BUSINESS ASSOCIATIONS OUTLINE PART 1: I.

AUTHORITY: AGENCY AND PARTNERSHIPS

AGENCY The fiduciary relation which results 1. from the manifestation of consent by one person to another that the agent shall act on the principals behalf and 2. subject to the principals control 3. and consent by the agent so to act. - But what if one acts to protect his own investment and has no intent on a principal-agency relation? (Cargill case) - Control: When the totality of the facts and circumstances show that there is interference on the agent's actions by the principal A. Actual Authority That which the principal actually told the agent to do. The principal will be bound when the agent does what the principal told him to do. Actual authority may be express or implied. An agents act binds a principal only if the agent acts within the scope of his/her authority. AA runs from the principal to the agent can flow from a K, title, job description, past course of dealing 1. Express Actual Authority a) Definition Authority that the principal expressly gave to the agent. b) Effect Express actual authority binds the principal. 2. Implied Actual Authority a) Definition Actual authority given implicitly by a principal to his agent. b) Effect May or may not bind the principal. c) Reasonableness The authority is implied and the principal is bound when the agent is reasonable in thinking that he acted as the principal wanted. If the agent acted unreasonably, then the principal is not bound. d) Sources of Implied Actual Authority 1) Necessity is the mother of implied actual authority. It could be implied if it was necessary to get the assigned job done. 2) Customary Things that are customary could also be implied actual authority. 3) Past experiences e) Example Authority to give test drive could be implied from the actual authority to sell cars. B. Apparent Authority 1. Definition Appears that the agent has authority to the third party. There is ostensible authority to act. The focus is on what it looks like to the third party. Did it look like the agent had the authority to do what he did? Can exist in the absence of AA where the prinicipal gives a third party reason to believe that AA exits. 2. Source - The manifestations of authority come from the principal. Must be something that the principal has done in order to create apparent

authority to third persons. The manifestation has to come from the principal because otherwise, the principal would be bound when it had no control. 3. When Arises - When the agent is doing something they are not supposed to do, the use of apparent authority arises. 4. Requirements for Apparent Authority a) There must be a manifestation by the principal that the agent has authority and b) The third party must have reasonably believed that the agent had authority. 5. Rationale a) Why should the principal be liable when the principal told the agent not to do what the agent has done? Protects the third party who relied on the apparent authority of the agent. The principal has created the appearance that the agent had authority. The principal should be bound because the third party relied on the impression that the agent had authority. Similar to estoppel b) If there were no agents to deal with, then people would always go to the principal, which defeats the purpose of the agency. c) You pick you pay. d) If a principal could rely on a secret instruction to avoid being bound, then the third party will only want to contact the principal and the agent would be useless. This is why principals are bound when they create the appearance that an agent had authority. C. Inherent Agency Power/Inherent Authority 1. Definition - Refers to things that are customarily done by someone in the agents position. 2. Is a repetition of implied actual or apparent authority coming from position. Similar to implied actual authority because things are part of inherent agency are things which are associated with the job the agent is performing for the principal. 3. NOT part of the Restatement. D. Ratification -If a principal, even thought he would not have been bound because of apparent or actual authority, approves of what the agent did, then the principal is bound. Principals after the fact approval of the agents unauthorized act, this binds the principals and relates back to the time of the unauthorized act.

II.

PARTNERSHIP A. Actual Authority Management of Partnership 1. Definition The voluntary association of two or more persons carrying on as co-owners of a business for profits. a. Creation: When two people getting together and agree to carry on as co owners of a business for profits 2. Partner is a co owner in a business for profit.

3. Agreement Partnership does not have to have a contract or a formal partnership agreement. Defined by circumstances, sharing of profits (but not gross revenue. Sharing gross returns does not) 4. Agency/Authority a) Every partner is an agent for the partnership when they are acting to carry on the business in the usual way. (UPA 9) The partnership will be bound if the agent has apparent authority. This statute codified apparent authority for partnership. b) The partnership will not be bound if there is no authority to act AND the third party knows there is no authority to act. 5. Rights of the Partners in Management - Voting (default rules only) a) Parties have equal rights in the management and conduct of the partnership. b) Each partner has one vote of equal weight with the others, unless otherwise provided for in an agreement. The default rule is that each partner has one vote. c) In a disagreement over ordinary matters, the majority rules. d) For unordinary matters, there must be a unanimous decision. e) If there is a tie, then the person opposing is bound as long as the decision regards the normal operation of the business. The partnership will continue was has been done before rather than changing operation. A tie goes to the status quo, things dont change from before the vote. 6. Ratification If a principal, even though he would not have been bound because of apparent or actual authority, approves of what the agent did, then the principal is bound. 7. Anytime a person is providing services to a business, is that person an employee or a partner? B. Apparent Authority 1. Elements Occurs in a partnership when these elements exist: a) Manifestation by the principal The manifestation is making them a partner. You give others the belief that they have authority b) Reasonable belief by 3rd party Based upon position/custom. It is reasonable when they are carrying on in the usual way, they are acting in the interest of the principal, when it is a regular type of transaction carried on by the partner. C. Determining whether a Partnership Exists: (rather than a lender or employee) 1. California Civil Code 2410 In determining whether a partnership exists: a) People who are not partners as to each other are not partners as to 3rd persons. (If you tell others you are partners, then you cannot try to tell your partners that you are not partners.) b) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or part ownership does not of itself establish a partnership, whether such co-owners do or do not share any

D.

D. E.

F.

profits made by the use of the property. (Co owning property does not necc make you a partnership) c) Sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing then have a joint or common right or interest in any property from which the returns are derived. (there is a difference between a share of the gross returns and a share of the profits. If you share only the gross returns, you will not make any money. The profits are what you have after you have paid all your expenses used to make the money. The owner gets whatever is left over after everyone else gets their money. They get the residual after lenders; employees, etc have been paid). d) A percent of the profits is prima facie evidence of a partnership. The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business, but no such inference shall be drawn if such profits were received payment: 1) as a debt by installments or otherwise 2) As wages of an employee or rent to a landlord 3) As an annuity to a widow or representative of a deceased partner 4) As Interest on a loan, though the amount of payment may vary with the profits of the business 5) As the consideration for the sale of a goodwill of a business or other property by installments or otherwise. 2. Elements of a Partnership include: a) Intention of the parties b) Right to share in profits c) Obligation to share in losses d) Ownership and control of the partnership property e) Community of power in administration f) Language in the agreement g) Conduct of the parties towards third persons. h) Rights of the parties on dissolution Liability - If a business fails, a lender loses money while a partner would have unlimited personal liability for the entire debt of the firm. 1. Policy - A partner makes the decisions. A lender just gives money. The people that make the decision that could cause the business to lose money must face the consequences of that decision. If they have to pay, they will make better decision. 2. Partnership bound -- A partnership is bound by partner's wrong acts as those wrong acts are within scope of partnership. Silent Partners Even if the third party did not know about you being a partner, you are still liable for the debts of the partnership. Ratification - If a principal, even though he would not have been bound because of apparent or actual authority, approves of what the agent did, then the principal is bound. 1. When principal is under duress to ratify, it is not valid ratification. Dissolution of Partnerships

1. Definition - Dissolution is change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business. It is not the business dissolving, it is the relationship between the partners that dissolves. Debt of a partner automatically disolves the partnership. (UPA 38) Revised act came up with new word: Dissociation (broke apart relationship between people and ownership). 1. Ways of dissolution a. Breach b. Death c. Negotiation for buy out d. At will but cannot be in bad faith (or depriving other side of taking advantage of the K) e. End of term b. Good agreement usually has terms as to when the partnership dissolves, and who takes what. 2. At will - Barring an implied or express term, a partnership may be dissolved at will. If there is no dissolution agreement then the court assumes it is at will. 3. Assets If there is no agreement regarding the distribution of assets upon dissolution, the default rule is that they are equally distributed among the partners, regardless of how much they invested, after assets are sold. a. If dissolution was caused due to breach, then you don't sell the assets and the innocent party keeps the assets. (see UPA 38) b. Purchase of dissociated partner's interest: 1. How much should someone have gotten for his share in the business? Never answered question 4. UPA 31 - Dissolution is valid when it is done in accordance with the partnership agreement a) the dissolution must be done in accordance with the power conferred by the agreement between the partners b) If an agreement says the majority can kick out a partner, then it must be bona fide. Cannot have a bad reason for kicking people out. c) If an agreement is silent regarding the power to expel, then the partners may not expel a partner. 5. Role of the Courts (UPA 32) A court can order the dissolution of a partnership even when dissolution would breach the agreement. a) Courts can supervise the winding up of the partnership. b) Statute states that a partnership may be dissolved in contravention of partnership agreement when: 1) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of the business, 2) A partner willfully or persistently commits a breach of the partnership agreement, or otherwise so conducts himself in matters relating to the partnership business that is not reasonably practicable to carry on business in partnership with him, (need to

show that other side was at fault in the business marriage) 3) Other circumstances render dissolution equitable. c) The statute states that if the expulsion would hurt profits, they may rightfully split. Statute calls for a judicial resolution on the prospects of the partnership to determine if the inclusion of the partner harms profits. d) This section is the equivalent of fault divorce. The impact is that there are very long trials arguing which partner harmed the other. Also end up with long fights over whether the business is viable. 6. UPA 31 The partnership is by the express will of any partner, when no definite term or particular undertaking is specified. There has to be a contract to specify that the partnership it is not at will. This means that a partner can leave on their own, without need for expulsion of the partner they dont want. G. Remedies upon Dissolution (under UPA 38, dissolution can happen at any time) 1. UPA 38(2) Addresses Wrongful Dissolution with a partnership Agreement - Partners who have not breached the partnership agreement wrongfully are given damages. They can keep the business and kick out the partner who wrongfully breached. The breaching party must be paid the value of their interest minus damages. The breaching party does not get any credit for good will. Partner used not to get paid until term ended. Nowadays, partner gets paid right away unless you show court hardship. 2. UPA 38(1) Addresses Rightful Dissolution with a Partnership Agreement When there is no breach of the partnership agreement upon dissolution, each partner may demand assets be used to pay debts and the surplus be given in cash to the partners. Therefore, assets must be sold. Parties could agree not to pay off the debts and sell off the assets. (2 caveats: Only if there is breachless dissolution, and will happen unless otherwise agreed) 3. Rights of Non breaching Party The non-breaching party may leave the partnership to the breaching party on their own. 4. Judicial Sale Partners may bid on the partnership when it is put up for auction so that they may exclude another party. 5. After Dissolution Upon dissolution of any partnership, the partnership property is sold, debts are paid, and surplus is given to the partners. 6. UPA 18 Each partner must be repaid his contributions of capital or advances to the partnership property and share equally in the profits and surplus remaining after all liabilities, including those to partners are satisfied. All partners must contribute to the losses whether of capital or otherwise sustained by the partnership according to his share in the profits. 7. Unfinished business After dissolution of a law partnership, income received by the former partners from cases unfinished at the time of dissolution is to be allocated on the basis of the partners respective interests in the dissolved partnership, not on a quantum meruit basis. H. Expulsion Clauses 1. UPC 38 states that a partner who is expelled pursuant to the clause cannot

demand liquidation of the business assets. This is why expulsion clause is better because the partner who is expelled cannot require the business to be sold. I. Fiduciary duty/Good Faith 1. Fiduciary duty originally was a judicial concept. It arose out of case law. 2. UPA 404 codified concepts of fiduciary duty 3. Partners owe each other a duty of utmost good faith and loyalty. 4. Basic Duties: a) Duty to Disclose 1) Silence is a lie. The partners trust that each will tell the other important information. So, holding something back is false. 2) Materiality If one partner cannot do anything with the information not disclosed, there is no causation. The breach would not be material. The partner must be harmed by detrimental reliance upon the non-disclosure of the other partner. 3) Sometimes disclosure may not be enough, might also have to share the benefits if approached by someone outside the partnership. (Meinhard v. Salmon) b) Duty of Care Fiduciary relationship creates a duty of care. This means they must act to benefit the partnership or not to harm the partnership. Cannotact in grossly negligent or reckless conduct or intentional misconduct of the law. No violation if conduct futhers the partner's own interest c) Duty not to Compete 1) Cannot compete as a partner with the partnership unless the contract says you may compete. 2) When no longer in the partnership, you may compete, except where there is a non-competition clause in a contract. d) Taking Opportunities Overlaps with competition. There is a subtle difference between taking an opportunity for yourself and competing 1) If the 3rd party wants only the defendant and not the partnership, then the opportunity should be disclosed but not turned over. If the 3rd party doesnt want anything to do with them, then it would do no good to turn it over. 2) Consider where the opportunity came from: Is there a strong nexus between that person and the business. e) Freeze out To what extent is freezing someone out of the firm going to be a breach of fiduciary duty? If you are going to force someone out, it must be in good faith. f) Duty of loyalty: refrain from dealing in conduct on behalf of a party having an interest adverse interest to the partnership and not competition. 5. When does a fiduciary duty begin? It is uncertain. Some courts say that when entering into the partnership, a fiduciary duty exists. Saying that it started at formation not when the partnership begins. UPA takes the position that

6. When does fiduciary duty end? When the partnership ends. 7. Even people at an arms length relationship may not lie. J. Limited Partnership (need general partnership) 1. Definition: This form of business organization permits investors to share the profits of a business, with their risk of loss limited to their investment if the investors comply with certain legal formalities a. A limited partnership has two classes of partners. (need at least 1 general partner) 1) One or more general partners, who have complete control, manage the enterprise and are subject to full liability. 2) One or more limited partners, who are very similar to firm creditors but are subordinated to creditors if the firm becomes insolvent or is liquidated. The limited partner ordinarily does not take part in the day to day control of the business 2. Section 303 -- Statement of partnership authority a. No liability as limited partner for limited partnership obligations 1. An obligation of a limited partnership, whether arising in K, tort or otherwise, is not the obligation of a limited partner. A limited partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for an obligation of the limited partnership solely by reason of being a limited partner, even if the limited partner participates in the management and control of the limited partnership. Exceptions: a. Ok to exercise control and power of a GP, but just make sure that client does not reasonably think that you are a GP. b. Control but not = GP: If limited partner's participation in the control of the business is not substantially the same as the exercise of the powers of a general partner, he is liable only to persons who transact business with the limited partnership with actual knowledge of his participation in control. 1. If limited partner participates in the control of the business, he is liable only to persons who transact business w/the limited partnership reasonably believing, based upon the limited partner's conduct, that the limited partner is a general partner (reliance) b. Liability for General partners for limited partnership obligations (comes from statutory construction and not from common law.) 1. Policy: If you are in control, only fair if you pay for what you've done c. Safe Harbor: Things that do not constitute control (see 303) H. Limited Liability Partnership

1. Creation of partnership a. Filling out the form and file it and pay fees b. Comply w/the statute or will just be a partnership. 2. Liability (rules of perception for LP applies here too) a. Not liable for firm's debts b. Liable for your own debts (ie, committing torts) -- how much you owe based on your contribution 1. Two types of debts (see statute for applicability) a. Breach of K that you made yourself b. No vicarious liability if you commit your own tort (if you are negligent as LP) Pay for your own tort. 3. LLP --- All are partners and all have limited liability. (no such thing such as limited or general partner) 4. UPA creates the rest of the rules of LLP. 5. Piercing --- Same as corps J. Limited Liability Companies 1. Limited Liability for all members a. Key difference between LLC and LLP: LLC make up new statute. Lots of new ambiguities 1. Elf Case: Attempt to deviate from arbitration clause of operating agreement by relying on ambiguity of new statute and that it was suing on behalf of someone else. (derivative suit). Court said no no 2. Resolving disputes of LLC a. Look at operating agreement for help b. If there is an ambiguity or if can't resolve issue, look at the default rules or statute a. Lieberman v Wyoming: Default rules basically allowed company to keep P's interest share while returning only his original contribution regardless of the market value. Wyoming SC refused. Avoided statutory glitch by saying that is not the intent of the drafters of the statute. Result would be too unfair. 1. If in Delaware, P would have gotten his fair value back. 18-604 2. If in Delaware, P would not have been able to leave if others won't let him 18-603 (morale of the story, read the whole statute, because one provision could lead you in one direction and another provision leads you to another direction) 3. If in Delaware, P would have to sue to get out and dissolve the business. 18-602 4. If in Delaware, if others want P to leave and accede to his demands but P does not want to leave, then vote him out (but not enough votes). a. In that case, go ahead and do merger. (hidden provision 18-209) 1. Create new entity and then merge it with old LLC. Exclude P from created new LLC. Then merge new

w/ old LLC. From old LLC, all members are paid in cash. 2. Or create new entity, merge and dilute P's ownership share by bringing new owners. 5. If in Delaware, the other members want to change his shares and keep him in, so that they don't have to pay his market value. Amend the agreement via majority vote. 18-209f1. But that would be amending terms of the K w/o consent of all parties involved. c. If statute does not resolve, look at other provisions to see if it can open a way out for you. (statutes are very sneaky) d. Always look at secondary sources. e. Be very careful in drafting the agreement f. Don't believe too much in the statute. Statutes are designed to fool people. Make your own judgment on the statutes. g. The newer the statute, the more hidden provisions there will be. (since there will be less lawsuits to expose them) 3. Creation of LLC a. File document w/secretary of state + pay dues 4. Danger of new statute a. Be very careful about LLC glitches due to new statute. b. Statutes mix and match all the time. 5. Fiduciary duties: Look at operating agreement, if none, ordinary ones apply 6. Voting: Look at operating agreement. If none, some states grant LLC members an equal voice, while other states set voting rights based on proportional ownership 7. Dissolution: Look at operating agreement. If none, apply partnership laws. 8. Piercing: Look at corp. III. AUTHORITY: GENERAL CONCEPTS A. Why are partners liable? 1. Notions of control and incentive. If I am using someone elses money and I will be liable for losses, then I will use the money in a wiser manner than if I could spend someone elses money with no consequence 2. Agreement. Liability exists because that is what two people agreed to. B. Default Rules: How do you pick them? 1. Incentive Pick them to make incentive for people to make their own contract. This is a penalty for people who do not make their own contract. 2. Reasonable Person Pick one that most would have picked themselves. Pick what a reasonable person would have done. One way is to assume that people are rational wealth maximizers, therefore the way to pick what most people want is to pick the way that maximizes wealth. Court will often pick a default rule in a case. They usually pick the simplest rule. C. Residual claimant: Who is the owner? 1. Person who sticks their paw in last. They get the money after everyone

else has been paid. Since they get what is left over, they may want more control over what others are getting or more control over how much money is left over. 2. Typically if someone is last in line, they will demand more. 3. In the absence of contract, the one who should have the most liablility is the one who makes the decisions. D. Uncertainty: Are there ways to find certainty? 1. A person could be found to be partner or a lender. Sometimes there is uncertainty. 2. Sometimes there is not a right answer.

Liab. Control P&L

P / LP / LLP / LLC / Corp U U/L L L L K UL/K K K Stat/K K K K K Shares

Items for Comparison with Partnership and Corp Partnership Does not require a written document or even a document that is to be filed, except in the case of a limited partnership (only the general partner is liable for the debts of the partnership) Each partner is jointly and severally liable for the partnerships debts and obligations. Thus, if the business fails, each partners personal assets may be reached by the creditor of the partnership. Exception is for limited partnership where liability is limited by the partnership agreement for some partners. As co-owners, each partner has the actual authority to transact any business within the scope of the partnerships Corporation Requires the filing of articles of incorporation with the state official.

Formation

Liability of Owners

Shareholders enjoy limited liability for the debts of their corporation. Upon insolvency, an individual shareholder will lose only the amount already paid for his stock.

Participation in Management

Shareholders have no authority over the conduct of the corps business. This power is conferred by

Transfer of Ownership

Duration

Profits and Losses

business. Partners may delegate, in the partnership agreement, management responsibilities to certain partners or a single partner. In spite of delegations, each partner has apparent authority in the eyes of others to carry out partnership business, unless the 3rd party has knowledge that management duties were exclusively delegated. Majority of partners may vote to make decisions. Amendment requires a unanimous vote. Unless modified by the partnership contract, a partner may transfer his interest in the partshership so that the transferee becomes a full partner only if the all the remaining partners approve The partnership is dissolved upon death, bankruptcy, or withdrawal of any of its partners, unless the partnership agreement provides otherwise. Effect of a dissolution is to terminate each partners actual authority to carry on a partnership business, except for the purpose of winding up and liquidating the business. The partnership, although required to file an information return, is not a taxable entity. Profits and losses are attributed to its partners, who must report their share of the income or losses of the partnership.

statute directly upon the board of directors which may delegate it to officers or subordinates. Therefore, a shareholder may not enter into a contract on behalf of the corporation. Makes a tighter chain of command.

Unless subject to a written restriction on transfer, shares of any corporation are freely alienable.

The corporate existence is perpetual and is not terminated by death, withdrawal, or bankruptcy of any shareholder.

Corp is a taxable entity and its income and losses belong to it exclusively, unless the income is distributed through a dividend authorized by the board of directors. Small corps may elect to be treated as a partnership so that income and losses are

attributed to shareholders regardless of whether distributed.

PART 2: I.

CORPORATIONS

FORMATION A. Available Choices of Business Form 1. Sole Proprietorship a) One individual is the owner 1) Owner is personally responsible to repay whatever he or she borrows and to pay for whatever he or she rents or buys. 2) Owner is vicariously liable for any torts committed by his or her employees within the scope of their employment 3) If there is any profit (money left over after payment of the business expenses) the owner gets that profit. 4) Owner is entirely in charge of the business. 2. Partnership a) An association of persons carrying on, as co owners, a business for profit. b) Partnership is a label for a relationship between co owners of a business c) Individual partners have unlimited personal liability for debts incurred in the business 3. Limited Partnership a) A limited partnership has two types of partners: 1) General Partners Ordinary rules of partnership, including unlimited personal liability apply to the general partner. 2) Limited Partners The limited partner abstains from controlling the business and the statute limits liability of loss to the limited partners investment in the business. That way, individuals may invest in a business in return for a share of the profits and still avoid liability for the firms debts. 4. Corporation a) Corporation is a legal entity separate and distinct from its owners. The entity has its own rights and obligations. b) Management - Control over the corporation resides in a board (the board of directors) elected annually by the shareholders. The board then appoints officers to carry out day-to-day management. c) The directors and officers, as agents, have no personal liability for the debts of the business 5. Limited Liability Company and Limited Liability Partnership a) New business forms enacted by statute. Idea is to have a business form which federal income tax authorities treat like a partnership, thereby avoiding the tax disadvantages of the corporations separate

entity treatment while still keeping limited liability for owners. b) Limited Liability Means that the owners liability is limited to debts of the business. Owners are not personally liable for the debts of the company. 1) Tort However, creditors may go after owners if the owner committed a personal tort or malpractice. 2) Contract The owner may be personally liable for a contract debt if they give a personal guarantee ( I will pay if the company does not pay) c) LLC Owners in these firms enjoy limited liability, just like shareholders in a corporation. Membership ownership is represented by an interest in the company rather than by stock. d) LLP All the owners of the limited liability company or limited liability partnership enjoy limited liability regardless of their participation or control. 1) The LLP continues to operate under the law of ordinary partnership but the partners enjoy limited liability. State adds a few sections to the UPA in order to create an LLP. They must register in order to get limited liability. B. Factors in Selecting Between Business Forms 1. Limited Liability a) Partnerships and Sole Proprietorships 1) Partnership agreement dictates how much of the business losses each partner is supposed to suffer. 2) Outside creditor has the right to seek payment of the entire debt from any partner. So, each partner is at risk for potentially the entire amount of the partners debts. Or, the sole proprietor is liable for the entire amount. 3) However, there are ways for the partnership or sole proprietorship to achieve a degree of protection. (a) Non recourse Loan The business may get a non recourse loan where the creditor agrees only to look to the collateral and not the borrowers other assets for repayment (b) Insurance Owners can also purchase liability insurance in order to get protection from tort claims. b) Corporations (came before LP and LLP and provided people w/control and limited liability) 1) Stockholders have no liability for all the corporations debts simply by virtue of being shareholders. All they stand to lose as stockholders if the corporation goes under is whatever they paid to purchase their stock. (This is why it is said that stockholder liability is limited to their investment). 2) Those who manage the company do not have personal liability for the corporations debts simply by virtue of managing the company. 3) While stockholders and managers are not liable for the corporations debts, they are liable for any contract to which they

agree to become a party personally or for any torts they personally commit. 4) Downside of corporations is taxes, since they get double taxed. c) Limited Partnership 1) Individuals wishing limited liability must be willing to give up control. (a) Limited partners who exercise control only face liability to creditors who, because of the control, mistakenly thought that the limited partner was in fact a general partner. 2) Even if limited partners are satisfied with limited control, there must be at least one general partner willing to face unlimited liability. The general partner manages the limited partnership. (a) One common response is to make a corporation act as the general partner. Then the business would still have tax perks of a limited partnership. d) Limited Liability Company and Limited Liability Partnership 1) Provides the same limited liability to its owners and managers as a corporation does to its shareholders and managers. 2) Therefore, from a limited liability standpoint, neither form of business should have an advantage over the other. 3) However, some jn LLP only provides protection from tort claims and not contract debts. Other jn a LLP provides the partners with protection from both tort and contract claims. 2. Exit Rules What happens when someone decides to sell, dies, or goes bankrupt? a) Sole Proprietorship 1) If the owner decides to sell, or dies, or goes bankrupt he or she must sell the entire business or pass it on to his heirs. b) More than One owner Three different models for handling an owners death, bankruptcy, or desire to sell. Different business forms follow different models. 1) Buy Out Model If the other owners wish to continue the business, they must buy out the interest of the owner who dies, goes bankrupt, or desires to sell. 2) Free Transfer Model One owners death, bankruptcy, or desire to sell does not affect the legal right of the other owners to continue the business. (a) Sell If an owner wishes to sell his or her interest, the owner has the right to sell the interest to any buyer (b) Death If an owner dies, the deceased owners interest passes to his or her heirs. (c) Bankruptcy If an owner goes bankrupt, his or her creditors can force the sale of the bankrupt owners interest. The buyer or heir then picks up the rights to profits and control which the departing owner had by virtue of the ownership interest. 3) Lock in Model the owner who wishes to sell has not right either

to do so or to force the other owners to buy him or her out. However, lock in cannot prevent a transfer to somebody in the case of death or bankruptcy. c) Corporations Follow the free transfer model. Better for big companies. (a) If you want out, sell it to someone who wants it. (not applicable for partnerships, since interests implicate unlimited liability) d) Partnerships, LP and LLC and the Buy Out Model. 1) Partnerships and the Buy Out Model (a) Under UPA, each partner (barring other agreement) has the right to dissolve the partnership at any time. Any partners death or bankruptcy also causes dissolution of the partnership. (b) However, dissolution does not terminate the business. Upon dissolution, each partner who has not breached the agreement has the right to demand the sale of the business assets, payment of its debts, and distribution of the remaining proceeds to the partners (liquidation). (c) But, partners may agree to some other outcome to follow dissolution. So, Partners who wish to continue can either attempt to purchase the business in the liquidation sale or else reach an agreement with the departing partner to buy out that partners interest in lieu of liquidation. 2) Limited Partnership and the Buy Out Model (a) A general partners departure by virtue of death, bankruptcy, a decision to withdraw, or the like triggers dissolution and liquidation barring other agreement or consent of the partners to continue without dissolution. (b) A limited partners departure does not trigger dissolution. (c) In lieu of the right to demand liquidation of the firm, the UPA gives general partners (or their estate) the right to demand that the limited partnership pay them the fair value of their interest when their departure does not result in dissolution , and gives limited partners the right to withdraw and receive similar payment from the limited partnership upon 6 months notice. 3) LLC and the Buy Out Model (a) Departure of an owner from a LLC because of death, bankruptcy, a desire to withdraw or the like triggers dissolution unless there is a contrary agreement or the remaining members consent to continue the company without dissolution. (b) IF there is no dissolution, then in most states, members can withdraw and demand the company buy them out. Many states require 6 mo notice. (c) Members can alter this by agreement. e) Partnerships, LP, and LLC and the Free Transfer Model 1) Owners can change the business to follow the free transfer model by agreement.

2) Agreement could provide that upon a partner or members departure, the remaining partners or members have the right to continue the business without buying out the interest of the departing partner or member. 3. Governance a) Corporate law republican/representative style of governance 1) Stockholders elect a board of directors who are in overall charge of the corporation. 2) Directors, in turn, appoint officers to handle day to day management. 3) Voting Some fundamental decisions may require a vote of the shareholders. They normally vote either to elect directors or on fundamental decisions, in proportion to their stock ownership. 4) Director and shareholder decisions are typically by majority vote. b) Uniform Partnership Act and most state Limited Liability Company 1) Direct democratic governance. All owners participate in management. 2) For ordinary matters, the majority rules. 3) Under UPA, partners each have an equal vote, even if their contributions or interests in profits are unequal. 4) LLC statutes vary. Some follow UPA approach. Some follow a proportional approach. c) Limited Partnership 1) General Partners manage the business under the same rules, as between themselves, as partners in an ordinary partnership. 2) Limited partners are for the most part supposed to be passive. 3) Owners of a limited partnership do not annually elect the general partners to run the company. Instead, the agreement initially entered between the partners normally specifies who are general partners. 4. Cost, Acceptance, and Coherence a) Costs 1) Attys fees 2) Burden of convincing the participants in the venture and those doing business with it to accept unconventional agreements 3) The cost of contracting mistakes and omissions. b) Coherence All terms governing the business venture work together in a sensible fashion. 1) Examples the republican model of corporate governance in which shareholders elect directors by voting in proportion to their stockholding is well suited to the firm with free transfer of ownership. 5. Taxes a) Corporation 1) A corporation is double taxed: (a) The corp pays a tax on its income.

