BUSINESS ORGANIZATIONS FALL 2007 – PROFESSOR HARPER

Basic Business Forms

I. Introduction to Business Forms
a. Unincorporated Business Forms (not nec creatures of statute) and Corporations
(always creatures of statute)
i. Business is a profit-making activity in which people come together in a legal
relationship. The nature of the relationship will determine the form of the
business entity.
b. Agency
1. This is a fiduciary relationship in which one person manifests
authority to a third person to act on behalf of the principal person.
2. Types of agency authority:
a. Actual authority – the power of an agent to affect the legal
relations of the principal by acts done in accordance with the
principal’s manifestations or directions.
i. Scope: agent has authority to take action designated or
implied, which are necessary or incidental to achieving
the principal’s objects
b. Apparent authority – not actual authority. It is created by
conduct of the principal that creates the impression in the
mind of the third party that a person is authorized to act on
behalf of the principal when in fact that person does not have
authority.
II. Proprietorship
a. Ownership – ownership by a single individual
b. Liability – owner is singularly liable for all obligations
c. Management – owner has the sole right to manage
d. Profits – owners is solely entitled to the profits
e. Tax – not a separate entity; an extension of proprietor that is transferred directly to
his federal income tax return.
f. Not viewed as a separate legal entity, but rather is an extension of the proprietor
himself.
III. The General Partnership (GP) – Default**
a. Creation/Formation – formed by an oral or written agreement between two or more
parties; or if the parties engage in a business agreement for profit, they become
partners. It is not necessary for the parties to intend to form a partnership in order for
a partnership to be formed.
i. See UPA 202(a): two or more people form a GP, regardless of whether they
intended to or not.
ii. Changes in form:
1. When a new partner enters the partnership, it dilutes the partnership.
2. When a partner leaves the partnership, it concentrates the partnership.
iii. Partnership Agreement: The partnership agreement is the “law” of the
partnership and is binding on all partners. However, it is not binding on
persons who are not partners: Third parties may recover on partnership
obligations from any partner without regard to the arrangements set forth in
the partnership agreement.

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 1. The PA is the law of partnership only for that particular partnership.
The one agreement does not apply to other partnerships between the
parties.
iv. Creation by “estoppel” – two people can be found to be in a partnership with
each other if they represent to the outside world that they are in a partnership
together.
b. Responsibilities/Liabilities
i. Joint and Several Liability (UPA 306)– all parties share in the partnership
losses and are personally responsible for all partnership obligations.
1. A partner is entitled to indemnification from the partnership – any
partner can be subject to suit, but that partner can go after the other
partner to recover for losses.
a. Exceptions to J/S Liability:
i. A partner is not liable for obligations incurred before
the person’s admission as partner
2. The partnership is primarily liable, and the partners are jointly and
severally liable secondarily.
ii. Losses (UPA 401) - Shared according to the agreement, or in the absence of
the agreement, in proportion to their profit sharing ratios (ownership interest).
1. Richert v. Handly – all losses will be shared equally in accordance
with statute unless a written agreement provides otherwise
c. Rights of Partners
i. Profits – parties share the right to profits; profit participations may be
allocated by agreement. In the absence of an agreement, profits are shared
equally.
1. Example: A and B form a partnership. The partnership purchases
computer equipment. A and B have no rights to the equipment, but
they do have a financial interest in the partnership. A and B do not
directly own the assets, but they do have capital accounts that reflect
the profits acquired by the partnership. The profits acquired by the
partnership are distributed out as property to the partners by way of
tax. Each partner’s capital account will be credited proportionally and
each partner will pay taxes at an individual level based on receipt of
those funds.
a. Partnership does have to distribute all of its income, but the
partners should not have to suffer.
ii. Management:
1. Default Rule: In the absence of a specific agreement, all partners shall
equally in management decisions (See UPA 1914 18e)
a. Nabisco v. Stroud – Actual Authority to Restrict
i. FACTS: Stroud tells Nabisco not to authorize the sale
unless he approves it. Freeman places an order in the
normal course of business – this order is binding on the
partnership because Stroud cannot restrict Freeman
like that.
ii. RULE: Each partner has the authority to make
decisions in the ordinary course of business. One
partner cannot restrict the other partner’s ability to

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 make decisions unless such a restriction is actually
spelled out in a written agreement.
iii. Absent a written agreement, all partners have equal
rights regardless of their percentage of ownership or
capital contribution.
iv. Remember: A partner can bind the partnership by
acting within the normal course of business, put cannot
bind the partnership if doing so places a restriction on
the other partner that prevents him from acting within
the normal course of business.
b. Smith v. Dixon – Apparent Authority
i. RULE: When a partner acts within the scope of his
apparent authority, that action will bind the
partnership.
1. Burden is on the party asserting the apparent
authority.
c. Rouse v. Pollard – Scope of Business
i. FACTS: Lawyer acts outside the scope of being an
attorney – is the firm bound by his actions?
ii. RULE: Partners’ actions can bind a partnership as long
as the partners conduct is within the scope of the
partnership’s business. Inadvertent activity (not related
to the scope of the business activity) falls outside of
that scope.
d. Roach v. Mead – Scope of Business and Third Parties
i. RULE: In determining the scope of business under
Rouse, the court will determine whether, from the
perspective of the third party, the action taken by the
partner was within the scope of the partnership
business.
ii. All that matters is the apparent authority – not actual.
d. Duties of Partners
i. Meinhard v. Salmon –
1. FACTS: Facts entered joint venture and took out a lease. When the
lease was nearing its end, D renewed the lease independently, failing
to inform P. P wanted the lease held in trust as an asset of the venture.
2. RULE: Joint adventurers owe to one another the duty of the finest
loyalty. As between partners, there is a fiduciary duty not to usurp
partnership opportunity to the detriment of the other party. This is true
even if the parties agree to the contrary – you cannot contract for
something that is against public policy.
ii. UPA 404 sets forth 2 duties of partners:
1. Loyalty – cannot usurp partnership opportunity for yourself
2. Care
e. Financial Accounting:
1. Capital Accounts: maintained for each partner, it consists of the
original contribution of the partner to the partnership, increased by
earnings and profits credited to the account (split equally unless

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 specified otherwise by written agreement), and reduced by losses and
distributions to the partner. The capital account shows the “stake” of
the partner in the business.
a. When a partner withdraws from a partnership, he is typically
entitled to the funds in his capital account. If the capital
account is negative, the partner may be entitled to make a
contribution to eliminate the negative amount.
b. If the entire partnership is being wound up and terminated, all
capital accounts are reduced to zero by distribution or
contribution.
A partner is not entitled to remuneration for services
performed for the partnership, except for reasonable
compensation for services rendered in the winding up of the
partnership. Partners do not get paid – they share in the profits
and losses of the partnership.
2. Assignation of Interest: a partner may assign his financial interest in
the GP, but the assignee does not automatically become a partner. The
assignee is entitled to whatever distributions the assigning partner was
entitled to. The assignee is not personally liable on partnership
obligations and is not required to make a contribution to the
partnership on dissolution – the assigning partner is still responsible
for this stuff.
3. Creditors: may proceed directly against the partnership. Partners are
jointly and severally liable.
4. Financial Statements:
a. Income statement
i. Reflects the revenues minus the expenses
ii. Income = Revenue - Expenses
iii. Shows a snapshot at a particular moment in time
b. Balance sheet
i. Shows the equity of the partnership
ii. Assets = Liability + Equity
iii. This presents the whole picture
iv. T balance sheet with Assets on the left and Liabilities
and Equity on the right – must be equal on each side
c. Capital accounts
i. Reflects investment
5. Taxes – any/all partnerships get pass thru tax treatment
f. Dissolution
i. Dissolution is a change in the legal relationship caused by any partner
ceasing to be associated in the carrying on of the business. It does not
necessarily mean a winding up of the affairs of the business, but rather a
change in the relationship of the partnership. The old relationship dissolves
and a new relationship among the remaining partners continues.
ii. GP is dissolved automatically when a partner dies or leaves the partnership,
or when the partner expressly states that he no longer wishes to be partner.
1. Exception: Collins v. Lewis (cafeteria case) prohibits a bad actor from
procuring dissolution. Bad actor cannot just walk away. His only

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 remedy if he wants out is to sell his interest to someone else who then
becomes partner. Equity prohibits a partner from dissolving in bad
faith.
iii. Dissolution and Law Firm Partnerships:
1. Bane v. Ferguson
a. RULE: Partners do not owe a fiduciary duty to partners who
have withdrawn from the partnership because by virtue of that
withdrawal, the partnership has been dissolved.
2. Lampert, Hausler & Rodman v. Gallant
a. FACTS: D left law firm, dissolving the partnership. He
remained shareholder, but then opened his own firm in the
same town as the partnership. P wants court to enforce D’s
fiduciary duty with regard to improper solicitation of clients.
b. RULE: Ethical duties will trump fiduciary duties. There is a
strong public interest is allowing clients to retain counsel of
their choice – ethical duties are there to protect clients, not
lawyers.
i. However, the agreement between D and P will be
enforced generally – so the fiduciary duties between
and among the shareholders (incl D) will be enforced
generally, with the exception that the court will deny
enforcement such that it would prohibit D from
practicing law.
3. Expulsion – partners have the power to expel another partner only
when that power is specifically provided for in the partnership
agreement. There is also an inherent power to expel a partner by the
unanimous vote of the remaining partners in limited circumstances.
a. Bohatch v. Butler & Binion
i. FACTS: Bohatch suspected overbilling; she
approached other partners. They froze her out.
ii. RULE: There is no fiduciary duty on the part of the
partners to keep them from expelling another partner.
A partnership is a business choice and they can choose
who to work with, including being able to force a
whistle blower out. Consider the erosion of trust here
and the effect that that has on the partnership
relationship.
iv. The Value at Dissolution
1. Cauble v. Handler says that when dissolving a partnership, look at
the fair market value of the partnership (not the book value)
v. Dissolution and a Written Agreement
1. Adams v. Jarvis – an agreement between partners not to dissolve
upon withdrawal of a partner is enforceable as long as it is not
contrary to public policy. However, the remaining partners do have a
good faith fiduciary duty to collect whatever it is that the withdrawing
partner gets upon withdrawal.
vi. Dissolution and Liability
1. 8182 Maryland Associates v. Sheehan

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 a. FACTS: Partner signed a lease and then withdrew. When he
signed the lease, he became jointly and severally liable for all
obligations resulting from the lease regardless of whether he
was still a partner.
b. RULE: Withdrawal of an existing partner constitutes
dissolution, but not termination. A partner’s personal liability
for all acts prior to the withdrawal is not discharged merely by
the dissolution of the partnership. The partnership will
continue its business operations so long as the withdrawing
partner does not insist on the winding up of the business
affairs.
i. See UPA 36 – dissolution does not discharge the
existing liability of a partner.
c. What about subsequent partners who join after the partnership
has entered into the lease?
i. RULE: Partner becomes liable as a subsequent partner
if you are involved in the partnership at the time of the
occupancy of the premises for which the lease was
made. When Partner withdraws, the privity with
landlord ceases to exist and Partner is now longer
liable. New partners’ liability is limited to the period of
occupancy.
d. Remember that any change in membership by death or
withdrawal constitutes a dissolution of the partnership
automatically and similarly and the automatic creation of a
new partnership unless the withdrawing partner demands the
winding up affairs and final termination of the partnership.
g. Termination
i. Winding up is the process that occurs after dissolution of collecting claims,
satisfying liabilities, and reducing assets in cash in order to permit a final
distribution and settlement of the partnership accounts. Upon final settlement
and the distribution of remaining assets to the partners, the partnership
terminates and ceases to exist.
h. The Inadvertent Partnership
i. An inadvertent partnership occurs when two or more people join together and
carry on as co-owners of a business for a partnership even if it was not their
intent to do so.
ii. Section 7 (1914) – the receipt of a share of profits of a business is prima facie
evidence that he is partner.
iii. Martin v. Peyton
1. FACTS: Friend loans his friend money. They draft an agreement
saying that they are not partners – that friend is a creditor.
2. RULE: The court may look beyond the written agreement to
determine if there is a partnership based on conduct. The court must
look at the K, as well as the associations between the parties to
determine if they “carried on as co-owners a business for profit”.
iv. Smith v. Kelley

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 1. FACTS: An employee was held out as a partner, though no written
agreement as such. He did not control, manage, hire/fire.
2. RULE 1: Two persons who operate as co-owners of a business for
profit will be deemed partners whether they intent it or not (See UPA
202a).
a. Must look for evidence of co-ownership – did the parties
intend to share profits??
3. RULE 2: If you are seeking to be considered partner for your own
personal gain, the courts are likely to reject your claim.
IV. The Limited Partnership
a. This is a partnership in which there are one or more general partners and one or more
limited partners.
i. GPs – viewed as having the rights and duties of partners in a partnership
without limited partners (i.e. GP is unlimitedly liable for debts of the
partnership and is has general powers of management).
ii. LPs – have no personal liability for the debts of the business (except to the
extent of their capital contributions) and have only limited rights to
participate in management. If they exceed these limited rights, they become
GPs and become personally liable for partnership liabilities.
b. LP is a creature of statute – it is formed by filing a document or certificate with the
Secretary of State or with a specified government official. A failure to fail or filing in
the wrong office results in the creation of a general partnership (default).
c. How does an LP differ from a GP?
i. Presence of limited partners – very little power to participate in the
management of the firm. A limited partner who participates in
management/control of the business loses his limited liability shield.
d. Defining Factors of Limited Partnerships
i. Taxation
1. Pass thru tax treatment (like GP)
2. Offer the benefit of pass thru taxation – this is one level of taxation
(as opposed to two levels at the corporate level).
3. Bottom Line: the IRS starting taxing corporations doubly (at both the
individual and the corporate level). Corporations did not like this, but
they did not want to become general partnerships because investors
did not want to open themselves up to unlimited liability. The LP
allowed a limited partner is invest money without incurring unlimited
liability and without being taxed doubly.
ii. Liability
1. Like corporations, LPs offer partners the option of limiting their
liability.
a. Example: LP invests $10,000 in capital. If the company goes
broke, LP owes nothing, but does not get back his $10,000.
The risk is limited to the investment. Limited partner is never
liable to a creditor or third party.
2. In a limited partnership, the GPs are personally liable but the limited
partners are liable only up to the amount of their capital
contribution. In order to get the benefit of limited liability, the limited

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 partner must be truly passive – once a limited partner becomes
active, he automatically becomes a general partner.
V. The Limited Partnership with Corporate General Partner
a. Typical Structure:
i. The corporation serves as the GP. The corporation assumes
management/control rights and full liability.
ii. LPs have zero control, but their liability is limited to their investment (then
would be the Board if Directors controlling the partnership).
iii. Corporation is taxed, as are LPs (but LPs only taxed once).
b. USA Cafes Litigation
i. FACTS: LPs brought action against corporate GP and operators of corporate
GP after they sold the company to another company for cheap.
ii. RULE: Directors of a corporate GP owe an underlying fiduciary duty to the
partnership. That duty entails the requirement that you not use your control
over the property of the partnership to your own advantage.
1. While the duty of a director of a partnership may not be at the same
level as the duty of the director of a corporate trustee, the duty that the
director does have is not to use control over the partnership’s property
to advantage the corporate director at the expense of the partnership.
c. In re Spree.com
i. FACTS: D was organizer of the corporate GP. He made a statement that GP’s
“cash runs out soon”. LPs sued.
ii. RULE: While the operator of the corp GP does owe a duty to LPs, his hands
are not so tied that he cannot speak about the state of affairs of the GP –
especially those affairs that have already been disclosed.
VI. Limited Liability Company
a. Created by filing a document with the Secretary of State or other state officer.
b. Combines the corporate benefit of limited liability for all participants with complete
flexibility in internal structure and management.
c. Liability – liability limited to the investment, but members may freely participate in
management of the business without becoming liable. This protection is provided by
a provision in the LLC statute that states that members are not personally liable for
the organization’s debts.
d. This is the most flexible business form – it gives the protection of limited liability
with the benefits of a corporation.
e. Major Characteristics of an LLC
i. Limited Liability
1. Liability limited to the extent of the investment for every member
regardless of how involved that member is in the daily operations of
the business
ii. Pass thru Taxation
1. Like partnerships
2. Check the box – benefit of pass thru taxation if you elect to be taxed
as a partnership.
iii. Chameleon Management/Flexibility
1. Members can exercise control – can choose between centralized or
direct member management.

