Business Organizations



Business Organizations

Summary of Handouts on Agency:

▪ Principal is bound by those contracts he actually authorizes AND those he has by word or conduct apparently authorized the agent to negotiate.

▪ Partnership is founded on the agency of the partners.

▪ Each partner is an agent of the partnership & has the authority to represent and bind the partnership in all usual transactions pertaining to the partnership business.

▪ A corporation—an artificial legal entity—must function through the agency of its officers and employees.

▪ Agency is primarily governed by state common law.

▪ Employer-employee vs. independent contractor ( a person who hires an IC does not have the right to control the physical conduct and activities.

▪ Restatement: Section 15 Agency is a consensual relationship that may be formed by contract or agreement b/w P and A; restatement requires “manifestation by P to A that A on his account & consent to act by A”

▪ Restatement: Section 16: Where agency is created w/o consideration, it can be terminated w/o liability on the part of either party.

▪ A = fiduciary

▪ Although A has the power to exceed his actual authority and as such binds P, he did violate his duty of obedience and is liable to P for any loss sustained as a result of his acting in excess of his actual authority

▪ Rules:

o Disclosed P and 3P are contractually bound if the agent acts w/in actual or apparent authority

o Partially disclosed P and 3P are contractually bound if agent acts w/in actual or apparent authority

o Undisclosed P and 3P are contractually bound if A acts w/in actual authority unless (1) P is excluded by terms of the contract; (2) Ps existence is fraudulently concealed.

o No P is contractually bound to 3P if A acts w/o any authority unless a disclosed/partially disclosed P ratifies.

▪ Valid ratification is irrevocable.

▪ Ps are generally not liable for tortious acts of independent contractors b/c there is no element of control. However, tortious and unauthorized misrepresentations can be imputed to P if the misrepresentation by the independent contractor or non employee agent if it was apparently authorized.

Murphy v. Holiday Inns, Inc. (1975)

▪ Murphy sued HI for injury sustained while she was a guest (tort negligence action: duty, breach, injury in fact, proximate cause). HI argued that they had no relationship w/the hotel, only licensed them w/the name.

▪ One element of agency: continuous subjection to the will of the P

▪ Rule: franchise agreement/contract does not insulate parties from agency relationship: element to look at is control; did HI have it? No. the agreement provided for standardization, but not control over how Betsy Lynn operated/priced/hired or fired employees, etc. & therefore the franchise agreement did not give HI control over the defendant hotel.

▪ Holding: regulatory provisions of the franchise contract did not constitute control w/in the definition of agency.

Massey v. Tube Art Display, Inc.(1976)

▪ Massey brought action against TAD who hired an independent contractor to dig a whole; contractor inadvertently caused an explosion, killed 2.

▪ Trial court found agency relationship b/w TAD and contractor.

▪ To find agency b/w P and contractor:

o Extent of control; whether the one employed is engaged in a distinct occupation or business; the kind of occupation; the skill required to do the occupation; whether the employer or the workman supplies the equipment; length of time employed; method of payment (by time, or by the job); if the work is part of the regular business of the employer; if P is in the business; if they believe they are creating a master-servant relationship.

▪ Court found that TAD did control (controlled area to be dug, etc.); agency existed = liability.

FW Myers & Company v. Hunter Farms (1982)

▪ Hunter sued Myers for not advising him properly; court found that Myers had no notice of Hunter’s need for special advice & as such was not under a duty to provide him w/anything more.

▪ Rule: A is subject to a duty to use reasonable efforts to give his P information which is relevant to affairs entrusted to him and which, as the A has notice, the P would desire to have and which can be communicated w/o violating a superior duty to a 3P.

Detroit Lions, Inc. v. Argovitz (1984)

▪ Argovitz, holder of interest in a member club, acted as the contracting agent or representative for Simms ( against the USFL rules; breach of fiduciary duty; conflict of interest ( Result: contract b/w Simms and Gamblers invalid.

Hilgendorf v. Hague

▪ Hil wrongfully terminated listing agreement before the designated term; Hil had power to terminate, but not the right. Hague owed no duty to release the agreement b/c the agency contract established that both were working for themselves.

▪ Hague: to show damages ( that he produced a willing and able buyer; that he would have sold the parcel during the term; that he would have made a commission ( commission is used to measure damages.

▪ Court ruled for Hague.

▪ You don’t need to establish a business entity to do business; you do need a business permit though. Why?

o Government’s get revenue (you have to pay for the permit); regulation; permits become like licenses; safety; consumer protection; standard of care; monitoring/tracking business (tax purposes –businesses are taxed on sales, income, and profit); zoning (ex: commercial or industrial next to residential zoning).

▪ Types of business entity:

o Limited liability corporation – a new entity; attempt to give business the benefits of partnership and corporation law w/o the detriments.

o Limited liability partnership

o S corporation

o C corporation

o Sole proprietorship: single owner; owner has complete responsibility and liability; a permit is necessary, but there is no filing requirement to register this type of entity.

▪ Can you have a corporation w/one owner? Yes.

▪ Can you have a one owner LLC? Yes.

▪ Can you have a one owner partnership? No. (but you can have a one person partnership if the other partner is a corporation owned by the original owner; but the corporation is legally considered a “person”)

▪ The government does not require that you be one of these entities to do business. There are some requirements (ex: professional entity such as an association of lawyers may be restricted to certain types of entities such as no limited liability corporations). So, why would you pick any one of these entities when you start a business? Some of the entities allow you to limit your liability; taxation; how much involvement you want to have in the business.

▪ Agency: is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control.

o Not really a legal entity

o It is the foundation for doing business regardless of what type of entity you are; it is a means of multiplying your effort (

▪ Elements of Agency:

o consensual relationship in which one person, to one degree or another, acts as a representative of or otherwise acts on behalf of another person w/power to affect the legal rights and duties of the other person.

o Only the interactions that are w/in the scope of the agency affect the principal’s legal position.

o Common law definition ( the agent holds power (encompasses authority but is broader)

o Concept of power is neutral ( states a result but not the justification for the result.

o An agent who has actual authority holds power as a result of a voluntary conferral by the principal & is privileged to exercise that power

o An agent has the power to affect P through the operation of apparent authority

o The P and A retain separate legal personalities.

o It is not an agency unless the A consents to act on behalf of P and P has the right throughout the duration of the relationship to control A’s acts.

o Reason for holding P accountable ( P has ability to select & control agent & to terminate the agency relationship + the agent has specifically agreed expressly or implicitly to act on P’s behalf.

o

Hypo: JB, broker, contracted to buy Dawn’s land (possible oil site) and agreed to a restrictive covenant not to drill; JB turned around and contracted w/TX, oil company. JB wasn’t expressly hired by TX as an agent; TX made an announcement asking for brokers to bring them deals

▪ Dawn would have to argue:

o Requisites for agency: implied authority of Joe Bob; JB acted under that authority & as a consequence is an agent of TX

o Apparent authority: there is an agency relationship and there is an appearance from a 3P point of view that the agent has the authority to act on the principals’ behalf; this apparent authority rests w/the actions/conduct of the principal ( the principal is responsible for the appearance of apparent authority.