(b) When a corp pays a dividend to its shareholders, the shareholders must recognize, as taxable income, the dividend they receive. 2) Corp can avoid the double tax by: (a) Having the corp not pay dividends. Instead, pay reasonable salaries. IRS can challenge the reasonableness of the salaries. 3) Losses: Court treats losses as tax deductible expenses, but treats them on an individual basis instead of a corporation basis. b) Partnership 1) Not a tax paying entity. 2) When the partnership makes income, it pays no tax. Instead, each partner treats his or her share of the partnerships earnings as part of the partners taxable income. 3) Partners generally do not recognize as taxable income any money distributed by the partnership to them. This is because the partners already paid a tax on the income when they earned it. c) Sole Propietership 1) The income of the business is simply the proprietors taxable income, and it is his or her money to use. C. State of Incorporation and Governing Law 1. The Internal Affairs Doctrine When a corporation does business in a state, it must observe the states laws generally applicable to persons doing business there. However, courts look to the law of the state of incorporation in dealing with internal corporate affairs a) Internal affairs include: 1) Powers and obligations of the corporations managers vis a vis the corporation and its shareholders 2) Rights and duties of the corporations shareholders vis a vis the corporation, its management and shareholders b) Qualifying Out of State Corps States deal with out of state corporations by requiring them to qualify to do business in the state. Normal requirements include: 1) Filing a document (normally it is a copy of the doc filed to form the corp in the state of incorporation) with a state official (normally the same official with whom one would file to form a corp within the state) 2) Appointing a local agent for service of process (thereby facilitating local lawsuits on out of state corps) 3) Paying a fee or tax for the privilege of qualifying 1. Selecting State of Incorporation a) Four main criteria help a corp to determine which state to incorporate in: Flexibility Parties generally want a state which will not prevent them from governing the corporation in the manner they desire. 1) Default Rules Parties consider which state provides default rules that more closely resemble what the parties would provide if they

expressly contracted on the question. 2) Predictability A well developed body of corporate case law gives parties planning various corporate transactions confidence in knowing what the law requires and allows. This is valuable for parties conducting corporate transactions and their attorneys. 3) Attorneys Familiarity If the attorney is more familiar with a certain states laws, he may be able to work more effectively. This is often the state in which the atty and client reside. 2. The Race to the Bottom Thesis a) Courts have recognized a race among states to adopt less restrictive corporation law in order to gain revenues from incorporation and franchise taxes. C. Promoters Contracts 1. Generally a) Promoter Someone putting together a new business. Can be a person or a corporate entity. b) The new business usually needs capital, services, and property. 2. Rights and Obligations of the Corporation a) Authority Since corporations are fictitious entities, they cannot enter into contracts themselves. They have to enter into contracts through the actions of people who have authority. b) Lack of Authority A promoter lacks authority to bind a planned corporation because there is no principal in existence at the time the agent acts. Therefore, the promoter lacks authority to bind the corporation to any transaction entered before the corporation existed. c) Liability the Corp is not liable on promoters contracts until the corporation adopts the contract. d) Options after Corp Exists 1) Adoption Court can adopt the contract. This means that the corporation agrees to abide by the deal. Courts can adopt by a vote of the board or by implication when the corporation accepts the benefits of the promoters contract. (a) Express adoption through a board of directors resolution (b) Implied adoption comes from accepting benefits of the contract. 3. Liability of the Promoter to the Third Party a) Non performance by Corporation There are three reasons for corporate non performance: 1) Failure of the corp to come into existence 2) Refusal of the corp to adopt the contract 3) Financial inability of the corp to perform or else pay damages. b) Suit If the corporation does not carry out the contract, the third party will often sue the promoter c) Promoter Liability Courts generally recite the rule that promoters are liable on contracts they enter before the corporation exists even though the contract is to benefit the future corporation.

d)

e)

f)

g)

1) Exception is that the promoter is not liable when the third party only intended to look to the planned corporation and did not intend to bind the promoter to the contract. 2) Exception is when there is a novation an agreement between the promoter, the corporation, and the other contracting party that the corporation will replace the promoter under the contract. Intent The status as a promoter does not create liability. The issue is intent. If the parties intended to bind an individual making preincorporation deals to a contract, this party will be liable. If not, then he or she is not liable. Options 4 options of what the parties intended when they entered into the contract: 1) No present Agreement Between Promoter and Third Party No contract at all because promoter is not promising anything and corp does not exist (a) This one is not in either partys interest. 2) Default rule The contract is between the third party and the promoter. The corp may adopt the contract when it becomes a corp. If the corp does not perform, the promoter is liable because the contract was ultimately the promoters contract. 3) The Promoter is Liable until and unless the corp fully performs The parties might intend to have a present contract between the promoter and third party, but the contract is subject to the understanding that if the corp comes into existence and adopts the contract, the promoter will be off the hook even if the corp does not perform. (a) The contract is subject to advance agreement by the third party to accept the corps promise as a novation of the promoters obligation. 4) Third party may be making an offer to corp The promoter could make a revocable offer or an option contract with consideration to keep the corps offer open. Generally Liability is created when the promoter makes a contract that they may be liable for instead of making a contract that only the corporation could be liable for. What can courts look to in order to determine the parties intent? 1) Language Obvious place to start looking for intent is with the language the parties used in the contract. Often the only relevant language is the way the promoter signed the contract. Typically, the promoter will point to the signature block as showing the parties intent that the promoter was not to be bound. Where a corp exists a signature form identifying the signer as an agent of the corp would normally be enough to show intent to bind the company and not the agent personally. 2) Extrinsic Circumstances also shed light: (a) Contract could call for some performance before the parties

expect the corp will be in existence, suggesting an agreement on the part of the promoter to be a party to the contract. (b) Promoter might have to perform in order to meet the contract schedule, showing the promoter is a party. h) Default Rule If courts cannot determine intent of the parties regarding whether the promoter is personally liable, the default rule is that the promoter is liable. D. Incorporation 1. How to Incorporate a) Purpose of Article of Incorporation 1) Contract between corporation and shareholders 2) Contract between the corporation and state. a. Can be incorporated in any state you want. But if you incorporate somewhere else besides your home state, you may be sued in the non-home state, and you have to pay non home state for filing/incorporation fees and pay home state franchise tax as foreign corporation. So if you are a small business, incorporate in the state where you are doing business. Only when your business is big and does business everywhere, then it is a better idea to incorporate in another state, since you are going to get sued pretty much everywhere. Del charges companies depending on the scale of their business. b) There are 5 provisions in incorporation statutes that are usually mandatory: 1) The corporations name Name should indicate that it is a corporation. Name must be distinguishable from names already taken by companies incorporated or doing business in the state. Many statutes also require that the name include words indicating the corporate form of business such as corporation, incorporated or and abbreviation thereof. 2) The name of the corporations registered agent, and the address of its registered office, in the state This is so public records show where one can serve the corporation with legal documents. 3) The purpose of the corporation Modern statutes allow the corp. to simply state that its purpose will be to engage in lawful business. 4) Authorized stock the articles specify: (a) The type of stock the corp is authorized to issue (b) The total number of stock that corporation can issue (c) Often they will also specify the par value (minimum value) of the stock (d) Privileges, rights, and preferences to be enjoyed by each class of stock. 5) The name and address of the incorporators 6) Execution must be signed by one or more individuals whose signature must be notarized.

7) Filing Articles, accompanied by the statutory filing fees, are filed with the designated state officer, generally the secretary of state. c) Organizational Meeting Statutes typically require for the incorporators or initial directors to hold an organizational meeting. At this meeting the initial incorporators or directors will usually: 1) Appoint the initial directors 2) Adopt bylaws 1) Approve a corporate seal 2) Form for stock certificates 3) Adopt pre-incorporation contracts made by the promoters. 4) Approve the establishment of a corporate bank account 5) Appoint officers 6) Issue stock, thereby establishing the corps first group stockholders and giving the corp some beginning capital. d) Amending Articles Amendment to the articles usually requires approval by a majority of the shares of each class of stock entitled to vote on the amendment. 2. When does the Corporation Exist? the corp exists when the Secretary of State accepts and records the corps articles. 3. Consequences of Defective Incorporation a) De Jure Corporation If the failure to comply is trivial, the courts might deem there to be substantial compliance with the statute and a legally valid corporation exists. A de jure corp is a corp that is legally valid. b) Three Theories of liability for when a defective corporation fails: 1) Agency theory No one has authority to bind a corporation to a contract before the corp comes into existence. (a) Promoter liability depends on the intent of the parties. If the creditor only intended to look to the later formed corporation for performance, then the promoter is off the hook. (b) When there is a defective incorporation, the creditor only intended to look to the corporation for performance. However, the person purporting to represent the corporation has misled the creditor as to the existence of the corporation, and his power to bind the corporation. (c) Thus, misleading the creditor is the basis for a possible claim for fraud. (d) The person dealing with the creditor must knowingly misinform the creditor. The agent must know that the corporation had not been validly formed. (e) This theory would not apply to tort claimants because it is a contract theory. 2) Legal Form If the participants failed to establish a corporation, one must ask in what legal form are the participants carrying out their business. (a) If there is one or more participant, they are working as a

partnership. If there is only one, it is a sole proprietorship. (b) Thus, the individuals would be personally liable because they are (c) operating as a partnership or sole proprietorship.Who are the Partners? When someone is a shareholder and a director or officer, then they are a co owner and are liable. It gets difficult when it is unclear whether they are a co-owner or not. 3) Statutory Liability exists because the corporation statutes in many jurisdictions so provide. (a) Model Act has imposed joint and several liability upon persons who assume or purport to act as or on behalf of a defectively formed corporation for the resulting debts. (b) Most recent versions limits this liability to those who knew the corporation existed. 2. De Facto Corporations, Estoppel, and Other Defenses a) De Facto Corporations The court will treat the venture as if it was a corporation for the purposes of determining the rights and liabilities of private parties, despite the failure to comply with the statutory requirements for incorporation. 1) Effect is that parties will not face liability under the agency or partnership theories above. 2) Typically there are three requirements to be a de facto corp: (a) The existence of a statute allowing incorporation of the venture (b) A colorable or good faith attempt to incorporate under the statute (this is the most important element) (c) Some action as a purported corporation. 3) No Shareholder liability A de facto corporation has the same capacity as a de jure corp to enter into contracts. Thus shareholders will not be liable for the de factos contract because of the defect. b) Estoppel Concept behind estoppel in general lies with injustices created when one party seeks to gain an advantage by changing his or her story as to the existence of the corporation. 1) Usually available only in contract, not tort. 2) If a speaker makes a misrepresentation upon which a listener reasonably relies to the listeners detriment, a court can estop the speaker from asserting the true facts in litigation against the listener. 3) Here, this means that if an individual makes assertions regarding the existence of a corporation, and actually no corporation existed, they will be estopped from later asserting that the corporation does not exist. The creditor relied on the assertion that the corp existed and the individual may not escape liability assumed by the corp by arguing that the corp never existed. This would allow for piercing to get personal liability. 4) Often arises when a party seeks to escape from a contract with the

company by arguing that the corporation did not exist when the contract was executed. 5) Effect of Estoppel (a) Prevents a person who has dealt with a corporation, believing it is a de jure corporation from avoiding a contract. (b) Prevents a person who has dealt with a corporation, believing it is a de jure corporation from holding the officers or shareholders personally liable on the contract. c) The Impact of the Model Act 1) IF the defendant does not know of the problem with incorporation, they may not be held liable. 2) De Facto Defense (a) Model act has abolished the doctrine of de facto corporation. It does not ban the application of de facto defense by courts, but it comes across in the comments that they sought to abolish it. (b) Under the Model Act there is no need for de facto defense if the defendant is not aware of the problem with incorporation. And, courts would not find a de facto corp when there is no knowledge of the problem. 3) Estoppel Defense (a) The Model Act does not address estoppel. Comments rule it out as a defense also. (b) The effect of this is questionable because it is questionable whether a court would apply estoppel where there is no knowledge of the problem. 3. Post Incorporation Filing and Franchise Tax Requirements a) States typically impose a periodic obligation on companies incorporated in the state to pay tax for that privilege. b) Sanctions attend a failure to pay taxes. Usually will suspend the corp or even dissolve the corp. II. PIERCING THE CORPORATE VEIL A. Generally 1. General Rule A shareholder is not liable for the debts of the corporation, but a court might pierce the corporate veil and hold shareholders liable personally if they have abused the privilege of the incorporating and limited liability would not be equitable. 2. Most courts will pierce to avoid fraud or unfairness. A. Sources of Confusion 1. Template Approach Do not use the template approach. a) Elements The elements used by the template approach are: 1) Under-capitalization, 2) Failure to observe corporate formalities 3) Non payment of dividends 4) Insolvency of the corporation at the time (what time, the court does not say)

5) Siphoning of corporate funds by the dominant shareholder 6) Non functioning of other officers and directors besides the defendant 7) Absence of corporate records 8) Non participation in corporate affairs by the shareholders other than the defendant. b) This approach is not helpful because: 1) Listing facts from other cases is not effective because they have questionable significance outside the facts of the case the factors came from. 2) Relevance of the fact in the list may depend on the circumstances. 3) It is indeterminate because there is no indication as to how many factors must be present and to what extent it must be present. B. Tort Claimants v. Contract Creditors 1. Policy Writers have argued that tort claimants and contract creditors should be treated differently in piercing case: 2. Contracts Creditors (voluntary) The contract creditor chose to do business with an entity whose owners have, as a general rule, limited liability. IF the contract creditor wanted to look to the assets of the owner, the creditor could have negotiated for a personal guarantee. a) What grounds justify letting the contract creditor out of its agreement to look only to the corporation for recovery? 1) Fraud If the creditor can show that the defendant induced the creditor to do business with the corporation by making misrepresentations, there will be grounds to pierce. 2) Material Breach The creditor must be able to point to the nonperformance by the defendant shareholder of some personal obligation which was a quid pro quo for the creditors agreement to limited liability. 3. Tort Claimant (involuntary) Generally did not choose to deal with a corporation and did not choose to accept the consequences of limited liability. Corporate tort liability largely arises from the doctrines of vicarious liability and products liability. a) Vicarious liability making the corporation liable for the torts of its employees committed in the scope of their employment. b) Products liability making the corporation liable for defects in the products it produces. c) Internalization of Accidents Corporations must internalize the costs of accidents so that those costs become part of the cost of the goods or services that created those accidents. 1) This doctrine creates an incentive for producers of goods to adopt cost justified accident prevention measures. 2) Allowing liability for tort claims undercuts cost internalization. C. Control or Domination 1. Control on its own is not enough (gevurtz and sea land, but this case makes the control part too complicated)

2. 3 Prong Test One test regarding whether to pierce is a three prong test: a) Control, not merely majority or complete stock control, but complete domination, not only of finances but of policy and business practice in respect to the transaction attacked so that the corporation had at the time no separate mind, will or existence of its own. b) The defendant used the control to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal duty, or dishonest and unjust act in contravention of pl legal rights and c) The fraud or wrong proximately caused injury to the pl. 3. 2 Prong Test There is an alternative 2 part test: a) There must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist. b) Adherence to the corporate fiction under the circumstances would sanction a fraud or promote injustice 4. Courts generally do not pierce simply because one or more shareholders exercise control over the corporation. Many courts throw in other factors as part of the test for impermissible domination or control. a) In Sea land, court examined 4 factors to determine if the case met the shared control/unity of interest and ownership element for piercing: (these factors only create confusion) 1) Failure to maintain corporate records and comply with corporate formalities. 2) Commingling funds or assets 3) Undercapitalization 4) Treating the assets of the corporation as the defendants own (seems like commingling) b) Three way split on the control issue: 1) Sea land approach to control is to analyze the above factors this creates confusion because it uses factors that are used to determine whether the court should pierce to define what impermissible control is. 2) Conjunctive test Must have control plus something else. (a) The fraud or injustice element tells the court when to pierce and the control element tells it against whom. 3) Disjunctive test Control or wrong alone leads to piercing. This theory states that meeting the impermissible domination and control element can, in itself, justify piercing. D. Disregard of Corporate Formalities 1. Failure to observe corporate formalities is really only a piece of a larger problem like undercapitalization. The fact that the defendant failed to observe corporate formalities is often mentioned when the decision to pierce is reached on other grounds. Usually the court will not pierce unless there is something else like undercapitalization, fraud, or commingling. 2. Conduit The corporate entity was not intended to confer the advantages of limited liability upon its shareholders when the corporation is a mere

conduit for the personal activities of its dominant stockholder. a) When determining whether a corporate entity is merely a conduit, great weight is attached to whether the corporate business was conducted in the corporate form. 3. Formalities There are three main formalities that courts point to: a) Failure to issue stock 1) Impact of failure to issue stock: (a) Prejudice creditors issuance of stock is normally how a corporation obtains capital from its owners. So, this impact is really concerned with undercapitalization. (b) The corporation has no shareholders so the court is referring to the defendant as a shareholder, but no stock has been issued. This reflects the idea that it would be poor policy to allow a party to avoid liability because he or she never formally became a shareholder but who had control over the corporation so as to justify piercing. b) Failure to formally approve or document transactions 1) Real concern here is unfair self dealing between the shareholder and the corporation, which results in the removal of assets from the reach of the corporations creditors. c) Failure to have shareholder meetings to elect directors, or to hold director meetings, or keep minutes of such meetings 1) This is a pretty useless factor. 2) One argument states that iF the defendant is not going to respect the corporation, then the court also need not respect the corporation. 3) Another arg is that without meetings, questions are raised about the authority of the party dealing with the creditor to bind the corporation in the transaction. 4) Irrelevant for tort claims also because has nothing to do with limited liability. 4. If the business has been continuously and systematically conducted for several years by the fiat of the stockholders without regard to authorization of the board of directors, or the scope of authority has been delegated to its officers, the corporate status will be disregarded. 5. Effect of lack of corporate formalities is that the shareholders of the corp have ignored the corp as a separate entity and have treated its operations as their own. E. Fraud - Defendants wrong dealings with the Creditor (mainly nondisclosure) 1. Personal assurances a personal assurance, if enforceable, makes the shareholder a party to his or her own contract with the creditor. 2. Fraud Most common example of this factor involves statements or actions by the defendant which mislead the creditor in doing business with the corporation. 3. Three types of representations arise when asserting fraud in piercing cases:

a) Representations concerning the corporations financial status No court is likely to pierce based upon inadequate capitalization in favor of a creditor who was fully informed of the corporations financial condition and chose to do business solely on the corporations credit. However, if there is non disclosure, the result could be fraud. b) Statements make by the defendant in promising corporate performance There is fraud if at the time of the promise, the controlling shareholder intended to have the company default. If the speaker never intended to perform, then the statement is fraudulent. If they did intend to perform and did not, then it is a breach of contract. c) Representations and other actions which lead the creditor to believe that someone, other than the corporation it is seeking to pierce, stands behind the debt If the representations meet the requirements to constitute a binding contract, then there is no need to discuss piercing. If no contract can be established, can the creditor pierce based on fraud? 1) Three issues help resolve this issue: (a) Will allowing such a piercing claim circumvent the policies behind the statute of frauds or the parole evidence rule? (b) Should the existence of ambiguity or confusion as to who is the obligor be enough to pierce or must the creditor to believe that someone other than the corporation was bound? (c) Did the defendant intend to mislead or confuse the creditor? If both parties were sloppy, who should bear the loss of the misunderstanding? The party who created the potentially misleading or confusing situation or the party who cold have checked ore carefully. One arg says that the def was generally in a position to have more cheaply prevented the confusion and hence ought to bear its consequences. F. Fraud Defendants wrong dealings with the Corporations Assets (Use for own benefit) 1. Unfair self dealing such conduct can constitute fraud and courts commonly state that fraud provides grounds to pierce. 2. Abusive self dealing may provide grounds to pierce in a tort claim also because it undercuts the goal of internalizing the costs of accidents. However, courts could pierce for this reason based upon inadequate capitalization. 3. Commingling of Funds Treating the corps assets as his own is abusing the corporate form. The court could pierce base upon fairness. 4. Confusion of Shareholders and Corps Affairs The fact that a corp is a separate entity, compiled with the need for certain corporate formalities, leads naturally to the rule that there must be a clear distinction between the shareholders personal affairs and assets of the corporations. a) This creates confusion for creditors. b) If the dominant shareholder has ignored the corporation as a separate entity, choosing to treat its business and assets as his own, that

shareholder may be held responsible for the corporate obligations. G. Inadequate Capitalization 1. Definition When it began its operations, the corps stockholders had not invested sufficient cash or property in the corporation to meet its prospective business risks. a) The amount of capitalization deemed adequate is a question of fact, depending upon the business economic needs and risks. b) Veil is pierced solely for inadequate capitalization only when there has been no investment in the corp by its shareholders. c) Where there has been some investment, but the amount is inadequate to meet the prospective needs of the business, some slight showing of one or more of the other factors for piercing the veil is necessary. 2. Should it be grounds to pierce? Most courts believe it is just a factor to be taken into consideration and not THE factor to pierce. a) Should not be grounds to pierce in favor of many contracts creditors who could have checked into the corporations financial posture. Policy: If legislatures did not allow inadequate cap to pierce, courts should not either. If legislatures said ok, must follow leg cap b) Should also consider whether the particular defendant was in sufficient control of the corp so as to bear responsibility for its undertaking operations without capital. c) Some courts have recognized that inadequate capitalization will not be relevant on its own but will provide the basis for a claim of fraud or abusive self dealing. d) Contracts: (courts are no very sympathetic to K creditors who don't ask about disclosure of cap of company, except to those creditors who need to get paid in like 30 days) 1) Piercing an underfinanced corp in favor of contract creditors is as much about non disclosure as it is about inadequate capitalization. 2) Had the controlling shareholder fully disclosed the financial status of the corp, and the creditor still agreed to do business solely on the corps credit, a court should not pierce based upon inadequate cap. 3) Had the creditor requested financial information and the controlling shareholder lied in response, there would be fraud and grounds to pierce without the need to discuss capital itself. 4) Some courts have recognized that in some cases, inadequate cap will not be relevant on its own, but will provide part of the basis for a claim of fraud or abusive self dealing. e) Tort: (Tort victims would solely focus on insurance and not stocks and shares) 1) Inadequate capitalization externalizes the cost of accidents. 2) If one can operate a corp with insurance which will not cover foreseeable risks, then the corps premium costs are lower. 3) This externalization of accident costs is not what limited liability should achieve.

4) Insurance is enough when it is sufficient to cover the perceivable and foreseeable amount of damages. (creating 10 companies to bear losses is indication that you foresee creating a lot of damages) 5) Court very sympathetic to tort victims since tort victims rarely check D's cap when using D's facility 3. What is inadequate capitalization? (or when do we have inadequate cap? Use coventional law + common sense) a) What is capital? 1) Is money given by a shareholder as a loan part of the capital that may be taken in piercing? 2) Depends on why you are looking. Traditionally, loan is considered capital. But there is split. (use common sense) Some courts look at everything, some courts look at only stuff that shareholders put in for stocks. b) How much capital is enough? 1) Not trifling relative to the risk to be done or the need for the total money needed to run the business. (putting a small fraction of money for capital in comparison for the money for business to operate. Though this is a weird result, since corps would have to go to the bank for more capital, or sh have to buy more money or would force corp to have small capital and collapse quickly) (this is an inadequate definition, but it is the one used by the court) 2) Some say the shareholders should put in enough capital in order to cover their debts. 3) Sophisticated analysis goes back to the policy of having shareholders invest enough so that they will not gamble with the money. If there is an adequate amount, then the shareholder has a stake in the business so that they will responsibly manage the business. 4) The fact that they borrowed money does not help the analysis of whether they were inadequately capitalized because borrowing money is essential when starting a business. (a) Money borrowed from a third party is not considered capital because there is an equal claim for that money somewhere else. IS THERE A SPLIT HERE? (b) There is a split on whether money put up by a third party for which the shareholder has made a personal guarantee to the third party is capital or not. If the debt is not paid, then the shareholder must pay out of own funds, thus meeting the policy basis for inadequate capitalization the shareholder will have a stake in making correct business decisions. However, there is another claim on the money which would make it a debt and not capital. 5) For trade creditors, enough capital to prevent piercing is whether the capital is enough now to pay the trade creditors or to pay them in 30 days.

c) When do we measure the amount of capital? (makes no sense for torts victims) 1) Most measure at the inception of the company or when company starts business (traditional rule) 2) Exception is when the company expands the size and risks of its business, or when shareholders take all of the capital back soon after inception. (look at a different time if these situations appear) -- Common sense 3) If you measure capital at the end when the company has nothing, then you will always have nothing and would make corp to have unlimited liability since people would then pierce all the time. d) For contract creditors: (when cap is enough) 1) Creditors have a strong incentive that the business has enough capital to get started. (unless creditors that require capital to be paid back in 30 days or so. All they care about is whether there is capital 30 days from now. Courts very sympathetic to this group in regards to inadequate cap) If they cared enough, shouldnt they have checked how much capital the business had? They should have to be held responsible if they entered into a contract when they knew there was not adequate money and they did not get a personal guarantee from the owners. e) For tort victims (when cap is enough) 1) Look at liability inurance to make sure there is enough cap

H. Multiple Corporations 1. Artificial division If there is an artificial division, it could lead to fraud because creditors could be lead to believe that the company has more assets than it really does. Artificial division occurs when the parent controls the subsidiary to such an extent that the subsidiary is an instrumentality of the parent. (for piercing, put back artificial div into principal) a) Parent company would be responsible for the contractual obligations of the subsidiary under agency principles. b) Parent may also be liable when the subsidiarys business is conducted solely for the benefit of the parent with total disregard for producing a profit for the subsidiary or for pursuing business policies which would assure the continued financial viability of the subsidiary. 2. Inadequate cap of subsidiary If the subsidiary has not been set up with adequate capital to meet its prospective needs and risks, the parent will be held responsible for the subsidiarys obligations. 3. Represented as One When the subsidiary and the parent are respresented to the public as the same enterprise, they will be treated as one entity, and each will be responsible for the others liabilities. - Use of the same office or business location by the corp and its individual shareholder

- Employment of same employees by the corp and shareholder 4. Contracts Creditors who choose to do business on one corporations credit cannot, barring fraud or abusive self dealing, go beyond the company for repayment. They could have checked out the corp first. I. Whose Law and Who Decides? 1. The law of the state of incorporation governs the internal affairs of a corporation. J. Piercing in Other Contexts 1. When a party forms a corporation with the hope of gaining an advantage under a statute or contract, which the party would not gain if he acted as an individual, the court may pierce. 2. LLC may be pierced even though there are no shareholders. III. FINANCIAL STRUCTURE ************ A. Issuing Stock 1. Generally Issuance of stock occurs when a corporation sells or trades its own stock. 2. When a corporation issues stock, two things happen: a) The corporation obtains money, property, or whatever other consideration the buyers pay to the corporation for the stock, and b) The buyers become the owners of the corporation , known as stockholders or shareholders. B. Specifying the Rights of Shares 1. The Utility of Creating Classes of Stock with Different Rights a) Owners of any business must agree how they will divide the basic incidents of ownership: the right to obtain the wealth of the business and the right to control exercise over the venture. b) Partnership owners can answer questions about the allocation of wealth and power directly in a contract among themselves. Agreement can specify what portion of the profits and distributions each owner is entitled to and what voting rights the owners have. c) Corporation There is no contract that directly states which owner is entitled to what proportion of any distributions from the business. Also no contract to say who has what control. (a) Allocation of weath and power flows from the ownership of stock. d) Stock basic idea is to create fungible (transferable) units of ownership, each one of which has the right to receive the same amount of distributions and has the same voting power, as each other one of the fungible units. (a) Rights of specific owners to receive distributions and the voting power of specific owners depends on the relative holdings of stock. (b) Policy avoids the need for owners to read an agreement to determine their rights and the need to amend an agreement each time an owner transfers his interest to some one else.

e) Different Classes Different classes of stock have different rights to distributions or different voting power from other classes. f) One document One governing document can specify the differing rights between the classes, with the result that the company can accommodate desired tradeoffs between owners in terms of distribution and voting rights, and a the same time, not lose the advantage of free trading which comes with fungible units of ownership. 2. Drafting Articles to Define the Rights of Classes of Stock a) Default rule regarding relative rights of stocks All shares have the same rights as all the other shares. b) Dividends traditional term for current distributions from a corporation. 1) Creating classes which receive some greater multiple of dividend is usually not done because the same thing can be accomplished just by giving out more stock. 2) It is more useful to create one or more classes of stock which have the right to receive a certain amount of dividends before the company may distribute any dividend to shareholders of other classes. 3. Dividend Preference The right to receive dividends before another class of stock. If an investor wanted a steady source of income he could obtain a dividend preference so that he would get first crack at any distributions during both lean and fat years. An investor who wanted to make a big killing could take common shares so that he could receive more of the dividends in fat years. a) Preferred Stock Shares having such a right are called preferred. An example is when the articles specify two classes of stock. One would be entitled to $5 per share before the board could vote to have the corporation pay a dividend for the other class. Preferred means pay first. b) Common Stock Shares without a preference are called common c) Drafting a dividend preference requires answering 2 questions: 1) What is the amount of the preference? (a) Articles often specify the preference as an amount accruing over a period of time (such as $5 per year). (b) Cumulative If the articles state that the stock is cumulative it means that the articles require the corp to distribute all of the accumulated skipped dividends before paying dividends on the other shares. Dividends may be skipped if the corp does not have the money, or wants to do something else with it. If articles are ambiguous, they are interpreted as cumulative. Cumulative means add them up. (c) Non cumulative If the articles state that the stock is non cumulative, then the skipped dividends are lost, and the company need only pay the preference amount for the present

period before declaring a dividend for the other shares. 2) Is the preferred stock entitled to any further distribution after it receives the preference amount? (a) Non participating If the articles give the stock no right to receive dividends beyond the stated preference, the preferred stock is called non-participating. (b) Participating- If the preferred stock is entitled to receive additional dividends under the terms specified by the articles, the stock is called participating. Participating means pay again. (c) These provisions sometimes call for a certain amount of money to go to the common before the common and participating preferred stock share any additional dividends. 4. Liquidation Preference a provision entitling a class of shares to receive a certain amount of money from the corporation upon liquidation before the company may pay anything to other shares. a) Liquidation preferences serve three purposes: 1) First purpose is to disconnect the right of return of invested capital from the division of profit. It could make sense for the parties to agree that when the corporation is liquidated, the corp will return the cash contributors investment before a services contributor receives anything. If the cash contributor was issued a liquidation preference, it would achieve this purpose. They would get a return of their capital thru the liquidation preference. 2) Second purpose involves the allocation of losses. If a stockholder is given a liquidation preference, he can make up his losses before another stockholder without a preference. 3) Third purpose is to allocate profits. Much of the dissolved corps assets will represent the accumulation of retained earnings which the directors reinvested rather than issuing a dividend. If there was only one class of stock, each share would obtain its pro rata amount of all profits made by the corp, whether paid as dividends or retained until liquidation. If there is only a dividend preference, earnings which would go to the preferred holders if paid as dividends would go to the common holders if the company skipped dividends and retained earnings until liquidation. Thus, a corp could skip dividends in order to favor the common upon liquidation. Thus, corps usually set up dividend and liquidation preferences so that the shares claim against earnings is the same regardless of whether the distribution is done by dividend or liquidation. b) Drafting a Liquidation Preference raises two questions: 1) What is the amount of the preference? (a) If the purpose is either to sever the connection between the profit division and the right to return of invested capital or to allocate losses, then the preference amount is normally the

issue price of the stock. (b) If the purpose is to ensure the allocation of profits in conformity with a dividend preference, then an amount equal to any arrearage is reasonable. 2) Can the shares participate in any further distribution? (a) Liquidation preference may be participating or non participating, just as with dividend preferences. (b) Failure to specify whether the preferred participates in liquidating distributions beyond the preference amount can lead to litigation. 5. Voting Rights for Preferred Stock a) Preferred articles often deny the preferred the right to vote but there is no legal requirement that they be non voting. If the articles are silent, they may vote. b) Fundamental changes statutes may require the vote of the holders of preferred stock, even if otherwise non-voting, to approve certain fundamental changes, particularly if the changes prejudice the preferred shareholders rights as a class. 6. Convertible stock a) Articles sometimes make preferred shares convertible into shares of another class (typically common). b) Convertible share allows its owner to exchange the share for shares of another class of corporate stock. c) Advantage holder may claim the advantage of the dividend preference to obtain a greater portion of a low level of corporate earning. If the corp does very well, he or she can convert the stock into common and enjoy a greater share of higher levels of corporate earnings. d) Restrictions articles often specify when the first and last time the owner can convert and what type of notice the owner must give to convert. Articles also specify the conversion ratio (how many shares of common does the owner have to receive for each share of preferred surrendered.) 7. Rights of the Corporation in relation to Preferred Stockholders a) Stock repurchase Many articles authorizing preferred stock give the company the right to buy the shares back for a certain price. b) Reason Puts something of a cap on the amount of the corps profits going to those holding the redeemable stock. Corp might choose to redeem preferred when the corp can raise money at a lesser claim against profits. II. CONSIDERATION FOR SHARES ************** A. Statutory Constraints on Stock 1. Statutes limit: a) The amount and b) Type of consideration.