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 2. Law of the operating agreement is determined by the Operating
Agreement – very similar to a Partnership Agreement
3. Members may provide that action may be taken without a formal
meeting by a vote of a majority of “managers”
iv. Creditor Protection Provisions
f. LLCs may not go public. Any pass-thru entity may not go public unless it wants to
lose its tax advantages.
g. Freedom to contract
i. Elf Atochem North America v. Jaffari & Malek
1. FACTS: P and D entered into an agreement to form Malek LLC. The
agreement called for arbitration and CA venue. The LLC did not sign,
though both parties did. D wanted to get out the terms.
2. RULE: The operating agreement is the law of the LLC. If a provision
is in the agreement, courts will enforce it, no matter how oppressive.
a. LLC is largely driven by contract.
ii. Poore v. Fox Hollow
1. FACTS: Non-lawyer filed a brief on behalf of LLC, arguing that
because it was an LLC and not a corporation, he could represent the
company without a license.
2. RULE: LLC is a separate entity, so a license attorney is necessary.
h. Bottom Line for LLC: They are a hybrid – part corporation and part partnership.
VII. Other Basic Forms of Unincorporated Business
a. Limited Liability Partnership (a subset of LP)
i. In an LLP, each partner may participate fully in the business affairs without
becoming liable for the entity’s debts.
ii. There are professional groups that are viewed as providing individualized
services and it is against public policy to allow them to incorporate, thereby
limiting their liability for malpractice or negligence.
iii. But if they form GPs, they are exposing themselves to unlimited liability,
including for the actions of their clients.
iv. The creation of the LLP (first in TX) was designed to authorize GPS to limit
the liability of innocent partners to their investment in the firm.
v. A GP elects to become an LLP by filing a statement with the Secretary of
State electing LLP status.
vi. Liability provided by LLP status is not available to partners who themselves
commit acts of malpractice or negligence. Or to partners who have oversight
obligations, are negligent, etc.
1. Supervisory liability - but not direct.

The Development of Corporation Law in the United States: Jurisdictional Competition

I. Formation of Corporations
a. Corporations are creatures of state statute. To form a corporation, you have to follow
a state statute that has very specific rules. If you do not follow the rules correctly,
you default into a general partnership and no corporation exists.
b. Choosing Where to Incorporate
i. Look at the flexibility of the laws of the state, the state’s approach to
incorporations, case law of the state, and expertise of the judges.
c. DE has adopted the most progressive and hospitable corporate law choices:

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 i. Dole Food Company Proxy Statement
1. Articulates the benefits of incorporating in DE:
a. Body of DE case law means a greater measure of
predictability
b. DE law itself is the most advanced and flexible corporate
statute
c. DE Court of Chancery has more experience, speed of decision,
degree of sophistication, and understanding
d. DE legislature adopts statutory amendments to meet changing
business needs
e. DE has a more favorable tax system
f. DE has a quick filing system
g. DE has a generally corporate-friendly environment
ii. However, if another state had relatively flexible laws and you are going to be
taxed in your state anyway, it is a good idea to incorporate in that state.

The Formation of the Closely Held Corporation

II. Process of Incorporation
a. Decide where  Delaware or your place of business
i. Companies will compare costs, convenience, defense of a suit in a remote
location
ii. Bottom line: Unless you need to avail yourself of the benefits of DE’s
offerings, you should incorporate where most the business will operate.
1. The organizers of a closely-held corporation should normally choose
to incorporate in the state in which they have their principal place of
business.
2. For a publicly-held corporation, the cost-benefit analysis cuts toward
incorporating in DE.
iii. Internal affairs rule: it is the law of the state of incorporation that controls
issues of internal corporate governance.
b. Filing documents with the secretary of state
i. Articles of Incorporation – the birthing instrument of the corporation.
ii. Review by state official – the official determines that the document is in
satisfactory form, files the document, and the corporation is treated as being
formed. The date of incorporation is usually made retroactive to the date of
filing.
1. The state usually shows that it has accepted the corporation merely by
issuing a receipt for the filing fee, though some states still issue a
more formal charter or certificate of incorporation.
iii. Bylaws – the governing instrument of the corporation
1. The bylaws will structure the entire corporation
2. This is the operational document of a corporation (like an operating
agreement in LLC or partnership agreement in a GP)
3. Unlike AI, bylaws can easily be amdended
iv. Must be signed by the incorporators!!
1. Incorporators need not reside in the state of incorporation and need
not expect to have any connection with the corporation.

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c. Articles of Incorporation must comply with the MCBA or other local statute
i. Section 2.02(a) – must include the name of the entity, number of shares
authorized to issue, registered address, and name of each incorporator
d. Articles in Incorporation may comply with the items in Section 2.02(b).
i. Names and addresses of the initial directors
1. Incorporators may have the power to elect initial directors or the state
may allow initial directors to be named in the certificate of
incorporation,
ii. The purpose for which the corporation is organized
iii. Management of the business and regulations of the affairs of the corporation
iv. Powers of the corporation, the board, and shareholders
v. Par value for authorized shares or classes of shares
vi. Imposition of personal liability on shareholders for the debts of the
corporation
e. Pay attention to what is mandatory and what is permissive
f. MCBA 2.03 – Time of Incorporation
i. Unless a delayed effective date is specified, the corporate existence begins
when the articles of incorporation are filed.
ii. You cannot retroactively create a corporation
g. After AI are filed – 2.05 of MCBA
i. If initial directors are named in the AI, the initial directors shall hold an org
meeting to complete the organization of the corporation by appointing
officers, adopting bylaws, etc.
ii. If initial directors are not named in the AI, the incorporators shall hold an org
meeting to elect directors and complete the organization of the corporation or
to elect a board of directors who shall complete the organization of the
corporation.
iii. Action to be taken at the organizational meeting may be taken without a
meeting if the action is taken consented to by each incorporator.
iv. Organizational meeting:
1. Receive bylaws, charter, etc.
2. Set up bank account
3. Elect officers of the corporation for purposes of running the entity or
call the first meeting of the initial board of directors (if named in the
AI)
4. Incorporators then fade away – shareholders elect directors and
directors elect officers
5. Shareholders become owners of the corporation
6. The duties of the directors are determined by statute, case law, and
bylaws
h. Amending the articles
i. The articles can be amended at any time, but there are two significant
limitations on this right to amendment:
1. Must be allowable as original articles – amended AI must be ones that
could be adopted if the amended articles were being filed as new.
2. Voting rights – any class of stockholders who would be adversely
affected by the amendment must approve the amendment by majority
vote.

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 i. Incorporators Rights and Liability
i. The incorporators may voluntarily dissolve the corporation if it has not
commenced business and has not issued shares
ii. The incorporators may amend the AI by unanimous consent if the corporation
has not commenced business and has not issued any shares
iii. No liability for actions taken as an incorporator – therefore really anyone can
serve as incorporator
j. Naming the Corporation
i. The MCBA requires that the name be “distinguishable upon the records of
the secretary of state” from any other corporate name – purpose is make sure
each corporation has a unique name.
1. Some states adopt the “same or deceptively similar” standard, which
is premised on avoiding unfair competition – this requires the
Secretary of State to make a decision on the basis of unfair
competition, a policy which the Secretary is often not well equipped
to enforce because they just rely on the computer list of corporation
names. No resources to really conduct an independent investigation to
determine whether use of the name would constitute unfair
competition.
k. Purposes and Powers
i. Many state statutes still require that the AI specify what the corporation’s
purpose or purposes are, but usually permit a general statement that the
corporation is formed “for lawful business purposes” or “to engage in any
lawful business”.
III. Ultra Vires
a. Traditional UV doctrine: If you lack the authority to engage in the act, you cannot be
responsible for the act. When a corporation will be held accountable for its actions
depends on:
i. The stated purpose of the corporation
ii. Authority granted to the corporation
b. Modern UV doctrine:
i. MCBA eliminates this doctrine – it wants to hold corporations accountable
for the activity that they engage in even if they are not authorized to engage
in such activity.
c. Modern trend is to eliminate UV:
i. MCBA Section 3.04: “The validity of corporate action may not be
challenged on the ground that the corporation lacks or lacked power to act”
1. However, lack of capacity can be challenged in the following
circumstances:
a. In a proceeding by the corp or shareholders against the
incumbent or former officers or directors for exceeding their
authority
b. In a proceeding by the AG to dissolve the corporation or to
enjoin it from the transaction of unauthorized business
c. In a proceeding by a shareholder against the corporation to
enjoin the commission of a UV act or the UV transfer of real
or personal property of all parties before the court and
circumstances make such an action equitable

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 ii. A shareholder may still sue to enjoin the corporation from acting beyond its
power. Most shareholder injunction cases involve:
1. Charitable donations – corporations have been held to have the
implied power to make reasonable charitable contributions.
2. Pensions, bonuses, and other fringe benefits -
a. Recipient is still employed – the arrangement will not be
attackable by shareholders unless it is clearly excessive or
based on self-dealing.
b. Recipient is retired – the direct-incentive justification no
longer applies, but courts will stretch to approve this
arrangement.
d. 711 Kings Highway Corp. v. F.I.M.’s Marine Repair Serv.
i. FACTS: Corporation formed for the purposes of conducting marine
activities. The corp then entered into a lease agreement to use property as a
movie theater. Landlord sought to have the contract void under the UV
doctrine because the lease was very favorable to the tenant on the grounds
that the lease was unenforceable by the tenant because it had no authority to
enter into the lease to begin with.
ii. RULE: No act of a corporation shall be invalid by reason of the fact that the
corporation was without capacity or power to engage in such an act except
when it is an internal action by a shareholder, internal action by a corporation
against a director, action by the AG (only third party allowed to invoke UV).
e. Sullivan v. Hammer
i. FACTS: P stockholders brought a suit alleging corporate waste when D
corporation gave money away to a Museum in return for publicity, etc. The
parties entered a settlement agreement, brought before the court to approve.
ii. RULE: The business judgment rule will protect the corporation here. As long
as the actions of the directors were valid, the court will not look at the
reasonableness of the action. Corporations have the power to make charitable
contributions and other payments or donations in furtherance of the
corporation’s business and affairs.
f. UV Bottom Line:
i. UV largely abolished
ii. Cannot challenge the corporation’s actions unless it is by shareholders, the
corporation itself, or the AG
1. Directors will still be entitled to bus jdmt rule
IV. Premature Commencement of Business Operations
a. Official corporate existence does not occur until AI are filed by the Secretary of
State. Most statutes say that acceptance of the AI is conclusive proof that all
conditions precedent to incorporation has been complied with. If the Secretary
accepts a filing, a de jure corporation is created. If articles are filed and not accepted
(i.e. filed defectively), you may have a de facto corporation or corporation by
estoppel.
i. Under the MCBA 2.03 – corporate existence begins when the AI are filed. A
de jure corporation is created when the AI are accepted by the Sec.
ii. Certificate of incorporation issued by the Secretary = Existence of
corporation.
b. Promoters

13
 i. A person who acts either alone or in conjunction with others to take the
initiative in founding and organizing the business or enterprise
1. Contrast this with the role of incorporator: the incorporator has the
responsibility of signing the document that forms the corporation; the
promoter is the person who has the responsibility of assuring that the
corporation is an economic success.
ii. Activities of a promoter:
1. Must arrange for the necessary capital for the corporation. This means
investing one’s own funds, loans from banks, or outside capital.
2. Must obtain the necessary assets and personnel so that the corporation
may function. He may obtain a lease, etc. or enter a contract to
purchase with the view of assigning the contract to the corporation.
iii. Responsibilities of promoters:
1. Fiduciary duty to other participants in the enterprise while promoters
are acting – promoter may not pursue his own profit at the
corporation’s ultimate expense.
2. Responsible for organization – once the promoter gets into the realm
of operation, he runs the risk of going beyond the definition of
promoter.
3. Promoters may be held liable toward shareholders, creditors, other
promoters
iv. Liability of Promoters
1. The promoter may begin investigation of the profitability of the
proposed business, etc.
2. Four types of contracts that the promoter can enter in to:
a. Contracts executed in the name of the promoter
i. Personal liability on the part of the promoter clearly
exists. The subsequent assignment of the contract to
the corporation does not relieve the promoter of
personal liability unless the creditor agrees to release
the promoter and look only to the corporation for
performance.
b. Contract entered in the name of the corporation:
i. Many cases say that the promoter is personally liable
on the theory that the promoter is acting as an agent of
a non-existent principle.
ii. If the promoter enters into a contract with a third
person in the name of the corporation without
disclosing that the corporation is not in existence and
the person does not know that the corporation does not
yet exist  promoter is personally liable.
1. However, if the corporation is thereafter
created and takes over the contract, the
promoter has a chance of being relieved of
liability but there is a substantial chance that a
court will conclude that no liability of the

14
 corporation was intended and the promoter
remains personally liable.
c. Contract referring to the fact that the corporation is not yet
formed
i. Both parties are aware that the corporation has not yet
been formed – there is no possible misrepresentation of
this fact.
ii. Courts are split:
1. Corp never formed  promoter likely to be
held liable. The parties intended for someone to
be liable, and in the absence of the corp ever
being formed, the liable party could only be the
promoter.
2. Corp formed, but no adoption  Same as
above.
3. Adoption by corporation  Question is one of
the intent of the parties.
a. Fact specific determination of the
parties intent – did third party intend to
hold the corporation liable?
d. Promoter is unaware that corporation has not been formed
i. If the promoter honestly believes that the corporation
has been formed, but due to some technical mistake of
he is unaware, the corp does not really exist at the time
he sign the contract, the court are more likely to be
sympathetic to the promoter.
v. Alternatives for Promoters:
1. Promoter may understand that the third party is making a revocable
offer to the nonexistence corporation which will result in a contract if
the corporation is formed.
2. Promoter may understand that the third party is making an irrevocable
offer for a limited time. Consideration to keep the offer open can be
found in a promise by the promoter to organize the corporation.
3. Promoter may agree to a present contract by which the promoter is
bound, but with an agreement that his liability terminates if the
corporation is formed and manifests its willingness to become a party.
4. Promoter may agree to a present contract on which, even if the
corporation is formed, he remains liable either primarily or as a
surety.
***Have to look at the facts of the case to figure out what was intended.
vi. Liability of Corporations for Promoters’ Contracts
1. No adoption = no liability.
2. There must be some form of assent by the corporation to the contract
after is has been formed – this may be express, or implied from the
circumstances