▪ EX: if the principal knows that A is acting beyond the scope of his authority in dealing w/3Ps but refuses to correct or make the overstep of authority known to the 3Ps, then the principal may be responsible to the 3P b/c he has allowed the agent to have the apparent authority

• But, 3P often has an affirmative duty to inquire into the actual or apparent authority of the agent.

o Express authority: authority that is given by express agreement, written or verbal instruction/agreement.

o Was there ratification: if TX paid JB the commission

o Implied authority: he is a real estate broker & the custom to deal verbally

o If there was no agency relationship established b/w JB and TX, can Dawn argue that there was an agency relationship b/w her and JB? There are dual agents which owe a duty to both parties (intermediaries or broker type agents). In this sort of situation, JB has a duty not to defraud or misrepresent in his dealings w/Dawn. The problem in finding the dual agency relationship is that there is no consent and Dawn doesn’t consent to the agency relationship; plus, the fact that JB was working for an undisclosed principal, Dawn wouldn’t be able to consent to the dual agency relationship.

o This was an undisclosed agency and A was perpetuating a fraud and knowingly misrepresented his relationship w/TX.

o Types of agency relationships:

▪ Undisclosed: Agent acts as if he were the principal; he is liable to the 3P; this type of relationship may be riding on the line of misrepresentation or fraud.

▪ Partially disclosed: A says that he is an agent, but doesn’t tell who he is agent for; P is still liable to the 3P; A may be liable to 3P but may be able to seek indemnification from P.

▪ Disclosed: Agent says that he is working on behalf of a principal to a third party; this is the best situation in terms of holding P liable to the 3P. in this instance, if Dawn doesn’t like P, then she knows not to deal w/A. The 3P cannot hold the A liable for the contract, can only recover from P.

▪ Third party

▪ Agent

o Dawn can’t sue TX under contract law, but may be able to sue under agency law (unless she can’t prove misrepresentation, in which case JB would be working alone as a principal who buys to sell to others at a profit).

o Dawn can sue JB b/c he misrepresented his relationship; also, she contracted to sell the land to JB with a restrictive covenant attached. JB is a party to the contract and if he breaches the contract, then he can be sued.

o Dawn may be able to argue agency by estoppel (equitable remedy)

▪ A person not otherwise liable as a party to a transaction purported to be done on her account is subject to liability to persons who have changed their position b/c of their belief and reliance that the transportation was entered into by or for her if:

o She/he intentionally or carelessly caused such belief or

o Knowing of such belief and that the others might rely and change their position b/c of it, she/he did not take reasonable steps to notify them of the facts.

▪ TX could argue:

o They were not a party to the contract ( no privity; can’t be sued

o There was no written agency agreement (you cannot assume an agency relationship)

o There needs to be an express agreement to deal w/real property

o TX may argue that Dawn can’t sue b/c the action isn’t one in which relief can be granted: there are no stated damages… how can she really win if she wouldn’t suffer any real damages.

o The funny thing about agency law and agency relationships is that if the deal is rich, the principal will argue FOR the agency relationship to restrict the agent’s ability to gain profits, etc., but if the deal isn’t rich, then the principal will argue AGAINST the agency relationship to avoid liability, etc.

▪ Joe Bob could argue:

o If JB went to TX w/the deal and TX refused to pay the commission, then there wouldn’t be ratification and JB would be a mere broker and would have to put his fee w/in the deal ( no agency relationship.

o But, JB may be able to sue TX for breach of the agency agreement (the verbal agreement to pay the commission if the broker brings the deal ( there was implied authorization to contract on TX’s behalf). Just b/c principals renege on a deal doesn’t mean the agent is left out in the cold; he still has recourse and is due restitution or compensation for the services he conducted on the principal’s behalf.

o JB could argue that he wasn’t acting as an agent: he was going to buy from Dawn and make a huge mark-up selling to TX ( this may skirt around the agency problem. If TX argues that JB can’t mark up too high b/c there is an agency agreement, JB could argue that there was no consideration or actual consent to the agency relationship.

o JB may be able to sue TX for indemnification if the agency relationship is established. (principle of agency law: the principal owes the agent indemnification, reimbursement, and compensation).

o Side note: you may be a partner w/someone even if the intention to enter into a partnership is completely lacking.

Agency Relationship based on Tort Law

▪ A hires B to run errand; B hits C. C can sue B. C can sue A if there is an agency relationship and B is acting w/in his authority during the scope of the authority for A. Independent contractors, however, are not necessarily non-agents. It depends on the level of control; the consensual relationship.

▪ ABC: Assent, benefit and control.

▪ A is liable if he has a non delegable duty (hiring someone to carry dynamite or toxic chemicals)

▪ When is A not liable for an employee’s tort? When the tort is intentional and not ratified or authorized or when the employee’s tort occurred outside the scope of his employment (frolic and detour)

Summary

▪ Relationship b/w principal and agent, ideally, is a contractual one. (real estate agency, retainer arrangements w/lawyers ( express agency relationships)

▪ What is different about agency is that contract law historically limited the authority of parties to those that had privity of contract making it difficult to hold a principal liable to a 3P if he wasn’t a party to the contract; so, agency is essentially an expansion of contract law.

▪ Basis of agency law: codified state statutes, common law.

▪ Authority: the key concept in agency law.

▪ Restatement: says that an agency is a fiduciary relationship ( highest duty/standard; it is a consensual relationship, often contractual. One exception is the independent contractor relationship.

▪ General agent; special agent

▪ Power of attorney: limited or special agency arrangement.

▪ Inherent authority: the authority to do the things necessary to complete your job as an agent.

▪ Agencies can be granted by written, spoken, or conduct indicating intention to enter into an agency agreement.

▪ Termination can be done at will by either party so long as there is notice given; compensation and reimbursement is given; the agent has a duty not to terminate the relationship in a manner that would be financially detrimental to the P, etc.

▪ What happens if the agent dies before the job is done? Is the agency relationship terminated? Yes. But, there are some lingering agency effects that may be still enforceable.

Quiz:

Moe messed up and gave Lisa some really bad and totally incorrect advice, the result of which cost Lisa $500 million. Moe is in a business w/ Curly and Larry. Curly and Larry go to you to ask for legal advice.

1) list the strategies they could use to limit their liability/exposure.

a. LLP: partnership assets would be fair game but the personal assets would probably be protected and they would probably avoid personal liability.

b. LLC: Entity created by one or more members who, after proper filing w/secretary of state, enjoy general limited personal liability for any LLC debt or liability whether arising in tort, contract or otherwise. Members are personally liable for their own torts or personal guarantees. It has the same powers as corporations to conduct business, own its own property, etc.

c. S corporation: Formed under state laws in which the incorporators have filed articles of incorporation, an initial report, and an affidavit signed by the agent for service of process accepting appointment as a registered agent. Must have at least one shareholder, a board of directors who govern the entity, a president, and one other officer. May have by-laws; capital and credit usually limited to the resources of the shareholders.

d. Shareholders generally have limited liability; they acquire shares of stock usually evidenced by stock certificates. They elect the board of directors who in turn elect the officers who then employ servants and other agents of the corporation; May have perpetual existence. Allows a “flow through” of profits and losses to the shareholders, thus avoiding a tax on the corporation as an entity; tax regulations require that the shareholders be US citizens or resident aliens; no more than 35 shareholders are allowed; it is subject to state franchise taxes. Close corporation: one w/articles, by laws, and shareholder agreements designed to create a partnership type owner/manager structure internally w/the limited liability of corporate shareholders and w/special limitations on the transferability of shares (this is what makes a close corporation). This corporation is an S one for tax purposes.