B. Permissible Types of Consideration 1. Money always okay. 2. Property permissible in every jurisdiction. Property must be worth at least the par value of the share per share. 3. Services permissible as long as the services are not overvalued. a) Some statutes require that the services have already been performed. Future services are not acceptable under these statutes. b) Model Business Corporations Act allows issuance of stock for nay type of consideration, including future services. 4. Intangible items these items (such as business plans, 3rd party loan commitments, and technical know-how) can be viewed as a euphamism for future services or promissory notes. Litigation often occurs over these items. C. Constraints on the Amount of Consideration 1. Definition This constraint deals with the amount of consideration which a corporation must receive for its shares. 2. Several aspects to this constraint: a) Corp must receive some consideration for stock. In other words, the court cannot vote to have the corporation simply give away stock. b) Statutes require a corp to set par value. 1) Par value is the minimum dollar amount per share which the corp is authorized to issue the stock at. 2) Par value may be large or small 3) There is no legal rule saying what the par value must be set at. 4) Impacts of par value: (a) States have imposed a tax on firms incorporated in the state based upon par value of the corps authorized shares. The higher the par the greater the tax. (b) The amount which the articles state to be par constitutes the minimum price at which the corp can legally issue its shares. (c) Issuing stock below par value is illegal, unless a statute states that stock may be sold at a lower price after a good faith determination by the directors that the corps stock cannot be sold at par value. D. Valuation of Property and other Non-cash Consideration 1. Property and other non-cash consideration directors must place a value on these types of consideration, which raises the question of whether they received sufficient consideration for the shares issued. 2. Did the corp receive consideration for the stock? a) In one sense, they did so long as the company actually received the property or other non-cash consideration. b) In another sense, the corp did not receive consideration specified for the shares since it did not receive property or other non cash consideration worth what the directors stated the corporation would receive for the shares. c) What if the corp overvalued the property or other non-cash

consideration? 1) Problem The valuation will appear on the corps financial statement, making the corp appear to be worth more than it is if the board over valued the property. This could convince parties to extend credit to or purchase shares from the corp on terms that they otherwise might not have agreed upon. 2) Contemporary Approach Board of directors determination as to the value of consideration received for stock is conclusive in the absence of fraud. The boards valuation is conclusive if it is in good faith. (a) Problems with this approach include: (i) How can the court know whether the directors knowingly or intentionally overvalued the consideration and (ii) If the corp was grossly negligent in valuing the stock, they would be violating fiduciary duties and this approach may water down that duty to state that they only had to avoid fraud. E. Valuation of Stock 1. Bonus stock - stock issued for no consideration 2. Discount stock stock issued for below par 3. Watered Stock stock that is overvalued (issued for overvalued property, other overvalued non cash consideration, or cash consideration) 4. It is common to say that all three lead to watered stock F. Consequences of Issuing Stock for Improper Consideration 1. Liability- A number of theories have evolved under which shareholders or directors might become liable to creditors due to improper consideration of stock 2. Contract theory When shareholders obtain stock for a promissory note or fail to pay the agreed consideration for the shares, the company may sue the shareholders upon the contract under which they bought the stock. a) The claim belongs to the corporation. b) Usually little help to creditors because such a claim will probably not result in recovery. 3. Trust fund theory Theory is based on the idea that the money which shareholders pay for stock constitutes a trust fund for the protection of the creditors of the corporation. Thus, shareholders who received discount, bonus, or watered stock must make good on the money which the shareholders should have put in the trust. a) This theory has mostly disappeared. b) It is hard to use because it is difficult to speak of a trust fund when there is no fund. 4. Fraud theory Prevalent theory. If issuing bonus, discount, or watered stock misrepresents the state of the corps finances to creditors who agree to do business with the corporation on the strength of this misrepresentation, then the creditors should have a remedy against the persons creating the fraud.

5.

6.

7.

8.

a) If you did not pay any consideration or you did not pay the appropriate type or amount, then you mislead creditors. b) Bonus and Discount Stock Creditors would not be fooled because could look at the balance sheet. The issuance of bonus or discount stock does not increase the asset side of the corps balance sheet. 1) Reliance requirement a claim of fraud would be easily defeated because the corp would ask the creditor if the creditor relied on or was aware of the corps capitalization. Expected answer would be no, so there would be no reliance on the corps capitalization and therefore no actionable fraud. c) Watered Stock Issuance of watered stock entails giving inflated values to assets appearing on the balance sheet. However, this inflation should only effect unsophisticated creditors. d) Who is liable? The directors who voted to issue the bonus, discount, or watered stock or the shareholders who received the stock. These are usually the same people. Statutory Consequences a) The statutes of many states establish the constraints on acceptable consideration and set out the consequences when parties do not follow these constraints. b) DE when a corp cannot pay its debts, the stockholders are liable for the unpaid balance of the consideration for which such shares were issued. Presumably, unpaid balance would be an amount sufficient to meet the statutory minimum price of par. Cancellation of Stock Other stockholders may sue to have the shares cancelled on the ground that the improper consideration rendered the issuance of the shares void. Stockholder liability Stockholders who receive a dividend distribution with knowledge of its illegality will be liable to the corp for repayments of the amounts received. Director Liability Directors who vote in favor of an illegal dividend are liable to the corp for the amount declared. A director who acts in good faith, upon corporate financial statements prepared by others in determining that a proper source exists for the declaration of dividends, will be protected.

III.

DEBT AS PART OF THE CORPORATE CAPITAL STRUCTURE A. Generally 1. Rationale There are a number of reasons why corporations borrow, rather than issue more stock, to raise capital a) Debt rule Basic rule upon dissolution is that a corporation must repay any outstanding debts prior to making liquidating distributions to the corporations shareholders. Debt requires repayment before distribution. Thus, it is a more temporary investment. b) Effect of Borrowing When a corporation borrows money, the effect for purposes of liquidation is much the same as issuing a class of stock

with a liquidation preference over all other classes of stock. 1) Such a priority to payment on liquidation can allow investors who do not want as much risk to shift a greater share of their investment to investors who are more willing to take the risk. c) Effect of Interest Debt ordinarily entitles the lender to receive interest. This creates an impact like a preferred stock dividend in that interest represents a priority claim on the corps current distributions. 1) Interest is a fixed obligation of the firm, payable regardless of whether the firm has earnings. Thus, it is even more stable that preferred stock. 2) Amount of interest is the same no matter what the business earns. Thus, if the company does very well, the creditor, like a non participating preferred stockholder, gets no extra return. 2. Basically, debt creates an investment for those who place a greater value on receiving a steady return then on the possibility of making a killing. B. Leverage 1. Leverage Those with stock gain a greater share of the rewards if the corporation borrows at a fixed interest rather than raising money by selling more stock. 2. Advantages of Leverage include: a) Debt magnifies both the rewards which the owners of the corporation gain if the company prospers and the fist the owners take if the company fails. b) Avoiding Dilution of Voting Power Borrowing rather than selling more stock allows stockholders to leverage their control over the corporation. Debt holders traditionally do not have any vote on who will be the directors of the corporation. Thus, borrowing can avoid the dilution of voting power which would attend issueing additional voting stock. c) Taxes Borrowing rather than issuing stock also has tax advantages. Interest payments may be deductible whereas dividend payments do not. 3. Leverage Buy Out A corporation may borrow money to buy a sufficient amount of stock in another business so as to gain control. Purchaser of a corp borrows money to buy another corp. 4. Steps in an LBO: a) You borrow money to buy the business (leverage is a euphemism for borrowing) b) Pay back the loan with the earnings of the business 1) When banks are at risk, they will often as for collateral. The collateral will often be the business itself. 2) Banks will not allow a business to put up stock because if the business goes bankrupt, they will only get what it left over after the companys creditors got paid. The stockholders get paid last. 3) The bank wants assets for collateral c) The same effect can be achieved through the use of merger statutes:

1) Allows two separate corporations to become, in the eyes of the law, one company. 2) Assets When they merge, the assets become the assets of the new/surviving company. 3) Debts The debts, by operation of law, are also assumed by the surviving company. d) So when the companies merge, then the new company is left with the debt in the amount of the loan that it took to start the thing in the first place. They could also get stock in themselves, which is not a benefit. e) In order to merge, it takes approval by both boards of directors and a majority of both shareholders. 5. The corp borrowed money and the corp itself ended up liable for that debt. C. Subordination of Shareholder loans (************) --- Less severe remedy for piercing in case of inequitable conduct. (you just get your loan subordinated) 1. Issue when a person loaning money is also a shareholder, it sometimes creates an issue as to whether a court should treat a loan from the corps shareholders the same as any other debt incurred by the company. a) If the corporation goes bankrupt, outside creditors might argue that the bankruptcy court should subordinate the loans from the shareholders to the loans of the creditors who are not shareholders. 2. Definition Subordinating a debt means only paying the debt if there is money left over after paying the corps unsubordinated debt. In bankruptcy, this usually means not paying the subordinated at all. a) Subordination can be voluntary or involuntary. b) Courts do not automatically subordinate loans. Often they will subordinate if there is inequitable conduct through the use of Equitable subordination. 3. Types of subordination: a) Voluntary subordination occurs when a lender agreed to subordinate his or her loan to others. b) Involuntary subordination shareholders can make some of their investment to a corp in the form of loans. Such loans normally are entitled to the same treatment in the event of corporate failure as loan to the corporation from outsiders. c) Equitable Subordination If it would be manifestly unfair and inequitable to permit the controlling shareholder who has loaned the corporation money to participate equally with the corps creditors, the court will subordinate the loan to the claims of other creditors. 4. Policy Reasons to reject the idea that all shareholder loans should automatically be subordinated: a) It is not necessarily desirable to deter shareholders from making loans to corps. b) A rule which subordinated any corporate debt held by a shareholder could present administrative problems when dealing with corporations with publicly traded stocks and bonds

c) It is not clear what policy a rule which automatically subordinated shareholder loans would achieve. 5. When should a court subordinate (if it is not automatic)? a) 3 part test Several courts have recited a 3 part test: 1) The shareholder engaged in inequitable conduct 2) This conduct resulted in injury to other creditors and 3) Subordination would not be contrary to the bankruptcy code (this element lacks significance because the code authorizes equitable subordination) b) Inequitable Conduct Test comes down to inequitable conduct. 6. Equitable subordination - occurs when there is inequitable conduct. a) Deep Rock Doctrine If it would be manifestly unfair and inequitable to permit the controlling shareholder who has loaned the corporation money to participate equally with the corporations creditors, the court will subordinate the loan to the claims of other creditors. 7. When does Equitable Subordination occur? a) Inequitable Conduct shareholder/lender took unfair advantage of the corporation and other creditors. b) Is it really a loan? When a shareholder/lender gives the corp better terms than an outside lender would get, courts have found that it is not really a loan, so may be subordinated. The so called loan is an equity investment in the corporation and thus falls under the rule that debt gets repaid before any shareholders get a return on their investment. c) Inadequate Capitalization Typically unfairness is found when the bankrupt corp was undercapitalized (the initial investment of capital by its shareholders was inadequate for the purpose of conducting its business in the view of economic needs and the risks of the enterprise as they appeared when it was formed. d) Control Also occurs when the corps creditors have been prejudiced by an abuse of control in connection with the loan by the controlling shareholder. Is most often applied where the parent has control over the subsidiary. e) Bankruptcy Bankruptcy court has the power to force equitable subordination. f) Pepper v. Litton Litton sole shareholder. Pepper brought suit against the company for unpaid royalties. Then it occurred to Litton that the corp owed him an unpaid salary. He got a judgement against the corp for his back wages. Pepper got a judgement against Ls corp. L filed for bankruptcy after getting his back wages. Court held that Ls claim should be subordinated to Peppers. 1) Any wrongdoing on the part of a controlling stockholder (defraud creditors or if corporate entity may be disregarded) that taints a claim submitted to a bankruptcy trustee is a basis for equitable subordination of that claim. g) Equitable subordination is a milder remedy than piercing because it

does not involve the personal liability of the stockholder for the corporations debts. VI. DISTRIBUTIONS TO STOCKHOLDERS ********** A. Statutory Limits on Dividends 1. Generally Corporation statutes impose restrictions upon dividends paid paid by corporations to their shareholders. The rules vary among state statutes. 2. Traditional Balance Sheet Statutes a) Definition Dividends cannot exceed the amount of the corporations surplus 1) Surplus means the difference between the corporations net assets and its capital. 2) Net assets the amount arrived at by subtracting the companys total liabilities from its total assets. 3) Equity/Net worth difference between the total assets and the total liabilities is the amount on the balance sheet. 4) Capital does not equal what the shareholders paid for their stock. (a) Instead, it is largely whatever sum the directors (and shareholders) decide to call capital. (b) Could be the entire purchase price, or any fraction of it so long as the total amount is more than the aggregate value of par value multiplied by the number of shares sold at that par value. (c) Directors can increase capital by resolution company increases the number shown for capital on the balance sheet and decreased the amount of surplus by the same amount. (d) Directors may reduce the amount of capital through several means: (i) Cancelling shares (ii) DE statute allows the board, by resolution, to decrease the capital until the capital equals the aggregate par value of the outstanding stock (stock that has been sold to people). (iii)Directors and shareholders can vote to amend the corps articles to lower par value which clears the way for a board resolution lowering capital. b) The balance sheet approach is somewhat of a joke purports to prevent shareholders from receiving dividends which represent a return of the shareholders investment capital. Yet, by allowing directors to designate as capital, sums which are less than what the corporation received for its stock, the statute undercuts its own purpose. c) Wrinkles in balance sheet approach: 1) It is possible for a corp to have surplus, but still be insolvent in the sense that it lacks sufficient liquid or current assets (cash and the like) to pay its current or soon to be due bills. 2) Some balance sheet statutes contain provisions prohibiting

dividends either when the corp is insolvent or when paying the dividend would render the corp insolvent, in the sense it could not pay its bills as due (a) A dividend under these circumstances might also violate fraudulent conveyance statutes. 3. The Earned Surplus Approach Pre 1980 Model Business Corporation Act a) Definition A corporation may pay dividends out of its earned surplus. 1) Earned surplus refers to the sum of the corporations income, net profits, and gains over the years, minus the companys losses and minus prior distributions to the shareholders. b) Differences Earned surplus approach is different from the balance sheet approach in two ways: 1) Document Instead of looking at the balance sheet, the old model act looks to the corps income statements. However, under accounting principles, the balance sheet should reflect the total of earnings over the years, less losses and distributions. (so not really a difference) 2) Earned surplus comes only from the corporations income over the years. Balance sheet surplus comes from earnings and any amount which the shareholders pay for their stock which the directors and shareholders choose to call capital. (a) Thus, if model act actually limited dividends to earned surplus, it would have prevented dividends which returned invested capital to shareholders. c) Capital surplus However, the old model act recognized a category of surplus called capital surplus. It is the difference between the corps surplus (defined the same way as balance sheet) and the corps earned surplus. It is generated by issuing stock. 1) Corp can pay dividend out of capital surplus if so authorized by the articles or if each class of shareholders votes to allow such a dividend. 2) Thus, shareholders have the power to withdraw their investment through dividends, despite the possible reliance by creditors upon the shareholders investment. 4. Modern Approachfes Current Model Business Corporation Act a) Definition modern approaches react by giving up. The concept of capital as a limit on corporate distributions is eliminated. 1) Instead, as long as the corp is solvent in an equitable sense, a corporation can declare a dividend up to the amount by which its assets exceed its liabilities. (a) Solvent in an equitable sense means that the company can pay its bills when they become due. (b) If the corp has outstanding stock with liquidation preferences, its liabilities are the amount by which the companies assets

exceed the combination of its liabilities and the liquidation preferences of its outstanding shares. b) Paying a dividend equal to the amount by which the corporations assets exceed its liabilities will leave no shareholders equity to cushion the companys creditors. c) CA Allows a dividend under either of two conditions: 1) The company may distribute a sum not in excess of the amount of the corporations retained earnings or 2) If there are insufficient retained earnings, the company can distribute a sum which leaves the corp with total assets in excess of 1 times the companys total liabilities and current assets greater than its current liabilities. 5. Accounting Questions a) Concern placing a dollar value on a corps assets or even stating the amount of the corps earnings during a period of time is not a straightforward matter. Valuing the assets is part of determining whether a dividend is legal. b) Conventional Accounting Practices book value of an asset is the cost of the asset, minus depreciation. c) Current Model Act allows directors to base their determination of the legality of a dividend upon financial statements prepared on the basis of accounting practices which are reasonable in the circumstances or on a fair valuation or any other method that is reasonable. d) CA mandates that corporations follow generally accepted accounting principles in determining the dollar amount of the companies assets. General accounting principles generally preclude revaluing assets at greater than the assets initial costs. 6. Remedies for Improper Declaration of Dividends a) Parties who may face liability: 1) The directors who voted to declare the dividend 2) Shareholders who received the dividend. b) Basis of liability: 1) Provisions in corp statutes 2) Common law 3) Provisions in creditor protection laws of general applicability (such as fraudulent conveyance statutes) c) Director liability statutes typically contain provisions which expressly impose liability on directors who vote to declare a dividend in violation of statutory dividend limits 1) Generally, these statutes do not impose liability without respect to fault. 2) The statutes condition liability upon negligence or bad faith. 3) The directors defense could be good faith reliance. d) Shareholder liability Shareholders face more diverse liabilities: 1) Statutes often contain provisions imposing liability upon shareholders who receive impermissible dividends. Two main

types: (a) Some statutes require shareholders to return improper dividend to the corporation. (b) Most statutes allow the directors who were liable for an impermissible dividend to seek contribution from the shareholders who received the illegal dividend. 2) Either type of statute only makes shareholders liable if the shareholder knew that the dividend was improper. B. Repurchases of Stock 1. Generally a) Corporation statutes typically contain express authorization for companies to repurchase or redeem their own shares. b) Repurchase of shares serves a variety of purposes: 1) Can provide an important source of liquidity to stockholders who lack the trading market available to shareholders of a publicly held corporation 2) Stock may be at a bargain price 3) Can be used to either facilitate or to foil an insiders or an outsiders purchase of control of the corporation. 2. Creditor Concerns a) Generally 1) From the standpoint of creditors, corporate distributions to repurchase shares present the same hazard as dividends. 2) Thus, state corporation statutes limitation on stock repurchase analogous to those they place on dividends. b) CA and Model Act place limitations on distributions. 1) Distributions include cash or property paid to shareholders either as a dividend or in exchange for selling back their stock. c) DE generally precludes repurchases when the companys capital is impaired, or when the repurchase will cause the capital to become impaired (when the amount paid in the repurchase exceeds the amount of the corporations surplus). 1) Statutes like DEs implicitly recognize treasury stock is not an asset; otherwise it would make no sense to talk about the purchase impairing capital or coming out of surplus. d) Effect The repurchase of stock lowers the corps assets by the amount paid out. e) Financial Limits There are typically 2 financial limits on share repurchases: 1) A surplus (or other balance sheet) test and 2) A requirement of equitable solvency f) IOUs Many times corps will not immediately pay cash for the repurchased shares, but instead will give the seller an IOU. This means the corp will pay for the repurchased shares in installments. 1) IOUs raise the question of when to measure the repurchase against the statutory financial limits for the purposes of determining if the

corp violated the statutory financial limits when it made the repurchase. The corp must have a surplus and have equitable solvency. (a) Can measure at the time the corp obtains the shares back in exchange for its promise to pay, at the time the corp actually makes each installment payment, or both. (b) Most courts apply the equitable insolvency test at the time of each payment of the IOU. (c) A few courts only look to whether the corp was solvent at the time they issued the IOU. (d) Courts disagree on when to apply the solvency test. B. Merger and Stock Repurchase Where there is a merger that results in the same economic result as stock repurchase, then the stock repurchase limitations will still apply to the merger. 1. Difference: a) In the merger, the new company buys the stock, then merges with the old company. b) In the stock repurchase, the old company just buys the stock. 2. Statutory limits on stock repurchases: a) What is a stock repurchase? 1) Distribution 2) Repurchase b) What are the statutory limits? 1) Model Act Limits distributions. Defines distributions to include repurchases. Under Model act, no distribution may be made if: (a) the corp would not be able to pay its debts as they become due afterwards, (b) if the corps total assets would be less than its liabilities. (i) We can tell that the corps assests would be less than its liabilities by looking at the balance sheet. Assets minus liabilities = net worth. (ii) We find out the assets by looking to see if there is cash, looking to facilities, property. (iii)Book value is what you paid for it at the time that you bought it. (iv) However, as long as we are reasonable in figuring out what are assets are worth, you do not have to go by book value. 2) Delaware Statute Limits repurchases of shares. No corp can redeem its own shares when the capital is impaired or the purchase will impair the capital (a) Impair capital Capital in this definition means something different than in piercing. What is capital for those purposes is not the same thing as what the statute means for repurchase purposes. (i) In this context capital is whatever the board of directors says is capital.

(ii) The basic idea is that it is some part of the money that the corp got when it sold its shares. (iii)Only constraint is that if the shares have par value, the lowest number that the board can set for capital is that par value. The number has to be more than the par value times each share at par value. (b) Placing value on assets (i) An asset is worth what you paid when you bought it. (ii) Can find out how much the shares of the company are worth (iii)Also look to how much the company will be worth in the future. PART 3: I. DUTIES OF DIRECTORS AND OFFICERS

DUTY OF CARE A. Generally 1. Duty Persons who engage in conduct which creates a risk of harm to others, have a duty to act as a reasonably prudent person would act under the same circumstances to avoid such harm. 2. Prudent Person Requirement This means she must act as a prudent person would with respect to her own business affairs. What would a reasonably prudent person have done differently than the directors did in the case? B. Inattention 1. Definition- One type of claim against directors or officers for violating their duty of care involves the allegation that the directors or officers were essentially asleep at the switch while subordinates harmed the corporation 2. Duty Directors must discharge their responsibilities with the degree of diligence care, and skill which ordinarily prudent me would exercise under similar circumstances in like positions. (Statute in Francis case w/Mrs. Pritchard) a) Appears to be nothing more than a restatement of the reasonably prudent person test. 3. Applying standard One must figure out what a reasonably prudent person would do when he or she is a corporate director. a) A director should acquire at least a rudimentary understanding of the business of the corporation. b) Directors are under a continuing obligation to keep informed about the activities of the corporation. c) As part of keeping informed, directors should make it a practice to attend board meetings, even if they cannot attend every board meeting. d) Directors should also keep informed by regular review of corporate financial statements. 4. Circumstances The duty required of a director depends on the

circumstances. This is consistent with the tort law principle which measures negligence based on what a reasonable person would do in the same situation a) What sort of circumstances do courts look at in deciding what efforts a reasonably prudent director would expend in monitoring corporate affairs? 1) Nature of the business Courts are more willing to find a breach of duty with bank directors than with corp directors because of the nature of the banking business. Directors are in charge of large amounts of money and have a fiduciary duty. 2) Role of the defendant in the corporation courts may expect more of a full time corporate executive than of an outside director. 3) Size of the corporation Directors of a closely held corporation might reasonably be more casual with their monitoring of corporate affairs than directors of a publicly traded corporation. Their own dollars are at stake in a closely held corp, so there is a less formal monitoring requirement. 5. Trusting Employees Directors are entitled to rely on the honesty and integrity of corporate employees until something happens to create suspicion. a) What the court meant was that directors need not automatically assume that all employees are crooks. b) A large business could not function if without giving its employees a substantial amount of trust. c) Many states, including DE, have a provision in their statutes protecting directors who reasonably and in good faith rely on records and reports of subordinates. d) At some point, trust becomes unreasonable (book keeper obviously living beyond his means) 6. Liability The director is liable for inattention only if his breach of the duty of care caused a loss to the corporation. This may be hard to prove because it is difficult to show if it was all his fault. The corporation might have lost money anyways. C. Business Decisions and the Business Judgment Rule 1. Definition Courts should exercise restraint in holding directors liable for (or otherwise second guessing) business decisions which produce poor results or with which reasonable minds might disagree. Decision must be made by the board. a) If the decision is one made by an employee, the regular negligence standard applies. When officers are also directors, the law is not clear whether the business judgment rule applies. 2. Outside Suit If the suit is brought by someone other than a shareholder, the business judgment rule does not apply as a defense for directors. Directors may only use the business judgment rule when the case is brought by a shareholder or the company itself. Ordinary negligence standard applies.

3. Difficulty Problems arise when courts and writers go beyond the general concept of judicial restraint and attempt to inject specific content into the rule. Then a lack of consensus emerges as to exactly what the bjr really is. 4. There are 4 main ways the BJR is approached: a) Tautology This statement of the rules is that courts will not interfere with the decisions of corporate directors so long as the directors act with reasonable diligence, are not in conflict of interest, and act in good faith. This is the same as saying that directors will not be liable for their decisions unless there is a reason for holding them liable specifically that the directors breached their duties of care or loyalty. b) Ordinary Negligence Directors are liable for negligence in the performance of their duties. Directors will not be liable for errors of judgment or for mistake while acting with reasonable skill and prudence. 1) Decisions over which reasonable minds may differ are not negligent. 2) An error in judgment or a mistake in the sense that a decision does not turn out as one hoped does not automatically equal negligence. c) Good Faith purely subjective test. If you thought what you were doing was in the best interest of the company, then it is fine. Good faith is a minimum requirement. 1) If the outcome makes no sense, then that is evidence that they did not think about it. 2) Effect of this interpretation is that the result of the bjr is to effectively abolish the duty of care for any situation in which the plaintiff challenges and action by the board. All that remains of the duty under this view is to avoid the sort of inattention and inactivity that Mrs. Pritchard did. d) Gross Negligence DE uses this standard. It is like negligence, but worse. (like not hiring experts, and not paying attention to what it's doing and doing it anyway) 1) One DE court explained that gross negligence would appear to be mean reckless indifference to or a deliberate disregard of the stockholders or action which are without the bounds of reason. 2) Gross rather than ordinary negligence has had little impact on the result. However, gross negligence entails a worse level of dereliction than ordinary negligence. (Is your heart in the right place?) e) Process of the decision v. Substance of the decision (ALI approach) 1) There are two ways in which a plaintiff can attempt to show that directors breached the duty of care in making a business decision: (a) Substantive merits of the decision (b) Process the directors used to make their decision (how you make the decision?) 2) Level of Scrutiny ALI sets up a distinction between the levels of judicial scrutiny of the directors decision itself (substantive)

versus the level of scrutiny the court will apply in reviewing the process the directors used to arrive at the decision (procedural). (a) Process As far as the process the directors used to reach their decision, whether the directors acted after gathering adequate information, a standard of reasonable belief is used. (b) Substance the standard of care for reviewing the substance of the decision is lowered to a rational belief. (c) Not liable unless 1. Bad Faith 2. Not reasonably informed 3. For Substance, need to be not rational
Misc note: Heightened standard for pleadings to survive dismissal for corporate law matters. Though you may need evidence, that can be unconvered discovery, that can survive the dismissal, SH can always request such info. D. Why a Special Rule for the Decisions of Directors?

1. There are several justifications for the bjr insulating directors from liability for ordinary negligence. They fit into four broad categories. a) Difficulties with after the fact review of business decisions b) Nature of the damages c) Nature of the plaintiff d) Utility of compensation or deterrence e) If directors are so worried to get sued, they may not serve anymore. 2. Testing the justifications in specific situations 3. Reconciling BJR with statutory standard of care standards E. To Whom do Directors Owe a Duty? 1. Generally a) Who A director owes a duty to 1) Corp A director owes a duty to the corporation Means that the director should be seeking to maximize the profits of the corporation. 2) Shareholders Directors also owe a duty to shareholders. 3) Clients A corp owes a duty to the corps clients. (Pritchard/banking context) b) Constituencies Whether a director owes a duty to other constituencies (corporations creditors, customers, employees, or the community) involves 2 questions: 1) Do directors have a legally enforceable duty to these other constituencies? 2) If directors do not have a legally enforceable duty to these other constituencies, will directors breach their duty to the shareholders if the directors act in the interests of these other constituencies at the expense of the interest of the shareholders? 2. Do Directors have a Legally Enforceable Duty to Other Constituencies? a) Court have refused to recognize that directors have fiduciary obligations to the corporations creditors and other groups outside the shareholders.