15
 a. A third party always has the right to pursue the corporation
even if the corporation has not ratified the contract and then
the corporation can proceed against the promoter.
3. If a corporation takes the benefits of a contract made by its promoter,
it will usually be concluded that it has assented to the burdens of the
contract
4. If the corporation is already in existence when the promoter is acting,
it will be responsible for obligations entered into by the promoter on
its behalf if the promoter is an authorized agent of the corporation.
vii. Stanley How & Assoc. v. Boss
1. FACTS: P and Boss entered into a contract – Boss signed his name
and then added, “agent for a Minnesota corporation to be formed who
will be obligor”. Boss then formed a corporation (he filed after
signing – he knew the corp did not exist). The partial payments
received by P were from this corporation. The project was then
abandoned by the D before P was fully paid.
2. RULE: A promoter, though he may assume to act on behalf of a
corporation and not for himself, will be personally liable unless the
third party agreed to look to some other person for payment.
a. Exception: Personal liability will not attach to the promoter if
the third party looks solely to the corporation for payment,
regardless of whether the corporation is in existence or not.
Does not have to be a written agreement – but there must be
some kind of manifestation to look to the corporation.
c. Defective Incorporation
i. How defects occur:
1. Promoter sends what he believes to be satisfactory AI to the Sec, but
the Sec rejects them
2. Promoter relies on a lawyer to file and the promoter is unaware that
the lawyer did not file
ii. Traditionally, three types of common law corporations:
1. De jure - incorporation conforms with mandatory statutory conditions
when you set it up. The result is that the corporation is not subject to
direct or collateral attacks by the state or by any other person.
a. If the Sec of State accepts a filing, a de jure corporation is in
existence despite any mistakes or omissions (MCBA 2.03(b)).
b. Agent is not liable because corporation was properly formed.
iii. What happens if incorporation is defective due to the fault of someone other
than the agent of the incorporation?
1. De facto – defective, but good enough to pass muster. Result is that it
is immune from attack by everyone, except for the underlying state
when you “incorporated”. Agent is not liable. Test for de facto
incorporation:
a. Was there a statute under which incorporation as permitted?
b. Was there a “good faith” or “colorable attempt” to comply
with the statute?
c. Was there actual use of the corporate privilege?

16
 2. Corporation by estoppel – Applied where the person seeking to hold
the officer personally liable has contracted with the association in a
manner that recognizes and admits its existence as a corporation. The
agent is estopped from claiming that no corporation ever existed.
a. This may apply even if there is no de facto corporation.
b. Cranson case- lawyer assured them that they were
incorporated.
c. Even where the defect in the incorporation process is too
serious to allow use of the de facto doctrine, the estoppel
doctrine can still be applied if the creditor deals with the
business as a corporation.
iv. Modern View
1. Most states have statutes that expressly impose personal liability as
the penalty for purporting to do business as a corporation that is not in
fact incorporated.
v. MCBA 2.04 says that all persons purporting to act as or on behalf of the
corporation, knowing that that there was no incorporation under this Act,
are J/S liable for all liabilities created while so acting. Getting the certificate
= knowledge of incorporation. ***This is the promoter rule.
1. The standard we have to know: if you file and it was accepted, you
will not be J/S liable because you were operating until the assumption
that you were incorporated.
a. MCBA 2.04 protects the promoter who acts without
knowledge that there has in fact been no incorporation.
2. Once you filed and have been accepted, that is conclusive proof that
the steps have been taken to incorporate.
3. Exceptions to liability under MCBA:
a. Agent believes articles are filed, but attorney made mistake –
no J/S liability
b. Articles were sent to the filing office, but not
received/processed through no fault of the filer
c. Third party knows corporation is unformed, but insists on
contracting with corporation immediately
d. Agent represents that corporation exists, but third party
demands recourse only from corporation
e. Agent received advance funds with instructions not to act until
corporation is formed, but acts prematurely
vi. Robertson v. Levy
1. FACTS: Levy filed, but AI were not accepted. Levy entered into an
agreement with Robertson in which Levy acted as the president of the
corporation. The certificate of incorporation was accepted 5 months
later. The corp folded and Levy still owed Robertson.
2. RULE: Personal liability will be imposed for pre-incorporation
transactions. Incorporation did not happen because not accepted by
Sec.
a. Note that MCBA 2.04 requires that the D know that there
was no incorporation in order to be held J/S liable – if you

17
 did not receive certificate of incorporation, you would not
have reason to think that there was incorporation.
b. This case was decided before the 1984 MCBA.
c. Several states have enacted this into statute.
vii. Hypothetical:
1. Promoter puts in a clause saying that the third party would not look to
the promoter of a corp that is not formed.
a. Boss rule  look to the intent of the parties; the third party
does not intend to hold promoter liable.
b. Statute  The promoter is acting knowing that the corporation
does not exist – this means J/S liability.
c. Which rules control??
i. Court says the Boss rule controls because there is an
express agreement
ii. Harper says this leaves the third party without a
remedy
viii. Frontier Refining Company v. Kunkel’s
1. FACTS: Frontier entered into a venture with Kunkel and 2 other guys.
The two guys gave Kunkel money. Frontier sues all three claiming a
partnership because Kunkel never incorporated. Ds allege that they
were just creditors and did not know that Kunkels was never
incorporated. Frontier knew there was no corporation formed.
2. RULE: No partnership when individuals did not “purport to act as or
on behalf of the corporation”. Kunkel was the sole promoter here and
he alone is liable because he knew that no corporation was formed
and he did not have an agreement with Frontier that it would look to
the corporation for performance

Disregard of the Corporate Entity

I. Common Law Doctrine of Piercing the Corporate Veil
a. Asks: Under what circumstances can we disregard the corporate entity?
i. Note that when the corporate veil is pierced to the detriment of individual
shareholders, it is almost always in cases where the corporation is dominated
by one or a small number of shareholders.
b. Note that there is no statute having to do with piercing the corporate veil  it is
determined by common law.
c. This situation comes up when you have a creditor who wants to hold the
shareholders responsible for corporate obligations because the corporation is
insolvent.
d. Individual Shareholders - Courts will look for the following factors:
i. Tort cases (as opposed to contract cases)
ii. Fraud or wrongdoing by the corporation’s shareholders
1. Siphoning of assets
iii. Inadequate capital
1. Initial Capitalization

18
 a. Majority view: grossly inadequate capitalization is a factor in
determining whether to pierce the corporate veil, but it is not
dispositive
2. Draining of assets
3. Failure to add new capital
4. Business grows – new capital needed
iv. Failure to follow corporate formalities
1. Shares are never formally issued, or no consideration
2. Shareholders’ meetings and directors’ meetings are not held
3. Shareholders do not distinguish between corporate property and
person property
4. Corporate financial records are not maintained
v. Required element: Some element of injustice or unfairness.
e. Usually, the court find at least 2 of the previous factors to exist before piercing the
corporate veil.
f. Bartle v. Home Owners Co-op
i. FACTS: P was trustee of D’s subsidiary. D provided low-cost housing and
Westerlaw undertook construction of the housing. Westerlea went bankrupt.
ii. RULE: The law permits the incorporation of a business for the purpose of
escaping personal liability – in the absence of fraud, misrepresentation, or
illegality, there are no grounds for piercing the corporate veil.
1. What will the court look at?
a. Capitalization of the sub
b. Overlap of directors and management
g. Dewitt Trucking Brokers v. W. Ray Flemming Fruit Co. – Dominant Shareholder
i. FACTS: P was a trucking company hired by D fruit broker to transport fruit.
P wanted to impose liability on President of D corporation. Corporation was
insolvent, but indebted to P for service rendered.
ii. RULE: If you use the corporation as an alter ego, then you expose yourself to
potential piercing of the corporate veil. If the dominant shareholder is
operating the corporation for his own benefit, there must be an element of
fundamental unfairness or injustice before piercing the veil. To determine
if alter ego, the court considers:
1. Gross undercapitalization?
2. Corporate formalities observed?
3. Payment of dividends?
4. Insolvency of the debtor corporation
5. Siphoning of funds of the corporation by the dominant shareholder
6. Non-functioning of other officers or directors
7. Absence of corporate records
8. NOTE that ownership by just one shareholder is not alone enough to
pierce.
h. Baatz v. Arrow Bar – Injustice/Unfairness
i. FACTS: Ps brought action against the owners of bar where motorist was
served alcohol after motorist was involved in DUI accident and against three
stockholders of the corporation that owns the bar. Stockholders contributed
$50,000 to the corp, the corp purchased the bar with $5,000 and personally

19
 guaranteed complete payment. One D is President of corp. and another D is
manager of the business.
ii. RULE: Absence of injustice or fundamental unfairness here means no
corporate piercing. The fact that individual does not have insurance here is
proper.
i. Note on tort and contract
i. In contract cases, the court is less inclined to pierce the corporate veil
because it believes that the third party assumed the risk when it entered into a
contract with the insolvent corporation.
ii. In tort cases, there is no element of voluntary dealing, and the question
becomes whether it is reasonable for owners of a business to transfer a risk of
loss or injury to members of the general public.
j. Parent/Sub Structure – Courts will look to the following factors:
i. A close relationship between between parent and sub is not sufficient to
pierce the corporate veil. Nor is domination of the sub’s affairs by the parent.
ii. Intertwined operations – same board of directors, etc.
1. Lack of separate corporate formalities
iii. Unified business and subsidiary undercapitalized
iv. Misleading to the public
1. P and S do not make it clear to the public which entity is handling
each particular aspect of the business
v. Intermingling of assets
vi. Unfair manner of operation
1. Operation in a way that is for the advantage of the parent, rather than
the advantage of the sub
k. Radaszewaski v. Telecom Corp. – Parent/Sub
i. FACTS: P was injured by an employee of Contrux, which was a subsidiary of
D. Contrux was put into business without sufficient equity investment, but it
did have $11,000,000 worth of liability insurance available to pay judgments.
ii. COURT: When determining the liability of a parent as shareholder for the
subsidiary, there is limited liability unless the same factors of piercing apply.
1. MULTI-PRONG TEST:
a. Control of the sub by the parent
i. Mere domination is not enough
ii. Similar Boards is a tell-tale sign
b. Was control used to perpetrate Fraud/Unjust Act
i. Siphoning or undercapitalization are considered
automatic injustice – the creation of an under-
capitalized subsidiary justifies an inference that the
parent is either deliberately or recklessly creating a
business that will not be able to pay its bills or
satisfy its judgments against it.
ii. BUT: Insurance is a form of capitalization
iii. RULE here: If the sub is financially responsible,
whether by means of insurance or otherwise, this prong
is satisfied.
c. Did control and breach of fiduciary proximately cause the
injury?

20
 iii. RULE: The purchase of insurance takes the place of adequate capitalization.
Insurance is often a form of capitalization in the parent/sub context.
l. Fletcher v. Atex – Parent/Sub in DE
i. FACTS: P filed suit against Atex and parent Kodak. Kodak was the sole
shareholder of Atex.
ii. RULE: DE test requires P to show that the parent and sub operated as a single
economic entity and that an overall element of injustice or fairness was
present
1. TEST in DE:
a. Adequate capital
b. Solvency
c. Dividends paid
d. Corporate records kept
e. Function – simply a façade?
f. Corporate formalities
g. Siphoning
2. Cash management is consistent with sound business practice.
3. Common officers and directors does not demonstrate domination.
m. NOTE that in all piercing cases, the courts agree that piercing is only appropriate
when recognition of the separate corporate existence would lead to injustice or an
unfair and inequitable result.
n. Should we abolish the piercing doctrine?
i. NO! It allows the court to provide redress for something for which otherwise
there is no redress.
II. Piercing the Corporate Veil in Federal/State Relations
a. Stark v. Flemming
i. FACTS: Woman placed all of her assets in a corporation for purposes of
qualifying for social security. Secretary held she was not entitled to benefits.
ii. RULE: In order to take advantage of social security benefits, you can put
your assets in a corporate form. Establishing a corporation to entitle one to
receive SS benefits is permissible.
b. Roccograndi v. Unemployment Bd. of Review
i. FACTS: Family members who started a corporation laid each other to get
unemployment benefits.
ii. RULE: You cannot avoid unemployment compensation responsibilities by
forming a corporation. The corporate entity may be ignored in determining
whether the claimants were in fact unemployed.
1. General Policy: You cannot use a corporation to avoid a statutory
obligation, but you can use it to obtain a public benefit.
III. Reverse Piercing
a. Reverse piercing occurs when the shareholders seek to have the corporate veil
pierced on themselves – A shareholder argues in a suit against a third party that the
separate existence of their own corporation should be ignored. Shareholder is
arguing that the corporate veil should be pierced  that the shareholder and
corporation should be viewed as one and the same.
b. Cargill, Inc. v. Hedge

21
 i. FACTS: A farming family created a corporation to own the land and
buildings that comprised their farm. They ran into financial difficulty, and a
creditor obtained a judgment and sought to execute on the land. MN had a
statute that provides an exemption from execution of farm property owned by
individual farmers. In order to avoid the forced sale of their farm, the family
argued that the separate existence of their corporation should be ignored.
ii. RULE: Court allowed reverse piercing because of an overriding policy
justification – the court cautioned that reverse piercing should only be
available in carefully limited circumstances.
c. Pepper v. Litton - Subordination
i. FACTS: Pepper sued Dixie, of which Litton was sole shareholder. Dixie had
defaulted on lease payments to Pepper. Litton had worked for the company
for years without taking a salary – letting his salary claim lie dormant. Litton
then goes and gets an accounting to be paid his back salary. Bankruptcy court
disallowed the claim by Litton and directed Pepper to recover.
ii. RULE: If you are a stockholder who does not advance your contribution
clearly as debt, the court of equity will treat your claim as an equitable claim
and will be subordinated. You won’t get paid until the creditors get paid.
1. Upon dissolution of a corporation, the order goes: (1) creditors and
(2) stockholders. Debt is prior to equity in repayment.
2. Critical here is the difference between subordination and piercing.
Subordination deals with the relationship between the creditor and the
stockholder. Piercing deals with shareholders being liable to everyone
as if there is no corporation.
d. Nissen Corp. v. Miller – Successor Liability
i. FACTS: Malfunctioning treadmill case.
ii. RULE: If the purchaser buys the assets of a selling corporation, the purchaser
is not responsible for the debts of the seller unless certain exceptions exist.
No successor liability for purchasing the assets of another company. Court
rejects the continuity of enterprise theory.
1. TEST: Successor liability will only be enforced if
a. There is an express or implied agreement to assume
liabilities
b. The transaction amounts to a consolidation or merger
c. The successor entity is a mere continuation of reincarnation
of the predecessor entity
d. The transaction was fraudulent, not made in good faith, or
made without sufficient consideration

