would be beyond management’s power (6)

• Relates to “ordinary business” (7)

o Cracker Barrel: Practice of refusing to hire gay workers is related to ordinary
business, so a shareholder proposal to stop the practice is permitted.

• Relates t the election of Directors (8)

o Not okay if it would tend to create contested elections

• Directly conflicts with a management proposal already on the ballot (9)

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 Voting and Appraisal in Mergers – Delaware Approach

Shareholders of acquiror and target get to vote on statutory merger or

consolidation, because this is a fundamental change.
• Substantial power because it is a check on management and such
Shareholders’ action can slow down the process of the merger
Voting Right
HOWEVER, there is NO VOTE on other forms of corporate combination
• This is an incentive for management to change form in another
way

Shareholders (of Acquiror or Target) who vote against merger that is

approved can demand that the corporation repurchase their shares at “fair
value”
• Shareholders get fair value as determined by the court (even if
less than the original merger price!)
Dissenting Shareholders’
Appraisal Right • Shareholders get NOTHING until the end of the proceeding, and
may be assessed court costs if the fair value is less than the
original merger price

BUT note the “Market exception” (see below) – the right to dissent does
not exist if there is a liquid market for the shares in question

Acquiror Shareholder: NO Appraisal Rights if:

• Dilution is minimal (less than or equal to 20%)
• Acquiror shares were publicly traded at the time of the merger

Exceptions to Target Shareholder: NO Appraisal Rights if:

Appraisal Right • Target stock was publicly traded at the time of the merger AND
consideration for the shares is either stock in the survivor or any
publicly traded stock
• Note that shareholders DO get appraisal if the consideration is in
cash

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 Conflict of Interest and Self-Dealing Compared

Conflict of Interest Self-Dealing

“Controlling shareholder”
influences directors to act for the
corporation and stands to gain
personally AND excludes other
minority shareholders from gain
Director Acts for the corporation
Description
and stands to gain personally
The controlling shareholder pick
up some of the Directors’ duty of
loyalty when the controlling
shareholder tells the Directors
what actions to take!

Burden of establishing the

fairness of the transaction is
usually placed on the interested
Controlling shareholder must
Burden of Proof director
prove the transaction’s fairness
However, a conflict alone does
not void a transaction if:

Sale of corporate property by/to

Example the director or the director’s
spouse

Sinclair: Sinclair did NOT

commit self-dealing by causing
Sinven to pay dividends. Why
not? Minority shareholders got
dividends too? Everbody
Cases Globe Woolen; Shapiro benefited!

With respect to the contract

between Sinven and Sinclair’s
subsidiary, the court finds self-
dealing. Why?

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 Directors’ Fiduciary Duty and the Business Judgment Rule: Review & Summary Under Delaware Law
When shareholders sue directors based on a business decision, it is insufficient to merely allege that the business decision turned out to be unsuccessful.
According to the Business Judgment Rule, the court will NOT second-guess the substance of the Director’s business decisions. Rather, plaintiffs must plead (and
ultimately prove) that the directors breached their fiduciary duty (either duty of loyalty OR duty of care). Remember that the Business Judgment Rule further
presumes that the directors were loyal & careful, so ¶s must plead (and ultimately prove) facts were sufficient to rebut one of these presumptions. Thus a
complaint must allege conflict, waste, or a breach of procedural due care.