1) Policy issues: (a) Directors would be unable to take actions in numerous cases without the fear that members of some constituent group will sue the directors, claiming the action prejudiced their group. (b) Groups like creditors, employees, and customers can protect their own interest by contract. (c) Communities can protect their own interests or the interests of employees, consumers, and creditors by regulating corporate conduct. (d) On the other hand, no contract or regulation can anticipate all of the events which might occur during the course of a long term relationship like the one that exists between the corp, its employees, between the corp and its long term creditors, and even between the corp and some of its customers. 3. To What Extent can Directors take the Interests of Other Constituencies into Account? a) Just because the directors have no legal obligation to take the interests of other constituencies into account does not mean that the directors might not voluntarily do so. 1) This raises the question of whether directors have the discretion to take into account the interests of other constituencies at the potential expense of the shareholders. 2) By and large, courts have not scrutinized business decisions to see whether directors sacrificed profit maximization to advance the interests of employees, creditors, customers, and the community. 3) Courts almost invariably accept some rationale as to how the business decisions were in the long-range interest of the shareholders and benefits the business. (since putting $$ to the community could have good PR effect or giving $$ to employees' widow could be good for morale and productivity, or putting money in the neighborhood in order to keep up value of commercial property) If rationale is not business related, or because rationale is due to personal relations, then it is ultra vires. Just need any articulation of a rationale. Only one time when the court would refuse the rationale, and that would be takeovers in cash where the deal made was the inferior one. (as can't say that cash takeover would benefit SH in the long run even though the deal is not as much, as SH would just bail) Courts usually like charities and expansion and would usually infer a profit rationale in spite of what D says. (Dodge v Ford case) a. If company wants to expand only and avoid dividends and does not pay dividends for a long time and is capable of giving out dividends, then court could order dividends to be paid since primary role of BOD is to profit the sharehholders and not reform America. b) Takeovers DE decided that in deciding to oppose a takeover bid, the

directors should consider the impact of the bid on constituencies other than shareholders. This includes creditors, customers, employees, and perhaps even the community generally. Courts usually answer the question of takeovers on the argument that the impact on other constituencies may eventually somehow impact shareholders, and you would have to talk about policy. c) State statutes many states have enacted provisions empowering directors to take into account the interests of the corps employees, customers, creditors, suppliers, and communities in which the company has facilities. 1) Several of these statutes also state directors must justify concerns for other constituencies by finding long range shareholder benefit and that the directors do not have to give primacy to shareholder interests.
F.

Exoneration by Statute and Charter Position 1. State legislatures have enacted provisions to limit the liability of directors. 2. DE/Charter Option Statutes Allows certificates of incorporation to include provisions which limit the liability of directors for breaching the duty of care. a) Only allows the certificate to contain a provision limiting the directors liability for monetary damages. Does not speak of limiting the ability of a court to grant equitable relief. b) Only discusses liability of directors. It does not authorize provisions to limit the liability of corporate officers. Thus, if an officer/director breaches duty of care, liability can still exist only if the person undertook the challenged action solely in his or her role as an officer and not also as a director. c) Only addresses liability to the corp or its stockholders. d) There is also a list of the claims which statutes do not allow the certificate to waive: 1) Breach of duty of loyalty 2) Actions not in good faith 3) Intentional misconduct 4) Knowing violation of law 5) Declaring dividends in excess of statutory limits 6) Transactions in which directors received an improper personal benefit. (same as duty of loyalty) e) This statute is rather ambiguous and repetitive. f) Requires a vote of the directors and the shareholders in order to add this to the articles of incorporation. 3. Model Act a) Model act is essentially the same as DE, except it deletes the exceptions for duty of loyalty breaches and actions not in good faith. b) However, the financial benefit and intentional harms exceptions substantially overlap the duty of loyalty and good faith exceptions, so there is not too much of a substantive difference between the 2.

4. Other Jn Some have a cap on damages, some have a willfull requirement. 5. Policy Shareholders in a corp ought to be able to agree to waive the liability of the corps directors for breaching the directors duty of care. PART 4: I. GOVERNANCE *******

THE DIVISION OF POWER UNDER STATE LAW A. Officers 1. Who are the Corps Officers? a) Required Officers 1) Many corporation statutes Require certain officers like a president, secretary, treasurer and sometimes a vice president. Also allow a corp to have any other officers which the bylaws specify or which the companys board of directors appoints. 2) DE and Model Act call for corp to have whatever officers the companys bylaws or its board of directors specify. Must be an officer responsible for taking minutes of shareholders and directors meetings. 3) This is ultimately a business rather than a legal decision. b) Hiring and Firing 1) Statutes commonly call for appointment of officers as provided in the bylaws. 2) Board of directors appoints the corps senior officers, who then appoint junior officers. 3) Board has the power to fire officers with or without cause, unless otherwise provided by contract. 2. What Authority do the Officers Possess? Do they have the authority to bind the corporation? a) Actual authority the agent doing what the principal gave the agent permission to do. 1) Express actual authority the principal explicitly granted the agent permission to perform the act. 2) Implied actual authority agent attempts to determine what the principal desires of them based upon previous course of dealing, the nature of the agents job, what is necessary to carry out express instructions, and the like. If the agent is reasonable in inferring the existence of such unspoken permission, then the agent has implied actual authority. b) Apparent authority When agent acts outside actual authority by doing what principal told him not to do or acting unreasonably, the principal may still be bound if by apparent authority if: 1) The principal in some manner communicated to the party with whom the agent dealt that the agent has the authority to act, and 2) Based upon this communication, the party with whom the agent dealt reasonably believes that the agent has such authority. c) Way to create authority By appointing someone to a position and

giving that person a title, the appointed individual, barring instructions to the contrary, might reasonably assume that he or she has permission to do those acts which other individuals who have occupied this sort of position with this title customarily have done. The position and title itself serve as communication from the corp which can form the basis for both implied actual and apparent authority. d) Apparent Authority of President 1) Test Ultimate test for the apparent authority of the President should call for an empirical assessment of business practice. Court will apply the ordinary v. extraordinary contract line in light of common expectations and business practices. This is because the important issue is whether the party dealing with the president reasonably believed that president had the authority to make a contract. 2) Factors General factors which suggest what the business practice should be include: (a) The impact of the contract, as measured by its reasonableness and its size relative to the size of the corporation. (b) Things that usually go to the board include changes in the corporate financial structure, changes in control over the corp, significant changes in what lines of business the corp conducts. (c) Binding corporate resources to bear on one side of an intra corporate control suit (having the corp file against a major shareholder) are usually beyond the scope of the Presidents authority. 3) Title of president seems to convey significant implied and actual authority, but it has greatly evolved so that in some corps it does not mean much. B. Directors 1. Composition of the Board a) Amount Normally, corps bylaws or articles specify how many directors will be on the board. b) Who Modern statutes tend not to impose any qualifications on who can serve on the board, leaving the limits to the articles or bylaws. 2. Voting by Directors a) At large shareholders normally vote for directors in an at large election. They do not vote for one individual for each position. Instead, they vote for as many individuals as there are open positions on the board. Those who receive the largest number of votes fill the position. b) Cumulative voting Allows a shareholder to concentrate the shareholders vote on a smaller number of individuals instead of voting for as many individuals as there are positions to fill. 3. Terms of Directors a) One Year Normally serve one year terms, with an election held at the annual shareholders meeting to fill the whole board.

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b) Staggered terms most state statutes allow a corporation, by a provision in its articles (some statues say articles or bylaws) to adopt staggered terms. Directors could have 3 year terms with 1/3 of the board up for election each year. 1) Reasoning - This helps to maintain continuity on the board. Others say it is just a means of frustrating cumulative voting or as a defense to corporate takeovers in which the majority purchaser wants to replace the board. Removing Directors a) Common law the shareholders possessed the inherent power to remove a director, but only for cause. Power struggle or policy disputes are not cause. Generally must have some sort of breach of duty by the director to have cause. b) Modern many statutes allow the shareholders to remove directors with or without cause. One limit on this power is that it may be subject to a contrary provision in the articles. c) Board Removing a Director At common law, the board did not have this power. However, some statutes now allow the board to remove a member for specified grounds. d) Court Removing a Director Some statutes allow courts to remove a director for cause. Courts applying the common law have been divided as to whether the court has the power to remove a director. Vacancy on the Board a) Wait Corporation could wait until the next annual shareholders meeting to fill the vacancy. b) Special Meeting Corporation may call a special meeting of the shareholders to fill the vacancy. c) Fill Statutes often empower the board to fill vacancies, unless provided to the contrary in the articles or bylaws. These statutes often limit the degree to which the board can expand its own size or, under an older approach, might limit the ability of the board to fill openings created by its expanded size. Law wants to prevent a court packing scheme. Exercise of Boards Authority a) Authority of the board is obtained by the corporation statute. b) Statutes normally state that the corporation will be managed by the board of directors. The more common formulation states that the corporation will be managed by , or under the direction of, the board of directors. How the Board Exercises its Authority a) Authority 1) Board operates as a group. Individually they have hardly any rights. 2) Authority of the directors as individual directors on their own is virtually nil. 3) Directors only have authority for actions taken as a board. Thus,

directors normally must take actions at a meeting of the board. b) Quorum refers to a minimum number of the group who must be present at the meeting in order to take valid action. Corporation statutes used to set a quorum for a meeting of the board as a majority of the members. Modern statutes usually allow the articles or bylaws (some statutes say just the articles) to contain a provision setting a greater quorum and many allow a lower quorum (but usually no less than 1/3 of the directors). c) Notice Many corporation statues do not require notice for a regularly scheduled meeting but do require notice of special meetings. Since this notice requirement exists for the benefit of the directors, a director may waive notice for him or herself. Showing up at the meeting can waive notice, if the director does not promptly object or refuse to participate. d) Approval of Board Action In the absence of a valid contrary provision in the corporations articles or bylaws, it takes a majority vote of directors present to approve an action. A majority of the entire board is not required. e) Proxy Voting Directors normally cannot vote by proxy. Modern statutes typically allow directors to be present at the meeting by telephone conference call or other such medium. 8. Individual Action by Board Members members acting on their own without board approval. a) Written consent Modern statutes typically allow directors to act without a meeting if the board members give unanimous written consent to the proposed action. It requires unanimous because if there is dissent, the board should meet to discuss it. b) Jn without a consent statute Where there is no statute allowing a board to act by unanimous written consent, or in situations where there was not formal written consent, or where the consent came only from a majority of the board, the issue arises of whether the corporation is bound by approval from most of the directors, even if the approval occurred without a valid meeting. 1) Traditional answer corporation is not bound. 2) Some courts over time have been willing to hold a corporation bound by the informal actions of the companys directors. (a) Most often occurs when all of the shareholders and all the directors concur in an action relied upon by an outside party. Here there would be no dissenting directors who would have tried to change minds at a meeting and the shareholders concur. It seems unfair to allow the corp to get out of a deal with a third party in this situation. (b) Outside of that situation, it is harder to avoid the traditional rule. Some circumstances include when there is a contract with the corporations directors instead of a third party, or when not all shareholders were aware of and concurred in the informal

action. (c) Fundamental question whether upholding informal board action which falls short of unanimous consent will frustrate the policies served by requiring that director consent to actions without a meeting be in writing and that the consent be unanimous. (i) Evidentiary purpose of written requirement if the court is confident that all of the directors tacitly concur in the challenged action, the fact that there is not a writing does not matter. (ii) Unanimous consent requirement dissenting directors are entitled to a meeting before the board takes action. 9. Committees a) Corporation statutes normally empower the board to establish committees of board members to which the board as a whole delegates some of its decisions. b) Statutes often restrict the board from delegating certain decisions to a committee including: declaring dividends, issuing or repurchasing stock, approving fundamental transactions like mergers and amendments of the articles or bylaws, and filling vacancies. 10. Rights of Individual Directors a) Individual members have certain rights necessary to carry out their role as directors. b) Each director has the right to obtain information about the corporation through its inspection of corporate books, records and the like. Some courts say this right is lost if there is improper motive. C. Shareholders 1. The Shareholders Role in Governance a) Actions Shareholder actions include: 1) Electing directors 2) Vote on certain corporate actions including: (a) Amendment of the articles (b) Mergers (c) Sales of substantially all assets (d) Dissolving the corporation b) Fundamental transactions Common to state that the law requires shareholder approval of fundamental transactions. However, shareholder approval is often required for trivial matter including amending articles while the board may restructure the nature of the business and the risk for shareholders without putting the change to the shareholders for a vote. c) Power Shareholders only have veto power. They only get an approval right or the right to veto an action. d) Amending bylaws state statutes typically allow the shareholders to amend the bylaws on the shareholders own initiative, rather than simply approving amendments proposed by the board. Are not given

the power to amend the articles. 2. The Mechanics of Shareholder Action a) Voting Shareholders exercise their voice through voting on electing directors or on approving various transactions. b) Similarities between Shareholder and Director Meetings There are several requirements for shareholder meetings that are similar to directors meetings including: 1) Notice of Shareholder Meetings (a) Most statutes entitle shareholders to notice of regular, not just special, meetings. (b) Same statutes also often require shareholders to receive notice not only of the time and place of the meeting but also notice of what the meeting is all about. (c) Waiver of Notice Shareholders may individually waive notice either before or after the meeting, and showing up at the meeting without objection waives notice. 2) Quorum (a) While some statutes indicate that a quorum of directors be present at the time the board acts on a particular action in order for that action to be valid, the statute might indicate that quorum for a shareholders meeting simply must be present at the beginning of the meeting, but the departure of shareholders will not effect the quorum. (b) Normal statutory requirement for quorum is a majority, but statutes commonly allow articles to set higher or lower quorums. 3) Voting Requirements (a) Election of directors normally a plurality is required. (b) Matter requiring an up or down vote typically a majority of the shares present at the meeting is required, so long as there is a quorum, rather than a majority of all shares. (c) Approval for mergers or certain transactions transaction must receive an affirmative vote for from a majority of all shares entitled to vote on the matter. Under same statutes, mergers require a 2/3 vote. (d) Model act instead of requiring a majority of the shares present, requirement is only for a majority of the shares voting. c) Differences between shareholder and director meetings There are several requirements that are not a concern with directors meetings that are a concern with shareholder meetings: 1) Control over the timing of the meeting (a) Corp statutes often mandate that corps hold annual meetings of their shareholders in order to elect directors and often empower the courts, upon petition of a shareholder, to order the holding of an annual meeting if a corporation does not do so within a specified period of time.

(b) Special meeting corp bylaws and occasionally the articles, commonly contain a provision stating who can call a special meeting of the shareholders. Sometimes, is the directors or the corps president. Some statutes empower a certain percentage of the shareholders to call a special shareholders meeting. (c) Directors can change the date of the meeting in order to gain an advantage, but this decision may be subject to judicial scrutiny where the directors have an inequitable advantage in the election. 2) Who is entitled to attend and vote? (a) Often the right to vote depends on the class of stock owned. (b) Corp is typically required by statute to provide a list of shareholders eligible to vote before each meeting. (c) Where the record voter is not the actual voter, the record owner has the right to vote the shares, but the record owner also has a fiduciary obligation to vote as directed by the actual owners. (d) Corporations cannot vote treasury stock because the directors could put themselves in power despite the wishes of the real owners of the corporation. (e) Corporation statutes often provide that subsidiaries cannot vote stock the subsidiary owns in the parent. This prevents the subsidiarys board from deciding who is on the parents board. 3) Concerns created by allowing shareholders to vote by proxy rather than in person (a) Voting by proxy a person, who is entitled to vote, authorizes another person to cast a vote. (b) If a person grants more than one person the right to vote by proxy, the basic rule is that the last grant of authority trumps all that came before. (c) Even if a person granting the proxy promises not to revoke the proxy, the party generally retains the power to revoke. (d) The proxy lasts as long as the document granting the proxy indicates. If there is no indication, corp statutes commonly contain default limitations. (e) Proxy holder owes a fiduciary duty to the shareholder who gave him or her proxy. (f) An additional issue is who pays to solicit the proxy voting. This question is unsettled in the law. d) What happens when action is taken without a meeting? 1) Corporation statutes typically allow shareholders to take action without a meeting if there is written consent by the shareholders to such action. 2) Under most corp statutes, shareholders can act through written consent without a meeting only if the consent is unanimous. 3) DE does not require unanimous consent. It is enough if there is a written consent from the owners of a majority of the shares entitled

to vote. 4) One problem is that it is hard to determine who owns how much stock when getting consent. 3. Shareholder Information Rights a) Origin Right of shareholders to inspect corporate records exists both by virtue of court opinions applying the common law and by provisions in the corporation statutes of most states. b) Burdens of Right This right creates two major burdens: 1) Hassle of making records physically available to the requesting shareholder. 2) Misuse of the corporate records by shareholders. (selling recipe for Coke) c) Approaches 3 principal approaches to deal with these burdens: 1) Focus on the shareholders purpose for demanding the inspection. (a) Not appropriate to use to gain names for an advertising list, to become or aid a competitor is not a proper purpose, for idle curiosity, or desire to burden corporate officials with the need to burden corporate officials with the need to respond to requests. (b) Proper purposes include obtaining a list of shareholders in order to communicate with ones fellow owners about the election of directors or other matters upon which the shareholders might act, and investigating possible management wrongdoing for the purpose of bringing an action on behalf of the corporation or the shareholders against wrongdoers. Also proper to ask to view in order to invite other shareholders to support a derivative action. (c) If a shareholder has a proper and improper purpose, one approach is to grant disclosure subject to an injunction against making improper use of the information. (d) Burden of proof shareholder who wants to inspect must show a proper purpose or the corporation to show an improper purpose? This is not clear in the law. 2) Avoid placing undue burdens upon the corporation from shareholder inspection demands by limiting the shareholders who can make such demands. (a) Several corp statutes adopt the idea that shareholders with a greater economic stake in the corporation should have more rights of inspection. 3) Draw distinctions based upon the type of document requested (a) DE statute shifts burden of proof on the question of a proper purpose, depending on whether the request is to see the shareholder list, or whether the request is to see other corporate records. If it is for the list, burden is on the corp to resist disclosure. If it is for other records, burden is on the shareholder.

(b) Model Act divides records into three camps. (i) First group are certain records which a shareholder has a right to see without regard to shareholders purpose (ii) Next group are board minutes, shareholder lists, and accounting records which can be inspected if the shareholder has a proper purpose. (iii)All other corporate records are beyond the reach of shareholder inspection rights. d) Disclosure Since it is impractical for shareholders to inspect, the law has mandated affirmative action by the corporation to disclose 1) Model Act calls for corporations to furnish annual financial statements to their shareholders and to report to the shareholders any indemnification by the company of a directors litigation expenses, and any issuance of shares for promissory notes or future services. 2) DE Directors owe the shareholders a duty of full disclosure whenever the board requests the shareholders to approve a transaction. II. THE ULTRA VIRES DOCTRINE (acting beyond authority given by articles of Inc) *********** A. Ultra Vires Is there any action which the board, with, if necessary, a vote of approval by the shareholders, lacks the power to undertake? 1. Ultra Vires Defined Beyond ones power. Certain actions are beyond the power of a corporation to perform. a) Any action by those in charge of the company beyond the grant in the charter is thus ultra vires and void. 2. Powers and Purposes a) Focus Used to use ultra vires in connection with the powers and purposes of the corporation. The focus was on why the corporation was acting rather than what the corporation was doing. b) Type of Action However, courts also held that corporations lacked the power to perform certain types of actions, regardless of the actions purpose. c) Modern law focuses on activities which are directed toward unlawful business (illegal activities) and activities which are not directed at any business goal at all (activities which are not directed toward any sort of profit making). 3. Gratuitous Activities a) Significance Activities without any business purpose remain the predominant significance potentially remaining to the ultra vires doctrine. b) Corporate gifts courts have generally rejected challenges that such gifts are ultra vires. c) Reasoning This is because charitable contributions are good for society and corporations are where the money is for such

contributions. d) Reasonable amount The contribution must be no more than a reasonable amount. Question then becomes, what is a reasonable sum? Some courts look to the deductibility of the contribution under federal income tax law. e) Widows Corporate payments to the widows of former executives were ultra vires. 4. The Impact of Being Ultra Vires a) Model Act reduced the impact to three basic consequences: 1) An action by the attorney general to dissolve the corporation. (a) This was based on the societal protection rationale for the ultra vires doctrine. However, no one believes in this rationale anymore. (b) Thus, it is difficult to imagine a court dissolving a corporation simply because the company engaged in activities beyond the purpose stated in the corporations articles. 2) An action by or on behalf of the corporation against the directors of officers who ordered ultra vires action. (a) This action is based upon basic agency law. (b) An agent who exceeds his or her actual authority is liable for any damages which the principal suffers as a result. (c) By definition, corp directors and officers exceed their authority if they have the corp engage in ultra vires actions. Thus, the directors or officers who ordered the ultra vires action can be liable to the corp for any losses the company suffers. 3) An action by the shareholders to enjoin the ultra vires transaction. (a) This helps to prevent use of the ultra vires doctrine from use to get out of bad deals. (b) Courts came to hold that unanimous shareholder approval would validate an ultra vires contract. This helped to protect minority shareholders. (c) Majority of courts refused to invalidate contracts which one side had performed, when the other side then sought to use the ultra vires doctrine to escape the still executory obligation. (d) Modern statutes expressly empower the courts to apply the courts sense of equity when it comes to enjoining an ultra vires contract at the behest of a complaining shareholder. 5. Remedies for Ultra Vires a) Dissolution of corp (obsolete) b) Allows suit for corporate officers who is responsible for acting beyond authority c) Enjoin action by shareholders. (courts get to look at equity to see if shareholders have already taken advantage of unauthorized act) PART 5: DUTIES OF OFFICERS AND DIRECTORS

I.

DUTY OF CARE A. Causation and Damages 1. Model Act the plaintiff, in an action seeking damages against directors for breaching their duty of care, has the burden to prove that the directors conduct was the proximate cause of the damage. B. Illegal Actions - What happens when directors or officers approve illegal corporate actions? 1. Sanctions Corporate directors and officers who violate laws including by ordering the corporation to break the law, face the sanctions which the particular law imposes on those who violate it. 2. What Authorizing illegal corporate conduct, in itself, could violate a directors fiduciary duty. a) However, what if the corporation would gain more through the violation, after the loss sanctions will entail if the corporation gets caught. b) Court has rejected the notion that the law cannot hold a corp responsible for an illegal act, since it was ultra vires for the corporation to do it. 3. BJR The BJR reflects the notion that courts should defer to the business expertise of directors, treating violations of law as a per se breach of the duty of care reflects deference to the sanction-setting expertise of the legislature.

II.

DUTY OF LOYALTY A. Duty of Loyalty 1. Definition The directors were greedy and put their own financial interests ahead of the interests of the corporation and its shareholders. 2. Contexts for breach: a) When directors or officers enter into a contract with their corporation b) When directors or officers learn of a business opportunity which may be of use to their corporation, but take the opportunity for themselves. B. Conflict of Interest Transactions: The Basic Approach 1. Theory If the officers or directors who negotiate or approve the deal on behalf of the corp are the parties on the other side of the transaction, they will face a clear conflict between their personal financial interest in obtaining the best terms for themselves and their obligation to seek the best bargain for the corporation. 2. BJR Does not apply to a transaction in which the directors have a conflict of interest where there is no approval by disinterested directors. a) Idea that directors, with their expertise, are more likely to reach a better business decision than the courts presupposes a situation in which we can trust the directors to act in the best interest of the corporation. 3. Remedy Typical remedy is to unwind the deal and force the directors to give back what they received.

4. Old Judicial Approach to C/I any contract in which one or more directors had a conflict of interest was voidable if any shareholder objected. Under this approach it did not matter whether the corporation received a good deal in the transaction or whether disinterested directors approved. 5. Modern judicial approach to C/I Courts will uphold a conflict of interest transaction if the transaction met two requirements: a) Directors, who had no personal financial stake in the deal (disinterested directors) approved the contract AND b) The contract was fair to the corporation. 6. Dominant Judicial Approach Ignore disinterested director approval and just require that the conflict of interest transaction be fair to the corporation. 7. Conflict of Interest Statutes a) These statutes state that the conflict of interest transaction will not be void or voidable because of the conflict, so long as the transaction meets one of three conditions: 1) Approval by disinterested directors 2) Approval by shareholders, or 3) Proof that the transaction is fair. C. The Fairness Test 1. Focus The fairness test can involve looking at either the substance of the directors decision, or the process that the directors used to reach this decision at the time. 2. Process of the transaction a) Merits Court will look at the merits of the transaction (not the typical issue with C/I transactions) b) Communications by the interested directors with the shareholders and any disinterested directors Courts have held that fairness requires candor by the interested directors in their dealings with shareholders or disinterested directors. 3. Substance of the transaction a) Questions Consideration of the substantive merits of the deal raises three questions: 1) What should courts measure in assessing substantive fairness? (a) Courts generally compare the value of what the corporation gave up in the transaction versus the value of what it received and its proportionality as well. 1. Looking at fairness of terms only work for fungible items. Very uncertain. (b) To be fair, a transaction should serve a corporate purpose. It is not enough that the objective value of what the corporation receives in a transaction with its directors equals the value of what the corporation gave. If the transaction does nothing for the corporation (the corporation has no use for what it received) then the transaction can still be unfair to the

corporation. 2) When should they measure this? (a) As a general rule, the time of measurement is at the moment the directors have the corporation enter the contract. Directors can only make a decision based upon the facts at the time that they act. (b) Later events If later events are ones that the directors anticipated (or should have anticipated), they bear upon the fairness of the transaction at the time the corporation enters the contract. 3) And against what criteria? (a) Basic idea corporation should receive value equivalent to what it gave up. (b) Test Whether this is the sort of bargain the corporation would have made if dealing with a stranger. In other words, directors should not have the corporation give to themselves a better deal than the directors would have the corporation give to outsiders. (i) This is not easy because the court must ask what price an arms-length negotiation would produce in a situation in which there was never an arms length negotiation by anybody. 4. Process court uses to evaluate fairness a) Second Guessing Court is free to second guess the decision of the board (unlike bjr). This is because the purpose of the fairness test is to have the court act as a disinterested decision maker. b) Burden The burden shifts to defendants to show that the challenged transaction is fair to the corporation and to show the process or disclosure of the transaction. c) Doubts Court tends to resolve doubts against the directors in a conflict of interest. Thus, mere possibilities that a transaction is unfair will doom the transaction. 1) Court resolves doubts against the directors because they normally will have better access to evidence as to the merits of a transaction than will a challenging shareholder. 2) If directors in a conflict of interest transaction know that the court will resolve any doubts as to fairness against upholding the transaction, the directors have an incentive to make sure that deal is a good one for the corporation, thereby removing doubt. D. Disinterested Director Approval 1. Who is a disinterested director? a) Model Act refers to qualified directors. These are persons who do not have a conflicting interest in the transaction. 1) Must not have a family, financial, professional, or employment relationship with an interested director of such significance that one would reasonably expect the relationship to exert an influence on the qualified directors judgment.

2. How many disinterested votes are needed? a) CA A vote sufficient without counting the vote of the interested director or directors. Thus, the number of disinterested directors voting to approve the transaction must equal a majority of the directors who are present at the meeting. b) DE Statute speaks of receiving the votes of a majority of the disinterested directors, even if they are less than a quorum. Thus, a majority of the total number of disinterested directors on the board must vote for the transaction. c) Model Act Basically follows DE, except adds a requirement that at least two qualified directors must vote to approve the deal. This was added in response to the concern that a single director would have the ability to hold out when reviewing a transaction. 3. When must the vote occur? a) CA Refers to authorization, approval or ratification by disinterested directors. Thus, an after the fact vote is acceptable (because mentions ratification). b) DE Looks only to a pre transaction vote. Refers only to authorization. c) Model Act Allows qualified directors to vote at any time. 4. What are the obligations of the interested directors in obtaining disinterested director approval? Disclosure. a) Requirements Conflict of interest statutes carry forward the requirement on agents to fully disclose when dealing with their principal. 1) Most statutes also require the interested directors to disclose any material facts they know about the transaction itself; in other words, the directors must disclose any facts relevant to the deal, which they know and which the disinterested directors reasonably would want to know. 2) Some only expressly require disclosure of the conflict of interest, but make no mention of disclosing other material facts about the transaction. b) Cure In order to cure the conflict by disinterested director approval, the interested directors must disclose the conflict of interest to the disinterested directors. c) Where the director does not disclose He or she cannot take advantage of approval by disinterested directors. d) Saving the transaction A transaction is not void because of the conflict either if: 1) There is disinterested director approval following full disclosure OR 2) The transaction is the transaction is fair. e) Statutes are divided on when the transaction may be saved 1) NY expressly allows directors in a conflict to save a transaction by proving it to be fair despite their lack of disclosure.

2) Number of courts have held that non-disclosure in itself can render a conflict of interest transaction unfair. 3) Model Act supports the view that unfairness in the approval process, and specifically non disclosure, can make the deal unfair regardless of its terms. f) Role of interested directors statutes allow interested directors to attend the meeting, count toward a quorum, and even vote on the transaction without rendering the transaction void simply because the interested director did so. 5. What is the impact of the vote? a) No Disinterested Director Approval Context Where board does not satisfy the requirements for disinterested director approval: 1) Statutes make fairness an alternative to disinterested director approval. (a) Hence, interested directors can still save the transaction, despite not obtaining disinterested director approval, by proving the deal is fair. (b) This means that a conflict of interest transaction may be valid, even though most of the disinterested directors voted against the transaction, and the board only approved the transaction by virtue of the votes of disinterested directors. (c) However, sometimes the fact which prevented the disinterested director vote from meeting the requirements of the c/i statute will also convince the court that the transaction is unfair. Presumably a court would be highly dubious of the substantive merits of a c/i transaction opposed by most of the disinterested directors. (d) Where the statute refers to fairness of the transaction at the time the board or the shareholders authorize, approve, or ratify the deal, the fairness prong cannot be applied because there was not authorization, approval, or ratification, courts will still apply the fairness test as a matter of common law. b) Disinterested Director Approval Context Where the transaction receives disinterested director approval meeting the statutory guidelines: 1) Point of contention is whether or not the court can still review the fairness of the transaction. 2) Statutes list disinterested director approval and fairness as alternate means of saving a c/i transaction. Hence, if the transaction receives approval by disinterested directors, it should not be subject to judicial review for fairness. However, courts can still review transactions in which there was no c/i by using the business judgment rule. (a) Disinterested director approval of a c/i transaction should cause the court to treat the transaction as if it did not involve a conflict to start with. (however, modified fairness test, where

burden of proof is on P, may be applied because minority disinterested directors may have voted for approval because afraid that there would be payback) (b) Thus, judicial review of the transaction should follow the business judgment rule, rather than the fairness test. 3) Number of courts have reviewed c/i transactions for fairness despite compliance with disinterested director (or shareholder) approval prongs of the conflict statutes. 4) Number of states the confict of interest provisions in a number of states now explicitly provide that fairness remains at issue despite disinterested director approval. 5) Model Act In contrast, model act provisions seem to contemplate no fairness review in case of qualified director approval. Qualified director approval must comply with good faith and due care provisions of the Model Act and that terms of the deal might be so unfavorable as to show bad faith. E. Shareholders and Conflict of Interest 1. Shareholder approval of director conflicts a) Options Statutes create three avenues for upholding transactions despite a conflict of interest by directors 1) Fairness 2) Disinterested director approval 3) Approval by shareholder vote b) Who is disinterested? 1) CA and Model Act only the votes of shareholders without a conflict of interest count toward curing the conflict. Model act refers to qualified shares to limit the shares which count. (a) Qualified shares excludes shares owned by the directors in a conflict of interest, by specified close relatives of such directors, or by trusts and estates for the benefit of such individuals, or administered by such directors. 2) DE Does not expressly address the problem. (a) Structure of statute suggests that the votes of the shares owned by interested directors count. Refer to votes by disinterested directors when discussing disinterested director approval, but do not use the term disinterested when referring to shareholder approval. Negative implication is that shareholders do not have to be disinterested. (b) Language of statute Provision refers to the shareholders entitled to vote theron. This likely refers to the fact that the corporation might have outstanding classes of shares which lack voting rights under the companys articles. Also might mean that shareholders must vote in good faith. c) How many votes are necessary to cure the conflict? 1) Statutes treat shares owned by parties in a conflict of interest as if the shares did not exist.