Financial Matters and the Corporation

I. The Distinction between Debt and Equity
a. Capital is the funds used by the business to operate the business
b. Two types of capital:
i. Debt – borrowed amount
1. Represent obligations that must ultimately be repaid, usually on or
before a specific date.
2. Fixed repayment schedule

22
 3. Amount is fixed – it does not change, regardless of what the business
does
ii. Equity – investment amount/net worth/ownership
1. Refers to all securities that represent ownership interests in the
corporation
2. An investment constitutes an ownership interest, that is given a
percentage of the business
3. If one person gets equity, another person’s equity goes down – equity
is spread across the corporation to equal 100%
4. Equity has two characteristics:
a. Voting
b. Ownership
iii. Repayment Priority
1. Debt has priority over equity
2. Debt relationship is a contractual relationship, whereas equity
relationship is not.
II. Issuance of Common Stock
a. Common stock – fundamental units into which the proprietary interest of the
corporation is divided.
i. MCBA 6.01(b) – Two fundamental characteristics of common stock
1. Right to vote for election of directors and on other matters
2. Right to receive the net assets of the corporation when distributions
are made
b. Articles of Incorporation must state the number of shares of stock the corporation is
authorized to issue
i. The capitalization of the corporation is based on the number of shares
actually issued and the capital received therefore, NOT on the number of
authorized shares. Capital received in exchange for common shares is usually
referred to as the corporation’s “invested capital”.
c. Par Value and “Watered Stock”
i. Par value – a dollar amount designed per share of common stock in the AI
1. This is NOT an indication of the price at which most shares are issued
2. Par value serves as a minimum value – the price per share must
always be equal to or greater than the par value
ii. Par value in modern practice
1. RULE: to avoid liability for water stock, the issuance price for the
stock must always be equal or greater than par value
2. Modern practice is to minimize or eliminate par value
3. Goal is to have nominal low par stock
4. Torres v. Speiser
a. FACTS: P claimed that the sale of his minority interest in the
C corporation to individual D is invalid because below par
value.
b. RULE: Par value relates only to the original issuance of shares
and has no application whatsoever to subsequent transactions
in the shares themselves, which may be bought and sold at any
mutually acceptable price.

23
iii. Watered Stock – stock issued for less than par value is called watered stock;
an investor who purchases watered stock is automatically liable to the
corporation for the difference between par value and what he actually paid.
1. Types classes of watered stock:
a. Bonus – par value shares that are given to the shareholder for
nothing
b. Discount – par value shares issued for cash less than par value
c. Watered – par value shares issued for property or services that
is worth less than the par value of the shares
2. Liability
a. Only involves the initial purchaser or subscriber of the shares
b. Once shares have been issued, they may be sold to subsequent
purchasers at whatever price is set by market or is agreed upon
by the purchaser and seller. The original par value is relevant
only to the original issue of the shares.
3. Hanewald v. Bryan’s Inc.
a. FACTS: Corp sold shares shareholders without consideration.
Corp then entered into a contract with P for sale of the store
which the corp owned. Corp dissolved and did not pay
promissory note to P. P sued corp and shareholders, seeking to
hold them personally liable.
b. RULE: A shareholder is liable to the corporate creditors to
the extent his stock has not been paid for. The shareholder
is liable to the extent of the difference between the par value
and the amount actually paid and to such an extent only as
may be necessary for the satisfaction of the creditor’s claim.
i. Note the difference between liability here and liability
of shareholder when corporate veil is pierced – total
liability of the shareholder.
ii. NOTE that there is no watered stock liability on a re-
sale – only the person who purchases from the
corporation directly is liable for the watered
amount.
4. Alternative theories by which creditor might hold shareholders liable
for watered stock:
a. Trust fund theory – treats the stated capital of the corporation
as being a trust fund available for the payment of creditors,
and failure to pay in the proper amount is therefore actionable
by any creditor. Under this theory, a creditor could recover
even if he became a creditor before the wrongful issuance, or
if he issued the credit after the wrong but with full knowledge
of it.
i. Hopses v. Northwestern – this trust fund theory is
fiction.
b. Fraud/Holding out theory – presumes that creditors rely on the
stated capital of the corporation when extending credit. On
this theory, creditors with claims arising prior to the wrongful

24
 issuance, or subsequent creditors who were aware of the
wrongful issuance, cannot compel additional creditors.
i. One who becomes a creditor before the wrongful
issuance and one becomes a creditor after the wrongful
issuance but with knowledge of it, may not recover,
since by definition, they have not relied.
c. Implied contract theory – corporation has collected enough
equity so that they can fulfill creditors contracts.
5. Bottom Line for Watered Stock – Par value shares should not be
issued for less than par value amount (do not want shareholders liable
to creditors to the extent that their stock has not been paid for)
6. Consideration for Shares
a. Most of the time, stock is issued to shareholders in return for
cash. Other times, it may exchanged for property, services,
promises, etc.
b. Have to look at the statute to know what is acceptable
c. Property and services exchanged for shares need to be of
equivalent value of the shares
d. Just because something other than cash is given in exchange
for shares, does not mean no consideration
e. See MCBA 6.21(b)– very broad scope of consideration, in
which notes, contracts for future services can be consideration
for shares
i. 6.21(c) – Board determines what is adequate
consideration for shares
f. Usual rule: Promises to perform services, donate property in
the future, or pay cash in the future, are not valid
consideration. Note the discrepancy with the MCBA.
d. Capital Accounts
i. On a balance sheet, the right side includes the liabilities and net worth of the
corporation – which balances to equal the assets of the corporation (on the
right).
ii. Net worth includes
1. Stated Capital – “locked in” the corporation and cannot be distributed
a tall except upon liquidation of the corporation.
2. Capital Surplus – assets may be distributed to the extent of capital
surplus simply with the approval of the holders of a specified fraction
of the common shares.
3. Earned Surplus
e. Common Stock: Non-Voting Shares
i. Typically have the economic characteristics of common stock but lack the
power to vote for directors. However, they have the right to vote on
amendments to the AI, and on proposed mergers, share exchanges, and other
extraordinary events that may affect the class of nonvoting shares as a class.
f. Common Stock in a Closely Held Business
i. In closely held corporations, classes of common stock are primarily used to
effectuate control, voting, or financial arrangements of the type described in
the preceding section.

25
 ii. Can divvy up common stock by having a voting and non-voting class.
iii. But making too many distinctions between common shares classes will push
you in to preferred.
1. Class A
2. Class B
g. Common Stock in Publicly Held Businesses
i. Not as common to create classes in publicly held businesses
III. Preferred Stock
a. Owners of preferred stock have certain rights in addition to the rights of common
shares
i. MCBA 13.01 – Preference of preferred shares MUST BE designated in the
AI
b. What rights are preferred shareholders entitled to?
i. Preference over the common shares in payment of dividends and/or
preference in the receipt of the assets of the corporation upon the voluntary or
involuntary liquidation of the corporation
ii. Cumulative dividends – dividends are carried forward to subsequent years
and in any subsequent year all prior unpaid cumulative dividends plus the
current year’s preferred dividends must be paid in full before any dividend
may be declared on the common shares.
iii. Redemption – Shares are redeemable by the corporation at a specified price
so long as there remains outstanding one class of common shares with full
voting powers. Price is usually set by the AI.
iv. Convert preferred shares to common stock – preferred shares may be
converted into common shares at a specified price or specified ratio.
Typically, the original conversion ratio is established when the class of
preferred stock is created.
v. Participating preferred – entitled to original dividend, and after common
received a specified amount, they may share with the common in any addtl
distributions.
c. Usually preferred shares are non-voting shares that have a fixed and limited dividend
that is not dependent on the earnings of the corporation.
d. Flexibility
i. State corporation statutes give corporations almost complete flexibility in
establishing terms of preferred shares.
ii. Because of this flexibility, preferred shares are widely used to create
innovative means of raising capital from third parties and to effectuate intra-
corporate agreements in closely held corporations.
IV. Debt Financing
a. Debt financing, from an economic standpoint, is more important than equity
financing
i. Once you give the equity away, it is gone forever
ii. Allows you to borrow money and use that money to get a greater value
1. Leverage – the ability to generate more funds from borrowed money
than the cost of borrowing the money to begin with.
a. The excess is allocable to the equity accounts of the
corporation, thereby increasing the rate of return on the equity
invested in the corporation.

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 2. Where the shareholders are debtors, payment of interest on debt is tax
deductible and there are significant tax advantages.
a. Whereas dividend payments on an equity security are not tax
deductible
b. No tax advantage in debt owed to individuals other than
shareholders, but interest is still deductible.
iii. BUT – a corp needs to have equity before it has debt
iv. Banks/investors don’t want to have a situation where there is an imbalance of
debt to equity ratio – they want to be sure that the debt gets paid back
V. Preemptive Rights and Dilution
a. “Preemptive Rights” refers to the power often granted to existing shareholders of an
on-going corporation to purchase a proportionate part of new issues of common
shares.
i. Designed to allow existing shareholders to retain their relative ownership
interests in the corporation when the corporation issues additional stock.
ii. This right is now usually codified in statute, and is also subject to significant
limitations or qualifications.
iii. Modern statutes make preemptive rights permissive, not mandatory, meaning
that corporations may limit or deny preemptive rights by appropriate
provisions in the AI. Every state governs preemptive rights by statute. All
modern statutes allow the corporation to dispense entirely with preemptive
rights if it so chooses.
iv. Where do these new shares come from?
1. They may be shares that are newly authorized by the corporation in an
amendment to the AI.
2. They may be shares that were previously authorized in the articles but
never previously issued.
3. They may be “treasury shares” – shares that had been issued at one
time but have been subsequently reacquired by the corporation.
v. Exceptions – not covered even if the corporation has preemptive rights:
1. Initially authorized shares – a diligent shareholder should understand
at the time he makes his initial purchase that the corporation may
ultimately be selling to persons other than himself the entire rest of
the initially-authorized amount.
vi. Stokes v. Continental Trust Co. of City of New York
1. FACTS: P was an original shareholder – the corp wants to increase its
capitalization and so sold shares to Blair corp. P asked to purchase
new shares, but his demand was refused. Upon sale, P’s voting and
ownership interest was immediately cut in half.
2. RULE: While shareholder cannot prevent the issuance of new shares,
the Board of Directors cannot take steps to diminish ownership rights.
The stockholder has an inherent right to a proportionate share of new
stock issued.
a. See MCBA 6.30 – preemptive rights put into statute. This is
where you look to determine what rights are opt-in and what
are opt-out – AI will either make preemptive rights opt-in or
opt-out rights.

27
 b. Opt-in – preemptive rights are not inherent – you must elect
them. No right unless you select to have them. It is presumed
that you do not have the right. The corporation does not have
preemptive rights unless it expressly elects, in the AI, to have
such rights.
c. Opt-out – you get the right even if you do not select it. You
cannot be diluted unless you elect to take them out of the AI.
It is presumed that you do have that right.
3. NOTE that most public corporations do not have preemptive
rights, but most closely held corporations do have preemptive rights
so that shareholders do not have to have their interest diluted.
4. Role of the lawyer here is to explain to the client what preemptive
rights are so that they can make a choice about whether they want
them or not
vii. Katzowitz v. Sidler
1. FACTS: Three owners each with 1/3 interest. Two of them decided
they wanted the third (K) out. K retired from management; everything
remains the same. The two decided to loan the money the corporation
owed to them to another corp. K said no. The two then sold 75 shares
of common stock at 1/18th the book value. They purchased their
portion; K did not. Corp dissolved, with K having 5 shares and the
two having 30 shares each.
2. RULE: Offering exercise preemptive rights is not enough; they
must be offered at a fair price pursuant to a transaction that
accomplishes a valid business purpose.
a. When the price is markedly below book value in a close
corporation and when the remaining shareholder-directors
benefit from the issuance, a case for judicial relief has been
established.
b. It is NOT ENOUGH that K had the opportunity to purchase
additional shares to avoid dilution, the important right here is
the right not to purchase additional shares without being
confronted with dilution of his existing equity if no valid
justification for the dilution exists.
c. With any kind of recapitalization – the court will look to see if
there is a valid business purpose.
viii. Lacos Land Company v. Arden Group
1. FACTS: P was a shareholder of Class A Stock. Corp proposed a
recapitalization in which a new Class B would be created and owned
by one individual who had dominant voting rights. In the proxy,
mgmt states that this individual made threats that unless the proposed
amendments were approved, he would use his power as CEO to block
transactions. Shareholders voted to allow formation of Class B.
2. RULE: Two step analysis of (1) was the action legally or statutorily
permissible and (2) was there a valid business purpose for the
recapitalization.
a. Here, this was just a means of transferring control to the one
guy through threats, etc.

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 b. Cannot coerce the vote! The manner in which the vote is
passed matters (was it coerced?)
c. Note that preemptive rights are not the only rights to which
minority shareholders are entitled – here, Briskin breached his
fiduciary duty by acting in his own best interests instead of the
best interests of the corporation.
VI. Distributions by a Closely Held Corporation
a. Closely held corporation vs. publicly held corporation
i. Publicly held – sufficiently large number of shareholders and active
established market in which its shares are traded
ii. Closely held - no market to enter or exit and are generally small
b. Close Corporations
i. General rule: a majority stockholder in a close corporation has a fiduciary
obligation to a minority shareholder, and must behave toward him in good
faith.
ii. Application:
1. Share repurchase – if a corporation repurchases shares from one
stockholder, it must offer to repurchase from other holders on the
same basis.
2. Squeeze outs – if the majority attempts a squeeze out of a minority
holder, the majority holder may be found to have violated this
fiduciary obligation.
a. Refuses to pay dividends
b. Refuses to employ the minority shareholder
c. Legitimate business purpose test
c. Gottfried v. Gottfried
i. FACTS: P wanted D directors to declare dividends on its common stock.
There were three classes of stock – preferred, A, and common. Prior to 1944,
there was no enough surplus to pay on common. Ps claim that Ds were
hostile, paid themselves excessive salaries, etc. which drained the corp and
made it impossible to pay dividends on common stock.
ii. RULE: If an adequate corporate surplus is available for the purpose, directors
may not withhold declaration of dividends in bad faith.
1. There must adequate surplus and bad faith in order to find liability on
the part of the directors.
2. Dividends compelled if:
a. Corporate surplus
b. Bad faith
i. Test: Was the policy of the director directed by
personal interest rather than corporate welfare?
ii. Directors’ actions must be egregious in order to find
bad faith – there is a presumption toward finding
regularity in dividends actions.
3. What might the court consider?
i. Policy by the directors to withhold to freeze out?
ii. Legitimate business purpose?
iii. Were resources invested in a valid business
enterprise/purpose?