e. Is this a partnership?

i. “A partnership is a juridical person, distinct from its partners, created by contract b/w two or more persons to combine their efforts or resources in determined proportions and to collaborate at mutual risk for their common profit or commercial benefit”

ii. In LA, it is a legal entity that must sue and be sued in its own name. The entity owns its own property and assets, incurs its own liabilities, and continues to exist even if there is a complete change in the persons of the partners by substitution of new partners

iii. Uniform Partnership Act: partnership is not an entity but rather an aggregate of members

iv. Revised Uniform Partnership Act: partnership is an entity

v. LSA requires a contract b/w 2+ (including legal persons such as corporations, etc) to combine their efforts in determined proportions (if none is stated the law presumes equal ones) and to collaborate at mutual risk (sharing losses) for their common profit or commercial benefit (profit sharing as principals).

vi. Partnership contract doesn’t have to be in writing unless the entity as such is to own real estate.

vii. Majority rule is the norm for ordinary operations; unless otherwise stipulated; unanimity required to amend the agreement unless otherwise stipulated.

viii. It is primarily liable for its own debts.

1. LA: each partner is secondarily liable

2. Common law: partners are either jointly liable or jointly and severally liable for partnership obligations; liability is imposed b/c of the status as partner and is strict and vicarious; silent or dormant partners are also held liable.

ix. Termination of the entity can also occur by unanimous consent by partners, judgment of termination; bankruptcy; in LA, clear distinction b/w partner’s cessation of membership and the termination of the entity; member can cease to be partner w/o terminating the entity.

f. UPA: determining the existence of a partnership:

i. Joint tenancy, tenancy in common, etc. does not of itself mean there is a partnership.

g. So ( one strategy is to say that there was not a partnership. How would the court determine that issue?

i. Three criteria (Cutler case: how are profits shared; how are liabilities or losses distributed? How much decision making capability does each partner have?)

h. What do you think Curly, Larry, and Moe were doing? How were they operating?

i. They could argue that they weren’t operating a partnership.

ii. Moe was the general partner w/all of the decision making ability & the other ones were more like employees.

iii. You could argue also that the business invested in real estate and did not operate on consulting or advising how to invest; this argument would advocate that Moe was acting outside the scope of the partnership.

i. Class Notes: Partnerships: bind partners on each other as agents in the ordinary course of business; so, if B enters a contract, both the partnership and the other partners (as well as B) are liable. In a partnership there is usually double liable: both the partnership and the partners are liable. Under the old rule (common law), A and B were jointly and severally liable for torts and breaches of trust. Louisiana has followed the concept of liability on the basis of verile share (means that if there are 2 partners, each one is liable for 50%, etc.). Under the Revised Uniform Partnership Act, each partner is jointly and severally liable for everything: some states have made changes; So, basically, each partner is risking their fishing boat: when you are personally liable, they can come after your stuff. This is why we have LLC so that only the partnership is liable.

j.

2) Would it matter if they dissolved the business?

a. You cannot dissolve your liability by dissolving the business; so, it depends on whether the partnership was in place during the time of the event/tort, etc.

b. What if you just joined the partnership( you could argue that you weren’t a partner during the time the liability was incurred, but you may be accepting that liability for going into the partnership? Article 17: incoming partners are liable except that his liability is only his verile share amount (percentage of the partnership assigned to him based on his percentage of work/profits, etc.) Maybe not b/c they weren’t agents of the partnership when the tort took place. What about outgoing partners, are they personally liable? They are still held liable

3) What if they were a close corporation?

a. Paradigmatic publicly held corporation; no restrictions on shareholder numbers or status or on the transferability of shares; shares may be divided into different classes of shares or common stock; unlimited access to the capital markets subject to securities laws.

b. Generally has the greatest stability of any business organization b/c it will not terminate and financially will continue as a success or will be merged or consolidated w/another corporation.

c. Must pay federal and state income taxes at the entity level: no “flow through” characteristics. Must also pay corporate tax ( “double taxation phenomenon”.

d. A close corporation is not publicly traded.

e. Here, you avoid the liability of a partnership b/c you are not a partnership, you are a corporation; liability is taken only from the corporation assets.

f. As a practical matter, banks won’t lend money unless someone personally signs.

g. So, could incorporation avoid personal liability? Piercing the corporate veil ( courts do this when there is a co-mingling of funds; interspacing personal funds; avoiding corporate formalities; undercapitalization (hiding/funneling/laundering assets making sure that the corporation doesn’t have enough assets to fulfill its obligations).[bankruptcy laws protect shareholders] Single act, largest corporate liability ( Exxon Valdese. So, when do corporate veils get hit? ( the small corporations (9 or less shareholders) that are undercapitalized or don’t follow corporate formalities are the ones that get pierced by the court.

4) Why would anyone want to be a partner? The extent of profit is generally larger. (but you can also have full distribution to the owners of the corporation; so the profits can still be passed on ( that’s why we have LLC) You are not doubly taxed and you typically have more decision making ability. Historically, we didn’t allow professional services to limit personal liability ( that is contrary to public policy to limit professional liability ( why do we hold professionals to a higher standard ( type of relationship held b/w the professional and the client.

a. If the partnership agreement is silent on the issue, the profits are shared equally.

b. Losses follow profits ( so, if the profits are equally distributed, then the losses would be distributed equally; if the profits are distributed equally, then neither are the losses.

c. Never assume that a partnership is or is not in existence. You have to test it! You may have intent and not be partners (if the elements of the partnership aren’t met: ex: profits weren’t made) ; you may not have the intent to be a partnership and be found to be a partnership.

d. General vs. limited partners

e. Limited partner: person who agrees upfront that they’re going to look like a shareholder; they’ll be liable for their personal contribution ( downside is that he won’t fully participate in the profits. There has to be a limited partnership established by state statute (you have to file); each limited partnership has at least one general partner. LLPs look like a shareholder agreement.

f. 1986 tax reform act: tax write offs: you can be a silent partner in ventures that have tax benefits;

5) What should Plaintiff cite to hold the partners liable? Ex: what if

a. Article 15: all partners are liable jointly and severably

Partnership—UPA [71-89]

Girard Bank v. Haley (1975)

▪ §31 UPA: Dissolution of a partnership is caused by the “express will of any partner”; the expression of that will need not be supported by justification. At-will dissolution does not violate the partnership agreement if there is no definite term or particular undertaking pending.

▪ Issue: Does Reid’s letter expressing at-will dissolution violate the partnership agreement?

▪ Holding: NO.

Dreifuerst v. Dreifuerst (1979)

Limited Partnerships

▪ Definition:

o Partnership formed by 2+ persons under the laws of a state and having one or more general partners. “Person” includes a natural person, partnership, limited partnership, or corporation. It differs from a general partnership b/c:

▪ There must be a statute in effect providing for the formation of limited partnerships;

▪ The limited partnership must substantially comply w/the requirements of such statute.

▪ The liability of a limited partner for partnership debts or obligations is limited to the extent of the capital which he has contributed or agreed to contribute.