2) This means that a conflict of interest transaction involving a majority shareholder could be cured by a vote of a majority of the minority owned shares. d) Timing of disinterested shareholder approval? 1) CA and Model Act allow after the fact ratification 2) DE Ambiguous as to whether ratification will cure the conflict e) Impact of the shareholder vote? 1) Where there is disinterested shareholder approval, courts generally do not apply the fairness test to review the transaction. At the least, the highly intrusive fairness test described earlier is not applied. 2) NY Court stated that the transaction must be fair, even with shareholder approval. Court also held that shareholder ratification shifted the burden of proof to the plaintiff to show that the transaction was unfair, but the court did not apply the rigorous fairness test. (a) Exception if a transaction with majority or controlling shareholders receives approval from most of the other shareholders (a majority of the minority), some courts may shift the burden of proof to the objecting minority shareholder to show the transaction is unfair, but still may be willing to give the transaction a degree of scrutiny consistent with the fairness test, as opposed to the bjr. 3) BJR will normally not apply because it does not apply to shareholders because they do not have duty of care. 4) Gifts/Waste Shareholder approval cannot save a transaction which amounts to gift or waste. (if corp gives 10k for company salad that is worth 30bucks, the rest of the $ is waste) (a) Anything less than unanimous shareholder approval cannot save a transaction which simply gives away corporate assets. (b) Also, corporation may receive something in return that was worth less than what the corporation gave in the transaction. (c) Burden In looking at waste or gift, the burden is on the shareholder challenging the transaction to show that no reasonable person would conclude the corporation received the equivalent to what it gave in the deal. Thus, requires a highly circumspect judicial review with doubts resolved in favor of upholding the transaction. 2. Dealings with majority or controlling shareholders a) Why should it matter whether a majority shareholder engages in a conflict of interest transaction with the corporation? 1) Directors and officers have the power to enter transactions between themselves and the corporation which might advance their financial interests at the companys expense. However, no one pays shareholders to act on behalf of the corporation. Thus, shareholders have some right to selfish ownership,

2) A majority shareholder, acting as a shareholder, generally cannot bind the corporation to a conflict of interest transaction. Unless the majority shareholder is an officer or director, the majority shareholder must negotiate with individuals who have a duty to the company and all of its shareholders. 3) Ways to attack a transaction between a corp and its majority shareholder (a) If the majority shareholder is himself a director, can find a conflict of interest on the part of the director. However, this will not work if the majority shareholder is a corporation. (b) Conflict of interest can occur when the officers or directors have a financial stake in or a management role in another firm that enters into a contract with the corporation. (c) If the shareholder tells the directors what actions to take, the controlling shareholder will pick up the directors duty of loyalty. In this case, the directors are dominated by the shareholder. 4) Special Points for transactions between a corporation and its controlling shareholder (a) Each of the above challenges depends on the existence of action by the corporations board. (b) All of the challenges outlined above ultimately entail evaluating the independence of the directors who approved the transaction. (c) A large percentage of stock, even if not a majority, can yield working control over the board of a widely held corporation. (d) What is the difference between independent and dominated? Simple approach is to say that ownership of a majority of the voting stock is equals domination. (e) Majority shareholders, and not just directors, might personally be liable for an unfair conflict of interest transaction. (f) A conflict of interest on the part of a controlling shareholder also can introduce additional complexity into determining fairness. F. Executive Compensation 1. Issue A corps officers are interested in obtaining the most generous compensation package they can. 2. Rule While courts normally demand that directors prove the fairness of any compensation which the directors vote to have the corporation pay to themselves, disinterested shareholder approval generally shifts the burden to the party challenging the compensation to prove gift or waste. Approval by disinterested directors often leads courts to review the compensation under the bjr. a) Rare for the court to find compensation which received disinterested director or shareholder approval to be so outlandish as to flunk the bjr or to constitute waste.

b) Not unusual for a court to find compensation which received no disinterested approval to be unfair. 3. Problems Problems faced by court in reviewing whether compensation paid to directors and senior executives is fair a) There is a problem of finding arms lengths comparisons. To the extent that the compensation a court uses to compare also comes from an arms length transaction, this does not tell the court what an arms length transaction would produce. b) There is the question as to how much the court wants to insist on an exact quid pro quo when reviewing compensation. Where the employer provides benefits, they might not be tied directly to performance. Also occurs where the corp has stock option or similar plans.. G. Corporate Opportunities 1. Issue Corporate opportunities present the second major type of duty of loyalty problem. This occurs when directors or officers take for themselves business opportunities which could be of use to the corporation. There does not have to be a transaction by the corporation with anyone. 2. Problem Figure out when the directors and officers must give the opportunity to the corporation and when they may keep it for themselves. 3. The Judicial Tests a) Official v. Individual Capacity A corporate officer can only take opportunities that come to him in his individual rather than official capacity. A corporate officer can never take an opportunity that comes in his or her corporate capacity. (critical issue: To Fred as Fred, or Fred as president of Fred Inc.?) If offer made to u in corp capacity, must pass it on to corp. Offer is intended FOR the corp. If your job is to look for that very offer, then u can't take offer for yourself. 1) Oppt. must be also essential to the survival and success corporation. b) Line of Business Test (use or not use? Depends on the court) 1) A corporate official (high up official) must turn over to the corporation any opportunity which is in the corporations line of business, in other words, opportunities which relate to the business the corporation engages in. (oppt just needs to be logically extension to corp's activities) 2) Problem with this approach is that it can threaten to make practically every opportunity the corp might desire, into an opportunity the officer or director must give to the corporation. c) Interest or Expectancy Test 1) Concept of interest or expectancy has typically come to refer to opportunities the corp already has some tentative claim to, or , at the least, actively is seeking or negotiating for, even if the corporation does not yet have a contractual or property interest in the opportunity,

2) As applied, this test runs through a spectrum of possibilities: (a) Where the corp already has a contract to buy the opportunity in question (b) Where the corporation has has some property interest in the opportunity (c) Where the corporation is actively seeking this particular opportunity (d) Where the corporation is seeking this general type of opportunity. (e) Where the opportunity is essential to the corporation, meaning the corp needs the opportunity in order to continue its operations. 3) This test is normally narrower than the line of business test d) Other Factors and Fairness Test 1) This fairness test is different than the c/i fairness test. 2) Courts will look at a variety of factors similar to what is used in conflict of interest (a) How the defendant learned of the opportunity (b) Was it part of the defendants job to acquire such opportunities for the corporation (c) How important was the opportunity to the corporation (d) Whether the corporation was seeking the opportunity (e) Whether defendant used the opportunity to compete with, or sold the opportunity to, the corporation (f) Whether the corporation had the resources to develop the opportunity to decide whether it was fair for the defendant to take the opportunity. 3) Miller test is a variation where the court created a two part test: (a) Court considered if the opportunity was in the corporations line of business (b) Court asked if it was nevertheless fair for the defendant to take the opportunity. 4. Triangulating corporate opportunities (check out why there are triangulating of corp oppts, and what tests are involved) a) Issue The previous tests do not encompass all the factors that courts find relevant in deciding whether an opportunity should go to the corporation rather than to one of its officers or directors. b) Meinhard v. Salmon Test When determining that Salmon could not take the opportunity for himself, the court considered 3 factors: 1) The manner in which Salmon learned of the opportunity 2) Salmons position in the venture 3) The nexus between the opportunity and the business of the joint venture. c) Relationships These factors show that three relationships are considered when deciding whether the opportunity should have gone

to the corporation. 1) Relationship between the opportunity and the person who took the opportunity 2) Relationship between the corporation and the person who took the opportunity 3) Relationship between the opportunity and the corporation. d) Effect Results in the corporate opportunity cases often depend on the interplay between these relationships. 1) The more one relationship suggests a particular opportunity belongs to the corporation, the less the other relationships must provide grounds for finding the opportunity should go to the corporation. 2) In some instances, one relationship is so decisive that it makes the opportunity one which belongs to the corporation, regardless of the other two relationships. 3) In other instances, one relationship is sufficiently in favor or finding the opportunity belongs to the corporation that courts, consciously or unconsciously, apply broader tests through the other relationships for finding a corporate opportunity. 4) Conversely, the weaker the grounds one relationship gives for finding the opportunity should be the corporations, the stronger the grounds which the other relationships must provide before the court will order the opportunity turned over to the corporation. e) Opportunity and Person Relationship between the opportunity and the person who took it. Question here is how did this person learn of the opportunity. 1) Where it is the individuals assignment to go out and look for this opportunity for the corporation, the agent is taking for himself the very opportunity he was hired to obtain for the corporation. If a corporate official receives an opportunity from a party who originally expected the official to pass the opportunity on to the corporation, then it is the corporations opportunity. 2) Individual learned of the opportunity because being an agent for the corporation placed the agent at the right place at the right time to learn of the opportunity. (a) One approach here states that in this situation, the facts weigh in favor of finding that the opportunity belongs to the corporation, but it is not decisive. Meinhard also looked at the role of the agent in the venture and the nexus between the opportunity and the venture. (b) Another approach states that the corporation has a claim here because the information about the opportunity is somehow corporate property. If the agent learns of, or exploits, the opportunity by using corporate trade secrets, then the corporation certainly has a claim. 3) Agent learns of the opportunity completely independent of his role

with the corporation (a) One or both of the other two relationships must point extremely strongly to toward finding the opportunity to be a corporate one. Otherwise, the agent can take the opportunity for himself. f) Agent and Corp Relationship between the agent and the corporation. Significance of this relationship depends on the answer to two questions. 1) How high up is the agent in the corporate hierarchy? (a) The greater the agents management responsibilities, the broader the scope of the opportunities which the agent must give to the corporation rather than keep for himself. (b) ALI imposes broad obligations for senior executives. They must turn over 1) Any opportunities the executives receive in their official capacity, 2) Any opportunities they obtain through the use of corporate information or property, or 3) Any opportunities which are closely related to the corporations current or expected business. 2) Does the agent have a full time or part time position? (a) ALI imposes narrower obligations on outside directors/directors who are not full time employees of the corporation than are imposed on full time directors. (b) Outside directors need only turn over opportunties if the director received the opportuntiy in his or her official capacity or obtained the opportunity through the use of corporate information or property. They do not need to turn over the opportunity simply because the opportunity is closely related to the corporations business. (c) When a corporation employs someone on a part time basis, it understands that the individual will have other business activities and the corporation can expect this individual to pursue for himself some opportunities which might be of use to the corporation. g) Opportunity and Corp Relationship between the opportunity and the corporation. This relationship is addressed by both the interest or expectancy test and the line of business test. 1) The strongest relationship between the opportunity and the corporation occurs when the opportunity is absolutely essential to the corporations business. (a) This opportunity belongs to the corporation, seemingly without regard to how the agent obtained the opportunity or the agents position with the corporation. 2) Weaker relationship exists for opportunities in which the corporation has an interest or expectancy. Several reasons exist as to why an interest or expectancy creates a strong claim for the corporation (a) Existence of an interest or expectancy normally rebuts the

possible concern that the corporation only became desirous of the opportunity after it turned out to be a success. (b) Existence of the interest or expectancy typically gives the agent more notice of the corporations desire to obtain the opportunity than would be true if the agent seizes the opportunity having little, or only a more generalized connection with the corporations activities. (c) Where there is a corporate interest or expectancy the image appears that the official snatched away the opportunity and that the corporation would have gotten the opportunity but for the interference of the agent. 3) Line of business test encompasses opportunities having an even weaker link to the corporation. Use of this test requires a strong relationship in one or both of the other two legs of the corporate opportunity triangle in order to find a corporate opportunity. 4) Where the opportunity has little connection to the corporation, the only way to find an opportunity belongs to the corporation is for one of the other two relationships to completely dictate the outcome. H. Justifications for Taking Corporate Opportunity or Defenses for taking corp oppt (Defenses) 1. Corporate Rejection a) Justification Most universally recognized justification for taking a corporate opportunity is that those in charge of the corporation turned down the opportunity. If the corp had a chance at the opportunity and did not want it, the company is hardly in a position to complain just because one or more of its personnel then took the opportunity b) Where person taking opportunity is a lower level employee or officer Works simply because this person was not involved in the decision regarding whether or not the corporation should take the opportunity. c) Where directors take the opportunity Trickier when the person is a director because he might have been part of the group of persons who decided to reject the opportunity. 1) Here, the conflict of interest statutes do not apply because there is no transaction between the corporation and its directors. 2) ALI requires disinterested director approval, shareholder approval, or proof of fairness in order to validate the rejection. 3) Determining fairness: (a) Different than fairness test used to determine whether something is a corporate opportunity. (b) Look to what the corporation gains from turning down the opportunity. The obvious reason to reject an opportunity is if it would not be profitable. (c) However, directors who reject an opportunity then take it for themselves will lack credibility if they state they did not think

it would be profitable. (d) Thus, directors in this situation should come up with another reason the corporation should not pursue the opportunity. One common response is to say the corporation did not have the financial ability to take the opportunity. 2. Financial inability a) Justification Def may claim that the corporation lacked the money to take the opportunity for itself. Courts have responded in different ways. b) One extreme Financial inability is never a defense for taking a corporate opportunity. (Irving Trust) c) Other extreme Part of the very definition of a corporate opportunity is the corporations financial wherewithal to take advantage of the opportunity. (Dicta in Guth and Miller) d) Between the two extremes Variety of judicial viewpoints: 1) ALI financial inability of the corporation to take an opportunity is not a justification in itself, for an official personally taking the opportunity. This does not mean that financial inability can never be relevant. It can be relevant if the official offers the opportunity to the corporation, the corporation turns down the opportunity, then the pl challenges the decision to reject the opportunity. Here, the person would argue that the rejection was in the best interests of the corporation because it could not afford it. 2) Other courts accept corporate financial inability as a defense, regardless of any formal rejection, but place the burden on those asserting financial inability to prove the corporation could not come up with the funds 3) Other courts look at financial capacity without focusing on who has the burden of proof, or else shift the burden of proof on the issue of financial capacity back and forth depending on the circumstances. 3. Third party offeror unwillingness to do business with the corporation a) Justification Corporate officials can try to justify seizing an opportunity on the ground that the party who offered the opportunity absolutely refused to do business with the corporation. 1) Energy Resources case court would not recognize a refusal to deal defense unless, before taking the opportunity, the corporate official disclosed all the facts to the corporation, and allowed the corporation a chance to convince the third party to do business with the corporation. Court who decided this pointed out that one can never be sure that the 3rd party would not have dealt with the corporation until the corporation had a chance to convince the 3rd party. 2) Other courts If the party with the opportunity is unwilling to deal with the corporation, the opportunity is not a corporate opportunity and the corporate officials can take the opportunity without

disclosure. 4. Ultra vires or other legal incapacity a) Justification Corporate officials might argue that they can seize a corporate opportunity because it is ultra vires or it is otherwise legally impermissible for the corporation to take the opportunity. However, if an opportunity is ultra vires or prohibited by regulation, it typically would not fit within the various tests for a corporate opportunity anyways. b) Some courts would not accept ultra vires as an excuse to allow corporate officials to take what would otherwise be a corporate opportunity because they could have amended the articles if the opportunity was good enough. c) Other courts recognize ultra vires as an excuse for corporate officials to seize what would otherwise be a corporate opportunity. I. Taking Corporate Property and Competing with the Corporation Corporate opportunity cases sometimes involve charges that the def took corporate property for use in developing the opportunity or that the development of the opportunity placed the def in competition with the corporation. 1. Taking corporate property a) Conflict of Interest Taking corporate property for personal use without consent is actually an extreme case of an unfair conflict of interest transaction. The terms are unfair because the agent gets property from the corp while the corp gets nothing. Also, process is unfair because it is usually done without disclosure and is often concealed. Thus, it is really conversion or theft. b) Debates regarding whether the agent took corporate property 1) Where the so-called property consists of information, the corporation will claim it is a trade secret. 2) Disputes also arise when there is a factual dispute over whether the corporation gave the employee express or implied consent to make personal use of some corporate assets. c) Remedies 1) Corporation may get its property or the value of the property back. 2) ALI The corporation is entitled to an opportunity that was discovered by use of corporate property, without regard to other factors so long as the official should reasonably expect the corporation would have wanted the opportunity. ALI does not address where the opportunity was developed (rather than discovered) by use of corporate property. 3) Tracing allows a victim of conversion, not only to obtain return of wrongfully taken property but also to receive any profits made by the converter through the use of the property. However, this remedy should not be taken to extremes 2. Competing with the corporation a) Rule Competing with the corporation while employed by the

company is an elementary breach of an agents duty of loyalty. b) Consent Where the employer agrees to let the employee compete, it is not a breach of the agents duty of loyalty. c) Former Employees Former employees may compete with their former employer unless they signed non-competition covenants. d) Before Leaving Employment How far can employees go to compare a competing venture without crossing the line and engaging in impermissible competition before the employee quits. 1) Things that are permissible (a) Incorporating the new business (b) Liming up its finances and facilities 2) Things that are not permissible (a) Soliciting employers customers 3) Things that are borderline (a) Soliciting ones fellow employees to leave and join the new venture (b) Notifying customers of the employees intentions without soliciting their business. J. Remedies for Duty of Loyalty Violations 1. Voidable/Rescission unfair conflict of interest transactions are voidable. Corporation has the right to rescind the transaction and get back what the corporation paid. Normally, rescission also requires the corporation to return what it received in the transaction. 2. Constructive Trust Usual remedy for usurping a corporate opportunity is to turn the opportunity over to the corporation. Courts refer to this as imposing a constructive trust on the opportunity in the corporations favor. The corporation must normally reimburse the defendant for what the defendant paid to obtain opportunity. 3. Sanctions Courts have occasionally ordered corporate officials to repay to the corporation any salary the corporation paid them while they were breaching their duty. Courts have also imposed punitive damages. III. DERIVIATIVE SUITS A. Generally Who decides whether the corporation will assert such potential claims against its directors? 1. Derivative suit Individual shareholder sues on behalf of the corporation. Cause of action belongs to the corporation. 2. Recovery With rare exceptions, any recovery must go to the corporation. The plaintiff serves merely as a self appointed champion of the corporate right. Harm only to SH does not justify derivative suit, but corp. must be harmed in order for DvS. (Ex: Just because Corp issued more stocks and diluted price of stocks, this is no ground for DVS, because this only harms SH and not the corp.) B. The Nature of a Derivative Suit 1. Derivative versus Direct Suits a) Fundamental feature of a derivative suit Pl shareholder is asserting

the corporations cause of action and seeking recovery for the corporation. However, shareholder might prefer to argue that he or she is asserting his or her own cause of action. b) Advantages of asserting a direct claim are: 1) The shareholder may personally recover 2) A direct suit can avoid the need to deal with the various procedural barriers confronting derivative suits. c) Harm Suffered When both shareholders and the individual have suffered harm, courts have held, with limited exceptions, that shareholders cannot bring suit on their own behalf. Examples of such situations: 1) Directors make grossly negligent decisions which cause the corp to incur substantial losses. 2) Directors have corp enter into unfair contracts with the directors 3) Directors usurp a valuable corporate opportunity d) Damage Essence of the shareholders claim is for damage the shareholder suffered by virtue of the directors conduct harming the corporation and thereby lowering the value of the shareholders stock, then the shareholder must bring the action as a derivative suit. e) Rationales for refusing to recognize personal claims based upon the argument that harm to the corporation lowers the value of the shareholders stock: 1) Avoiding the large number of suits which would result 2) Shareholders who do not bring suit will be left out 3) Interests of corporations creditors who might not be paid if the corp is subject to the these suits because the shareholders rather than the corp would recover the money f) Where Rationales do not Apply Some courts and the ALI would allow the shareholder to bring a direct suit. Other courts still refuse to recognize an exception here. g) Circumstances under which shareholder clearly has a direct suit: 1) If majority shareholder breaches a shareholders agreement, the minority shareholder has a direct cause of action for breach of contract whether or not the majority shareholders action also breached a duty to the corporation. 2) If director misleads a shareholder in order to induce the shareholder to buy or sell stock, the shareholder has a direct cause of action against the shareholder for fraud. 2. Implications of Seeking corporate recovery a) Is the corporation an indispensable party Yes. Otherwise, an action brought on behalf of the corporation would not be res judicata on the corporation, and another shareholder, or even the corporation itself could bring action again. Corp is named as a defendant in the action. b) Defenses Since the suit seeks recovery for the corporation, why would the corporation assert a defense? 1) Since any defense is probably really an attempt by the real

defendants to have the corp pay for their defense, courts generally do not allow the corp to assert a defense on the merits or a procedural defense designed to protect the real defendants. 2) The corp can assert various procedural defenses when the procedure involved is for the protection of the corp. May raise lack of jn or improper service. 3) Corp may also raise defenses based on procedures designed to protect the corporations interest specifically in derivative suits: (a) May challenge the pl shareholders standing, (b) May make a motion to dismiss for failure to make a demand on directors or shareholder, (c) May make a motion to dismiss on the grounds that the suit is not in the best interests of the corp, and (d) May demand that the pl post security for the corps litigation expenses. c) Attorney Can the attorney who represents the corporation in the derivative suit also represent the real defendants in the action? 1) Number of courts have held that such dual representation is a conflict of interest which violates rules of professional responsibility. 2) Other courts have allowed dual representation, at least in some cases. 3) Attorney-Client Privilege Since the shareholder pl is suing on behalf of the corporation, does the pl pick up the corporate clients right to obtain information covered by privilege? Court adopted a multi-factor test to determine this: (a) Whether the pl, is just one shareholder with only a few shares or whether the demand for the information comes from a number of shareholders with a greater percentage of outstanding stock; (b) Whether there is a reason to doubt that the pl, is asserting a colorable claim in the lawsuit or there are other grounds to question the pls bona fides (c) How important is it for the pl to get this information from this source (d) What is the nature of the pl action and of the alleged wrongful conduct (e) Whether the communication between the corporate officials and the corporations attorney related to past or prospective acts, or whether it involves legal advice concerning the present litigation (which would make the court especially reluctant to give the pl access to the communication and (f) Any interest of the corporation in keeping the communication confidential (for instance because it involves trade secrets). d) Remedy Is corporate recovery the appropriate remedy? 1) Concern since the def in case are still in charge of the corp, if the

corp recovers, the money the corp obtains will be at the mercy of the def. Thus, a few courts have ordered the def to pay damages directly to the innocent shareholders instead of to the corporation 2) More common A court might deny corporate recovery in favor of innocent shareholder recovery when the owner of a large percentage of the outstanding stock should not benefit from the recovery. Otherwise, the wrongdoing shareholder might benefit. C. Who Has Standing to Bring a Derivative Suit four common limitations on who can bring the derivative action: 1. Pl must be a shareholder at the time of the lawsuit a) Generally, pl must also remain a shareholder through the life of the action. b) What about when the corporation engages in a transaction, like a merger, which forces pl to give up his shares? Court have reached different results, but the outcome may depend on: 1) Whether the purpose of the transaction was simply to force out the pl and get rid of the suit 2) Whether the pl received shares in another company which succeeded to the rights (including the cause of action) of the corporation on whose behalf the pl originally sought to sue 3) Whether the transaction which removed the pl was itself fraudulent or illegal 4) Whether the pl acquiesced in the loss of his or her shares c) Double derivative suit where the pl is a shareholder in a parent corporation and wishes to complain about the breach of a duty owed to the subsidiary corporation. Since the parent is itself a shareholder, the parent could bring the derivative action on behalf of the subsidiary. 2. Pl must also have been a shareholder at the time of the complained wrongdoing. a) Exception exists if the pl obtained his shares by operation of law (inheritance) from someone who was a shareholder at the time of wrongdoing. b) Have to determine when the wrongdoing occurred. 3. Occurs in situations in which the pl is subject to some personal defense. a) Pl might have participated in the wrongdoing, ratified it, or acquiesced to it. In this circumstance, courts might deny shareholders subject to personal defenses the right to bring a derivative suit. b) Other courts, noting that recovery is for the corporation rather than the shareholder, have allowed the shareholder with personal defenses to bring a derivative action. 4. The pl must fairly and adequately represent the interest of the corporation. a) It is permissible if the pl has little idea what the suit is about, but simply brought suit at the urging of an attorney. b) If the pl is pursuing the action to further some personal side agenda, such as gaining leverage in a wrongful discharge suit against the corp, then the pl is an inadequate representative.

D. Demand on Directors This is the most significant procedural rule involving derivative suits. The pl, prior to bringing suit, must make a demand upon the directors to take action to sue someone. 1. The traditional rule FRCP 23.1 the complaint in a derivative suit must allege with particularity the efforts, in any, make by the pl to obtain the action the pl desires from the directors and reasons for the pl failure to obtain the action or for not making the effort. a) Rule The pl must allege that he made a demand for action upon the directors, or the pl must allege a good excuse for not making a demand. b) Central issue under traditional rule what is an acceptable excuse for not making a demand? 1) Futility the accepted excuse for not making a demand under the traditional demand rule is that a demand would be futile. (where the board would automatically say no for sure and would not listen to your demand) (a) A demand is futile if the demand would be for the directors to have the corporation sue themselves or sue a party who controls the directors. (b) Also futile if the pl states a claim against a majority of the board of directors. If the pl sues only a minority of the board, the courts will generally hold that demand is not futile. 2) If you send off a demand, you are said to waive the futility excuse. (Levine) 3) However, this rule could also encourage people just to name a majority of directors and not state demand in the suit. c) How much detail must the pl complaint contain in order to avoid demand? 1) DE test trial court, using its discretion, must determine whether the particularized and specific facts alleged in the complaint contain a reasonable doubt that: (a) The directors are disinterested and independent about decision of whether corp. should bring suit and the action in question (if P plead specifically enough facts to show that directors are not independent or that directors are D or are controlled by D and directors do not provide rebuttal, futility test would be satisfied) AND (b) The challenged transaction was the product of a valid exercise of business judgment. d) What happens when the shareholder demands the corp bring a lawsuit and the directors refuse? 1) Courts generally treat the decision as a business decision, thereby invoking the bjr (need grossly negligence). Court will defer to the directors decision not to sue unless the pl can show a conflict of interest, a lack of good faith, or a lack of due care by the directors in deciding not to sue.

2) Where the suit is against the majority of directors or a party controlling a majority of the directors, then the directors are in a conflict of interest in deciding upon the suit and the court should not defer to their decision. 3) If the suit is not against either a majority of the directors or a party controlling a majority of the directors, then the pl must show that the boards rejection of the demand was in bad faith, or else breached the directors duty of care as measured under the bjr. 2. The Universal Demand Rule ALI Abolish the futility excuse and require demand in all cases except where the delay resulting from in making the demand and waiting for board to respond would result in irreparable harm to the corporation (like s/l running). a) Exception for irreparable harm: 1) ALI still requires a demand, but will allow the pl to make the demand after filing the complaint. 2) Model Act still requires a pre filing demand, but will excuse the pl from waiting for a reply. b) Decision Court must still decide, based upon the pleadings, whether to defer to the directors decision against bringing a lawsuit. 1) ALI Pl must plead with particularity facts which raise a significant prospect that the challenged transaction entailed a breach of duty by directors or controlling shareholders. (a) In addition, if the board rejects the demand, then the pl must pleas with particularity either that (i) a majority of the directors were interested in the challenged transaction (ii) were otherwise not capable of objective judgment in rejecting the demand or (iii)that the rejection flunked the bjr. (b) In other words the pl must plead the same kind of facts necessary to show futility. 2) Model Act the pl, when faced with a rejection of the pl demand, must allege with particularity that a majority of the board was not independent or that the board did not make the rejection in good faith after reasonable inquiry. (a) Act does not define independence except to say that merely because the complaint names a director as a def or alleges that the def selected this director, does not preclude this director from being independent. 3) Neither ALI or Model act change the basic nature of what the pl must plead in order to deprive the directors of their normal role in deciding whether the corporation may sue. 3. The reason why there is a requirement for demand on directors is because they are in control. However, there are exceptions because they are in most cases the defendant and because people on the board could be interested directors or that the disinterested directors could think alike as D.