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d. Dodge v. Ford Motor
i. FACTS: P minority shareholders sued Ford when Mr. Ford used the profits
from the business to expand the business instead of giving back dividends.
Ford wanted to use the funds to do philanthropy.
ii. RULE: Where accumulated surplus is so large that there has been an arbitrary
refusal to distribute funds that should have been cast as dividends, the court
will compel a dividend.
1. You cannot operate a corporation for individual benefits – it must be
operated for the benefit of the larger group of shareholders.
Community interest takes a back seat to the rights of shareholders.
2. Surplus has to be really huge here – the magnitude of the earnings
compels the making of a dividend because there could not possibly be
a legitimate business purpose for withholding.
e. Wilderman v. Wilderman
i. FACTS: P and D were married and were 50/50 shareholders in a corp. After
divorce, P claimed that D caused excessive and unauthorized payments to be
made in the form of unearned and unauthorized salary. She wanted the
money put back into corp so that she would get half as dividends. D ran the
corporation.
ii. RULE: Where you have a controlling stockholder who establishes his own
salary, the burden of proof should shift to the controlling stockholder as to
the fairness of withholding dividends.
iii. NOTE that when there is a surplus, there can never be veil piercing because
assets > liability.
iv. What if this were an LLC?
1. Compensation held to a reasonableness standard
2. Would look to the operating agreement to determine the allocation of
assets
f. Donahue v. Rodd Electrotype – Equal Opportunity Doctrine/Fiduciary Duties of
Controlling Shareholders in Close Corporations
i. FACTS: 2 shareholders – one dies, leaving to his family his 20% interest in
the corp. The remaining 80% shareholder brings his son into the business,
and he becomes President. He distributes his shares to his kids, and then sells
his remaining 45 shares to corp. The dead shareholder’s son says that he
should be allowed to sell his shares back to the corp. Corp is by law allowed
to do this.
ii. RULE: When a close corporation reacquiring its own stock is a close
corporation, the stockholders, who act as directors or controlling
stockholders, have a fiduciary duty of utmost good faith and loyalty to one
another.
1. How to determine “utmost good faith”?
a. Is there a valid business purpose behind the action?
b. Is there a less harmful corporate alternative to achieve the
same objective?
2. This is a higher standard that for publicly held corporations.
3. Definition of a close corporation:
a. A small number of stockholders
b. No ready market for the corporate stock

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 c. Substantial majority stockholder participation in the
management, direction, and operation of the corporation
4. Test: If the stockholder is a member of the controlling group, the
controlling shareholders must cause the corporation to offer each
shareholder an opportunity to sell a ratable number of his shares to the
corporation at identical price.
5. Close corporation – like a partnership!
6. The fiduciary duty principle may apply in numerous situations –
disclosure of information, etc.
7. Equal Opportunity Doctrine - If the stock holder whose shares were
purchased was a member of the controlling group, the controlling
stockholders must cause the corp to offer each stockholder an equal
opportunity to sell ratable number of his shares to the corp at an
identical price. Does this apply to s/hs who are minority?
a. BUT: a close corporation may purchase shares from one
stockholder without offering the same opportunity to others is
all stockholders give advance consent.
iii. Note that not all jdxs have adopted the fiduciary duty doctrine and the equal
opportunity doctrine.
1. Also, you would have to look at the language of the AI to determine if
there is some other agreement about that allows the corp to purchase
shares without adhering to the EE Doctrine.
VII. Legal Restrictions on Distributions
a. See MCBA 6.40
i. Two tests:
1. Equity insolvency – does the corp have the opportunity to pay its
debts as they become due? If not, the corp cannot pay dividends. Corp
must be able to pay its debts as they become due.
2. Balance sheet – look at the assets and liabilities to see if there is
enough to satisfy the preferential rights of shareholders. If there is
equity left, you can distribute that. This test prohibits a distribution if
after the distribution the total assets would be less than the sum of its
total liabilities.

Management and Control of Corporation - Overview

I. The Corporate Structure - Statutory scheme
a. Shareholders – act principally through two mechanisms: (1) electing and removing
directors and (2) approving or disapproving fundamental or nonordinary changes
b. Directors – “manage” the corporation’s business. They formulate policy, and appoint
officers to carry out that policy.
c. Officers – administer the day-to-day affairs of the corporation, under the supervision
of the board.
d. Note that statutes give corporations the power to modify this traditional scheme
where appropriate, but unless a particular modification of the statutory scheme is
authorized by state, the corporation disregards the statutory scheme at its peril.
II. Powers of shareholders
a. Methods of influencing the conduct of the business:
i. Elect and remove directors

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 1. Directors usually serve a one-year term
2. Modern statutes have expanded the shareholder power to remove
directors
ii. Approve or disapprove of changes to the AI or bylaws
iii. Approve or disapprove of fundamental changes – such a merger, sale, or
dissolution
iv. Some transactions are void or voidable unless ratified by a vote of the
shareholders
b. Note the shareholders do not have the power to bind corporations – they must
operate through their control of the board.
III. Powers of directors
a. The board is an independent institution with responsibilities for supervising the
corporation’s affairs.
b. Board’s main function is to set the policies of the corporation, to authorize important
contracts, declare dividends, initiate fundamental change in the corporation
c. Composition of the Board:
i. Insiders – executives or employees of the corporation
ii. Quasi-insiders – people who have some other significant relationship with the
corporation
iii. True outsiders – those who do not fall into either of the two previous classes
IV. Removal of directors
a. Most statutes allow this to be done by either a shareholder vote or by a court order
i. Shareholder vote: Directors may be removed by a majority vote of
shareholders, either with or without cause
ii. Court order: A court may order a director removed, but only for cause.
V. Powers of officers
a. Serve under and at the will of the board of directors and carry out the day-today
operations of the corporation.
b. Officers are essentially agents of the board of directors
c. Authority to act for the corporation:
i. Four doctrines used to describe when an officer has bound a corp:
1. Express actual authority – comes into existence by an explicit grant of
authority to the officer to act on behalf of the corporation; usually
through bylaws or resolution adopted by board
2. Implied actual authority –
a. Inherent in the actual post occupied by the officer
b. Bd by its own conduct or inaction may have implicitly granted
the actual authority to the officer in question
3. Apparent authority – the actions of the principal (corp) give the
appearance to reasonable persons that the agent is authorized to act as
he is acting.
a. Mere position can provide a source of apparent authority, esp
when coupled with industry practice (pension case).
i. Exception for extraordinary actions
ii. Will always be a question of fact for the jury
4. Ratification – if a person with actual authority to enter the transaction
learns of the transaction and either expressly affirms it or even fails to
disavow it, the court may find that the corporation is bound.

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 ii. Drive-In Development Corp.
1. FACTS: Parent/sub relationship in which the sub guaranteed a
payment to a third party to make a loan to the parent. The guarantee
was made by an officer but not contained in the corporate record
book.
2. RULE: Statements made by an officer or agent in the course of a
transaction in which the corporation is engaged and which are within
the scope of his authority are binding upon the corporation.
a. Unless there is actual knowledge that statement is not binding.
3. Actions taken by officers who certify that they have taken certain
action that is within their authority will be binding on the corporation.
iii. Lee v. Jenkins
1. FACTS: Director promised an employee a pension regardless of what
happened with his employment. The agreement was never put in
writing. When P was discharged, he sued for the pension.
2. RULE: Unless otherwise restricted by a corporate standard that the
third party had reason to know of, the President by virtue of his
position of a corporation only has authority to bind his company by
acts arising in the usual and regular course of business but not for
contracts of an “extraordinary” nature.
a. What does “extraordinary” mean?
i. Employment contracts for life
ii. Unduly restrict the power of the shareholders and
future boards of directors
iii. Inordinate amount of liability
3. Apparent authority is a factual question in which reasonable
people could differ as to what constitutes “extraordinary”
a. This is a question for the jury
b. Depends on the nature of the contract, the officer negotiating
it, the corp’s usual manner of conducting business, the size of
the corp and the number of shareholders
iv. When dealing with officer’s authority to act 
1. Look to AI and bylaws to determine what that authority is.
2. Look to statutory rules that are either permissive and mandatory
3. Look at written agreements between the parties/contracts

Close Corporations – Voting and Agreements

I. Close Corporation Statutes - A number of states require corporations to elect to be
treated as close corporations.
II. Agreements Restricting the Board’s Discretion
a. Traditional rule: agreements that substantially fetter the discretion of the board are
unenforceable.
b. Modern rule in NY (McQuade and Clark): To be valid, the agreement between
shareholders (1) must not harm creditors, the public or non-consenting shareholders,
and (2) must involve an “innocuous variance” from the rule that a corporation’s
business should be managed by the record.

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c. Other jdxs/widespread rule: The court will uphold the agreement, even though
it limits the discretion of the board of directors if (1) there is no minority
interest who is injured by it, (2) there is no injury to the public and to creditors,
and (3) the agreement must not violate a clear statutory prohibition.
d. McQuade v. Stoneham
i. FACTS: Shareholders agreed to use their best endeavors for the purpose of
continuing as directors the three of them. P became Treasurer for nine years
and then someone else took over. Four other directors voted to have P
replaced. D did use his best efforts to continue P as Treasurer.
ii. RULE: A contract is illegal and void so far as it precludes the board of
directors, at the risk of incurring legal liability, from changing officers,
salaries, or policies, or retaining individuals in office, except by the consent
of contracting parties.
1. i.e. A shareholder cannot enter into an agreement to bypass or restrict
the powers of directors.
e. Clark v. Dodge
i. FACTS: Agreement was made among shareholders that P would be retained
as director. All shareholders signed the agreement.
ii. RULE: Where the deviation from corporate authority is slight and innocuous,
the agreement will not be invalidated, even if there is an invasion of the
powers of the directors.
1. When there are no minority shareholders harmed by the agreement,
the court will uphold it.
f. Long Park v. Trenton-New Brunswick
i. FACTS: Agreement given to one shareholder to supervise and control and
could be removed only by arbitration.
ii. RULE: An agreement in which the restrictions are not innocuous or slight,
for example when the agreement totally eliminates the role of the directors,
the agreement is invalid.
g. Bottom Line here regarding agreements among shareholders: It is a weighing test to
determine whether a contract will be recognized by the court. The question is what
damage is done relative to the usurpation of authority.
h. Galler v. Galler – Current Law on Shareholder Agreements
i. FACTS: Parties had equal proportion shares. They each contracted to sell 6
shares to a third party. The parties entered into an agreement that stipulated
that they wanted to provide income for the support and maintenance of their
immediate families. When one party went to the other to have the agreement
carried out, they refused. D then purchased the 12 shares back from the third
party. P sought to get 6 of those shares transferred back to her.
ii. RULE: When the parties to the action are the complete owners of the
corporation, there is no reason why the exercise of power and discretion of
the directors cannot be controlled by a valid agreement between themselves,
provided that the interests of creditors, minority shareholders, and the pubic
generally are not affected.
1. If everybody agrees, there can be no injury
iii. This is a complete rejection of McQuade and Clark v. Dodge
1. Now, we are just looking to see if there is an injury to anyone.
iv. Evolution

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 1. McQuade – outlawed agreements
2. Clark – tested the reasonableness of an agreement
3. Long Park – looked at slight v. total abrogation
4. Galler – closely held corp agreements protect minority interests and
are upheld unless there is an objecting minority interest or a
detriment/injury suffered. Without an injury, court will uphold.
i. Zion v. Kurtz
i. FACTS: Parties entered into an agreement that no business activities of the
corporation shall be conducted without the consent of the minority
shareholder (one of the parties). The board then approved two agreements
over the objection of the minority shareholder. He sued, claiming that the
agreements violated the shareholder’s consent agreement.
ii. RULE: If the shareholders can agree to modify rights, the court is going to
uphold the agreement if all shareholders agree to it.
iii. Note that the court here says that it does not matter that the corp did not elect
to be treated as a close corp because this is a close corp on a practical level.
j. Nixon v. Blackwell
i. DE SC refused to adopt the DE principle that you do not have to be officially
incorporated as a close corporation to get the benefit of the Zion rule.
1. If you want to qualify for the benefit, you have to file an evidence on
your certificate of incorporation that you are in fact a close
corporation.
k. Matter of Auer v. Dressel – Publicly traded corporation
i. FACTS: Bylaws provide a shareholder meeting if there is a requisite number
of voters. Class A stockholders asked President to hold a meeting; he refused.
ii. RULE: Court will require a strict adherence to corporate bylaws,
including holding a meeting when the bylaws require it. It does not matter
that the results of the meeting are not binding or may be arbitrary.
1. Note that this is a publicly traded corporation. In a publicly traded
corporation, there’s not much that shareholder can do in the way of
managing the business. Calling a meeting to vote on the director helps
keep the directors in check.
III. Share Transfer Restrictions
a. Stockholders of close corporations usually agree to limit the transferability of shares
in the corporation.
b. General rule: Courts are far more willing than they used to be to uphold share
transfer restrictions.
i. Modern: Courts require the restrain to be reasonable.
c. Techniques for restriction:
i. Right of first refusal – a shareholder may not sell his shares to an outsider
without first offering the corporation or the other current shareholders a right
to buy those shares at the same price and terms as those at which the outsider
is proposing.
ii. First option at a fixed price – price is determined by the agreement creating
the option.
iii. Consent – a shareholder’s transfer of stock may be made subject to the
consent of the board and other directors.