▪ You should be careful not to do, as a limited partner, what a general partner would/could do; if you do, then you will be liable for more than you signed on to be responsible for. Limited partners are held responsible beyond their capital contribution by operation of law if/when they look like a general partner [participate in management; provide services at general partnership level, etc.]. Key: CONTROL and ACTIVITY. General partners are jointly and severally & personally liable.

o Who has the burden of proving the limited partner is acting as a general partner? [banks, sources of capital would generally be those persons trying to hold limited partners as general partners]

o Why would someone take the risk of being a general partner? General partners can use other peoples’ money to create the business.

o Historically, corporations weren’t allowed to be the general partner b/c someone needed to be at risk/responsible for the borrowing/management of lenders’ money.

▪ General partners have authority to bind the partnership as to ordinary matters. RULPA §403. Limited partners have voting authority over specified matters, but cannot bind the partnership. RULPA §302.

▪ Created pursuant to state statute [more akin to corporation than it is to partnership; on the other hand, every partnership requires a general partner, so you still have to know about general partnership]

▪ A general partner cannot transfer his interest unless all the other general and limited partners agree or the partnership agreement permits it. RULPA §401.

▪ Limited partner interests are freely assignable. RULPA §702.

▪ Limited and general partners can assign their rights to profits and distributions. RULPA §703.

▪ Limited partnerships are attractive b/c they look like shareholders: liability is generally limited to their investment in the venture. So, unlike the term “partner”, limited partners liability is similar to the liability of shareholders in corporations [you do have to look to the documentation of how the partnership is created; some limited partnership contracts/agreements include clauses (common in real estate limited partnerships) that extend the liability of the limited partner.

▪ Limited partnership had tax advantages; used in real estate, oil and gas, motion pictures, and research and development; after the tax reform diminished the huge tax advantages, they became less frequently used for those purposes, but nevertheless, there are advantages to organizing your business as a limited partnership rather than as a corporation.

▪

The Corporate Form

Hypo: Client comes to you and wants to start a recording company; she asks you if it is a good idea to incorporate.

▪ Pros:

1. Corporations give greater flexibility for management of the venture ( it can borrow money; accept investments from prospective shareholders; it can use funds generated internally by its business [corporate earnings].

2. It would be a publicly held enterprise ( lots of people can invest: growth may be easier to achieve.

3. Continuity of legal existence ( legal existence of a corporation is perpetual, unless a shorter term is stated in the certificate of incorporation. As a result, a corporation is relatively secure against early termination.

4. Limited liability ( shareholders are not personally liable for corporate obligations. Shareholders have limited liability. The managers of a corporation are also normally not personally liable for corporate obligations: as long as corporate managers act on the corporation’s behalf and w/in their authority, they are treated like agents, not principals, for liability purposes.

5. Free transferability ( ownership [equity] interests in the corporation—represented by shares of stock—are freely transferable.

6. Centralized management ( under the corporate statutes, a corporation is normally managed by or under the direction of a board of directors, and a shareholder as such has no right to participate in management.

7. Entity status ( corporation is a legal entity; it can exercise power and have rights in its own name.

8. The corporation can use funds generated internally by its business; the corporation can borrow money—debt financing.

9. The corporation can issue shares of stock [equity financing]; shareholders pay the corporation for their shares [common and preferred stock].

10. Start up corporations can take advantage of equity financing, debt financing and corporate earnings.

11. Personal liability can be distant from business liability; personal taxes can be distant from business taxes.

12. Small, closely held corporations (no more than 75 shareholders, no more than one class of stock, no non-resident alien shareholders) enjoy the S corporation tax advantage: flow through entity.

▪ Cons:

1. 5th amendment does not apply to corporations.

How do you incorporate?

( Does the limited liability of corporations allow for shareholders and participants to be dishonest, etc.

( Corporations allow people to invest in potentially illegal/harmful activities for profit w/o the liability.

(

6.22 Liability of Shareholders [p662 supp]

▪ unless the articles of incorporation provide otherwise, shares may be issued pro rata and w/o consideration to the corporation’s shareholders or to the shareholders of one or more classes or series. An issuance of shares under this subsection is a share dividend.

▪ shares of one class or series may not be issued as a share dividend in respect of shares of another class or series unless (1) the articles of incorporation so authorize, (2) a majority of the votes entitled to be cast by the class or series to be issued approve the issue, or (3) there are no outstanding shares of the class or series to be issued.

▪ if the board of directors does not fix the record date for determining shareholders entitled to a share dividend, it is the date the board of directors authorizes the share dividend.

• Corporate law is a shell box for dealing w/corporate entities; each state has their own specific state statutes dealing w/corporations. This class deals w/the revised model business corporations act. To be successful in this class you have to know the UPA, Restatement 2nd of Agency, and the Revised Model Business Corporations Act ( use this on the exam in great detail, you have to master these 3 statutes to pass the exam. The issues reflected w/in these statutes will, of course, come up. There is some case law, but this is a statutorily driven exercise. You need to outline and memorize these statutes.

Page 169.

▪ For several reasons, the courts do not like to mess with business. The subjects that fall w/in the corporate law box is held similar to “private” areas. (analogous to courts not liking to get into domestic disputes) Now, if you go outside the box and injure some third party, then you get into the tort law realm and that is typically where the courts will come in. So, it is important to learn what is IN the corporate law box.

Things included in the corporate box:

▪ State for corporation statute + RMBCA

▪ Articles of Incorporation

o Contract b/w shareholders of corporation

▪ By-laws

o Board of directors owe a fiduciary duty to the corporation, not the shareholders! We’re talking about power games here.

o Business judgment rule: if a director makes the wrong decision, it is covered by this rule; we permit directors to make mistakes (can’t sue or remove a director for making a mistake; mistakes don’t constitute fraud or misrepresentation).

▪ Federal securities laws

o Whoever has the right to vote the shareholders weight has the power.

▪ Judicial decisions

o Schnell-Blasius standards, for example

Schnell v. Chris-Craft Industries, Inc. (1971)

▪ Courts view board manipulation of the voting process during a pending voting context as inequitable—a presumptive breach of fiduciary duty.

▪ Courts have invalidated board manipulation:

o The board cannot advance the annual meeting date if it would burden insurgents in a pending proxy context.

▪ This is an appeal from a denial from the court of Chancery (why is the court of chancery taking this case? B/c of the equity situation b/w shareholders and corporations; this is court of equity and they are seeking equitable relief; they’re seeking equitable relief in form of injunction on the basis voting rights/annual meeting date. The management wanted to advance the date of the annual shareholders meeting (why would they want to do this? Certainly it is for their own interest, in this case, possibly to avoid the mobilization of dissent among shareholders…they don’t want to be voted out of their position).

▪ Most shareholders don’t vote their own share; usually they give their share to management to vote; dissent shareholders not wanting to give their share to management would threaten the management officers.

▪ When the by laws of a corporations designate date of annual meeting of the shareholders it is to be expected that those who intend to contest the reelection of incumbent management will gear their campaign to the by law date. It is not to be expected that management will attempt to advance that date in order to obtain an inequitable advantage in the contest….an inequitable action does not become permissible simply because it is legally possible.

▪ Note: this is the Supreme Court of Delaware deciding this case: Delaware is on the forefront in the development of corporate law.

Blasius Industries, Inc. v Atlas Corp (1988)

▪ Rule:

o “Unless the board can articulate a “compelling justification” for its action, courts intervene to protect “established principles of corporate democracy.”

▪ What are the director’s duties?

o To perform the directorship. You can perform in a lousy manner and not be held liable, but if you don’t perform at all, then the “business judgment rule” won’t shield from liability on negligence actions.