E. Special Litigation Committees (alternative for demand on directors) 1. Purpose committee serves as a way to allow the innocent minority of the directors to make the decision as to whether the corporation should sue the majority of its board members. 2. Structure board creates a committee consisting of some or all of the directors who are not defendants in the derivative suit. The board then delegates to this committee the boards power to decide if the corporation should pursue the lawsuit against the majority. 3. Outcome special litigation committees, almost without exception, have concluded that derivative suits which the committee looked into were not in the corporations best interests. Then the corporation moves to dismiss the suit would be based upon the committees determination. 4. Dismissal court will dismiss the derivative suit upon the committees recommendation unless the pl can prove that the committee members a) have a conflict of interest, b) acted in bad faith, or c) violated their duty of care in recommending against the suit. 5. Conflict of interest under this approach, the question of whether the directors have a conflict of interest in considering the lawsuit involves only the directors who are in the special litigation committee. The fact that a majority of the directors who appointed the committee have a conflict of interest is irrelevant. 6. Why Committ should bring suit: It is composed of neutral directors, but such directors may be suspect to the same thinking as the D directors due to their employment. F. Demand on Shareholders 1. Requirement Rule 23.1 also requires the pl to make a demand for action upon the shareholders if necessary, or else to plead an excuse for not making a demand on the shareholders. 2. Difference the demand on shareholders and demand on directors rules are different because courts have accepted more excuses for not making a demand on shareholders. 3. Possible excuses for not making a demand: a) Futility pl might allege that a demand on the shareholders would be futile because the proposed lawsuit is against the owners of the majority of the outstanding stock. Courts have accepted this excuse, but the reactions are mixed when the pl alleges that the def owns a controlling percentage of the stock but does not own the majority of the stock. b) Too expensive and burdensome to contact shareholders to demand action expense and burden occur when dealing with a widely held corporation with numerous, scattered shareholders. c) Shareholders cannot ratify the def conduct this is the most common excuse. A majority of the shareholders cannot vote to approve a transaction amounting to waste

4. Policy: Reason for shareholders to get involved is because they may have a stake. However, they may not have enough incentives to make a demand is because what is at stake is too low on the personal interest and the cost for bringing lawsuit is too high or risks involved are way too high. G. Security for Expenses Statutes 1. Definition allow the corporation to require that the pl in a derivative suit post security to cover the expenses which the corporation reasonably expects to incur in the litigation. (so that corp's attorney fees can be repaid) 2. Impacts the requirement has two impacts: a) Pl shareholder who loses a derivative suit ends up reimbursing the corporation for much or all of the expenses which the company incurs in the action. Includes all the corps attorneys fees and attorneys fees of the corps directors or officers which the company has indemnified. b) Second impact comes from the requirement of posting security. Because the pl must post security (put up a bond) early in the lawsuit, the pl faces up front costs in pursuing the action, even if the pl ultimately prevails. 3. Effect the impact of these suits has been rather minor. Most states do not have such statutes. H. Settlement and Plaintiffs Attorneys Fees 1. Settlement a) Problem in many cases, derivative suits result in settlements in which the corporation, rather than the real def, paid off the pl. b) Solution to solve the problem of abusive settlements at the expense of the corporation, court rules and statutes governing derivative suits generally require the court approve the settlement of a derivative suit. c) Procedure court will hold a hearing prior to approving a settlement. Sometimes, shareholders who oppose the settlement will appear at the hearing and attempt to convince the court to reject the settlement. Court will hear evidence as to the merits of the settlement, including what the likely outcome of the litigation will be and the burdens of further litigation. d) Standard general standard is whether the settlement is within a range which is fair to the corporation. 2. Plaintiffs Attorneys fees a) Rule If the litigation produces a substantial benefit for the corporation, even if the benefit is not monetary, the court can order the corporation to pay the pl attorneys fees. 1) Example obtaining changes in the corporate management structure designed to prevent future misconduct. b) How much should the attorney be paid? 1) Salvage approach awards the attorney a percentage of the recovery 2) Lodestar approach essentially this is an hourly fee. The court

sets the hourly rate based upon the variety of factors and then pays the pl attorney this rate multiplied by the number of hours worked on the case c) Why attorneys should not be able to bring suit: Attorneys may not care about the corporation's well being when bringing the suit, and would just focus on personal gain. I. The Fundamental Question Who Should Represent the Corporation? 1. The Court maybe should represent the Corp, since it is neutral and usually knows chances of success for a lawsuit and thus would probably be able to ascertain what is in the best interest of the corp. However, the problem is that in order for the court to get facts in order to ascertain the situation, there must be a pleading and all the discovery stuff and maybe trail and this will cost a lot of money. (that is necessary to get facts straight before making a decision) Courts cannot only make a decision by knowing facts that can be discovered only through adverserial proceedings IV. INDEMNITY AND INSURANCE A. Introduction there are two mechanisms whereby the corporation might protect its directors and officers from the financial consequences B. Indemnity (reimbursement) To what extent can directors, officers, and employees obtain indemnity from the corporation for litigation expenses? Statutes draw four distinctions when stating when litigation expenses may be recovered 1. Disposition of the suit did the official win, lose or settle the action for which he seeks indemnity. a) Where official wins on the merits statutes require the corporation to indemnify litigation expenses incurred by a corporate official who prevails upon the merits in defense of a suit arising out of his or her job. b) Where official wins on procedural point 1) Most indemnity statutes automatically entitle corporate officials to indemnity when they are successful on the merits or otherwise 2) Some statutes do not provide for automatic indemnity in this situation but may allow for indemnity at the option of the corporation c) Partial victories and partial defeats 1) DE partial success entitles an official to partial indemnity 2) Model Act only require indemnity if the official is wholly successful d) Where official loses May still make sense to indemnify a corporation despite losing the suit. Look at other distinctions. 2. Whether the lawsuit against the official was on behalf of the corporation, or whether the suit was on behalf of an outsider to the corporation a) On Behalf of Corp It would not make sense for the corporation to indemnify its official who lost an action brought by or on behalf of the corporation.

b) Outsider When it is an outsider who brings suit, result could be different. The argument for indemnity is that the official might have been trying to advance the corporations interests through the unlawful conduct. If liability was based on negligence, the official may not have even realized that he or she was exposing himself or the corporation to possible liability. 3. Type of costs for which the corporate official seeks indemnity Statutes may take different approaches to fines and other damages imposed to deter unlawful conduct, damage awards intended solely to compensate, and the costs of litigating over the officials liability. 4. Distinction between automatic and permissive indemnity a) Automatic indemnity statutes universally require the corporation to indemnify officials who prevail on the merits. No statute provides for such automatic indemnity in favor of an official who loses a lawsuit. b) Permissive many statutes permit the corporation to indemnify an official who loses. 1) Typical criteria to determine when to indemnify an official who loses: (a) The official acted in good faith in undertaking the challenged conduct (b) The official reasonably believed that the challenged conduct was in the best interest of the corporation and (c) If the indemnity claim involves a criminal action, the official had no reasonable cause to believe that the challenged conduct was illegal. 2) Who decides whether the corporate official meets the criteria for indemnity? Statutes specify four possibilities: (a) Directors who were not parties to the lawsuit for which the official seeks indemnity (b) The Stockholders (c) An independent attorney (d) Judicial determination, in some states 3) Many statutes allow indemnity for corporate officials who lose an action brought by or on behalf of the corporation itself. However, these statutes impose two additional constraints on indemnity in this situation (a) First constraint is the requirement that a court determine that, despite the adjudication of liability, the corporate official is still fairly and reasonably entitled to indemnity (b) Statutes may limit indemnity in this instance to litigation expenses, and exclude amounts the official must pay under a judgment in favor of the corporation. 4) When an official loses an action brought by or on behalf of the corporation, a few states have eliminated or greatly reduced the distinction between suits by outsiders and suits on behalf of the corporation

5) Bylaws/Contract In DE and others, it is possible for a corporation to contract with its officials, or provide in its bylaws, for indemnity even when the officials would not qualify for permissive indemnity in the statute. 6) Settlement statutes have treated settlement as a subject for permissive rather than mandatory indemnity. When should we treat settlement more favorably than losing as far as indemnity? (a) If the official acted in good faith, should be indemnified or (b) Look to what expenses the corporation may indemnify. DE does not allow the corporation to indemnify amounts which a corporate official paid to the corporation by virtue of a judgment in the corps favor, but allows indemnity of amounts paid to the corporation under a settlement. 7) Indemnity statutes commonly allow the corporation to advance to the companys officials the sums necessary to pay the officials legal expenses. C. Insurance 1. Corporations commonly purchase insurance covering directors and offices liability. 2. Policies typically cover two types of claims: a) Reimburse the corporation for the corps costs of indemnifying the corporations officers and directors. b) Reimburse directors and officers for expenses and liabilities for which the directors and officers do not obtain indemnity from the corporation. III. SPECIAL PROBLEMS OF CLOSELY HELD CORPORATIONS (small number of stockholders, no ready market for corp stock {usually in a small # of SH, there is no ready market for corp stock as minority SH would not have much power} and substantial majority SH participation in the management, direction and operations of the corp) A. Judicial and Statutory Remedies for Shareholder Dissension 1. Generally a) Potential for deadlock exists when there are two shareholders each owning equal stock who cannot get along. b) Squeeze out where there is one shareholder who owns more stock than another, and the minority shareholder does not get along with the majority shareholder, the minority may become the victim of a squeeze out. 1) Definition Majority owner uses the majoritys control over the corporation to deprive the minority shareholder of any say in management and to deprive the minority of any distribution of the companys earnings. c) Solution there are two main solutions to the deadlock and squeeze out problems: 1) Fiduciary duty claims

2) Dissolution 2. Fiduciary duty claims a) Fact patterns that lead to these claims 1) Majority shareholders vote a minority shareholder off the board of directors, thus preventing the minority from having a voice in making management decisions. 2) Majority shareholders, acting as directors or shareholders, fire the minority shareholder form his or her employment with the corporation. b) Problem The failure of the minority to be able to work for the corporation means that could lose money because of the common practice of closely held corporations distributing the bulk, if not all, of their income to their owners through salaries rather than dividends. c) Traditional Approach to Fiduciary duty claims it is necessary to divide the majoritys actions into those undertaken in their role as shareholders and those undertaken as directors Little protection for minority shareholders. 1) Actions taken as shareholders here there is little duty at all by the majority. Shareholders can vote for whoever they want, no matter how irrational or disloyal and there is no relief for minority shareholders squeezed out of any say. 2) Actions taken by directors these actions are subject to the duties of care and loyalty. Actions include refusal to declare dividends, terminating compensation, or terminating employment. (BJR v conflict of interest) (a) Actions that do not involve conflict of interest are subject to the bjr. The minority shareholder must prove that the action taken was irrational from the perspective of the corporations interest. (almost impossible to overcome) (b) Strongest claim for squeezed out shareholder under traditional rule lies in challenging compensation or other benefits received by the majority from the corporation. This is because the majoritys receipt of salaries is a conflict of interest transaction and without disinterested approval, the majority bears the burden of proving what they received was fair. (still tough for minority SH) d) Wilkes Rule Shareholders in a closely held corporation owe each other a fiduciary duty similar to that owed between partners. (partnership theory --- involves utmost loyalty) Need to demonstrate legit business purpose for firing or any other action. 1) Squeeze out the court held that this duty requires the majority to show a corporate purpose for actions detrimental to the minority. If there is a legitimate purpose, then the minority can attempt to prove that the majority could achieve this purpose in a less harmful manner. 2) Firing Under Wilkes, it would appear that directors might not be

able to fire a minority shareholder from corporate employment without good cause. 3) Refusal to Declare Dividends Under Wilkes, it might be up to the directors to justify their refusal to declare dividends, rather than up to the complaining shareholder to show that things had reached such an extreme state that the failure to declare dividends amounted to an abuse of discretion. e) DE rejected the Wilkes rule and rejected the idea that there should be special judicially created rules to protect minority shareholders in a closely held corporation. 1) Rejected special fiduciary rules for shareholders because: (a) Minority shareholders may protect themselves through contract (b) Special closely held corporation legislation in DE preempts the field of special rules for closely held corporations. f) Donahue shareholders must receive an equal opportunity to all of the benefits of corporate ownership. 1) Fiduciary duty means the utmost good faith and loyalty. 2) This case was decided before Wilkes and the court did not give it a broad reading in Wilkes. g) Right to Fire traditionally, courts have ruled that employees can fire at any time, with or without cause, employees who have no express or implied agreement for employment to continue for a specified term. Jurisdictions have qualified this rule: 1) Most hold that firing an employee for refusing to break the law gives even an at will employee a claim for wrongful discharge. 2) Some hold that the implied covenant of good faith and fair dealing tempers the right to fire an at will employee at any time, with or without cause. 3) Other have refused to recognize such a good faith limit on the right to terminate at will employee. 4) Courts have to reconcile the Wilkes rule with the fire at will rules. Might not be too tough because termination, without cause, of a shareholder from at will employment might establish both a breach of fiduciary duty toward the individual in his or her role as shareholder and establish a breach of the requirement of good faith toward the individual as employee. 3. Dissolution and Other Statutory Remedies for Deadlock and Oppression a) Generally If one shareholder cannot buy out the interest of the other shareholder, one or more shareholders may go to court and ask for a judicially ordered dissoluton. 1) Corporations statutes typically authorize the court to dissolve the corporation in case of: (involuntary dissolutions) (a) Deadlock in management, voting and (b) When those in control of the corporation have acted oppressively or otherwise wrongfully toward the minority shareholders.

b) Why be afraid of dissolution? 1) Dissolving the corporation means destroying the business, with the result that employees will lose their jobs and the economy will be harmed. 2) Freeze out a concern is that one or more shareholders may seek dissolution of the corporation as a technique to force the other shareholders to give up ownership in the company (one might not be able to bid as much as the other). 3) Hold up a minority might use a demand for dissolution as leverage to renegotiate the way the corporation operates. The difference between a hold up and a reasonable demand lies in the eye of the beholder. 4) Plus, usually, P asks for dissolution in order to get a better bargaining power for buyback of stocks. (these matters usually end up w/buyout) c) Deadlock In the event of dissension between two 50 percent shareholders creates a potential for deadlock. 1) Deadlock can manifest itself on one of two levels (a) On the shareholder level with respect to the election of directors (8 way tie for 4 positions for ex) and (b) On the board of directors level with respect to management decisions. 2) Election of directors (a) Where 2 50 percent shareholders vote for different directors Corp statutes typically allow the old directors to remain in office until the election of new directors. Thus, in the case of an election deadlock, the old board will remain in power. Also, statutes normally authorize the directors to fill vacancies on the board between directors. (b) Even number of directors tie on the board is not a deadlock. However, if the board has turned into two hostile factions so that virtually every motion results in a tie vote, then it is a deadlock. (i) CEO has ability to make at least ordinary business decisions for the corp. to break the deadlock. 3) Model Act A court may dissolve a corporation (a) If the shareholders are deadlocked in voting power and have failed for a period of at least two consecutive annual meetings to elect successors to directors whose terms have expired. (b) If the directors are deadlocked in the management of the corporation, the shareholders are unable to break the deadlock, and the deadlock threatens irreparable harm to the corporation or means that the corp can no longer be conducted to the advantage of the shareholders generally. 4) Model Act What harm must the deadlock cause in order to justify dissolution?

(a) Irreparable injury to the corporation or (b) When the deadlock prevents the conduct of the corporation to the advantage of the shareholders generally 5) Some statutes deadlock itself may be the grounds for dissolution. 6) Discretionary the Model Act, and statutes generally, state that a court may dissolve a corporation upon finding shareholder or director deadlock which has the impact specified in the statute. The statutes do not say that the court must order dissolution. 7) CA Where there is a deadlock between two 50 percent shareholders, CA empowers the holders of at least 50 percent to dissolve the corporation simply by voting for such. (a) It is not necessary for the shareholder owning 50 percent to go to court and show that there is a deadlock in order to dissolve the corporation. Can dissolve even if there is no deadlock. (b) CA courts have decided that the shareholder must act in good faith for a legitimate business purpose when voting to dissolve. 8) Veto Power Deadlock can occur when agreements or supermajority vote requirements give a veto power to minority shareholders, (a) Most statutes the fact that a deadlock results from a veto, rather than an equal division of stock, is irrelevant to the courts power to order dissolution. (b) Some statutes only expressly authorize the court to order dissolution in the case of a deadlock from an equal division of stock, and presumably do not cover the situation in which a veto power produces the deadlock. d) Oppression and the like 1) Generally Corporation statutes in most jn also allow the courts to dissolve a corporation for misconduct or abuse of minority shareholders by those in control of the corporation. Shareholders who lack a veto or face a squeeze out benefit from these statutes. 2) DE no provisions which allow the court to authorize dissolution based upon any sort of majority misconduct or abuse of the minority. 3) Traditional (least useful) grounds for dissolution fraud, illegality, or misapplication or waste of assets. 4) Model Act also authorizes dissolution in the case of oppression. 5) Early Definition of Oppression conveyed a subjective, fault oriented standard that considered: (a) Wrongful conduct (b) Violations of the duty of good faith and fair dealing (c) Breaches of fiduciary duty 6) NY Test for Oppression/Reasonable Expectations Test looks at whether the majoritys conduct frustrated the reasonable expectations of the minority shareholders seeking dissolution. This test shifts the focus from the subjective, fault oriented

approach to an approach rooted in notions of implied contract. (a) Conduct is oppressive when the conduct defeats the reasonable expectations under which a shareholder invested. (b) The expectation must be one which the majority knew or should have known that the petitioning shareholder had at the time the petitioning shareholder bought his or her stock. (Kemp) (c) The expectation, viewed objectively, must be both reasonable and central to the petitioning shareholders decision to invest. (d) Reasonable expectations were not limited to expectations which existed at the time the complaining shareholders purchases their stock. Judge should examine the entire history of the parties relationship to see how expectations have developed over a course of dealing. (Meiselman) (e) Frustration of the pls reasonable expectations must not be the fault of the pl. 7) Standing Statutes authorizing judicially ordered dissolution sometimes impose a standing requirement limiting which shareholders may seek dissolution. (a) May set a minimum percentage of the outstanding stock which a shareholder must own in order to have standing to petition for dissolution. (b) Most states, and model act, impose no minimum share holding requirement for standing to seek dissolution. e) Alternate remedies there are remedies short of dissolution 1) Model Act (a) Authorizes a court to appoint a custodian to run the corporation in lieu of dissolving the company. (b) Gives the corporation or the non petitioning shareholders an option to avoid dissolution by purchasing at fair value the stock owned by the shareholder who petitioned the court for dissolution. 2) Many courts have held that under the courts general equity powers, the court has the ability to order remedies short of dissolution. (a) Might order an end to conduct found to constitute oppression (b) Might order a buy out instead of dissolution (c) Might order the payment of dividends 3) DE statutes (a) Authorize a court to place a custodian in charge of a deadlocked corporation. His task is to continue the business. (b) Court can appoint a provisional director, who can break a tie on an evenly divided board. 4) Buy out court can order the corporation or the def shareholders to buy out all of the stock owned by the p shareholder (or other way around). If parties cannot agree on a price, court will set it.

(a) In ordering a buy out, court can face the need to make two critical decisions which do not need to be made with dissolution. (b) Who will buy out whom? Most lawsuits end with the shareholder opposing dissolution buying out the petitioning shareholder. Most courts will use this method. If both parties want to buy out the other, court will order an auction. (c) Price? first, court will allow the shareholders to negotiate the price. If then cannot set a price, the court will set the price at the so called fair value of the stock. B. Distributions to Stockholders outflow of money or property for the corporation to the shareholders by virtue of their position as shareholders. 1. The Directors Discretion over Dividends a) Dividends defined common term for the distributions from a corporation to its shareholders by virtue of their position as shareholders b) Discretion normally, it is within the boards discretion to decide at any given time whether the corporation will pay a dividend to its shareholders and what amount of dividend the corp will pay. c) Limitations on Discretion 1) Contractual restrictions generally come from lending agreements which often contain terms restricting how much dividends a corporation can pay to its shareholders. Articles of incorporation may also contain provisions governing dividends. 2) Statutory states may place statutory limits on permissible dividends. 3) Lawsuit Minority shareholders might bring a lawsuit against the directors, arguing that the board abused its discretion either in declaring, or refusing to declare, dividends. (a) Courts are hesitant to find an abuse of discretion in the absence of extraordinary facts. The court is reluctant to second guess the directors decision to withhold or declare dividends. (b) Closely held corporation refusal to declare dividends can alter the relative shares of profit received by the companys owners instead of merely postponing owners enjoyment of the income. (c) Publicly held corporation directors might have incentives to declare less than optimal amount of dividends because by retaining money for corporate expansion, the directors may personally benefit through larger compensation, more stability, and psychological satisfaction. C. Duty of Loyalty 1. What is a conflict of interest? a) BJR without a conflict of interest, the bjr applies. With a conflict, court turn to the fairness test. b) DE refers to two types of conflict of interest:

1) Direct conflict Contract or transaction between the corp and one or more of the corps directors or officers. 2) Contract or transaction between the corp and another firm in which one or more of the corps officers or directors have an interest. c) Declaring Dividends If directors who are also stockholders declare a dividend, they will receive money from the corporation. d) Sinclair test is whether the parent corp received something to the exclusion of and detriment to the minority shareholders. e) Model Act Identifies a number of persons whose involvement in a transaction , either as a party or because the person has some financial interest linked to the transaction, might create a conflict of interest. 1) Covered persons include director, specified close relatives of the directors, other entities in whch the director is a director, general partner, agent, or employee. 2) Transactions between the corp and a director always constitute a conflict of interest under the Model Act 3) Directors or other covered persons interest in the transaction must be of such financial significance that would reasonably expect the interest to influence the directors judgment. D. Special Governance Arrangements for Closely Held Corporations 1. Ensuring Positions on the Board of Directors for Minority Shareholders Minority shareholders who wish to ensure a position on the board must employ various techniques in order to achieve this goal. a) Cumulative voting technique created to give minority shareholders sufficient voting power to elect themselves to the board of directors. (where u vote all ur votes on just 1 person. So if u got 30 shares, and there are 7 positions, u would put 210 votes on just 1 person) 1) Straight voting in an at large election each voter votes to fill as many positions as are available for election to the board. 2) Cumulative voting shareholder can concentrate all of his or her votes on less candidates. This allows a minority shareholder to avoid the dilution of his or her voting power which occurs when the shareholder must spread out his or her votes among a number of candidates equal to the number of positions to be filled. But still depends on the % and how many positions (wouldn't work for 90% against 10% for 3 positions) 3) Number of votes equals the number of his or her voting shares multiplied by the number of director positions to be filled in the election at hand. 4) What must occur for a corporations shareholders to have the right to use cumulative voting? (a) Most jn to allow cumulative voting, the corps articles must contain a provision stating that the shareholders may use cumulative voting. (b) Some jn allow shareholders to employ cumulative voting regardless of what the articles provide.

(c) Few jn go beyond this to require that corporations give their shareholders the right to vote cumulatively regardless of what the articles provide. (d) Some states feel that this is such an important right that the states Q, rather than just the states corporation statute, requires corporations to allow cumulative voting. 5) 2 methods exist to reduce the number of positions on the board up for election: (a) Obvious one is to reduce the size of the board (b) One might use staggered terms to reduce the number of directors elected at one time without reducing the size of the board. Staggered terms have been held unQal if they competely destroy the effectiveness of cumulative voting when cumulative voting is in the state Q. b) Shareholder voting agreements ***** contracts between shareholders to vote their stock in a prescribed manner constitute another way in which minority shareholders may attempt to ensure election to the board. 1) How agreements accomplish this goal either by (a) Combining minority interests together into a majority or (b) By obtaining a majority shareholders commitment to vote for the minority. 2) Statutes States have enacted statues which state that shareholder agreements are valid. They typically do not limit their reach to close corporations, nor do they generally require that all of the shareholders be a party to, or at least have notice of, the agreement in order for it to be valid. 3) Consideration can sometimes present a problem (a) Mutual voting promises some courts have refused to find that exchanging mutual voting promises alone constitutes adequate consideration to create an enforceable contract. (b) Cash most courts hold that buying votes for cash is against public policy. If the person giving cash is already a substantial shareholder, or there is some other reason to allay any suspicion as to the motives for the contract, then maybe courts should not automatically condemn the contract. 4) Provisions (drafting) (a) Simple promises to vote for eachother raises little problems (b) Approach sometimes used in drafting is to focus less on specifying who the parties will vote for and more on equalizing their voting power. (c) Statutes seeking to validate shareholder voting agreements may have the effect of invalidating some voting agreements for failure to comply with the statute. 5) Remedy where there is a breach of a voting agreement, court may

(a) Invalidate the defendants votes (b) Order specific performance. (c) Money damages are generally inadequate. 6) Proxies - Enforcement mechanism. Someone can vote someone else's share in accordance to the K. One problem, the breaching party could be acting to revoke the proxy. Default rule for proxy: Revokable at any time. (termineable at will). In case of promise and w/consideration, right to terminate is gone and damages may be sought in case of breach. (but damages are ard to figure out) c) Voting trusts ***** 1) Definition shareholders transfer their stock to one or more persons who take title as trustees. (don't have to worry about K, and proxies) (a) The trustees have a fiduciary, as well as contractual, obligation to carry out the terms of the agreement under which they received the shares. (b) Because the trustees become the legal owners of the stock their right to vote does not depend on the courts ordering specific performance of a voting agreement or finding a proxy coupled with an interest. (c) Voting trust can provide a self executing mechanism for ensuring the voting of shares in accordance with the agreed plan. (d) Former shareholders give up title but retain legal ownership. Thus, the trustee normally forwards to the former shareholder any dividends received from the corporation and transfer stock back to the former owners upon termination of the trust. 2) How useful ensure management acceptable to creditors, way to give shares to junior members of the family without giving them control, can transfer share to trust then sell part of beneficial interest. 3) Requirement for Voting Trust statutes require (a) The transfer of shares to the trustee pursuant to a written agreement between the trustee and the transferring shareholders (b) Parties must file the trust agreement with the corporation, thus providing shareholders who are not participants in the trust with potential notice. 4) When is an agreement which does not explicitly transfer legal title in stock to a trustee nevertheless a voting trust? DE has a 3 part test: (a) The separation of voting rights from beneficial ownership (b) This separation is irrevocable for a definite period of time and (c) The object of the agreement is voting control over the corporation. 5) Termination Common feature in statutes validating voting trusts

is that these statutes typically provide that the trust terminates 10 years after the creation of the trust. 6) Fiduciary the trustee has a fiduciary obligation to the beneficiaries of the trust. Thus, courts might limit the actions of trustees when those actions are contrary to the interests of the benes. d) Classified shares another way to ensure that a minority shareholder can elect himself to the board is by having the corporation issue two or more classes of stock with differing voting rights. 1) Procedure corp could issue two classes of stock, equivalent in all respects except that one class has the right to vote and one class does not. Then the parties could each purchase 50 percent of the voting stock. This ensures that neither party has the power to vote the other off the board, while the individual who is to receive the greater share of dividends (because gave more money) would purchase additional non voting stock. 2) Alternative can have the articles authorize the corporation to issue different classes of stock that are entitled to an unequal number of votes per share. Issuing the stock with more votes per share to a party who will receive a smaller economic interest in the corp can give this party an equal vote to a person receiving a greater interest in the company, but who will receive the shares with only one vote per share. 3) Alternative articles could authorize several classes of shares, each class being entitled to elect some fraction of the board members. (Lehrman case: Class A-C can only vote for 2 directors out of 5, and Class A-L can only vote for 2 directors out of 5, Class A-D can only vote for 1 director) 4) Courts generally uphold the sort of classified stock described here. 2. Controlling Specific Management Decisions just getting a position is not enough. Thus, minority shareholders use various techniques to control the management decisions which would normally be within the boards control. a) Shareholder agreements controlling board decisions shareholders may enter into agreements to govern specific management decisions. 1) Directors may not contract away their obligation to exercise independent judgment in deciding what is best for the corporation. It would be a breach of the duty of care and loyalty if the director contracted away their votes. 2) Some courts have drawn a distinction between agreements controlling board actions when all shareholders are a party to the contract, and agreements only among some shareholders who attempt to control board policy. They hold that the former, and not the later, are valid. 3) Other courts have been sympathetic towards such agreements, especially in the context of closely held corporations.