BREACHES OF FIDUCIARY DUTY

Breaches of Duty of Loyalty (BJR doesn’t apply) * Breaches of Duty of Care+
Usurpation of Corporate Opportunity Lack of Procedural Care
Unless disclosed to and passed up by board, director Extreme failure to take steps to become informed
may not take a “corporate opportunity” before action (e.g., Smith v. Van Gorkom)

Corporate Opportunity is Defined by a Balancing Test: Failure to act/make a decision (failed to use your
Lack of good faith
1. Corporation has financial ability business judgment)
2. Within the corporate line of business
3. Corporation has interest or expectancy Unlike some states, Delaware DOES NOT recognize a
4. Will put director in conflict with duty to duty of “substantive due care”
corporation (e.g., Broz v. Cellular)
Lack of Candor
Conflict of Interest Failure to Monitor
Waste
Conflict alone is NOT a breach if cleansed by Directors ultimately monitor officers and employees on
Corporate assets given for
disclosure and approval/ratification by directors or behalf of the shareholders.
consideration so low no
shareholders (Del. § 144(1), (2))
reasonable person would have
Because directors must delegate, the duty, especially in
agreed.
Conflicting transaction without cleansing is subject to a larger corporations is to establish monitoring
fairness review (Del. § 144(3)) procedures, not spy on employees (e.g., Caremark)
Waste is far worse than
unfairness
(cf. Globe Woolen; Shapiro v. Greenfield)

*These duties are sometimes characterized as involving both care and loyalty, and sometimes as independent categories
+
In Delaware, corporate certificate can exculpate directors from personal liability for some breaches of care.
Note: Waste is in the middle because in some sense, it is a kind of proxy. The directors were either careless or disloyal, but we do not have the
facts to prove it either way.

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 Demand Requirement Flowchart – Delaware

Situation: Shareholder wants to sue Directors for violation of Fiduciary Duty

1. Did shareholder demand that Board bring corporate suit against Director(s)?

Yes – NEVER HAPPENS

In this scenario, it is unlikely that the Board will bring suit. The
Board will likely DENY the request, and if the shareholder sues No – ALWAYS HAPPENS
the Director(s) anyway, the Board will move to dismiss, and the Board moves to dismiss. Go to #2 below
standard will be BJR review (i.e., suit will probably be dismissed
because you’re basically admitting the board IS impartial)
2. Was the shareholder’s demand futile?
(Apply the Aronson test: was there reasonable doubt regarding (a) the Board’s disinterestedness, or (b) BJR?)

No Yes
Demand is not excused. Suit is dismissed (Aronson). Demand is excused. Suit can proceed.

3. Does the Board allow the suit to proceed?

No
Yes
Board appoints a Special Litigation Committee (SLC); SLC
End of analysis
recommends dismissal

4. Does shareholder oppose dismissal?

Yes
No Court applies the Zapata test to the SLC:
End of analysis 1. Was the Special Litigation Committee independent?
2. Court applies its own business judgment

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 Rule 10b-5 and Insider Trading

We want people to think that the market is fair; the goal is to

build trust in our markets
Primary Arguments for
Punishing Insider Trading
• We don’t want investors to pay too much

• By punishing insiders, we deter the behavior

“It shall be unlawful to employ any device, scheme, artifice to

defraud; make any misstatement or material fact, or omit to engage in
Rule 10b-5
any act…that would operate as fraud in connection with the purchase
or sale of any security.”

“Insider” is a term of uncertain scope that refers to persons having a

relationship with a corporation, its directors, officers, or senior
Who Is An “Insider”? employees. We DO know that officers, directors or employees w/ FD
directly to company involved in transaction with a potential for profit
ARE “insiders”.

• Chiarella: “Duty to disclose under 10(b) does NOT arise

from the mere possession of nonpublic market
information. The duty to dsclose must have some separate
basis (e.g., fiduciary duty to the other party; duty to correct
previous statements that are now misleading)

• “Tippees”: It’s not what you know, but how you came to
know it. A tippee “inherits” fiduciary duty to the corporation
Who Has a Duty to Disclose or
(and thus the duty to disclose) IF:
Abstain Under 10b-5?
o Tipper is a corporate insider who violated fiduciary
duty by giving corporate information to tippee
 Violation of fiduciary duty = Benefit to
insider
 Benefit to insider includes tipping as “gift” to
friend or relative
o Tippee knew or should have known that tipper was
violating fiduciary duty

Between the extremes of skillfully or innocently acquired nonpublic

information on the one hand, and inside information on the other, is
information that a noninsider wrongfully acquires, i.e.,
Misappropriation
“misappropriates”. The misappropriation theory is most useful where
and
▲ had no independent fiduciary duty to the party with whom he
Rule 10b-5
traded. However, whether a person who trades on the basis of such
information is liable under rule 10b-5, and if so, the extent of liability,
are questions that are not completely settled.