Hypo: Question 4 on old exam

1) Failure to attend a meeting is not per se negligible; unless, it is an EXTREMELY important meeting. If director admits that he didn’t care about going to the meetings; this, in a sense, may be an element of breach of obligation to perform in good faith…. But at the same time, there needs to be some showing of damages in order to have actionable damages. Occupying position of director is accepting a post of confidence ( charged w/an active duty to learn whether the company was moving to production, etc.

The Duty of Care/Business Judgment Rule [520-569]

Francis v. United Jersey Bank (1981)

▪ Issue: is a corporate director personally liable in negligence for failure to prevent the misappropriation of trust funds by other directors who were also officers and shareholders of the corporation?

▪ The shareholders are suing Mrs. Pritchard’s estate for the money fraudulently conveyed by her sons; the money was trust money (Pritchard was a reinsurer). The sons were the ones who embezzled the money, but this case is in court b/c the company filed for bankruptcy; the only person who has money to satisfy the suit is the dead Mrs. Pritchard (they’re suing her estate—which, consequently will affect the actual embezzlers in terms of inheritance, etc.).

▪ The shareholders are suing for negligence, which if proven (Court held that it was proven) would strip her of insulation from personal liability and the Business Judgment rule, which protects a director from liability due to mistake.

▪ Mrs. P was a director but took little interest in the financial affairs; didn’t review any financial statements, which would’ve clearly shown misappropriation of funds ( she “should have realized”. She had a duty to deter the depredation of the other directors (her sons); she breached that duty & caused the damages [court had to find proximate cause & negligence]

RMBCA Subchapter C §8.30 §8.31 (highlighted points)

▪ Director shall act (1) in good faith; (2) in a manner he reasonably believes to be in the best interests of the corp.

▪ Director can rely on others for information if they are officers/employees he reasonably believes are competent; legal counsel hired by the corp.; committee of directors of which he is not a member

o “Reasonable person in like circumstance” standard ( duty of care.

▪ §8.30 sets forth the standards of conduct for directors by focusing on the MANNER in which they perform their duties, NOT on the correctness of the decisions made.

Duty of Care/D&O Ins. [569-598]

The duty to ensure that the corporation has effective internal controls

In re Caremark International Inc. Derivative Litigation (1996)

▪ Caremark (subject to federal investigation in which they plead guilty to 1 felony making them liable for $250 million) sued to recover those losses from the individual defendants (board of directors of the corporation).

▪ Suit by shareholders claimed that directors breached their duty of care by failing to supervise the conduct of Caremark’s employees which made the company subject to fines and liability (they weren’t supposed to pay for referrals and recommendations, but some employees did anyway). Everyone wanted to reach a settlement on the issue: Caremark plead guilty to mail fraud, paid huge fine, and in return was allowed to continue to participate w/Medicare and Medicade programs. The board of directors approved the settlement; none were charged w/wrongdoing

▪ Rules:

o Potential liability for directoral decisions: Director liability for a breach of the duty to exercise appropriate attention may arise by: (1) a board decision that results in a loss b/c that decision was ill advised or “negligent;” and (2) an unconsidered failure of the board to act in circumstances in which due attention would have prevented the loss.

o Liability for failure to monitor: director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that a failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance w/applicable legal standards (proximate cause would have to be found, of course).

▪ Court found no real significant evidence that the directors were guilty of a sustained failure to exercise their oversight function: no breach of duty of care found.

Note on Corporate Criminal Liability

▪ 18 USCA §3553: corporation found guilty of a crime may be sentenced to a fine, probation, or both; sentencing guidelines use a scoring system; the corporation starts w/a score of 5 which is then increased upward by aggravating factors or decreased by mitigating ones (this sets the standard for how much of the base fine the company will be responsible for)

▪ Part of the board’s responsibility is oversight of the corporation’s policies and procedures regarding compliance w/law, etc.; board of directors should be confident that the code of conduct is distributed and adhered to, that the procedures are monitored and enforced

▪ Internal Control: (defined by Committee of Sponsoring Organizations, COSO) a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in effectiveness and efficiency of operations, reliability of financial reporting, and compliance w/applicable laws and regulations.” 5 components: control environment, risk assessment, control activities, information and communication, and monitoring: all 5 have to be functioning effectively to have an effective system.

▪ Reasons why internal control is the board’s responsibility ( (1) asymmetric information: decision making depends on the information provided to the decision-makers therefore it is imperative that the board monitors the practices, etc. to ensure that they are receiving correct and adequate information on which they will base their decisions affecting the success of the company. (2) managerial opportunism: managers are often short-tenured, are in the position to deflect blame, and face opportunity w/low risk to profit greatly by bending/breaking regulations.

Note on civil liability of directors to 3rd persons

▪ Director may be civilly liable to 3rd persons for acts he commits in a corporate capacity. Officers are agents of the corporation, so tortious activities done under the corporate cloak are not shielded from personal liability.

Limits on Liability

RMBCA §2.02(b)(4) ( states that the articles of incorporation may set forth a provision eliminating or limiting the liability of a director to the corporation or its shareholders for money damages for any action taken, or any failure to take any action, as a director except liability for the amount of a financial benefit received by a director to which he is not entitled; an intentional infliction of harm on the corporation or its shareholders; a violation of section 8.33 or an intentional violation of criminal law.

Director’s and Officer’s Liability Insurance (D&O Ins.)

▪ This type of insurance protects against liability and legal expenses; technically it is indemnification insurance b/c it doesn’t require the insurer to defend and the insurer’s obligations do not accrue until the claim is settled or adjudicated.

▪ 2 separate insurance agreements: (1) Corporate reimbursement: assures against potential liability to officers under their right to indemnification from the corporation; (2)Personal coverage: insures the officers against losses based on claims against them for wrongful conduct when they are not indemnified for the loss by the corporation.

▪ D&O does NOT render directors completely risk free regarding claims based on duty of care (there are a lot of claims that are excluded from coverage); the policy has coverage limits; insurance is written on a “claims made” basis—insurance applies to, but only to, claims made while the policy is in force; D&O insurers are often willing to litigate the enforceability of their policy: simply not filling out the questionnaires accurately may be enough to render the policy ineffective.

Duty to Act Lawfully

Miller v. American Telephone & Telegraph Co. (1974)

▪ Derivative action: for failure of ATT to collect an outstanding debt of $1.5million owned by Democratic National Committee; claimed breach of duty to exercise diligence which effectively afforded a preference to DNC; claim asked for injunction to collect on the debt, to stop providing services until the debt was collected.

▪ DC dismissed complaint for failure to state a claim for which relief could be granted (court said collection procedures were w/in discretion of directors whose decisions could not be overturned by the court absent allegation that the action was illegal, unreasonable, or a breach of fiduciary duty.

o Business Judgment rule: eschews courts intervention in corporate decision making if the decisions are uninfluenced by personal considerations and exercised in good faith.

▪ Appeals court notes that the allegation of not collecting is potentially an illegal violation of NY law ( federal prohibition against corporate political contributions. Appeals court reversed district court decision; found that directors did violate NY law (remanded, Ps have to show that ATT made a contribution during an election time w/purpose of influencing the election).