b) Statutes which validate shareholder agreements controlling board decisions and which establish treatment for electing close corporations 1) Statutes expressly validating shareholder agreements which control board actions fall into two broad camps: (a) General applicability validating statutes general applicability because the corporation does not need to elect special status in order for the statute to validate shareholders agreements controlling management decisions. (b) Elective close corporation statutes Those which require corporations to make an election to be a close corporation in order to take advantage of the statutes provisions validating shareholder agreements impinging upon the boards control. 2) There are 3 essential differences between the elective close corporation statutes and general applicability validating statutes: (a) Elective statutes are more restrictive as to which corporations can even elect come under the statutes special provisions. The statutes typically limit the number of shareholders a corporation can have if it wishes to elect to be a close corporation under the statute. (b) To trigger the statute, the shareholder must elect close corporation statutes. This may be as simple as placing a provision in the corps articles which states that the corp is a close corporation. (c) Electing close corporation status triggers more provisions in the statute than just those which validate shareholder agreements seeking to control actions ordinarily made by the board of directors. Example in DE, allows shareholders to take broader actions such as dispensing with the board of editors, empowers the court to appoint a provisional director to break deadlocks on the board. 3) Only a small number of corporations elect to be close corporations. Why? (a) They dont want to make shareholder agreements, so do not need the validation of the statute. (b) Do not think validation is necessary because of court opinions upholding such agreements. (c) Possible liability of the shareholders to creditors based upon piercing because of the lack of corporate formalities. 4) Significance main significance of elective close corporations statutes may lie in their influence on judicial treatment of non electing corporations. c) Arbitration agreements shareholders in a closely held corporation may agree to arbitrate in the event of disputes between themselves. 1) Arbitration agreements raise a number of legal issues: (a) Arbitration agreement in shareholder voting agreement faces

challenge that the parties have separated control over the voting of stock from the ownership of shares. This challenge was rejected in Ringling. (b) Arbitrating board decisions faces the challenge that the arbitration agreement impermissibly usurps the boards discretion. d) Super-majority Requirements can place a provision in the articles or bylaws which requires a unanimous vote by the board in order to approve certain actions by the board. 1) Super-majority requirements basically give the minority shareholders a veto. 2) Statutes in most states now explicitly allow for super-majority voting requirements. (a) Some require the requirement if it is placed in the corporations articles. In these states, if it was in the bylaws it would be invalid. (b) Some shareholders may attempt to use high quorum restrictions. Problem with this approach is that a court might hold a director, who deliberately stays away from a meeting to block action, thereby breached his or her duty and cannot challenge the action taken at the meeting as invalid for lack of quorum. e) Employment contracts and shareholder election of officers a couple of techniques beyond those described above exist for ensuring continued employment: 1) Make a contract between the corporation and the shareholder, in which the company agrees to employ the shareholder for a specified period of time in a particular position and at a given salary, and the shareholder agrees to work under these terms. (a) This k avoids the charge that shareholders are usurping the discretion of the board. (b) Such k run into a problem if a court interprets a corps articles or bylaws to limit the term of office which is the subject of the contract, and to override any contractual right to continue in office past that term. 2) Have the shareholders elect officers. Many statutes enable the corps articles to call for shareholder election, instead of director appointment, of the corps officers. If shareholders elect officers, they could agree who to elect as part of a shareholder voting contract, rather than as a part of a contract seeking to control actions of the board. E. Share Transfer Restrictions 1. Generally shareholders in closely held corporations commonly make contracts restricting each others ability to sell or otherwise transfer stock. 2. Two broad types of share transfer restrictions: a) Consent restraints Prevent a shareholder form transferring his or her

stock without the permission of other shareholders or perhaps the corporation. A restriction which reads as an absolute prohibition on transfer under all or certain circumstances effectively functions as a consent restraint. b) Buy out agreements includes the rights of first refusal, first options and buy-sell agreements. 1) Right of refusal gives the other shareholders or the corp the right to purchase the stock at the price offered by an outside buyer, before a shareholder can sell to the outsider. 2) First option gives the other shareholders or the corporation the right to purchase the stock before a shareholder can transfer his or her shares to an outsider at a price specified in the first option rather than matching what the outsider would pay. 3) Buy-sell Agreement either requires the shareholders to sell, and the other shareholders or the corporation to buy, the shares upon the triggering event, or else gives one or other party the option to force such a sale upon the triggering event. 3. Validity courts will enforce restraints on alienation only if the restraint is reasonable. Courts have applied this doctrine to restrictions on the ability of a shareholder to sell his or her stock. a) When is a share transfer restriction reasonable? 1) Purpose for the restraint Model Act only authorizes restrictions on the shareholders right to transfer their stock is the restriction is for a reasonable purpose, which includes maintaining the corps status, preserving securities laws exemptions, or some other reasonable purpose. 2) Degree to which the restriction blocks any transfer consent restraints generally burden a shareholders ability to transfer his or her stock to a greater extent than do advance buy out agreements. Thus, courts often have struck down consent restraints. b) Several factors may impact the willingness of the court to uphold a restraint: 1) Whether the agreement imposes any conditions upon the power of the non transferring shareholders to withhold consent. Court was willing to allow the restraint if the agreement had stated that the non selling shareholder could not withhold consent unreasonably. 2) Whether the restriction lasts perpetually or whether there is some future point where the shareholder will have the right to sell his shares without consent. 3) Purpose of the restraint Courts consider how important it is for shareholders in closely held corporations to maintain harmonious relationships through the right to veto new entrants. c) Model Act expressly allows consent restraints so long as the requirement is not manifestly unreasonable. d) Advance Buy out agreements courts are likely to uphold them. e) Right of Refusal generally upheld

f) First options alter the price which the selling shareholder will receive, but courts still usually uphold the first options despite arguments that the price was much less than the value of the shares as to render the restriction unreasonable. 4. Drafting poor drafting of share transfer restrictions has resulted in considerable litigation over the years. A number of terms can provoke litigation: a) Events What events trigger a buy out under an advance buy out agreement be specific! b) Who Advance agreement must state who has the option to demand the buy out could be the buyer, the seller, or both. c) Price term the more the price favors one side or the other, the more likely there is to be a dispute over whether the triggering event occurred. PART 6: I. SECURITIES FRAUD AND REGULATION

SECURITIES LAWS A. State Securities or Blue Sky laws 1. Provisions These anti-fraud in securities statutes typically contain one or more of three types of provisions: a) Simplest imposes sanctions, such as criminal prosecution, for fraud in selling securities. b) Elaborate requires registration and regulation of persons, such as brokers, who trade securities in the state. c) Most impact imposes a requirement that persons must register any securities sold in the state. This provision prevents a corporation from selling stock within a state unless the corporation registers the stock (or the statute provides an exemption for the type of transaction in question). 2. Registration what does registration of securities under blue sky laws entail? a) Requirements Uniform Securities Act established 3 methods of registering the sale of securities in a state: 1) Notification Allows seasoned companies meeting certain financial tests to file a shortened registration statement. This was replaced by filing which allows blue chip companies to avoid merit review of their offerings. 2) Coordination allows a company registering under the 1933 securities act to file copies of its federal materials with the appropriate state agency, instead of preparing entirely new disclosure documents for the state. 3) Qualification requires preparation and filing of an extensive disclosure document (is done by companies that do not qualify for the other ways). 3. Merit Review significant requirement contained in a number of state

securities law is merit review. a) Number of states laws either 1) Require the seller to receive a state officials approval of the merits of the proposed offering before the issuer can sell the securities or 2) Allow the state official to stop an offering which the official finds to be unsatisfactory on its merits. b) Common formulation of merit review statutes whether the offering is fair, just or equitable. These statutes essentially vest the state agency administering the statute with broad discretion to decide what offerings are worthy of sale in the state. c) Themes 2 common themes in merit review: 1) Whether the investment is too risky to be sold to anyone but perhaps sophisticated and well healed investors and 2) Whether the insiders are too greedy in terms of how little of the company they are willing to give up to obtain the new investors money. B. The 1933 Securities Act 1. Assumptions Act reflects two basic assumptions: a) One assumption underlying the Act was Congress view that sales of stock and other investments through the dissemination of false or incomplete information was not simply a matter of private concern, but had an impact on the national economy. b) Second assumption was Congress view that the appropriate mechanism to protect investors is simply to ensure complete and accurate disclosure. 2. The Scope of the Registration Requirement a) Basic thrust require registration of public offerings of newly issued securities. b) Structure start with a blanket requirement of registration for all securities sales and then work the Acts way backwards by creating exemptions. c) Section 5 contains three prohibitions: 1) Prohibits use of the mail or means of transportation or communication in interstate commerce (or deliver for or after a sale) a security, unless a registration statement is in effect. One cannot sell a security unless one has registered under the Act. 2) Prohibits the use of the mail or means of transportation or communication in interstate commerce to make offers to sell or buy any security unless a registration statement is filed. 3) Prohibits the use of any prospectus (essentially any written document, radio or television communication, seeking to sell a security) unless the prospectus meets the requirements of the statute. d) Definition of Security Broad definition that includes an investment contract. An investment contract includes any contract by which a person invests money in a common enterprise with profits to come

solely from the efforts of others. Thus, all sorts of investments can be securities. e) Private Offering Exemption/4(2) exempts transactions by the issuer which do not involve any public offering. This exemption covers the situation in which a corp issues shares to the individual or individuals who founded the corp and will be in charge of the company. Criteria for public offering exemption is subject to two tests: 1) Largely useless test Test of four factors that includes: (a) How many units in total are offered (b) How much money the offering raises (c) Manner in which the issuer makes the offering (d) The number of offerees and their relationship to the issuer 2) More useful test Examines whether the offerees could fend for themselves, rather than needing the protection of registration. (a) The promoters or top managers of a company hardly need the protection of reading a registration statement for which they would have provided the information. (b) Sophisticated investors know what information to demand without reading the registration. f) Regulation D contains three specific exemptions 1) Rule 504 the rule provides an exemption for offerings of no more than $1 million. Principal limitation is that unless there is disclosure under state securities laws, offerings under 504 normally cannot include a general solicitation. A general solicitation might encompass any efforts to sell securities to persons who do not have some preexisting relationship with either the business or persons associated with the business. 2) Rule 505 allows an exemption for selling up to $5 million worth of securities. Rule limits the number of purchasers (up to 35 plus any number of accredited investors) and requires the purchasers receipt of specified information. Also limits general solicitations regardless of compliance with state securities laws. 3) Rule 506 There is no dollar limit, but the up to 35 unaccredited purchasers must all be sophisticated (must be able to evaluate the merits and risks of the prospective investment) g) Section 4(1) exempts the existing stockholders sale of his shares in the corporation, so long as the stockholder is not a dealer in securities and so long as the transaction does not involve an underwriter. Section 4(2) and Regulation D apply only to the issuer. This exemption applies to the average investors sale of his or her shares. 3. What Registration Entails a) Registration Statement Registration under the Act requires the preparation and filing with the Securities Exchange Commission (SEC) of a disclosure document known as a registration statement. b) Parts Registration has 2 parts: 1) Prospectus this is filed with the SEC and the issuer must deliver

a copy of the prospectus to each purchaser of the securities. 2) Additional information filed with the SEC, where it is available for public inspection. c) Liability Section 11 of the Securities Act creates liability for any untrue statements of material fact contained in the registration statement or for any omissions of material facts either required to be in the registration statement or which render the statements made in the registration statement misleading. 1) Who Imposes liability on the issuer, every person who signed the registration statement, every director of the issuer, every person who provides an expert certification of any portion of the registration statement, and the underwriters of the offer. Imposes liability on persons who may not actually have made the false statement. 2) Strict liability the issuer is strictly liable for any misrepresentations made in the registration statement. The other def can be liable unless they can establish their own due diligence. 3) Reliance section imposes liability without requiring the plaintiff to prove reliance. It is up to the def to show that the pl knew challenged portions in the registration statement was false. d) 12a2 allows a suit for false or misleading statements contained in any propectus or oral communication used to sell securities. Thus, it will cover misrepresentations made outside the registration statement. 1) No scienter requirement. It is up to the def to prove his lack of negligence in failing to discover the truth. 2) No need to prove reliance so long as the pl did not know the statements were false. 3) Misrepresentation must be made by the person who sold the pl the securities in question. e) 17a prohibits fraud, or making false or misleading statements, in the offer or sale of securities. 1) Violation of this section can lead to an action by the SEC or injunctive relief or to a criminal prosecution. C. The 1934 Securities Exchange Act 1. Focus concern is with what happens with the securities and their owners as they trade in the marketplace. 2. 12a requires companies with securities traded on a national exchange to register securities. 3. 12g requires companies with over $10 million (originally 1) in assets, and a class of equity securities (stock) held by over 500 or more persons, to register the securities. 4. Main significance regarding disclosure 13a requires that companies with securities registered under 12 file periodic reports as dictated by the SEC. Commission requires companies to file annual reports, quarterly reports, and reports for certain significant events. 5. Liability 1934 Act contains provisions seeking to ensure accuracy in

disclosure by imposing liability for false or misleading statements. a) 18a gives parties who read and relied on false or misleading statements contained in documents under the Securities Exchange Act has a cause of action against the person who made the false or misleading statement. Imposes the burden of proof on the def to show that he acted in good faith and did not know of the falsity. II. RULE 10B-5 A. Insider Trading 10b5 1. 10b makes it unlawful to use the mails, or any means of interstate commerce, to employ, in connection with the purchase or sale of any security, any manipulative or deceptive device or contrivance in contravention of rules promulgated by the SEC. (no fraud, lie or untrue statements, fraud in connection with purchase or sale of security) 2. Policy idea behind 10b is the complement the specific requirements and prohibitions in the federal securities laws with a catch all provision empowering the SEC to define and prohibit manipulative or deceptive conduct which otherwise might fall between the cracks in the statutory scheme. 3. Nutshell- 10b5 makes it unlawful to commit fraud in connection with the purchase or sale of a security. 4. Requirement to fall within the prohibition, the fraud must involve the use of either the mail, means or instrumentalities of interstate commerce, or a facility of a national securities exchange. 5. Parts Rules specification of prohibited fraud is set out in three parts: a) Makes it unlawful to employ any device, scheme, or artifice to defraud b) Prohibits engaging in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. Commission could have simply said that it is unlawful to commit fraud. c) Makes it unlawful 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 not misleading. It is unclear how much this part adds to the rule because false or misleading statements or material fact seemly fit in the definition of fraud. (untrue statements here are about questions of fact and not question of opinion) Have to find out first what is true and what is untrue. 6. Analysis there are three principal contexts in which 10b5 arises: a) Misrepresentations b) Trading on inside information and non disclosure c) Breaches of fiduciary duty involving the purchase or sale of securities. B. Liability for Misrepresentations (mostly brought by private action) 1. False or misleading statement of fact a) Must find a false or misleading statement regarding a material fact or omission of that material fact that leads to misrepresentation. b) Interpretation questions court may bring in some investors as

witnesses and ask them what they took the statement to mean. c) Even if a statement is literally true, the statement may be misleading. d) Opinion/Prediction Key to deciding whether an opinion or prediction constitutes a false statement; 1) Whether the person making the statement provided the information in good faith, which depends on whether the speaker, himself, believed the opinion or prediction and 2) Whether the speaker had a reasonable basis for the opinion or prediction. 2. Materiality a) Rule False or misleading statements will not violate Rule 10b5 unless the statements are false or misleading as to material facts. (who cares? facts do not count) b) Definition A fact is material if there is a substantial likelihood that a reasonable investor would find the fact important in deciding whether to buy or sell a security. c) Common materiality issues: 1) Where the significance of the facts showing the possibility of a future event, when the importance of the event is clear if the event actually occurs, but, at the time the statement is made, it is not clear whether the event will occur. (a) The materiality of these facts depends upon the magnitude of the event and its probability of occurring. (b) The more impact the event will have, the less certain its occurrence need be in order for investors to find the possibility of its happening to be significant. The more likely the occurrence, the less impact the event need produce in order for investors to take it into account. 2) Impact of the context defendants often argue that the false or misleading statements are not material because surrounding disclosures undercut the significance which a reasonable person would attach to the false or misleading statements. (a) Bespeaks caution doctrine this is the notion that warnings and caveats might render misstatements not material. (b) Most courts applying the bespeaks caution doctrine have required the cautionary language be detailed and specific in laying out why the projections might not pan out or why the opinions might be wrong. (c) The more the def statement lacks a reasonable basis or was not made in good faith, the stronger the warning should be. 3. Fault/Scienter (intent to deceive -- really means knowledge of falsehood. You knew what you said was false, we don't care why you said it. Motive irrelevant) a) Rule In order to violate 10b5, there must be scienter. Negligence is not enough. b) Scienter a mental state embracing intent to deceive, manipulate, or

defraud. c) Intent What is intent? Lower courts have held that recklessness is sufficient for a violation of rule 10b5 1) Some courts recklessness sounds like a worse form of negligence (deliberately refusing to believe otherwise though there are plenty of warnings) 2) More courts recklessness must entail something more than a greater degree of negligence. It is an awareness by the def of facts warning the def of falsity. 3) Other courts choose to define recklessness based upon multiple factors, including the relationship of the def to the pl and how much effort it would have taken for the def to check out the info which turned out to be false or misleading. d) Knowledge of Falsity Issue of sceinter might be better labeled as the issue of defs knowledge of falsity. (whether he knew what he said was false) Issue can also be why the def made the statement e) Pleading to make sure the pl has the goods on the def before launching the lawsuit, 10b5 requires that the pl in a private action under 10b5 plead with particularity the facts giving rise to a strong inference that the def acted with the required state of mind. 4. Private Causes of Action a) Courts have recognized an implied private right of action under 10b5. b) The private right of action raises issues not associated with a case brought by the SEC or a federal prosecutor: 1) How does a private pl establish that the defs misrepresentation caused harm to the pl? 2) What remedy can the pl obtain? 3) Are there any private parties who cannot bring an action under 10b5 despite having suffered injury under the rule? 5. Reliance and Causation (under private cause of action. Need reliance for private cause of action) a) Definition Reliance is the manner in which a private pl in a 10b5 case establishes a link between a defs misrepresentation and the pls injury. (need to hear statement, believed it, and relied on it, and had person known the truth he would have done something else. Got to be buyer or seller) b) Fraud on the market theory provides a means for traders in an active securities market to prove their reliance on a false or misleading statement of material fact, without each trader testifying that he or she heard, believed, and was influenced by the false statement. 1) This reflects the notion that false or misleading statements of material fact will impact the price of stock traded in a well developed market. 2) Theory is used in order to certify a class action where it would be impossible for the court to adjudicate whether each class member relied on the misrepresentation.

3) Triggering to trigger the fraud on the market theory, the stock must be well traded in a well developed securities market. To determine if it is a well developed market, court may look at: (a) Trading volume (b) How many analysts follow the stock (c) How rapidly the stock price has moved in response to corporate news in the past (d) Corporations ability to use federal securities law registration statements adapted to more widely traded securities. 4) Justified reliance must be justified. Def may assert that the pl was not reasonable in relying on the def false statement. (a) Where pl has ignored warnings courts might distinguish between def who knew their statement was false and def who were only reckless themselves in making the false statement. Pls conduct should not serve to exonerate the def unless the pls conduct was equally as culpable as the defs. 5) Transaction causation the pls reliance on a false statement is the normal mechanism by which a false statement causes harm to the pl. The statement caused the pl to enter into a transaction that pl now regrets. 6) Loss causation pl must also prove that the reason the transaction turned out to be a loser must have something to do with the substance of the misrepresentation. c) Efficient Capital Market Hypothesis stock prices in active trading markets move very rapidly in response to information relevant to a stock and thus the stocks price will incorporate the information very quickly. 1) This theory is useful where the corporation falsely denies something, resulting in a lower stock price than if they had told the truth. 6. Remedies a) Out of pocket loss difference between the stocks actual value at the time of the fraud and either what the pl paid for the stock or what the pl received for the stock. b) Benefit of the Bargain courts have refused to grant bob damages in 10b5 cases. BOB damages would be the difference between the stocks actual value at the time of the fraud and the value the stock would have ad if the representations had been true. c) Rescission alternate remedy is to rescind the transaction. The court gives the plaintiff who purchased based upon fraud his or her money back and give the pl who sold based upon fraud his or her money back. d) Punitive damages are not allowed under 10b5. 7. Standing a) Rule In order to bring a private action under 10b5, the pl must have been a purchaser or seller of stock or other securities. b) Forced seller doctrine courts consider mergers and the like to be

sales for securities laws purposes, and a person forced to exchange his or her shares in a merger or the like is a seller, even though this person had not choice in the matter. 8. Aiding and Abetting and Multiple Defendants Supreme Court held that there could not be aiding and abetting liability in a private suit under rule 10b5. 9. Procedural Issues a) S/L For private actions under 10b5 is the earlier of one year after discovery of the fraud, or three years after the fraud took place. b) Jn Federal courts have exclusive jn to hear actions brought under the federal securities laws, including for violation of 10b5. C. Trading on Inside Information and Non Disclosure 1. Introduction a) When problem arises when an individual knows facts (often referred to as inside information) which other traders do not know, and the individual does not disclose those facts. b) Contexts non disclosure can occur in two contexts: 1) Non disclosure by a person who buys or sells securities while knowing facts which the other party to the purchase or sale does not know and 2) Non disclosure by a person who does not buy or sell securities and does not pass the information off for another person to buy or sell securities. 2. When does trading on undisclosed information violate rule 10b5? (Policy: Full disclosure is necessary to establish presumption of fairness and level playing field for all shareholders and buyers so they won't get pissed off and stop investing) a) Traditional theory insiders have a fiduciary relationship, or a relationship of trust and confidence, with the shareholders of the corporation in which the insiders are directors, officers, or employees. This relationship between the insider, and the party with whom the insider trades, creates a duty on the insider either to disclose material information before trading or else to abstain from the trade. Insiders of a corp must disclose inside info or abstain from trading b) Dirks Supreme court in Dirks divides persons who receive information from corporate officials into three categories. There is a duty to disclose in the first two categories. There is no duty to disclose in the third category. 1) Temporary/Constructive Insiders these temporary insiders consist of persons like underwriters, accountants, lawyers and consultants, who enter into a confidential relationship with the corporation and are given access to corporate information solely for corporate purposes. (a) These insiders have the same obligations with respect to trading on information they receive from the corporation as do corporate officials and info is not known by the public.

(b) For temporary insider status to exist, the corporation must expect, and the relationship must imply, a duty to keep information from the corporation confidential. 2) Tippees Second category is tippees who receive information in breach of the insiders duty to refrain from profiting on undisclosed inside information. Cannot do something indirectly that you cannot do directly. (if insider benefits from passing information, then he breaches FD. Tippee would also be liable for enticing insider to breach duty) (a) Tippee individual who receives information (a tip) from a person (a tipper) who provides the information to the tippee with the expectation that the tippee will buy or sell based upon the information. (b) There is a two part test for when tippees will violate rule 10b5. There is a violation when: (i) An insider breaches his or her duty by passing a tip in order for the insider to obtain some personal benefit and (ii) The tippee knows or should have known that passing the tip was a breach of the insiders duty. (c) There can be chains of tipping, as one tippee turns around and becomes a tipper by passing information off to others. 3) Residual Category (a) Left overs the third category of persons who receive information from insiders includes everyone who does not fall either into the category of temporary insiders or into the category of tippees who receive information in breach of the insiders duty not to profit from trading on undisclosed information. (b) Under Dirks, a persons in this residual category can trade on undisclosed inside information without violating rule 10b5 as long as liability rests on the traditional theory. c) Misappropriation theory - There are two theories under which appropriating confidential information by trading on it can equal fraud: 1) Utilitarian approach the reason that silence is normally not fraud, despite one partys knowing material facts unknown to the other party to the transaction, is to encourage hard work in gathering and analyzing information. (a) On the other hand, if the hard work essentially consists of stealing information, this effort obviously is not something society wishes to reward or encourage. (b) The law should create a duty to disclose misappropriated information to the other party to the transaction, which would remove the reward from using ill gotten information and would place the parties to the transaction on equal footing. (c) Court did not use this theory in OHagan. 2) Sneaky theft theory (faking loyalty in connection w/the purchase

of security. victims here are firm and its clients) An individual who stands in a fiduciary relationship, expressly or implicitly represents to his employer or client that he or she will act loyally. In other words, that he will not embezzle money entrusted to his care, nor misuse information which his employer or client made available and does not wish disclosed or traded upon. (a) If, without disclosing to the employer or client the fiduciarys subversive intention, the fiduciary then embezzles the money or misuse the information entrusted to the fiduciary, the fiduciary has lied in making this express or implicit representation of loyalty, and thereby has defrauded the employer or client. (b) This theory was used in OHagan. (Theory is that u r telling people lies in order to get the information) d) Materiality the undisclosed information must be material. e) Non public- the non disclosed information must be non public. f) Use the information must be used, meaning that they must have motivated the insider to make the purchase or sale in question. 1) Use v. Possession circuits are split. Some insiders claim that they would have bought or sold the same amount of stock at the same time even if they did not know of the undisclosed inside information. 3. Why is there anything wrong with trading on inside information? (Is it fraud?) Under common law, no need to disclose and silence can only be fraud when there is a fiduciary relationship to the other party of the transaction. a) Equal information rule would mean that one party to a proposed transaction always discloses material information to the other side. 1) Equal information rule undermines the incentives to search for undiscovered values obtainable from entering a transaction. (no one would ever search information that is widely available) 2) The equal access rule was rejected in Chiarella. b) Fiduciary relationship there is a duty because when the fiduciary relationship involves trust between two parties. When the fiduciary fails to disclose, the implicit representation becomes false. (If you owe duty to corp then you owe duty to SH or would be SH of that corp) 1) It is also unfair for a fiduciary to use information to the detriment of a person on whose behalf the fiduciary is supposed to act, especially if the reason the fiduciary received the information was to act for the benefit of the person against whom the fiduciary uses the information. c) Problems with giving inside information as a form of compensation 1) Allowing officials to sell their stock before disclosure of bad news allows officials to avoid the consequences of bad developments at the corporation.

2) Means that each insider, within broad limits, essentially sets his own level of compensation by deciding how much he wants to trade. 4. Sanctions for trading on inside information in violation of rule 10b5: a) SEC Actions by the SEC b) Willful Violations Criminal prosecutions in the case of willful violations c) Express penalties provided for by the Securities Exchange Act for violating rule 10b5 through trading on inside information are now greater than the penalties for violating 10b5 through misrepresentations. d) Damages the SEC may seek a civil penalty for illegal trading on inside information of up to three times what the def made on the illegal trades. e) Controlling persons Liability extend to controlling persons of parties who engage in trading on inside information. 1) An employer would be a controlling person. 2) A controlling person can be liable for a civil penalty up to the greater of $1 million or three times the illegal traders profit, if either the controlling person knew or recklessly disregarded the fact that the illegal trader was likely to illegally trade or the controlling person failed to meet requirements imposed on brokers to establish internal controls to protect against securities law violations. f) Reliance positive proof of reliance is not necessary in cases primarily involving a failure to disclose. g) Section 20A creates an express private cause of action against persons who violate the 1934 Act by trading on inside information. 1) Pl must have purchased contemporaneously with a def who illegally sold using inside information or else the pl must have sold contemporaneously with a def who illegally bought using inside information. 2) Damages the section limits the total recovery to the total of all profits the def made (or loss the def avoided) by virtue of the illegal trades. 3) This section allows contemporaneous traders to sue those who violate 10b5 by trading on inside information, even if the violation is based upon the misappropriation theory. 5. Disclosure duties of those who do not trade a) Rule Non disclosure by a party not trading in stock or tipping others who trade will not as a general proposition, constitute fraud in violation of 10b5. b) Absence of trading Non disclosure in the absence of trading generally is not a violation of 10b5. c) Silence Silence, absent a duty to disclose, is not misleading under 10b5.

d) Later courts have held that the failure to issue a corrective disclosure violates 10b5 if the statement is still material to investors. e) Chit chat unless the corporation did something to encourage chit chat, it is difficult to blame the corporation for or require the corporation to respond to investors interpretations. D. 10b5 requirements regarding inside information and non disclosure: 1. Materiality 2. Non Public 3. Use 4. Duty III. FEDERAL PROXY RULES A. Overview 1. The Statute a) Section 14a makes it unlawful to violate the SEC rules when using the mails or any means or instrumentalities of interstate commerce to solicit proxies, consents, or authorizations regarding securities registered under the Act. b) Solicitation Even indirect or general communications can constitute a solicitation if reasonably calculated to influence shareholder votes in a corporate election. 2. The Rules a) Proxy there is no clear definition in the rules b) Solicitation includes not only requests for proxies, but also any communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy. 3. 14a Rules a) 14a2 gives exceptions to definition of solicitation. 1) Number of persons Solicitations which are not on behalf of the corporation so long as the solicitation is made to more than 10 persons 2) No actual proxy the rule provides an exemption for solicitations by persons who do not seek an actual proxy. This allows discussions among shareholders who do not have an axe to grind other than as shareholders. 3) Other exemptions cover specified communications between beneficial owners of stock and persons holding record title to the beneficial owners shares, and advice in the ordinary course of business by investment advisors to their clients. b) 14a3 Anyone who solicits proxies to furnish the solicited shareholders with a proxy statement containing certain information. The statement must give information about the meeting, the voting rights of shareholders, and about the person soliciting the proxies. The proxy statement for the annual shareholders meeting must also include an annual report.

c) 14a4 contains guidelines for the proxy form, which is the written document that grants authority to vote on behalf of the shareholder. Some of the guidelines include: 1) Requirement that the proxy form give the solicited shareholder the option to instruct the proxy holder to vote the shares either for or against the matters identified as being up for a shareholder vote at the meeting. 2) Requires the proxy form to give the solicited shareholder the ability to withhold authority to vote for any or all of the nominees for election to the board listed by the party soliciting the proxy. 3) Limits the ability of the proxy to grant discretionary authority upon the proxys holder. 4) Requires a place for dating the proxy and limits the proxys effectiveness to the next shareholders meeting. d) 14a5 designed to ensure clear and readable presentation of the material in the proxy statement. e) 14a6 Requires the filing of the proxy statement, proxy form and other soliciting materials with the SEC. This filing occurs in two stages: 1) If the solicitation involves something more than the corporations routine seeking of proxies for the annual meeting, then the party undertaking a solicitation must file a preliminary proxy statement and form of proxy at least 10 days before the distribution of the materials. The SEC uses the time to check for problems. 2) Then, a party soliciting proxies (even for an annual meeting) must file the final proxy statement, form of proxy, an copies of all other soliciting materials with the SEC no later than when the party sends the solicitation materials to shareholders. f) 14a7 requires the corporation which has or will make a proxy solicitation either to give a shareholder, who appropriately requests, a copy of the shareholder list or else mail the requesting shareholders proxy solicitation materials to the other shareholders. In order to be eligible to make such a request, the shareholder must be undertaking a proxy solicitation regarding the same subject matter as the corporations solicitation. 1) It is the corps option to choose between giving the list or making the mailing. 2) Since the shareholder must pay for the mailing, management usually takes this option rather than giving up the shareholder list. Thus, management might hope to hamper any efforts by the dissident shareholder to contact other shareholders personally and also can respond simulateously to the dissidents materials. Also, they can peek before mailing them. 3) Thus, it is better to demand a shareholder list pursuant to state law inspection rights than using 14a7 to wage a proxy contest. g) 14a8 deals with shareholder proposals (see later section).

h) 14a9 prohibits false or misleading statements in soliciting proxies. i) 14a10 prohibits soliciting undated and post dated proxies. j) 14a11 contains special provisions involving the timing of disclosure by those undertaking a proxy contest against the managements slate of directors. 1) If a shareholder decides to undertake a proxy contest at the last minute, he would be at a serious disadvantage because would have to wait 10 days for SEC review before beginning efforts to persuade other shareholders. 2) The rule allows the opposition solicitations, if not accompanied by a proxy form, to occur prior to furnishing the solicited shareholders with a proxy statement, which then must be sent to shareholder asap. k) 14a12 Provides a similar solution for those who decide with little time left, to try to dissuade shareholder form granting proxies in favor of a proposed action such as a merger or the like. l) 14a13 Designed to ensure receipt of the corporations proxy statements and annual reports by the beneficial owners of stock held in street name. Corps must provide parties holding stock in street name with sufficient copies of the corps proxy statement and annual report plus funds to cover mailing expenses in order for the record owner to send these materials to the beneficial owners. 4. Dissemination of annual reports and information without a proxy solicitation. a) Goals one of the principal goals of the proxy rules is to provide shareholders with information in order for shareholders to intelligently make decisions in granting a proxy. b) Relevance Corporate financial statements might be relevant to shareholders for purposes beyond the decision as to whether to grant a proxy. Might help the shareholder decide whether to retain or sell his stock. c) Corp Who do Not Solicit Proxies required to provide shareholders with the same disclosure materials which the corporation would have had the company made the solicitation. B. False and Misleading Solicitations litigation under rule 14a9 revolves around several possible issues: 1. False or Misleading Statements of Fact or Omission a) Types There are three types of falsity: 1) A false or misleading statement of fact 2) An omission of fact which makes a statement misleading (a half truth) and 3) The failure to correct a statement which subsequent events have rendered false or misleading, when the matter has not yet come to a shareholder vote. b) Outright falsity statements which are outright false are relatively rare.

c) Motives or Beliefs Court has refused to allow 14a9 claims based solely on misrepresentations as to motives or beliefs. d) Value/Price Descriptions Have recognized a claim based upon the notion that statements about high value or fair price could be false if the value is not high and the price is not fair. Court rejected the idea that the terms were too indefinite to be true or false, concluding instead that such terms in the commercial context are understood to rest on a factual basis. 2. Materiality a) Rule in order to violate rule 14a9 it is not enough that a proxy solicitation includes false or misleading statements or omissions. In addition, the facts misstated or omitted must be material. b) Definition a fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. 1) The standard does not require proof of a substantial likelihood that a reasonable shareholder would have changed his or her vote has he known the full truth. 2) Instead, the fact simply must be one that would have assumed a significant, even if not ultimately decisive, role in a reasonable shareholders deliberations on how to vote. 3) This standard refers to what a reasonable shareholder, not the pl shareholder, would consider important. c) Issues There are several recurring materiality issues in 14a9 cases: 1) Facts concerning ethically questionable practices If the charges of misconduct are not yet established a court might be less willing to treat them as material. 2) Facts whose relevance is clear should they occur, but whether they will occur is in substantial doubt the materiality of these facts depends on their probability of occurring and their importance if they do occur. The more important the fact will be if it occurs, the lower the probability of occurrence which is necessary in order to find materiality. The greater the probability of occurrence, the less impact the fact must have if it occurs in order for its possibility to be material. 3) Situation in which the def argues that omitted or misstated facts were not material because facts disclosed elsewhere undercut the significance of the misstatement or omission if it would take a financial analyst to figure out how the facts disclosed elsewhere corrected the misleading statements, then the misstatements or omissions are material. Courts have rejected this argument also when the corrective information is found in a document other than the document containing the misstatement or omission. 3. Fault a) Rule proxy solicitations shall not be made by proxy statements or other materials which contain false or misleading statements of facts.