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 Overview: 10b-5 Private Cause of Action

Threshold Issue:

• Standing
o Must be a purchaser or seller (Blue Chip)

Elements of the Cause of Action

• Material misrepresentation or omission

o Materiality: Substantial likelihood that a reasonable shareholder would consider
it important
o For materiality of statements/omissions regarding a contingent event (e.g., a
potential merger), the court must make a fact-specific inquiry considering:
 Likelihood the event will occur; AND
 Magnitude of the event

• Scienter
o PSRLA re Scienter: The 10b-5 complaint must “state with particularity facts
giving rise to a strong inference that the Defendant acted with the required state of
mind.
o Courts are split regarding 10b-5’s scienter requirement:
 Deliberate (“intentional”) – cause of action
 Reckless – possibly grounds for a cause of action (Novak)
 [Negligent] – probably not grounds for a cause of action (Hochfelder)
o The Second Circuit’s standard for scienter is as follows:
 Facts showing motive and opportunity to defraud OR
 Circumstantial evidence raising a “strong inference” of “conscious
misbehavior or recklessness”

• Reliance/Causation
o If you would have bought it anyway, you’re not entitled to relief
o “Fraud on the Market” Theory: Where securities are sold in a well-developed
market (rather than in a face-to-face transaction), a ¶ may be able to prove
reliance on a misrepresentation by alleging she relied on the integrity of the
market. You can rebut this presumption by showing:
 That the Market Makers hear the lies and don’t fall for them
 Information does not actually cause the price to change
 All the information the ¶s claim they were deprived of actually did enter
the market

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 Rule 14a-3

This rule requires disclosure of information pertaining to a tender offer. If you have information
about a tender offer, you have a duty to disclose it, or not to trade. It does not matter how you
obtained such information. This rule is broader because the SEC has broad authority to define
what is “fraudulent” under the statute.

Overview of Limited Liability Companies (LLCs)

A new solution for close/small companies
• Limited Liability

• Flexible Governance
o Member managed or manager-managed
o Few mandatory terms

• Substantial Tax Benefits

o Escape “double taxation” of corporations

LLC Governance Terms

• Statute
o Mostly “enabling”
• Contract
o Contract provides most of the terms (Elf Atochem)
• Fiduciary Duty
o How much? (at the very least, members of an LLC owe Fiduciary Duty to give
notice – see VGS case)
• Exit & Liquidity
o Fiduciary duty owed to LLC, not to the other members of the LLC (McGee)

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 Protecting Minority Owner from Majority Oppression

• Partnership: At-will withdrawal + dissolution (so majority must buy out the departing
Partner)

• Public Corporation: At-will withdrawal through sale on liquid market

How to protect the minority in closely held corporations,

where there is no dissolution right and no liquid market?

• Shareholders may contract ex ante (based on assumption & prediction) to sterilize

Directors if certificate states corporation is a “Close Corp” (DE, CA)

H&D Proposal “Modern” Approach

• Minority can demand buyout by • Minority has broader rights to ask court
majority for dissolution
• If majority does not buy out, minority • If court orders dissolution, majority can
can dissolve avoid by buying out minority

“Piercing the Corporate Veil”

Alter Ego/Instrumentality Test:

1. Did shareholder have complete domination and control AND

2. Did shareholder use control of the corporate form in an unjust, fraudulent or wrongful way,
AND

3. Did shareholder’s conduct cause actual harm to the plaintiff?

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