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 iv. Buy-back rights – given to the corporation to enable it to buy back a holder’s
shares on the happening of certain events, whether the holder wants to sell or
not.
v. Buy-sell agreement: corporation is obliged to go through with the purchase
upon the happening of the specified event.
d. Who has the right to buy:
i. Purchase by the corporation – typically the corp is given the first opportunity
to purchase the shares
ii. Purchase by remaining shareholders – if corp does not purchase, the
shareholders have the right to repurchase in proportion to their existing
holdings.
e. Notice and consent to restrictions:
i. A holder who purchased without either actual or constructive notice of the
restriction will not be bound by it.
1. Unless the restriction was conspicuously noted on the share
certificates
f. Case Examples:
i. DeBaun v. First Western Bank and Trust Co.
1. FACTS: Bank wants to sell its 70% interest in a corporation. The
Bank hired an investment bank to find a buyer. The investment bank
found a bad buyer who had a history of litigation, bankruptcies, etc.
Bank never pursued the records of the buyer. After buyer came into
control, the corp folded.
2. RULE: In any transaction where the control of the corporation is
material, the controlling majority shareholder must exercise good
faith and fairness from the viewpoint of the corporation and those
interested.
a. Duty to act reasonably with your controlling interest
b. The duty encompasses an obligation of the controlling
shareholder in possession of facts such as to awaken suspicion
and put a prudent an on his guard that a potential buyer of his
share may loot the corporation of its assets.
i. If you smell a looter, you must investigate and will be
held to a standard of good faith and reasonableness.
ii. You don’t have to be right, but you have to show that
you made a reasonable effort to protect the corp from
looters
ii. Perlman v. Feldman
1. FACTS: Corp benefitted from the Feldmann Plan, in which it secured
interest-free advances from a company in return for firm
commitments for future production. Feldmann sold his shares to the
company. Ps claimed that the price for which he sold his shares
included compensation for the sale of a corporate asset – the ability to
control the allocation of the corporate product in a time of short
supply.
2. RULE: When the sale of controlling stock necessarily results in a
sacrifice of the element of corporate good will and consequent

36
 unusual profit to the fiduciary who has caused the sacrifice, he should
account for his gains.
a. Court applies the duty of a director to a majority shareholder.
iii. Section 13 MCBA – Right to Appraisal and payment of Shares
1. If you are a disgruntled shareholder and you don’t think that the assets
of the business are being sold for enough, but you can’t block the sale,
the statute allowed you the right to say that the price is inadequate,
and dissent to the transaction.
a. You HAVE TO vote against first then go to the court. The
election still happens, you just get to recover the pro rata for
value for your shares.
b. File a notice dissenting and seeking appraisal rights with the
court
c. Court determines the fair value of shares and decides
d. This is not opt in/opt out – this is statutory
e. Majority has the obligation to notify minority shareholders
that they have the right to dissent.
2. Kaplan case –
a. RULE: It is okay to receive a control premium when you sell
majority interest because the shares are inherently worth more
than minority interest.
b. But remember that the majority shareholder has a duty of
uncorrupted loyalty to the corporation
iv. Ling and Co. v. Trinity Sav. and Loan Ass’n
1. FACTS: Shareholder agreement that made restrictions on transfer of
shares.
2. RULE: Restrictions on the transfer of shares must be conspicuously
labeled, reflected on a signed written agreement, and reasonable in the
eyes of the court.
a. Reasonableness
i. Cannot unreasonably withhold transferability
b. Conspicuous
i. On the shares itself, it should state that they are
restricted or subject to an agreement.
1. Exception is if the party knew or should have
known that there was an agreement
3. This is embodied in MCBA 6.27
IV. Shareholder Voting
a. Background
i. Voting agreement: an agreement in which two or more shareholders agree to
vote together as a unit on certain or all matters.
1. Time Limits: generally remain in force for an indefinitely long period
of time.
2. Enforcement:
a. Proxies – votes the shares as provided in the agreement
b. Specific performance – court orders the breaching shareholder
to case his vote according to the agreement.

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 ii. Note the difference from a shareholders’ agreement, which the broadest
agreement and does not just address voting
iii. Voting trust: shareholders who are part of the arrangement convey legal title
to their shares to one or more voting trustees, under the terms of a voting trust
agreement.
1. Shareholders become beneficial owners – they no longer have voting
power, even though they receive dividends, etc.
2. Maximum term – usually 10 years
3. Disclosure – most statutes require public disclosure of the trust’s
terms, so that the existence and terms will not be hidden from other
shareholders.
4. Writing: trust must be in writing
b. Salgo v. Matthews
i. FACTS: P presented proxy documents to the court in support of P’s
candidate to the Board. Beneficial title was owned by one person and record
ownership by another. Election inspector had refused to accept any of the
proxies.
ii. RULE: As among shareholders, you must go to the corporate record book to
determine ownership. Voting rights rest with the registered owner of the
shares, not with the beneficial owner unless the proxy is issued in favor of the
beneficial owner. Record owner has the right to vote.
c. Ownership
i. Two types:
1. Record/registered ownership – voting rights are vested here
2. Beneficial ownership – rights of shares are designated to best in this
person. No right to vote.
3. BUT, if the beneficial owner receives a proxy from the registered
owner, then they can vote as holder of the proxy.
ii. Quorum – MCBA 7.25
1. A quorum is the requisite number of shareholders necessary to be
present to take action/vote. All that matters are votes cast at the
meeting – not votes in absentia. If votes in favor are more than votes
against, the motion passes.
2. Quorum will be designated in the AI.
d. Voting
i. Pre-conditions for a valid vote:
1. Proper notice
2. Quorum
ii. Straight Voting – the pure majority controls; the one who garners the most
votes will win. Everyone votes once for each share they own.
1. Minority shareholders will always be oppressed – esp in a close
corporation.
2. Example: A owns 750 shares and B owns 250 shares. There are 4
directors to be elected. A votes 750 for C, 750 for D, 750 for E, and
750 for F. B votes 250 for each candidate.
iii. Cumulative Voting – system provides that a shareholder may multiply his
number of shares by the total number of open positions and case the total
number of votes for a single candidate. Governed by a mathematical formula.

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 1. Example: A and B can divide their shares appropriately. A has
(750x4) 3000 shares and B has (250x4) 1000 shares. B can vote all
his shares for 1 director and win one seat.
2. Formula: [nS/(D+1)] +1 = the number of shares needed to elect n
directors
a. n = number of directors desired to be elected
b. S = total shares voting (all shareholders)
c. D = number of positions to be filled
3. Note that cumulative voting is rarely used in publicly traded
corporations
iv. States and Voting
1. Mandatory: Seven states make cumulative voting mandatory by a
statutory or state constitutional provision. In these states, even an
amendment to the AI specifically banning cumulative voting will be
ineffective.
2. “Opt-in” election: Thirty states permit cumulative voting, but only if
the AI specifically elect to have it.
3. “Opt-out” election: Thirteen state provide that cumulative voting is
allowed unless the AI explicitly exclude it.
v. Stancil
1. FACTS: One shareholder votes cumulatively and one votes straight.
2. RULE: State law requires cumulative voting – guy who voted straight
should have known.
vi. Humphrys v. Winous Co.
1. FACTS: OH statute provides for the right to vote cumulatively.
2. RULE: Effectiveness of cumulative voting is not ensured by statute.
A court will guarantee the right to cumulative voting, but not the
effectiveness of minority representation.
a. Under the MCBA, corporations must opt-in for cumulative
voting.
i. Unless the state statute requires cumulative voting to
protect minority shareholders.
vii. Ringling Bros v. Ringling
1. FACTS: Shareholders made an agreement in which they agreed to
arbitrate the case of deadlock and to confer before voting. The arbiter
would not actually vote shares, but he could order a party to vote
shares. At to election of a director, they could not come to an
agreement. One asked for a postponement, but the other refused.
Shareholders voted and the party who refused did not comply with
arbiter.
2. RULE: The undertaking to vote in accordance with the arbitrator’s
decision is a valid contract and accordingly, the failure of one party to
exercise her voting rights in accordance with the arbitrator’s decision
was a breach of contract. A pooling agreement is a valid agreement
that must be upheld.
3. How does this measure against McQuade?
a. McQuade had to do with an encroachment on the directors to
act as directors.

39
 b. In shareholder agreement cases
i.  is there encroachment on the directors’ ability to act
as directors – have to go to the injury rule (will
minority shareholders, creditors, or the public be
harmed by the agreement?)
ii.  is this just an agreement between shareholders that
does not affect directors’ rights?
1. Court will enforce it.
viii. Vote Buying
1. Many statutes are silent on the issue of whether you can sell votes
2. Two tests for determining if buy/sell okay:
a. Is there any purpose designed to defraud or disenfranchise
other stockholders?
b. Does public policy make the sale impossible to enforce?
3. ***Very factually determined.
4. If deceit, it is per se illegal. If it is at arms length, the court will look
at the laws of the jdx to determine if the agreement would be
intrinsically unfair.
ix. Brown v. McLanahan
1. FACTS: P was a preferred stock owner who sued when the voting
trustees passed an amendment that vested voting rights in the
debenture holders and eliminated the preferred stock owners’ right to
vote.
2. RULE: Voting trustees cannot exercise powers in a manner
detrimental to the grantor extending to the debentures the voting right,
even if the power is within the general powers of the trustee.
a. Where there is a trust relationship, courts are going to look
askance at actions of trustees that thwart in any way the
underlying intent of the grantor.
x. Lehrman v. Cohen
1. FACTS: Two groups of stockholders with equal voting rights agreed
to establish a fifth directorship for purposes of avoiding a stalemate.
This third class was given to one third party. His shares were very
circumscribed – limited to the right to elect the fifth director with an
express recognition that there was no right to dividends or
distributions other than par value. He was given a K and options,
which one class voted against. When third party was elected president
of the company, the same class opposed that too. P argues that they
created a voting trust, which was illegal under state statute.
2. RULE: Deadlock breaking mechanisms are appropriate and
shareholders may decide themselves how to deal with voting issues.
a. A class of stock may be created that gives its holder voting
power without any real economic ownership.
e. Breaking a Deadlock
i. Create a separate class of stock
ii. Voting agreements
iii. Voting trust

40
f. Voting Deadlocks
i. Situations in which there may be a deadlock
1. All votes split evenly
2. Not enough votes for a quorum – no action possible
3. Even number of directors
ii. How to get around a deadlock
1. Give a specific share to a deadlock-breaking vote
2. Change the voting based on actual ownership
3. Put in a buy/sell agreement that forces action when there is a deadlock
circumstances – this is by contract
4. Send it to arbitration
iii. Gearing v. Kelly- Quorum and Meeting Attendance – NOT GOOD LAW
1. FACTS: Director did not attend a meeting for the sole purpose of
preventing a quorum from assembling. Other directors voted anyway
when she did not show up to the meeting.
2. RULE: The court need not permit a director to attack actions of the
Board when she intentionally refused to attend a meeting.
3. Bottom Line: P gets screwed either way  she either goes and votes
and loses and or stays away and they vote without her.
iv. In re Radom & Neidorff – Dissolution by the court
1. FACTS: Brother and sister jointly own a corporation. They are at a
stalemate as to corporate policies but the corporation is flourishing.
They cannot agree on anything and are unable to elect a third director.
P sought dissolution of the corporation.
2. RULE: Dissolution of a corporation is only necessary when the corp
cannot make a profit. As long as the corp is making a profit, the corp
is beneficial to the stockholders and the court will not dissolve.
a. STATUTE WILL GOVERN DISSOLUTION.
i. Modern grounds for dissolution: fraud, waste,
misconduct, abandonment
ii. MCBA 14.30:
1. Dissolution in a proceeding brought by a
shareholder
a. Business cannot be conducted to the
advantage of the shareholders
b. Oppression by directors
c. Failure to elect directors whose terms
have expired
d. Corporate waste
g. Modern Remedies for Oppression, Dissension, or Deadlock
i. Techniques for dealing with dissension:
1. Dissolution – corporation ceases to exist as a legal entity
a. No automatic right to dissolution
b. Under MCBA, must show:
i. Director deadlock; or
ii. Oppression; or
iii. Shareholder deadlock; or

41
 iv. Waste
2. Buy-out
a. No automatic right to a buy-out; it must be court-ordered.
3. Arbitration
4. Provisional directors
a. Impartiality, if the statute says so. If not, the provisional
director need not be impartial.
5. Custodian – runs the business
6. Receiver – to liquidate the corporation rather than continue it
ii. Davis v. Sheerin – Buy-out
1. FACTS: Minority shareholder sought to examine the corporate record
books, but majority shareholder refused. Majority claimed that
minority had gifted his 45% interest. Trial court ordered a buy-out.
2. RULE: The court will order a buy out where there is oppressive
conduct on the part of the majority over the minority and less harsh
remedies are inadequate.
a. The finding of conspiracy to deprive minority shareholder of
his interest in the corporation, together with the acts of willful
breach of fiduciary duty, are sufficient to support the
conclusion of oppressive conduct.
b. Oppression is burdensome, harsh, and wrongful conduct
3. OPPRESSION is found in two circumstances, generally:
a. The majority is defeating the minority’s interest in
participating in the venture
b. There is a systematic exclusion of the minority from the
affairs of the business
iii. Shoot-it-out clause
1. In a dissolution, everybody loses.
2. In a buy-out, the business continues and the majority gets to continue
the practice and make a profit.
a. Also requires a fair price for the minority shareholder
3. Shoot-it-out: If I tender my shares to you for $5/share, you have the
option of buying them or selling the shares to me at $5/share. The
person wanting out makes an offer to buy for a reasonable price,
which is also an offer to sell to the other shareholder if the other
shareholder does not want to sell his shares. The price of wanting the
deal – you set the price, but you let the other person decide who
remains as majority shareholder.
a. This is all contractual
b. This is an effective way to end a business without having to go
to court.
iv. Abreu v. Unica Indus. Sales, Inc.
1. FACTS: Trial court appointed a provisional director of a corporation
because of a conflict between two factions of shareholders.
2. RULE: In appointing a provisional director, the trial court only
considers the best interests of the corporation and not those of the
warring factions

42
 a. No strict requirement of impartiality in appointing a
provisional director, as long as the provisional director is not
oppressive
i. Provisional director must have necessary skill and
know the business.
b. Provisional director can only break ties – he cannot
unilaterally make decisions for the corporation.
3. NOTE: Only natural persons may be directors; a corporation cannot
be a director.

Duty of Care and the Business Judgment Rule

I. Business Judgment Rule – If you have not engaged in a breach and you have been duly
informed, the court will not second guess your judgments as director, even if the
judgment proves to be wrong/bad.
a. A decision is not protected if the directors making it have a disabling conflict of
interest or are involved in self-dealing.
b. This is process-driven, as opposed to substantive-driven
II. Relationship between the Business Judgment Rule and the Duty of Care
a. Once the procedural requirements of the duty of care are met, the business judgment
rule sets out a far more easily satisfied standard with respect to the substance of the
business decision: that decision would be upheld as long as it is rational.
b. Reqs of Bus Jdmt Rule:
i. No self-dealing
ii. Decision after gathering information
iii. Rational belief in the corporation’s best interest
III. Directors’ Duties
a. Duty of Care
i. So long as you act in an informed manner, as a reasonable person would
have acted, the decision will not be second guessed by the court.
b. Duty of Loyalty
i. No self-dealing
ii. Corporate opportunity
iii. Competition
iv. False/misleading information to shareholders
IV. Liability
a. If a director or officer violates his duty of care to the corporation, and this violation
causes loss to the corporation, the director/officer will be personally liable to pay
money damages to the corporation.
i. Injunction: situation in which the board of directors has approved a
transaction, and a shareholder or outsider sues for an injunction to block the
proposed transaction. If the court concludes that the directors or officers have
not acted with due care, and that shareholders as a whole would be injured, it
may block the proposed transaction until it is approved with the required
level of diligence.
V. Duty of Care Cases
a. Litwin v. Allen
i. FACTS: Corp A agreed to a deal with another corporation B in which A
purchased bonds for $10,000,000. The terms of the deal allowed B to

43
 repurchase the bonds for the original price if it did within 6 months of the
first deal. This was pretty much a loan transaction.
ii. RULE: The Court will impose liability if the directors’ actions are contrary to
a level of care exercised by a reasonably prudent person in the same
circumstances.
1. Minimum rationality test – This does not mean that the directors must
always act for profit; it just means that the directors’ must be
reasonably prudent.
2. Note this is there is no chance for any profit, then the transaction fails
the minimum rationality test
3. This is a factual determination to figure out what a careful and
prudent person would have done in the same situation.
iii. THIS IS NO LONGER THE LAW
b. Shlensky v. Wrigley
i. FACTS: Chicago Cubs case. Wrigley refused to install lights and schedule
night games because “baseball was a daytime sport” and he did not want to
change the nature of neighborhood.
ii. RULE: There must be fraud or breach of good faith on the part of the
directors in order to justify the courts entering into the internal affairs of the
corporation to resolve questions of policy and business management.
1. There is a presumption that directors’ actions will be appropriate in
the absence of fraud, illegality, or conflict of interest.
iii. NOTE: The court says that there is no obligation to follow the crowd; a
director may make his own independent judgment and that it is okay.
iv. NOTE: There was no personal benefit to the director here (different from
Ford). If Wrigley had personally benefitted, there would be a duty of loyalty
issue.
c. Summary of Business Judgment Rule
i. The bus jdmt rule is designed to limit liability when there is a good faith
pursuit of the director’s duties.
ii. Bus Jdmt Analysis:
1. Look for self-dealing (breach of duty of loyalty)
2. Look at whether the action is in the best interest of the corporation
(breach of duty of loyalty)
3. Look at whether the director took appropriate steps to be informed –
the process (breach of duty of care)
4. Look for egregiously bad judgment or bad faith
iii. Good faith + Process to be informed = Availment of bus jdmt rule
d. Smith v. Van Gorkom – this case is the most important duty of care case
i. FACTS: Director wants to arrange a leveraged buy out. He meets with CFO,
who suggests $50-$60 range. Director has an intrinsic sense that this is a fair
price. He calls buyer and they talk about price. Director does this without
consulting the Board. Buyer makes an offer. Director calls the Board. A draft
merger agreement is handed out – too thick to study. CFO objects to the
price. Directors approve the transaction. Shareholders sue, claiming not
enough information.
ii. RULE: When no informed judgment occurs, directors may not avail
themselves of the bus jdmt rule.