The rule does not say that the prohibition applies only when the def knows the statement is false or only when the def was reckless or even negligent in making the mistake. b) 8th Circuit declined to impose strict liability upon parties who misstated or omitted facts in soliciting proxies. c) 2nd Circuit refused to require a showing that the def knew the statement was false, or was reckless as to truth or falsity, in order to impose liability under 14a9. Instead, the court held that negligence in ascertaining the facts before speaking was sufficient. d) 6th Circuit concluded that knowledge of falsity or recklessness should be required under 14a9, at least in an action to impose monetary damages upon the corporations outside accountants. e) Policy perhaps the appropriate level of fault should depend upon the relief sought in the lawsuit. 4. Private Cause of Action a) Silent rule is silent about what happens if a person makes a false or misleading statement in soliciting a proxy. b) Rule There is a private cause of action under 14a9. c) Who the pl shareholder can bring a derivative suit on behalf of the corporation. 5. Causation a) Reliance the pl reliance is not what matters. Critical reliance comes from the actions of shareholders who together have sufficient votes to have decided the election. b) USSC test causation is based on the materiality of the false or misleading statements or omissions, combined with the fact that the proxy solicitation was an essential link in completing the transaction. If the def needed to solicit proxies in order to approve the transaction in question and if the def made material misrepresentations or omissions in soliciting the proxies, the court will presume that enough shareholders would have voted differently had they known the full truth would have changed the outcome. c) Damages even if there is causation, that does not establish that the pl suffered any monetary damages nor does it establish how much. 1) Where the lawsuit is resolved quickly, the failure to show money damages might not matter because the court can enjoin the voting of proxies or order the transaction unwound. 2) Where the court will not be able to resolve the matter expeditiously, equitable relief commonly becomes impractical. 3) Merger establishing damages in a case of a merger requires showing that the transaction did not give a good deal to the shareholders (that the transaction terms were unfair). d) What about when the def had the votes but still solicits proxies? Do I need to know this? C. Shareholder Proposals 1. 14a8 allows a shareholder to demand that the corporation include, in

both the companys proxy statement and form of proxy, a proposal which the shareholder wishes to put before his or her fellow shareholders for a vote at the annual shareholders meeting. a) Support Statement Must also allow the shareholder to submit a statement in support of the proposal, which the corporation must include along with the proposal in the corps proxy statement. b) Voting Instructions Proxy form must give the solicited stockholders the option to instruct the corporation to vote their shares for or against the proposal. c) Advantage This rule allows a shareholder to conduct a limited proxy campaign in favor of a proposal without having to spend his or her own money sending out proxy solicitations. 2. Types Shareholder proposals have fallen into two types: a) Concerning corporate governance issues example would be a motion to amend the bylaws to have the shareholders, rather than the directors, select the corporations outside auditors. b) Proposals motivated by social and political concerns example is to have the corporation adopt various resolutions designed to make the corp operate in a more socially responsible manner. 3. Litigation arises from a variety of restrictions which the rule places on a shareholders right to demand that the corporation include a proposal in its proxy statement. a) Who Rule limits shareholders who are eligible to make a proposal: 1) Must have owned at least one percent or $2000 in market value (whichever is less) of the outstanding voting stock in the corporation for at least one year before submitting the proposal. 2) Must continue to the hold the stock through the date of the stockholders meeting at with the shareholder will make the proposal. b) Delivery Rule requires delivery to the corp of the proposal a minimum time in advance of the meeting. c) Words Each shareholder has the right to submit only one proposal at a time, with a supporting statement no longer than 500 words. 4. Refusal there are grounds under which the corp may refuse to include the proposal a) Rule Violation the corporation can omit a proposal which would require the company to violate a law, or where the proposal or supporting statement itself violates the proxy rules, particularly by containing false or misleading statements. b) Personal The company may omit a proposal which simply pursues a personal grievance or is otherwise simply seeking a personal benefit not shared by the stockholders at large. c) Useless The corporation may omit proposals which are beyond the power of the company to effectuate, which have been rendered moot, or which substantially duplicate another shareholder proposal already slated for inclusion in the companys proxy materials.

d) Ordinary business corporation may exclude proposals which relate to the conduct of the corporations ordinary business operations and proposals which relate to operations which account for less than five percent of the corps assets and income and are not otherwise significantly related to the corporations business. 5. Opting Out Corporations cannot simply opt out of 14a8 by bylaw or article provisions denying shareholders the right to make motions which state law would not otherwise prohibit. Federal courts can use 14a8 to invalidate corporate bylaw provisions which the court finds to create too great a burden on the shareholders ability to make proposals. IV. TENDER OFFERS A. Takeover Defenses and the Board of Directors Fiduciary Duties 1. Three ways in which to Structure the purchase of the Business Conducted by a Corporation (target corporation): a) The individual or company seeking to acquire the target corporations business (the acquirer) can have itself (if the acquirer is a corporation), or a corporation controlled by the acquirer, merge with the target corporation b) The acquirer can purchase substantially all of the assets of the target corporation c) The acquirer can purchase most or all of the stock owned by the existing shareholders of the target corporation (thereby becoming the majority or sole shareholder of the target corporation). 2. Tender offer a direct solicitation of a corporations shareholders to sell their shares to an acquirer is known as a tender offer because the acquirer is asking the existing stockholders to tender their shares for sale. 3. The Arsenal a) Shark Repellent Provisions these are defenses erected prior to a hostile tender offer. 1) Staggered terms if the board of directors has staggered terms, it takes several elections before a purchaser of a majority of the corps stock can replace all or even most of the corporations directors. 2) Provisions limiting the power of the shareholders to call, or make motions at, a shareholders meeting, or to act by written consent in lieu of a meeting this provision seeks to limit an acquirers ability to replace the existing directors through an early shareholders meeting or by the written consent of most of the shareholders, or otherwise put the acquirers plans into play without working through the incumbent board. 3) Supermajority requirement articles can include supermajority requirements for a merger with a related person. A related person is typically defined as someone holding over a certain percentage of the companys outstanding stock. 4) Fair Price Amendment waives the supermajority requirement for a merger with a related person if the shares cashed out in the

merger receive a price at least equal to a formula specified in the provision. Formula is generous. This is often coupled with the supermajority requirement. b) Poison Pill Most effective and common takeover defense. 1) Original form a poison pill consists of a series of convertible preferred stock, which the corporation issues to its common shareholders as a stock dividend. These preferred shares may or may not have voting or mush dividend rights. What makes them a poison pill is their conversion rights, and specifically the flip over provision. (a) Flip over provision if an acquiring corporation purchases more than a certain percentage of the targets outstanding common stock, and then merges with the target, the holders of the preferred stock can convert the preferred shares into the acquirers common stock at a highly favorable ratio. (b) Impact to deter a two step acquisition, much like the supermajority voting requirements for mergers with a related party or a fair price amendment. (c) Result the targets board can remove the poison pill if the directors of the target corporation decide to support the acquisition. 2) Flip in option provision like a flip over except that the flip in becomes effective after an acquirer buys a certain percentage of the target corporations outstanding common stock, even if the acquirer does not merge with the target corporation. In this event, the holders of person pill preferred can convert it into stock or other securities of the target corporation at a highly favorable ratio. 3) Back end provision gives the holder the right to force the target corporation to redeem the poison pill preferred at a very generous price. Make the target common stock purchased by the acquirer much less valuable. 4) Dead hand poison pill limits the ability of newly elected directors to redeem the poison pill securities. Idea is to prevent an acquirer from persuading a majority of the shareholders to replace the existing directors with new board members, who will redeem the poison pill securities and thereby clear the way for a tender offer. c) Talk to Shareholders most straightforward and noncontroversial defense. 1) Can communicate with the shareholders in an effort to persuade them not to tender their stock. 2) Sometimes the targets board will seek to persuade other parties to oppose the bid. 3) The targets board might institute a lobbying campaign directed at the state legislature, hoping to convince the legislature to enact anti-takeover legislation. d) Pac Man amusing but not often used.

1) Refers to attempting to buy a majority of the acquiring corporations shares before the acquirer can purchase a majority of the target corporations outstanding voting stock. 2) If both corporations end up owning a majority of each others shares, apparently neither corporation will have the right to vote the shares it owns in the other. e) Defenses Involving Purchasing or Selling Shares in the target corporation 1) Self tender target might repurchase some of its outstanding shares on the open market or through its own tender offer. Directors hope that such repurchases create competition for the hostile acquirer and raise the price of the targets stock. 2) Greenmail can have the target corporation buy the shares in the target owned by the prospective acquirer. This is essentially paying of the acquirer to go away. However, this might tempt others to threaten a takeover. 3) Find Friendly buyer perhaps better than share repurchases by the target corporation, can find a friendly buyer for the targets outstanding stock. (a) White knight board may encourage another firm to enter the bidding for the corporation. (b) White squire better yet might be to find a purchaser who will buy enough of the outstanding stock in the target corporation to stop the hostile bidder, but not enough to control. (c) ESOP Employee Stock Ownership Plan one way to make a partial purchase is an ESOP set up by the target for the benefit of its employees, and with friendly individuals acting as trustees. (d) MBO Management Buy Out another bidder could be a corporation organized by management, often with outside investors and with considerable borrowed money, to buy the shares. Also an LBO. f) Target issue more stock notion is to keep supplying more stock which the hostile bidder will need to buy. Result, however, can be to lower the price of the targets shares and make the bidders offer look all the more attractive. 1) Leg up having the target issue new shares to a friendly party (white knight, white squire, and ESOP, or a firm set up for an MBO) might hold promise. This gives an advantage to the friendly party over a competitive bidder in seeking to be the first to acquire a majority of the targets outstanding stock. (a) Consolation prize another impact of the leg up is to act as a consolation prize for the friendly party if it loses the bidding war to the hostile acquirer. (b) Effect Since the leg up agreement invariably sets the price for the shares sold to the white knight at less than the hostile

acquirer must offer to outbid the white knight, if the white knight loses, the white knight typically can turn around and sell the shares it bought in the leg up to the hostile acquirer at a substantial profit. g) Scorched Earth Tactics another takeover defense involves transactions which make the target corporation, as a business, less attractive to the acquirer. 1) Target corporation, if it has a large amount of spare cash on hand, might use cash to repurchase its stock. The buyer may have planned to use the targets cash to help finance the purchase. 2) Target corporation might borrow heavily in order to repurchase its outstanding stock. A debt laden company might not seem like such a good buy. 3) Crown Jewel the target could sell a line of business it suspects the buyer is really after. 4) Lock up Agreement the board might have the target corporation contract to sell a crown jewel or other significant assets to a white knight if the white knight loses out to the hostile bidder in the race to purchase the entire target corporation. Impacts of a lock up include: (a) Makes target less attractive to the hostile bidder (b) Can serve to entice a white knight to enter the bidding for the target by assuring the white knight of a consolation prize (the favorably priced purchase of assets) if the white knight loses in the bidding for the target. (c) Can encourage shareholder approval of whatever merger agreement the board might have negotiated with the white knight, since the failure to approve the merger will result in the corporation selling, at a low price, some valuable assets. 5) Acquire additional lines of business which make the target corporation less attractive to particular acquirers the acquisitions could create anti trust problems for a particular acquirer, or because the acquisitions preemptively achieve the synergies which the acquirer hoped its acquisition of the target corporation would obtain. 4. The Legal Standard for Reviewing Defenses a) BJR some courts apply the BJR to board decisions involving takeover defenses, just as the court would do with any ordinary decision by the board of directors. 1) Problem directors do have a conflict of interest, even if there is no self dealing involved. This is because a takeover will probably result in the replacement of the current directors, which is something that most directors have a financial and psychological interest to avoid. b) Primary Motive Test some courts have responded to the potential interest of the director b adopting a primary motive test.

1) Test the BJR will apply unless the primary motive of the directors for the defensive step was to preserve their control, rather than advance the interests of the corporation or its shareholders. 2) Problem test is unworkable because unless the directors confess that their motive was to preserve power, how is court going to figure out what their primary motive was? c) Fairness few courts have viewed the conflict which the directors face in opposing a takeover as sufficient to require application of a fairness review, just as with any other conflict of interest transaction. 1) Problem all sorts of decisions, at least indirectly, impact the directors retention of control over the corporation. If courts apply the rigorous scrutiny of fairness review to any decision which might impact the directors continued control, then courts can end up second guessing much of what any board decides. d) Unocal Test courts have developed an intermediate standard to review board decisions to employ takeover defenses. 1) Test The DE supreme court set out a two part test to review directors decisions to employ takeover defenses: (a) Reasonable Belief Under the first part of the test, the directors must prove that they possessed reasonable grounds for believing a threat to corporate policy and effectiveness existed. (b) Reasonable measure in relation to threat The second part of the test requires that the defensive measure used be reasonable in relation to the threat posed. 2) Burden of Proof This test shifts the burden of proof to the directors to show a justification for their conduct much like the fairness test applied to conflict of interest transactions. e) Revlon Qualifier to Unocal Test court created a heightened level of scrutiny for situations in which the board decides that the sale of the corporation is inevitable. 1) Triggers it is unclear what triggers Revlon qualifier. (a) Inevitable The board must decide that the sale of the corp is inevitable. (b) Control where there is no shift in control when the acquirer takes over, court has found that the qualifier is triggered. 2) Heightened Scrutiny it is unclear what is required. (a) Involves both a narrowing of the range of acceptable goals for the boards action. (b) Now the sole acceptable goal is to obtain the best price for the stockholders. (c) Also, there is a greater willingness to second guess the directors actions. 5. Permissible Goals for Takeover Defenses a) First step Before applying a standard of review, the first step in applying the standard must be to ask whether the directors had a

legitimate goal for instituting the defense. 1) To find appropriate goals for action specifically directed at tender offers, it is helpful to focus on a basic jurisdictional question why should directors, rather than just shareholders, have a veto on whether to sell the company? One advantage of that the board of directors has in responding to an offer to buy the company lies in the boards ability to take coordinated action, in contrast to the atomistic response of individual stockholders 2) More ambitious goal for a takeover defense is to try to force the acquirer to pay a higher price even if the acquirer presented a non coercive offer for targets shares. 3) Board knows best board may be more knowledgeable or intelligent than most shareholders. b) Can the targets directors oppose a takeover based upon concerns regarding its impact upon the corps creditors, employees, customers, or even the community in general? 1) Unocal as interpreted by Revlon only allows the targets board to look out for parties other than the shareholders to the extent that it would be in the shareholders long range interest to do so, which cannot be the case when the shareholders are cashing out. 2) Number of states have added provisions to their corp statutes explicitly allowing directors to consider constituencies in responding to a takeover bid. 6. Issues Raised by Specific Defenses second prong of Unocal shifts our attention from the justification of the boards taking any action, to an examination of the actions which the target board chose to take. a) Rule Under Unocal, the defensive actions must be reasonable in relationship to the threat posed. In other words, there must be proportionality between the justification and the response. b) Shark Repellent have provoked few, if any, negative judicial reactions. There is typically legislative sanction for article provisions to create staggered terms, to establish super majority voting requirements, and to specify rights of stock. Also, normally the shareholders vote to amend articles to accomplish these defenses, so court is more willing to sustain them. c) Poison Pills have been subject to a number of challenges. 1) Flip over provisions how can one company create an obligation for another corporation to sell its stock at a favorable price. Survivor is liable for the contracts of the previous corporation, but this has never been tested. 2) Flip in and Back end courts outside of DE have reached conflicting results as to whether a corporation can discriminate between its securities holders in this manner. DE has no problem with this discrimination. 3) When to judge Acc to Moran, the time to judge whether a boards use of a poison pill was a proportionate response to a

legitimate threat was after the board decided whether or not to withdraw the poison pill. 4) Proxy the poison pill might not completely block the shareholders ability to sell the company because a prospective acquirer still could launch a proxy contest to elect directors who would redeem the poison pill before a triggering share acquisition terminated the corps redemption option. 5) No Hand has been invalidated by DE because precluding a board from deciding whether to redeem the poison pill securities constituted an infringement on the boards statutory powers to manage the corporation, which could only be done by a provision in the certificate of incorporation. d) Repurchase Provisions DE found a selective self tender to be a proportionate response to a coercive two tier tender offer. Problem lies in the price. If the corp offers the same price offered by the outside bidder, this removes the coercion, since shareholder know that they will not be any worse off by not tendering their stock, even if a majority of shareholders accept the offer. e) Unitrin Test was articulated in the context of a coercive self tender. So long as a defense is not coersive or preclusive, the defense need only be in the range of reasonableness. Whether a defense is within the range of reasonableness depended, in part, upon whether the defense corresponded to the magnitude of the threat. Might also be reasonable if it is the sort of statutorily authorized decision which the board routinely makes in an non takeover context, like doing a repurchase to provide liquidity for shareholders who want it. f) White Knight Attempting to attract a white knight, in and of itself, is not a controversial defense. Problems arise when the targets directors offer various inducements to the white knight. V. MERGERS AND ACQUISITIONS ***** Mergers make A corp and B corp into either A corp, or B corp or AB corp. Impact on: 1. Assets make more $, become more efficient) 2. Liability 3. SH Purpose: Combine business (to LBO Freeze-out

If A survives, it would be liable for B's debts. Leverage buy outs = someone who wants to borrow to buy a business and wants that business to be liable to debts incurred for buying the corp, then that person would merge the two corp and have the merged corp be liable for such debts. Mergers could also be used to kick out SH.

A. Sale of Control a party seeking to acquire a corporation typically will attempt to secure the cooperation of the individuals currently in control of the corporation. This section looks at the legal rules governing the permissibility of payments to those currently in control of a corporation by persons seeking control. 1. The Traditional Rules a) The legal rules governing dealings between a person seeking to acquire control of a corporation, and the individuals currently in control, reflect the interplay of two broad principles: 1) Stockholder one principle is that a stockholder traditionally has little fiduciary when acting solely as a shareholder. Following this principle, courts hold, as a general rule, that stockholders can sell their shares at whatever price a buyer will pay, and if a buyer will pay more for a controlling block than the buyer will pay for minority holdings, the selling stockholder is not obligated to share the premium with other stockholders. 2) Director Directors do have a fiduciary obligation to the corporation and all of the shareholders. This principle is supplemented by two other notions: (a) A controlling shareholder who tells directors what to do will pick up the duties of a director (b) A person who aids in the breach of a duty by corporate fiduciaries can become liable for the results of this aid. This principle leads to four limitations on the ability of those currently in control of a corporation to extract compensation for their cooperation with a person who seeks to acquire control (see b-e) b) Sale to looters one limitation on the right to transfer control arises if the person who acquires control loots the corporation (misappropriates the corporations assets). In this event, the person who sold a controlling block of stock to the looter, or otherwise helped the looter gain control of the corporation, can be liable for damages the corporation sustains as a result of the looting. 1) Question what obligation did the seller of a controlling block of shares have to check out the buyer to make sure they are not a looter? Several approaches to answer this question: (a) One extreme the rule could be that sellers will not be liable unless they know the buyer plans to loot. (b) Other extreme a few courts suggest that the seller has a duty to investigate a buyer even in the absence of any reason for suspicion. (c) Most courts take an intermediate approach under which the liability of the seller will depend upon whether facts came to the sellers attention which should have alerted the seller of the need for further investigation. Facts that could make the seller suspicous include the prior history of the buyer, the nature of

the corporations assets, and the nature of the sale itself. 2) Question what conduct constitutes looting? Misappropriation of assets. (a) When one takes the corporations assets and gives nothing in return. (b) A controlling stockholder cannot dispose of his controlling stock to outsiders without having to account to the corporation for profits when the sale necessarily results in a sacrifice to the corporation and unusual profit to the controlling shareholder who caused the sacrifice. c) Sale of Directorships second limitation on the ability to cooperate with a party seeking control over a corporation involves the sale of directorships. 1) Issue It is quite common, following the sale of a controlling block of stock for the corporations current directors to resign serially from the board and appoint the buyers nominees, one at a time, to fill the vacancies. 2) Difficulty looks like the sale of a corporate office by its current holder. Or, might appear to be an empty formality to require the buyer of controlling stock to call a shareholders meeting to replace the directors when the replacement of the current directors at the meeting would be a foregone conclusion. 3) Many courts have allowed a seriatim replacement of directors at the behest of a person purchasing a controlling block of stock. 4) How much stock must change hands in order to allow seriatim replacement of directors? (a) Majority should be enough, since then we know that the buyer normally has the bores to replace the directors at a special shareholders meeting. (b) Many courts have been willing to go below 50 percent threshold if the court is convinced that the buyer purchased sufficient stock to give working control in view of the high dispersion of the remaining shareholdings. d) Side Contracts with the Buyer 1) Situation many times a party seeking to acquire a corporation wishes to retain the services of the corporations key personnel or ensure that key personnel remain available for consulting and do not go into competition with the corp. 2) Issue a party acquiring a corporation often will enter into employment, consulting, or non competition agreements with some or all of the corporations current officers and directors. 3) Rule it will be a breach of the directors fiduciary duty if what the parties call an employment or consulting agreement is really a bribe to directors for selling out the shareholders interest while negotiating the sale of the corporation. e) Usurping an Opportunity last limitation on transfers of control has

less acceptance among the courts than the limitations discussed so far. 1) Situation arises when a court might view the sale of a controlling block of stock at a premium price, which is not also available to minority shareholders, to constitute the usurpation of an opportunity which otherwise would have been available, directly or indirectly to all of the shareholders. 2) Brown condemned this action as a breach of fiduciary duty. Not all courts have accepted this rule. 3) DE reasoned that shareholders have the right to vote their shares selfishly. 2. Proposals to Require Equal Treatment courts have not adopted a rule requiring controlling shareholders to share the profits they obtain in a transfer of control. B. Freeze outs 1. Purposes and Policy a) Contexts The desire of majority shareholders to force minority shareholders out of the corporation can arise in either of two contexts: 1) It can occur in a situation in which the majority and minority shareholders coexisted for sometime as owners of the corporation, but, for one reason or another, the majority has become dissatisfied with such co-existence. 2) Majority shareholder might have planned before becoming the majority shareholder, a two step acquisition of the corporation: (a) First step is to purchase enough stock to become the majority shareholder and (b) Second step is to eliminate any minority ownership b) Why would a majority shareholder might wish to force out a minority? 1) Increase return first motivation for removing minority stockholders is to increase the majoritys return by removing other claimants to a share of the corporations future income. Majority will argue that the minority is getting a free ride on increased value based on the majoritys actions. 2) Option contract another rationale involves treating stock ownership as subject to a sort of option contract allowing the majority to call the interest of minority. Corporation commonly issues classes of stock pursuant to article provisions which give the corporation the right to redeem stock. Allows corps to force holder to sell shares back to the corp when a freeze out is in the financial interest of the corp. 2. Mechanisms several methods exist to force out unwilling minority shareholders. a) Dissolve can dissolve the corporation and transfer its operating assets to the majority shareholders (or to a new corporation formed by the majority shareholders) and transfer cash to the minority shareholders as a part of the liquidation. b) Reverse Stock split the corp can undertake a reverse stock split in a

sufficiently large ratio so that none of the minority stockholders end up entitled to more than a fraction of a share. c) Freeze out Merger this is most popular freeze out technique is through a merger in which the plan of merger calls for the minority shareholders to receive cash from the surviving corporation in exchange for surrendering their shares. 1) Where maj shareholder is a corp then the freeze out merger can be between the majority and the susidiary. 2) Where maj shareholder is an indiv or parent does not want to assume the subsidiarys liabilities the maj can set up a corporation just for the freeze out merger. The maj shareholder can transfer the majority of the stock in the previously existing corp to the new corp in exchange for all the stock of the new corp. Then, the new corp can merge with the previously existing corp under a plan in which the shareholders of the new corp end up with all of the sotck of the surviving corp and the shareholders of the previously existing corp can receive cash or other securities. d) Authority Do statutes really provide authority for transactions whose purpose is to cash out an unwilling minority? 1) Dissolution courts typically viewed dissolution statutes as not allowing the freeze out. (a) Some courts have allowed majority shareholders to avoid this problem by having the corporation first sell all its assets to the majority shareholders for cash or securities and then distribute the cash or securities to all shareholders. (b) Some courts hold that any transaction which results in the continuation of the business unchanged except for the elimination of the minority is simply not a dissolution within the meaning of the statutory provisions authorizing corporate dissolution. 2) Merger courts have come to view merger statutes as authorizing freeze outs. Most corp statutes now allow merger plans to force shareholders to surrender their stock for cash or other property. (a) CA sought to curb the use of merger statutes to freeze out minority shareholders who have a combined ownership of more than 10 percent. 3. Judicial Review based upon Fiduciary Duty and Appraisal Rights (or protections for SH) a) Minority shareholders were left with two protections under state corporate law against losing stock in exchange for a pittance: 1) Suits for breach of fiduciary duty 2) Appraisal rights b) Appraisal Rights shareholders who dissent from a merger may demand that the corp cash them out at a fair price set by a judicially supervised appraisal. 1) Remedy minority shareholders have viewed appraisal rights as

not providing an entirely satisfactory remedy against a freeze out because of the exacting procedural requirements and the traditionally conservative valuation. 2) Valuation court is ultimately going to set a so called fair value for the stock based upon a bunch of expert witnesses hired to take extreme positions. c) Breach claims since many minority shareholders think appraisal rights are not satisfactory, they bring claims for breach of fiduciary duty. In response, majority shareholders often attempt to use appraisal rights provisions as a barrier to, rather than a protection for, complaining shareholders. 1) The proponent of the freeze out merger will argue that appraisal rights are the exclusive remedy for shareholders who wish to challenge a merger. 2) Thus, minority shareholders are precluded from challenging the minoritys forced removal on the ground that the merger constitutes a breach of fiduciary duty. Under state law for lawsuit for breach of duty, disinterested directors who are involved are subject to BJR. For freeze out, fairness test applies unless there is disinterested director approval. (usually, people in freeze out argue that price offered for shares is too low and thus unfair) People usually don't bring suit of appraisal rights and bring FD claims because they can get corp involved and have class action lawsuit going and thus cutting down costs. Under Fed law, can bring a misrepresentation suit, since it involves purchase of shares, as long as a lie is implicated. d) Are appraisal rights the exclusive remedy? 1) One extreme opinions holding that the appraisal provisions preclude any challenge to a merger, unless there is a failure to comply with statutory requirements or if there are misrepresentations. 2) Short of this extreme states differ: (a) CA makes appraisal the exclusive remedy for a shareholder challenging an arms length merger, but not for a shareholder challenging a merger with a controlling shareholder. Thus, appraisal rights would not preclude challenges to freeze out mergers in CA. (b) NY focus on the relief requested. The appraisal provision bars an action unless the action seeks primarily an equitable remedy, rather than money damages. (c) DE mixed CA and NY and added discretion. DE approach seems to be that appraisal rights are the exclusive remedy for those seeking damages, unless the court feels like appraisal rights should not be exclusive.

e) Differences between a suit for breach of fiduciary duty and appraisal rights 1) Allows a more generous measure of damages to reach a larger group of pl instead of measuring damages based upon the difference between what the minority shareholders received in the merger, and the value of the minoritys stock at the time of the merger, the court might award damages based upon the difference between what the minority shareholders received and the value of the stock at the time of the damage award (recissory damages). 2) Suit for breach potentially allows the court to examine a broader range of facts than would be relevant in an appraisal proceeding since a freeze out merger is a c/I transaction, the starting poit of a fiduciary duty analysis is that majority shareholders, barring some sort of disinterested approval, must show that the transaction is fair to the minority. (a) What is fair in a freeze out merger? Basic division among courts is those which require a business purpose for removal of the minority and those which do not. After a review (or lack of review, based on jn) of a business purpose, DE evaluates whether fair dealing and fair price existed. (b) Disclosure the court did not create a general obligation for majority shareholders to disclose the highest price it would be worthwhile for the majority to pay the frozen out minority shareholders. (c) Hardball tactic DE refused to treat the use of hardball tactics as, in and of itself, unfair and upheld one merger based upon proof that the price was fair. Thus, if the price was fair, the merger would be upheld. (d) Policy enforcing a duty of candor might push majority shareholders into paying a price closer to what they really feel the minoritys stock is worthl Control premium people will pay more than market share price in order to gain control of the company. Essay and multiple choice. Mult choice is comprehensive. Essay, may be fall but will mostly be Spring. One big essay but broken into 4 parts. Organization is not going to be to challenging. 6 precise subquestions. One hour and 45 min essay. Read b thru d before you start a. Multiple choice is closed book. 3 min per question. Essay is open book.

Office hours tues. and wed. around 10:30 till 3:30. Respond to email. Can also phone.