Derivative Suit: A suit by a beneficiary of a fiduciary to enforce a right belonging to the fiduciary; esp., a suit asserted by a shareholder on the corporation’s behalf against a third party (usu. A corporate officer) b/c of the corporation’s failure to take some action against the third party. [derivative action/shareholder derivative suit/stockholder derivative suit/representative action]

Appeal de novo: an appeal in which the appellate court uses the trial court’s record but reviews the evidence and law w/o deference to the trial court’s ruling (de novo review)

Corporate definition of “interestedness”: applies only when a director has a material pecuniary interest in a transaction or certain financial or familial relationships to a party to the transaction; this is far from equivalent to questionable impartiality. But, many of the statutes require that a fairness test be applied to the transactions even if they have been approved by “disinterested” directors (California); some require that the approval be given in good faith (Delaware); the Model rules only hold that a self-interested transaction is not “automatically” voidable, which just means that it is still subject to examination (disclosure, etc). The test the plaintiffs must satisfy is that the “disinterested directors could not have reasonably believed the transaction to be fair to the corporation.”

Duty of Loyalty [598-637]

▪ It was the rule that contracts b/w any director and the corporation was void regardless of approval by a board of disinterested directors. Rationale: when contract is made w/1 of the directors, the rest are placed in the position of having to check the transactions and accounts of one of their own body w/whom they are associated w/at same level of management.

▪ Rule was abandoned, replaced w/approval by disinterested majority of the board.

▪ Rationale: technical definition of trustee: director (sort of like trustee) ( a director who abstained from representing the corporation but dealt in his personal capacity w/a majority of disinterested directors ~ to trustee dealing w/the cestui que trust [if there is full disclosure and no unfair advantage].

▪ Now: contracts b/w director and corporation is not automatically voidable at the suit of a shareholder, whether there was a disinterested majority of the board or not ( BUT

▪ Courts use rigid and careful scrutiny when reviewing the contract in question.

▪ “Fairness” requires not only that the terms of a self-interested transaction be fair, but that entering into the transaction, even on fair terms, is in the corporation’s interest.

▪ Associate of director and senior executives: these are enterprises w/which the director has a significant relationship. These types of transactions can also pose conflicts of interest. How do you appropriate a remedy where the director only received part of the gain? Damages equal to the gain are appropriate b/c D violated his duty and the harm resulted from that breach. But, what if the A (associate) knew or should have known that D was breaching his duty when transacting? Should A be liable, too? If A knew or should have known, he may be liable under the principles of restitution, if liability is required to prevent

▪ Exam Question #4(3)( Director wants to purchase for himself a competing product that he believes will do well. The issue here is one of fiduciary duty.

▪ We have a self-interested transaction (conflict of interest) b/c the director will personally benefit. Not all conflicts of interest are illegal or unfair. One test to use is to determine if it is fair or in the best interest of the corporation. The conflict of interest can be permissible if:

i. It is ratified by board of directors

ii. After full disclosure

iii. W/o the participation of the interested director

▪ The test is whether the conflicting interest is UNFAIR to the corporation.

▪ What may happen during litigation if you have a conflicting interest transaction is that the shareholders will probably complain (they would probably claim corporate waste). But, if the director can show that it was disclosed and approved, and that it was fair, then the director will be off the hook.

▪ Note: a closely held corporation is like a partnership (this is something you should be wary of getting into b/c it can turn into a bad marriage: something that you can’t get out of later).

▪ Shareholders expect loyalty: this means no cheating and no unauthorized self-dealing.

▪ Judicial review ( fiduciary duty. BUT, the mere existence of a fiduciary duty doesn’t mean a violation of that duty. The fiduciary duty makes interested transactions suspect (but not automatically illegal).

▪ Ratification:

▪ Corporation took the benefit of the transaction

▪ Board can ratify subsequent to the transaction

▪ Shareholders can ratify a conflicting transaction.

▪ Summary/Need to know stuff:

▪ Need to identify self-interested transactions.

▪ Rationale for director fiduciary duty is trust law & agency law.

▪ Rule: no unauthorized self-dealings that are unfair to the corporation.

▪ Historical prohibition: historically, we had it right( directors can’t have a beneficial interest in a transaction b/w you and the corporation. BTW you can write that rule into the by-laws and hold the director of your corporation to a higher standard.

▪ Remedies for breach: fiduciary duty law is the law of chancery (equity)( restitution (disgorging profits); injunctions; constructive trust; but, we don’t necessarily penalize for breach of duty other than taking the ill-gotten gains, so in a way, this promotes the risk taking.

Lewis v. S.L. & E., Inc. (1980)

▪ Intra-family dispute over the management of 2 closely-held affiliated corporations. Donald charged that his brothers had wasted the assets of SLE by causing SLE to lease business premises to LGT; Court found that D couldn’t prove waste; awarded atty fees to defendants and specific performance to LGT (Donald had agreed to sell his SLE stock to LGT)

o Defendants ( Alan, Leon, Richard Lewis (Donald’s brothers; Donald appeals the judgment against him; Donald was a shareholder in SL&E; the brothers are the directors of SLE and officers, directors and shareholders of LGT

o Plaintiff ( Lewis General Tires (LGT)

▪ Father, principal stockholder in both companies gave his SLE stock to his children; upon receipt of the stock, they had to enter a stockholder agreement which mandated that if the recipients were not shareholders in LGT, they would have to sell their SLE stock to LGT for book value. LGT “rented” property from SLE; when its lease expired, no talk of a new lease was mentioned; LGT continued to rent at the old lease price;

o The LGT directors (also directors for SLE) operated as if SLE existed for the sole benefit of LGT; directors disregarded the fact that SLE had shareholders who were not shareholders of LGT and therefore couldn’t profit form actions that used SLE solely for the benefit of LGT.

▪ Appeals court found that district court erred in determining that Donald had the burden of proof to show waste; held that directors had to show that their actions were fair and reasonable.

o Note: Business Judgment rule places a heavy burden on shareholders who would attack corporate transactions; BUT, the BJR assumes that the directors have no conflict of interest, so, when a shareholder attacks a transaction in which the directors have an interest other than as directors of the corporation, the directors cannot escape review of the merits of the transaction.

o NY BCL §713 ( affirmative duty of director to show that transaction was fair and reasonable if there is a conflict of interest.

▪ On appeal, D didn’t have to share his stock to LGT for book value w/o the upward adjustment owed.

Remedies for the Violation of Duty of Loyalty

▪ Traditionally restitutionary (repay/relinquish the ill-gotten gains; also called disgorging profits).

o Ex: when director engages in improper self-dealing, remedy is rescission or an accounting for the difference b/w contract and fair price.

o Ex: when officer improperly appropriates a corporate opportunity, remedy is constructive trust in corporation’s favor.

▪ Sometimes courts have held that the officer who violates the duty of fair dealing may be required to repay any salary he earned during the relevant period.

▪ Punitive damages are sometimes available at court’s discretion wherever there has been proof of “fraud”: anything calculated to deceive, including all acts, omissions, and concealments involving a breach of legal or equitable duty, trust, or confidence justly reposed, resulting in damage to another.

▪ ALI, Principles of Corp. Governance, §7.18(d): officers normally required to pay the atty fees and other expenses incurred by corp. in establishing violation.

Talbot v. James (1972)

▪ Equitable action; Talbot sued James individually and as director/president of CA for an accounting; alleged that James violated fiduciary duty to corporation and stockholders by diverting specific funds to himself.

▪ Talbot and James set up corporation; T’s contribution was the land; consideration was 50% of stock; James would get the other half for his efforts in constructing/planning, etc. of the apartments.