44
 1. What constitutes informed judgment?
a. No valuation study = Lack of sufficient information necessary
to reach an informed bus jdmt.
b. Good faith is irrelevant for purposes of determining bus jdmt.
Personl gain, self-dealing, and bad faith are relevant for
purposes of loyalty, which is not at stake here.
c. Does not matter that these were educated men with
backgrounds in business and finance.
i. They did not review the proposal, did not inquire in the
CFO’s statement that the price as too low, did not
scrutinize the offer price, and did not question the tax
implications of the purchase.
iii. REMEMBER: If you don’t get the benefit of the bus jdmt rule, the
transaction will still be tested for fairness. If the transaction is fair for
shareholders, there will be no liability. Even if bus jdmt rule is not
available, liability only arises if the transaction is not fair.
iv. Aftermath of Smith v. Van Gorkom
1. Everyone went out to get fairness evaluations as a sort of insurance
policy.
2. A consequence of this case is that directors themselves can be sued, in
addition to the corporate entity.
3. Today, almost no deals are made without getting an independent third
party advice
4. Statutory response – MSCBA 2.02(b)(4)
a. Limits the personal liability of directors
b. AI may set forth language eliminating or limiting the liability
of directors except for liability for
i. The amount of a financial benefit received by the
director to which he is not entitled
ii. An intentional infliction of harm on the corporation or
the shareholders
iii. Violation of 8.33 – unlawful distributions
iv. An intentional violation of criminal law
e. In re Caremark Intern, Inc. – Building on Smith v. VanGorkom
i. FACTS: Medicare case. Corp entered into agreements for Medicare referrals,
which did not violate federal law, but which raised the suspicion of
kickbacks. Corp was indicted and settled. Ps then sued, claiming that the
directors allowed a situation to develop and continue which exposed the
corporation to enormous legal liability and in doing so, they violated a duty
to be active monitors of corporate performance.
ii. RULE: A director’s obligation includes a duty to attempt in good faith to
assure that a corporate information and reporting system, which the board
concludes is adequate, exists, and that failure to do so under some
circumstances may, in theory at least, render a director liable for losses
caused by non-compliance with applicable legal standards.
1. Directors do not actually have to know – they just have to put in a
system that allows the collecting and reporting of information so that
they conceivably would know.

45
 2. Caremark stands for the proposition that you need to have a sustained
and systematic information and reporting system – it cannot just
be a one-time action.
f. Review of Duty of Care
i. Directors must be informed.
ii. In a sale transaction (Smith v. VanGorkom) – Requires an independent
valuation by an outside third party.
iii. In day-to-day transactions (Caremark) – Requires a systematic reporting
and compliance system to monitor the business/provide oversight.
iv. If a director fulfills these requirements, he will be entitled to protection under
the business judgment rule.
g. Stone v. Ritter
i. FACTS: Corp paid money in civil penalties arising from the failure of bank
employees to file reports under federal law. Ps contend that the court needs to
evaluate the fairness of the transaction because they violated the duty of care.
ii. RULE: To show liability, P must show either that: (1) the directors failed to
implement any reporting or information system or controls, or (2) having
implemented the controls, they consciously failed to monitor or oversee its
operations.
1. This case affirms Caremark – you are acting in good faith if you have
a compliance and reporting system in place. If you take the necessary
steps, that is good enough to get the bus jdm rule.
iii. REMEMBER that first you have to be loyal and second you have to be
informed. If you are not loyal, the court is not going to get to the question of
care and whether the director is entitled to bus jdmt.
h. Malone v. Brincat – Honest disclosure
i. FACTS: Ps claim that directors intentionally overstated the financial
condition of the corp in disclosures to shareholders. Ps allege that directors
had a duty of disclosure.
ii. RULE: Directors who knowingly disseminate false information that results
in corporate injury or injury to individual shareholders violate their fiduciary
duty and are liable.
1. NOTE: It must be knowing dissemination of false information.
a. For example, if directors relied in good faith on information
from accounts that they had reason to believe are correct, they
will not be liable.
b. Directors do not have to be correct, but they must honest.
iii. This duty of honest disclosure really derives from the combined duties of
loyalty, care, and good faith.
iv. Applies even f the shareholders are not requesting information – just getting
it through financial disclosures.
v. NOTE: Shareholders are entitled to rely on director statements in three
situations:
1. Public statements
2. Statements about the affairs of a corporation without a request for
shareholder action
a. Failure to disclose here is a breach of duty of loyalty

46
 3. Statements to shareholders in conjunction with a request for
shareholder action
a. Failure to disclose here is a breach of duty of duty of
disclosure
b. When shareholders request action, there is a duty to obligation
to disseminate material information relevant to the requested
shareholder action
4. RULE of disclosure: When the corporation provides information
to its shareholders, it has a general duty as a corporation to
disclose fully and fairly all material information.
a. This applies to closely held corporations, as well.
vi. Derivative Suits - Gall v. Exxon
1. FACTS: Derivative suit. Corp paid $59 million in bribes or political
payments in Italy. Directors made a committee to determine whether
the corp should bring an action against the directors who gave bribes.
Committee determined that it was not in the best interest of the
corporation to bring an action against the directors.
2. RULE: Court employs a process test here to determine whether the
committee exercised its bus jdmt. If the committee satisfies the duty
of loyalty and duty of care, then it is protected by the bus jdmt rule.
3. NOTE: Litigation committee devices are the standard response of
corporations to derivative suits.
a. As long as committees follow a process to be informed and do
not violate the duty of care, they will be protected by the bus
jdmt rule.
vii. Demand Claims – NOT ON THE FINAL
viii. In re Oracle
1. FACTS: Derivative suit alleging insider trading. Corp formed a
committee to investigate the merits of the claim. Ps challenged the
independence of the directors on the committee.
2. RULE: Court will look at the social and institutional relationships of
the committee members to determine the independence of the
directors.
a. Have to look at the whole panoply of events – don’t always
assume an absence of independence because connections
exist.
ix. Cuker v. Mikalauskas – Bus Jdmt and termination of derivative lawsuits
1. FACTS: Board created a committee to consider potential litigation.
The committee found no evidence of bad faith, self-dealing,
concealment, or other breaches of duty of loyalty by any of the
defendant officers. It also concluded that the defendants authorized
sound business judgment and that proceeding with the actions would
not be in the best interests of the corp.
2. RULE: The business judgment rule permits the board of directors to
terminate derivative law suits brought by minority shareholders.
a. Factors in assessing bus jdmt: independence, counsel,
adequate investigation, good faith, disinterest, written report
by the committee.

47
 b. Bus jdmt will protect officers in the absence of fraud or self-
dealing, if challenged decisions were within the scope of the
directors’ authority, if they exercised reasonable diligence,
and if they honestly and rationally believed their decision were
in the best interests of the company.
3. Court here applies ALI Standard
i. Summary and Review
i. Duty of Care – process that you must go through to avail yourself of the bus
jdmt rule
1. Sale transaction – independent valuation
2. Everyday transactions – information and reporting system in place
3. Dismissal of derivative suit – independence and good faith of
directors/committee
4. Disclosure – part of the directors’ duty of care is to disclose honest
information to the shareholders – it is okay if it is not correct, as long
as it is honest
ii. Business Judmt Rule – even if you cannot avail yourself of this protection,
you are not liable unless the transaction was not fair to the shareholders.
iii. Duty of Loyalty –
1. Self-dealing
2. Corporate opportunity
iv. Has the director/officer breached his or her duty of care by not going
through the informed decision-making process?
1. No  protected by business judgment rule.
a. Has the director/officer breached his or her duty of loyalty
by acting in bad faith, self-dealing, or infringing on
corporate opportunity?
i. No  Ct upholds director.
ii. Yes 
1. Was the transaction inherently unfair to the
corporation?
a. No  Ct upholds action
b. Yes  Director liable.
2. Yes 
a. Was the transaction inherently unfair to the corporation?
i. No  Ct upholds action
ii. Yes  Director liable
Duty of Loyalty and Conflict of Interest
I. Self-Dealing
a. Marciano v. Nakash
i. FACTS: Corp owned 50/50. Faction A loaned $2.5 million in loans to the
corp without the requisite votes or authority. Deadlock over the questioned
transactions. Faction B says this was self-dealing by Faction B.
ii. RULE: In transactions involving self-dealing, those transactions will not be
voidable per se, but rather evaluated (1) under statutory standards if available
and (2) if you can’t avail yourself of the statute, under the intrinsic fairness
test.

48
 1. At the end of the day, if the transaction is inherently fair, regardless of
the director’s self-interest, then the transaction survives.
a. That is, when the transaction is inherently fair, you can still
not meet the statutory requirements and also still not be held
liable. A transaction may be interested, but may still be
intrinsically fair, in which case it is not voidable.
iii. NOTE: the federal Sarbanes-Oxley Statute makes it illegal for a corporation
to loan money to directors or officers of a corporation.
b. Heller v. Boylan – S/H approval
i. FACTS: Shareholders unanimously approved a bylaw that gave annual
profits to corporate officers. Various officers ended up making a lot of
money. Ps alleged corporate waste and spoliation.
ii. RULE: If the stockholders approve something, the court is not going to
overturn it unless it can find by a reliable standard the presence of waste or
spoliation.
1. Waste test: is the payment so large as to constitute waste?
a. This is going to be factually determined – this is going to be a
facts and circumstances test.
b. If the directors get information about the plan and reasonably
relied in good faith on that information, the bus jdmt rule will
apply and the court’s ability to prune the waste will be taken
away.
i. If no bus jdmt – fairness test
c. Brehn v. Eisner I
i. FACTS: Disney case. Ps claimed Old Board breached its fiduciary duty in
approving an extravagant and wasteful Employment Agreement with Ovitz
and that New Board breached its duty in agreeing to a non-fault termination
of the Agreement. OB failed to realize that the agreement gave Ovitz and
incentive to leave and NM was wasteful in computing the value of the
severance package at over $140 million.
ii. RULE as to OB: It is the essence of the bus jmdt rule that a court will not
apply 20/20 hindsight to second guess a board’s decision, except in rare cases
where a transaction may be so egregious on its face that the board approval
cannot met the test of bus jdmt.
1. Note the importance of reliance on an exper in bus jdmt.
iii. RULE as to OB for waste: If there is substantial consideration received by the
corporation, and if there is good faith judgment that in the circumstances the
transaction is worthwhile, there should be no finding of waste, even if the fact
finder would conclude ex post that the transaction was unreasonably risky.
d. Brehm v. Eisner II
i. FACTS: Remand to trial court. Ps appealed the finding that the compensation
committee breached no duty of care in considering the terms of the
Agreement with Ovitz.
ii. RULE: An informed committee does not breach the duty of care; bad faith is
defined as an actual intent to do harm – not just gross negligence.
e. Sinclair Oil Corp v. Levien – Parent/Sub and Bus Jdmt Rule
i. FACTS: Parent owns 97% of sub. P dominated sub’s Board. P caused sub to
pay out excessive dividends, sub’s industrial development was prevented, and

49
 sub became corporation in dissolution. All payments made by sub to parent
were made in compliance with statute. Plaintiffs allege that the dividends
were paid out because P needed the money.
ii. RULE: When a situation involves a parent and a sub, with the parent
controlling the transaction and fixing the terms (i.e. self dealing), the test
of intrinsic fairness, with its resulting shifting of the burden of proof,
applies.
1. For purposes of the intrinsic fairness test, if the parent receives a
benefit to the exclusion of the sub, then there is self-dealing and we
apply the intrinsic fairness test as opposed to the business judgment
test.
2. Bus judgment applies only when there is no self-dealing.
3. How to determine self-dealing?
a. Treatment of majority same as treatment of minority?
b. Did everyone share in the dividends?
f. Weinberger v. UOP**** Parent/sub with shared directors
i. FACTS: Signal buys an interest in UOP. Later it does a feasibility study to
determine whether to purchase the remaining shares in UOP. Signal decides
to acquire the shares at $20-$21. UOP retains Lehman for help with the sale.
Lehman says it is fair a price. He presents opinion to the Board of UOP and
directors vote in favor of the sale. Merger goes forward. Ps allege that the
guys who wrote the feasibility study were involves on both sides of the
transaction. Because of their unique position of straddling, they have
information that should be shared between the two companies and they did
not share it. They sat in both camps, but prepared a report only for the benefit
of one – this looks like self-dealing.
ii. RULE: Individuals who act in a dual capacity as directors of two
corporations, one of whom is parent and the other subsidiary, owe the same
duty of good management to both corporation, and in the absence of an
independent negotiating structure, or the directors total abstention from any
participation in the matter, this duty is to be exercised in light of what is best
for both companies (i.e. complete candor).
1. There was self-dealing here, so the court goes straight to the intrinsic
fairness test. Bus jdmt does not apply when duty of loyalty is
breached.
2. Duty of loyalty is only met if there is fair dealing in the utmost good
faith; if one party had information, it cannot refrain from giving it to
another group of directors.
3. Intrinsic fairness test:
a. Look at fair dealing and fair price
iii. NOTE: Parent/sub pattern is going to depend on common directors. If no
common directors, then no fiduciary duty. It is the relationship that the
individuals have to the two corporations that is important, not just the
parent/sub relationship.
II. Corporate Opportunity Doctrine
a. Implicates a right which belongs to the corporation but is usurped by another,
typically a director or an officer
b. Northeast Harbor Gold Club v. Harris