▪ Issue: could James, who was a stockholder, officer, and director, enter into a contract w/himself as an individual and make a profit therefrom from himself? Was the fiduciary duty violated?

o Corporation passed resolution authorizing borrowing $850,700. Contract price was significantly less; James paid himself over $25K for the deal and claimed that he was entitled to the money. The contract made individually was not disclosed as such to the other officers.

▪ Officers and directors of the corporation stand in a fiduciary relationship to the individual stockholders and in every instance must make a full disclosure of all relevant facts when entering into a contract w/said corporation.

o Rationale: to prevent directors from using their positions to their own advantage and to the detriment of stockholders/corporation.

o The burden of proof to show that the disclosure had been made rests w/defendant; James failed to show that the disclosure of his entitlement fee was made. This was exacerbated by the fact that James refused to make an accounting or show them the records of where the disbursement of the mortgage money went.

▪ Equity court remanded and reversed; judgment: disgorge profits ($25k)

▪ Dissent argued that James’ work should have been compensated (he acted more like a general contractor); and if the corporation should recover from James it should only be the amount of his actual profit ($2k) which accounts for his overhead expenses ($23k).

RMBCA §8.60-8.63 ( Also known as Subchapter F: Directors’ Conflicting Interest Transactions

▪ Deals w/conflicts only

▪ Only applicable if there is a “transaction”

o Definition includes negotiations or a consensual bilateral arrangement b/w the corporation and another party or parties that concern their respective and differing economic rights or interests—not simply a unilateral action by the corporation but rather a “deal.”

▪ Deals w/directors only.

▪ Definition of “Conflicting interest” requires that D know of the transaction; & his knowledge of the transaction at the time of the corp. commitment to that transaction; i.e. routine transactions of a large corporation may not be known to the director and thus will not fit the knowledge requirement necessary to satisfy “conflicting interest” definition.

o 3 conflicting interests:

▪ if the transaction is b/w D and X Co. (the personal economic stake of the director must be in or closely linked to the transaction; contingent or remote gain is not enough to give rise to conflicting interest; standard used is “would reasonably be expected to exert an influence”( objective standard)

▪ if the transaction involves a “related person” to D

▪ if the transaction contains conflicting interest of D through economic involvement of certain other persons (any other entity of which D is a director, agent, employee, etc)

o once the director’s “interest” is present, “conflict” is assumed.

▪ To constitute “transaction” ( it must be by the corporation, its subsidiary, or controlled entity in which the director has a financial interest. If there is no transaction, the rule doesn’t apply no matter how apparent the director’s conflicting interest. “transaction” is limited to action by the corporation itself.

Cookies Food Products v. Lakes Warehouse (1988)

▪ Shareholders brought suit majority shareholder; alleged that he breached fiduciary duty by executing “self-dealing” contracts, fraudulently misappropriated and converted corporate funds.

▪ Reason for bringing suit ( shareholders discontent b/c they are/were precluded from sharing in Cookies’ financial success b/c it is a Closely-held corporation and b/c it has not paid dividends. So, the shareholders are quibbling about H being compensated for his efforts at making the company successful, while they have to sit and wait for the corporation to pay dividends.

o Closely-held means that the shareholders have no ready access to buyers for their stock at current values that reflect the company’s success

o Dividends not being paid means that the shareholders have no method of realizing a return on their investment in the company. BUT, dividends CANNOT be paid until the Small Business Loan is repaid (which wasn’t paid until a month prior to bring suit)

▪ Facts:

o Cookies executed exclusive distribution agreement w/Lakes, which markedly improved sales; the agreement was amended accordingly to accommodate the increased sales, etc. giving Lakes more profit, allowing for advertising costs, etc.

o In 1981, majority shareholder (Cook) decided to sell his interest in Cookies, gave board 1st opportunity to buy; board didn’t buy; Herrig (Lakes) bought the stock, offered $10 for shares (over market value), which made him the majority shareholder. After H acquired majority control he replaced 4 of the 5 member board w/those he selected (created a division b/w him and the minority shareholders).

o Under H’s control, the distribution agreement was extended (the agreement was the same one used while 4 of the plaintiffs in the case were directors before)

o H assumed position as product developer in addition to his roles as director and distributor. (created a dispute as to the royalties he would receive)

▪ Claim: Shareholders claim that H negotiated the agreements w/o disclosing to them the amount of profits he would be making; they demand an accounting, his removal, the sale of the company, etc. Argue that the deal shouldn’t just be “fair price” but that director (as fiduciary) has to show the fairness of the bargain to the interests of the corporation.

▪ Court held (affirmed lower court) that:

o 1. distribution agreement was the key to the growth and success of the corp.

o 2. warehouse agreement was fair ( storage at “going rate” + board had considered and rejected building its own warehouse determining that renting would be cheaper

o 3. taco sauce royalty was appropriate

o 4. the consult fee was fair, reasonable and deserved compensation

▪ Rule to remember (Iowa law, RMBCA, Rowen v. LeMars Mut. Ins Co. of Iowa)

o ( Corporate directors and officers may under proper circumstances transact business w/the corporation including the purchase or sale of property, but it must be done in the strictest of good faith and with full disclosure of the facts to, and the consent of, all concerned.

o ( No transaction shall be void … if (1) the fact of the relationship/interest is disclosed or known to the board of directors or committee which authorizes, approves, or ratifies the contract/transaction…w/o counting the votes…such interested director; (2) the fact of the relationship/interest is disclosed or known to the shareholders entitled to vote and they authorize…such contract or transaction by vote or written consent (shareholders do not owe a fiduciary duty; a shareholder can have a conflicting interest and still vote); (3) the transaction was fair and reasonable to the corporation.

▪ Dissent argued that H didn’t show the actual “going rate” or market value of his services but that he tried to win his case based on the success of the company which doesn’t adequately reflect his “duty” and the fairness of the transactions to the stockholders.

Sidenote: Shareholders do not have a fiduciary duty; a shareholder who is in a conflicting interest situation, he can still vote.

Waste, Use of Corporate Assets [637-697]

▪ §6.24, §8.11

o Directors determine the price of shares; they determine the amount of compensation they get as well.

o “rights” are like options

▪ the law has a problem for issuing services for receipt of stock; you can do it, but there is an issue of fairness.

▪ Option to buy stock as part of compensation; ex: option to buy at $40, but the market rate is $30. Right now the option isn’t worth very much, but director can justify the option b/c by your services/buying the stock, you increased the value of the stock.

o Exam question: director going to get $13 million in salary and stock option worth $100 million.

▪ Issue: allegation of waste of corporate assets

▪ Issue: self-dealing: get out of this by approval and disclosure to disinterested board.

Lewis v. Vogelstein (1997)

▪ Shareholders suit challenged stock option compensation plan for the directors of Mattel, Inc. which was approved and ratified by the shareholders.

▪ Shareholders claimed that the proxy statements were misleading and incomplete; claim asserts that the directors had a duty to disclose the present value of future options as estimated by some option pricing formula.

▪ SH claim that b/c the transaction was self-interested, all of the directors who qualified under the plan had to justify it as “entirely fair” in order to avoid liability for breach of loyalty.