50
 i. FACTS: Harris was the president of the Golf Club. She purchased a bunch of
land surrounding the golf course and eventually sought approval to develop a
sub division. Board sued Harris, alleging that the proposed housing
developments were contrary to the best interests of the corporation.
ii. RULE: Corporate fiduciaries in Maine must discharge their duties in good
faith with a view toward furthering the interests of the corporation. They
must disclose and not withhold relevant information concerning any potential
conflict of interest with the corporation, and they must refrain from using
their position, influence, knowledge of the affairs of the corporation to
gain personal advantage.
iii. PROPOSED TESTS:
1. Line of Business test – was the opportunity so closely associated with
existing business opportunities as to bring the transaction within the
class of cases where the acquisition by the corporate officer would
bring that person in some kind of competition with the corporation?
2. Durfee test – whether the transaction resulted in unfairness in the
particular circumstances
3. Miller test – combines the line of business test with the unfairness test
4. ALI test –
a. Did the party offering the opp expect it to be offered to the
corporation? Is the party making the offer making it to the
corporation?
b. Was the opp that arose one that arose through the use of
corporate information or property and if so, should the director
reasonably be expected to believe the opportunity would be of
interest to the corporation?
c. Was the opp one to engage in a business activity that the
director should have known that the corp is engaged in or
expects to engage in?
5. Focus here is on disclosure – you must make the disclosure and then
have the Board say it is okay.
iv. NOTE on Financial Inability:
1. Courts differ on this, but most reject it because it would make officers
corporate opportunists – directors wait to being up an opportunity and
Bd has to reject because no money.
III. Duties of officers and directors that extend beyond duties to the corporation
a. Creditors – general rule of law is directors owe no fiduciary duty to creditors.
Courts have said that this is what a contract is for – you can protect your rights as a
creditor by entering into a contract.
i. Only duty is when the corporation is in the zone of insolvency – the only time
you find the court invoking a fiduciary duty as to the creditor is when the
corporation is in the zone of insolvency.
IV. Overview of Fiduciary Duties of Directors to Shareholders
a. Duty of Care
i. Was the director reasonably informed?
1. Sale transaction – valuation study
2. Everyday transactions – system of information and reporting

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 3. Dismissal of derivative suit – independence and good faith of
directors/committee
4. Disclosure – part of the directors’ duty of care is to disclose honest
information to the shareholders – it is okay if it is not correct, as long
as it is honest
b. Business Judgment Rule –
i. If the director was reasonably informed, he satisfies the duty of care and is
entitled to the bus jdmt rule
ii. If the director was not reasonably informed, he does not satisfy the duty of
care. However, he may still be protected if the transaction was intrinsically
fair (and he did not violate the duty of loyalty).
c. Duty of Loyalty – if director is fulfills duty of care and is entitled to business
judgment rule, still have to look at whether the director breached the duty of loyalty
i. Self-dealing
1. Not voidable per se  Have to look at whether the transaction was
intrinsically fair for the corporation.
ii. Waste
1. If there is substantial consideration received by the corporation, and if
there is good faith judgment that in the circumstances the transaction
is worthwhile, there should be no finding of waste, even if the fact
finder would conclude ex post that the transaction was unreasonably
risky
iii. Fraud
iv. Corporate Opportunity
1. Different tests – but comes down to disclosure and a broad definition
of corporate opportunity.
v. Parent/Sub
1. Directors acting in both camps – duty of complete candor to both
corporations
2. P controlling sub – intrinsic fairness test (with shifting burden of
proof)

Transactions in Shares: Rule 10b-5, Insider Trading, and Securities Fraud

I. Background
a. Definition: A person engages in “insider trading” if be buys or sells stock in a
publicly held company based on material non-public information about that
company.
i. NOTE: Not all insider trading is illegal. In general, federal securities laws bar
only that insider trading that occurs as the result of someone’s willful breach
of fiduciary duty.
b. Examples of insider trading:
i. Buying before disclosure of good news to the public.
ii. Selling on bad news before the disclosure to the public
c. State Common-Law Approaches
i. A shareholder may bring an action for deceit:

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 1. P justifiably relied to his detriment on a misrepresentation of a
material fact made by the D with knowledge of its falsity and with
intent that P rely.
2. Action for fraud under state law
II. The Development of the Federal Remedy: Rule 10b-5
a. Created be the Securities Exchange Act of 1934
b. Language of the statute:
i. It shall be unlawful for any person, directly or indirectly, by the use of any
means or instrumentality of interstate commerce, or of the mails, or of any
facility of ant national securities exchange,
1. (a) to employ any device, scheme, or artifice to defraud,
2. (b) to make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements made,
in light of the circumstances under which they were made, not
misleading, or
3. (c) to engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person in
connection with the purchase or sale of any security.
c. Summary of the Statute:
i. D bought or sold stock in a company. The issuer will usually be a publicly-
traded company.
ii. At the time D bought or sold, he was in possession of information that was
material, i.e. would be considered important to a reasonable investor in the
issuer’s stock.
iii. The material information was non-public at the moment that D bought or
sold
iv. D had a special relationship with the source of the information
1. True insider of the issuer
2. Constructive insider – e.g. lawyer
3. Tippee – given information by an insider in violation of the insider’s
fiduciary duty
4. Misappropriator – an “outsider” vis a vis the issuer who gets his
information from someone other than the issuer, in breach of a
promise of confidentiality.
5. D meets the jurisdictional requirements. That is, he traded “by the
use of any means or instrumentality of interstate commerce or of the
mails, or of any facility of any national securities exchange.”
a. In the case of publicly-traded stock, this requirement is always
met.
d. Kardon v. National Gypsum
i. RULE: Stands for the proposition of a private right of action (not just state
action)
e. Blue Chip Stamps v. Manor Drug Store
i. RULE: Limits the application of Rule 10(b)(5) to actual purchases and sales
of securities
f. Ernst & Ernst v. Hochfelder
i. RULE: D must have an intent to deceive, manipulate, or defraud
ii. Enforcement of 10b5 cannot be based on negligence

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 g. Santa Fe Indust. v. Green
i. RULE: A breach of fiduciary duty does not necessarily mean a 10b5 action –
breach of fiduciary duty does not create “constructive fraud”
ii. There must be actual fraud – i.e. misrepresentation, omission, etc.
h. Aiding and Abetting
i. Aiders and abetters are liable to the SEC, but there is no private cause of
action
i. ***Always remember to consider state law remedies
j. In re Enron Corporation Securities, Derivative & ERISA Litigation
i. Deals with third party liability: Court evaluates the conduct of the banks, law
firms, and accountants by analyzing the actions that would be taken by
similar institutions in the same position.
1. P must establish that the third parties knowingly or with reckless
disregard stepped outside the boundary of legitimate and professional
acceptable activities in performing material acts to defraud the public.
a. Banks – Severe recklessness
b. Law firms – breached duty of accuracy and truthfulness
i. As a lawyer, if you think that your client wants you to
be dishonest, you must resign.
c. Accountants – lacked necessary independence
III. Insider Trading
a. SEC v. Texas Gulf Sulphur Co.
i. RULE:
1. 10b5 is based on the concept of equal access to information
2. If you have material inside information, you have a duty to
disclose before engaging in the trade or refrain from trading.
a. Remember: this only applies to material information
ii. When can you trade freely?
1. You can act when there is a level playing field – this occurs when
information has been effectively disclosed in a manner sufficient to
ensure its availability to the investing public.
2. No guarantee of public understanding – just equal access
b. Chiarella v. United States
i. RULE: A purchaser of stock who has no duty to a prospective seller because
he is neither an insider nor a fiduciary has been held to have no obligation to
reveal material facts.
1. Mere possession of nonpublic information does not trigger a duty to
speak.
2. Burger – misappropriation rule (C was entrusted with the information
in confidence, which created a duty not to speak)
c. Carpenter v. United States (Wall Street Journal case)
i. RULE: Court will find liability under the misappropriation theory.
d. United States v. O’Hagan
i. RULE: Constructive insider commits fraud in connection with a securities
transaction when he misappropriates confidential information in breach of the
duty owed to the source of the information.
1. Key is whether D had a duty to the source of the information
e. Dirks v. SEC – Tippee Context

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 i. RULE: Tippees may assume an insider’s duty to the shareholders not because
they receive inside information, but rather because it has been made available
to them improperly.A tippee assumes a fiduciary duty to the shareholders not
to trade on material nonpublic information only when the insider has
breached his fiduciary duty to the shareholders by disclosing the information
to the tippee and the tippee knows or should know that there has been a
breach.
1. Have to look at the insider
2. Absent a breach by the insider, there is no derivative fiduciary duty
f. United States v. Chestman – Family relationship and fiduciary duties
i. RULE: A fiduciary duty can be created by a similar relationship of trust or
confidence.
1. Intimate involvement in the family business
2. Kinship alone does not create the necessary relationship
3. Inner circle of the family
g. Tender Offers
i. SEC Rule 14e-3: it is forbidden to trade based on tender offer information
derived directly or indirectly from either the offeror or the target.
1. Imposes a duty of disclosure on any person trading in securities being
sought in a tender offer so long as:
a. (a) the person possesses material information that he
knows/has reason to know is not public, and
b. (b) the material has been gained from:
i. Person making the offer
ii. Issuer
iii. Officer, director, partner, employee, or someone acting
for them
2. This would address the Chiarella issue today.
3. The concept of Rule 10b5 applies equally to a tender offer as to the
purchase and sale of securities

Indemnification and Insurance

I. Background
a. Indemnification policy must be stated in the AI
i. Directors should always make sure they have indemnification if they serve on
a board
b. Because of the possibility of liability out of all proportion to compensation, directors
and officers need protection.
i. Indemnification – the corporation reimburses the director or officer for
expenses and/or judgments he incurs relating to his actions on behalf of the
corporation
ii. D&O liability insurance – can be paid either to the corporation or directly to
the director/officer
c. Mandatory indemnification
i. There are two situations in which the corporation may be required to
indemnify an officer or director:
1. When the officer/director is completely successful in defending
himself against the charges

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 a. “Success” – must be successful on the “merits or otherwise”
i. S/L qualifies
b. Multiple counts, some dismissed:
i. DE  allows for indemnification pro rata
ii. MCBA 8.52  requires that D be wholly successful,
on the merits or otherwise, in the defense of any
proceeding to which he was a party because he was a
director of a corporation against reasonable expenses
incurred by him in connection with the proceeding.
2. When the corporation has previously bound itself by charter, by law,
or by contract to indemnify
d. Permissive indemnification
i. A large zone of circumstances in which the corporation may, if it wishes,
indemnify the director or officer, but is not required to do so. The corp is not
obligated to indemnify in this situations.
ii. Limits: States typically prohibit indemnification where 
1. D is found to have acted in knowing violation of a serious law
2. D is found to have received an improper financial benefit
3. D pays a fine or penalty where the policy behind the law precludes
indemnification; or
4. The amount in question is a payment made to the corporation in a
derivative action
iii. MCBA 8.51: Allows for permissive indemnification where director
1. Conducted himself in good faith; and
2. He reasonably believed;
a. That his conduct was in the best interests of the corporation;
and
b. That his conduct at least not opposed to the best interests of
the corporation; and
c. In the case of a criminal proceeding, he had no reasonable
cause to believe his conduct was unlawful; or
3. He engaged in conduct for which broader indemnification has been
made permissible or obligatory under a provision of the AI
e. Advancement of Expenses to help pay the defense
i. MCBA 8.53: Terms under which the corp may advance expenses
ii. Some states permit corporations to advance litigation expenses to directors
and officers as they are incurred.
II. Merritt-Chapman & Scott Corp. v. Wolfson
a. RULE: DE allows partial indemnification, but this varies from jdx to jdx
i. MCBA requires wholly successful
III. Insurance
a. Typical insurance policy:
i. Corporate reimbursement: The corporate reimbursement part reimburses the
corporation for indemnification payments it makes to a director or officer.
The corp is made whole when it indemnifies the director or officer.
ii. Personal coverage: Reimburses the director or officer directly for his losses to
the extent that he is not indemnified by the corporation.

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 iii. This is totally controlled by contract
b. Deductibles
i. The D&O policy usually has a deductible for each officer or director as to the
personal coverage part.
c. Exclusions: Nearly all policies contain exclusions.
i. Laser exclusion – a particular series of events that are so specific as to be
excluded from the policy (i.e wildfire)
ii. Personal profit or advantage – a claim based on the individual’s gaining a
personal profit or advantage to which he was not legally entitled.
iii. Active and deliberate dishonesty – a claim which results in a judgment that
the insured acted with “active and deliberate dishonesty”
iv. Illegal remuneration – a claim for return of illegal remuneration, if a court
agrees that remuneration was illegal.
v. Libel and slander
vi. Securities laws
vii. Fines, penalties, and punitive damages
d. Types of insurance:
i. Claims-made
1. Simplest policy
2. Event giving rise to the claim occurs during the life of the policy
3. Claim must be made during the life of the policy
4. Prior to the expiration of the policy, the insurer must be notified of
specific acts which potentially form the basis of claims that may arise
after expiration (McCullough case)
ii. Occurrence
1. If the event which gave rise during the coverage year, the policy will
cover you for all claims relating to the event, even if made during a
year with no coverage
2. Can get a rider, or tail, which will cover a factor that otherwise would
be excluded.

Corporate Books and Records

I. Corporate Records
a. Accounting Records – records that reviewers look at the get a sense of the
performance level of equity.
b. Activity Records – activities of the corporate entity, as well as all officers and
directors
II. “Keeping records”
a. What is means to “keep” is based on state statutes
b. Statues also provides the right of inspections so that shareholders can investigate the
goings on of the corporation
III. Thomas & Betts Corporation v. Leviton Manufacturing Co.
a. FACTS: Lawsuit to compel Leviton’s books and records – Betts is using the record
to force a dialogue over a potential merger. He alleges that his purpose is look for
waste and mismanagement, but it is really acquisition.
b. RULE: When a shareholder seeks access to records, other than the stock ledger and
stock list, the shareholder has the obligation of providing a valid purpose for
looking at the records. Burden is always on the shareholder to show a valid purpose.

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 i. This is essentially a balancing test between the shareholder’s right to inspect
for informational purposes and the corporation’s warding off of unwarranted
incursions into activity which are not in the best interests of the corporation.
IV. Sation v. McKesson HBOC
a. RULE: When evaluating the purpose, there has to bear a reasonable relationship to
the scope of inspection.
V. Parsons v. Jefferson-Pilot Corp.
a. FACTS: Shareholder was dissatisfied with her return. She wants information so that
she can communicate with other shareholders. P described the records she wanted
with reasonable particularity.
b. RULE: Even if you are not aware of the result, if you make an allegation related to
your role as the shareholder that is legitimate, if you describe it with reasonable
particularity, you will be able to pursue the information as is necessary. Allegation
must be made with reasonable particularity.

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