▪ Holding: didn’t breach duty by not disclosing

▪ Rules:

o Where shareholder ratification of a plan of option compensation is involved, the duty of disclosure is satisfied by the disclosure or fair summary of all of the relevant terms and conditions of the proposed plan of compensation, together w/any material extrinsic fact w/in the board’s knowledge bearing on the issue.

o Directors’ fiduciary duty of disclosure does not mandate that the board disclose one or more estimates of present value of options that may be granted under the plan…. But in no case is there an established rule that such disclosure of estimates has been mandated to satisfy directors’ fiduciary duty.

▪ So, absent allegation of intentional manipulation, Ps claim doesn’t stand or assert a claim for which relief can be granted.

▪ The reality is that courts only seldom overturn the compensation of senior executives in publicly held corporations if the compensation has been approved by disinterested directors.

▪ To state a cognizable claim for waste where there is no contention that the directors were interested or that shareholder ratification was improperly obtained, the well-pleaded allegations of the complaint must support the conclusion that “no person of ordinary, sound business judgment would say that the consideration received for the options was a fair exchange for the options granted.”

Note on Compensation Litigation

▪ It is difficult to successfully challenge executive compensation in publicly held corporations when the compensation has been approved by disinterested directors or disinterested shareholders.

▪ Courts often hold executive compensation to be unreasonable in close corporations:

o In close corporations, executive compensation usually is not approved by either disinterested directors/disinterested shareholders

o In close corporations, executive compensation is likely to involve a very significant fraction of the corporation’s earnings—often, half or more.

▪ Cases arise in taxation issues: except in S corporations, compensation paid to a corporate executive is a deductible expense, while a dividend paid to a shareholder is not; accordingly, the payment of compensation reduces the corporation’s taxable income, and therefore its taxes, while the payment of dividends does not. But, in close corporations, the same persons are typically both managers and shareholders so the money shouldn’t be treated the same way (flow-through or not) so that they would generally prefer to take the money out in terms of compensation rather than dividends b/c it reduces company’s taxable income. IRS regularly challenges compensation in close corporations as unreasonable & courts often agree w/it.

Non-qualified (nonstatutory) stock options: means a right granted to one or more employees or executives by a corporation (or by a parent or subsidiary corporation) to acquire shares of the corporations’ stock (or stock of a parent/subsidiary).

▪ Neither the options nor the shares issued upon exercise of the options satisfy the criteria of, or “qualify” for, the special, and generally favorable, income tax treatment provided under the Code for incentive stock options.

▪ Stock options are an important part of the compensation and incentive program of a corporation. By obtaining the right to acquire an equity interest in the corporation, whether at a discount or at market value, the executive acquires a stake in the long-term growth of the corporation, benefits from the capital appreciation of the corporation’s stock, and presumably will work diligently for the success of the venture.

Incentive stock option: stock acquired pursuant to ISO is not subject to federal income tax either at the time of grant of the option or at the time of exercise (if all the requirements are met); stock acquired cannot be disposed of until at least 2 years has elapsed since the option was granted, and one year has lapsed since the stock was acquired by the employee pursuant to exercise of the option.

Stock appreciation right: the right to be paid an amount equal to the increase in value or spread b/w the value (or a fraction of the value) of a share of employer stock on the date the SAR is granted and the value (or fraction of the value) of the share on the date the SAR is exercised; distinguished from “phantom stock” b/c SARs are usually granted in tandem or in conjunction w/another right, usually a stock option, and SARs generally don’t include (as phantom stock) a right to receive the value of dividends payable on the underlying stock while the SAR is outstanding.

▪ Principal advantage( permit the executive to realize the appreciation in the value of employer stock w/o making an investment, or provide cash w/which to pay taxes on exercise of non-qualified stock options; the employer is entitled to a tax deduction at the time of and equal to the amount the executive receives pursuant to the exercise of the SARs.

Phantom stock: any form of long-term executive incentive arrangement using units that are equivalent to, but are not, actual shares of employer stock; so, these plans might provide outright grants of phantom “shares” or options based on phantom stock.

Restricted stock: it is capital stock, generally the common stock of an employer, issued pursuant to a plan or agreement to an executive in connection with the performance of services to the employer; the shares may be issued w/o cost or for a nominal price; ownership is subject to certain conditions/”restrictions”; “vesting” is generally contingent upon the executive’s continued employment for a certain period; the stock may vest ratably over a period of time, or nonratably, according to a prearranged schedule; usually the plan requires the forfeiture of unvested shares upon the participant’s termination of employment during the restriction period.

Hawaiian International Finances, Inc. v. Pablo (1971)

▪ Issue: can a corporate officer and director, acting for the corporation in the purchase of investment real estate, retain a commission received from the real estate brokers representing the sellers, absent disclosure and an agreement with the corporation?

▪ Rules:

o A director, while engaged in a transaction for his corporation, can’t retain an undisclosed profit.

o The contention of ultra vires does not lie in the mouth of a corporate officer claiming the profits of a transaction for himself.

Northeast Harbor Golf Club, Inc. v. Harris (1995)

▪ Harris, director of golf club purchased land adjacent to the course in her own name w/o disclosing first to the board; she promised she would not develop the land. Later, she did plan to develop. Directors filed suit alleging breach of fiduciary duty by purchasing the lots w/o giving notice/opportunity to the corporation.

▪ Court found that Harris hadn’t usurped a corporate opportunity b/c the acquisition of real estate wasn’t in the Club’s line of business; the corporation lacked the financial ability to purchase the real estate at issue; relied on Harris’ good faith.

Sale of Control [697-767]

▪ Common voting stock: shareholders have a voice into the operations of the corporation

▪ Extraordinary things like the sale of assets, the sale of the company, etc. the shareholders will vote on, but they will vote on these things usually after the directors have voted on the issues.

▪ Proxies exist across the board. Proxies give someone else the right to vote for you; it may take the form of an authorization or it may be permission for someone else to vote how they want. It happens in both small and big corporations.

o Question: can a director give another director their proxy? No. directors don’t have to be at a meeting to vote (voting can be done by written, circulated vote), but we generally don’t allow directors to give other directors their proxy b/c it appears to be contradictory to the duties directors have to direct.

o Important things to remember: NOTICE, Quorum ( these are nit-picky rules that can make all the difference in the world. What constitutes a quorum? What do the rules say? When does the count, count? Does a quorum fail if the person walks out of the meeting? You need to know and be very attentive to the rules (some of those rules are in the articles of incorporation, or in the by-laws, or haven’t been written yet)

o Sometimes, the person who controls the proxies, controls the vote.

▪ In a closely held corporation and there are 3 shareholders w/1 vote each, then any one person who gets the proxy of another will always win (unless the proxy tells the person how to vote). That is the power of a proxy. That is why we don’t allow people to sell their votes; we are concerned about things that look like a pay-off for voting certain ways. It is less obvious, but more important in publicly traded corporations.

• Why is so important to solicit proxies in a publicly traded corporation?

o Whoever has all the proxies has the outcome they want.

• The process of soliciting proxies is that in order to solicit in a publicly traded corporation, you have to follow federal regulations. One of the rules is that you have to give notice and information as to why you are soliciting others’ proxy. The corporate law requires that there be an annual shareholders’ meeting (that’s a lot of people….how would you have a meeting for all the shareholders of ATT??.... directors have to come up with a record date and notice has to be given w/in 6 weeks of the meeting date: (1) board establishes a date of record to determine what shareholders are qualified to vote on the meeting date; (2)federal laws require directors to give an annual financial report to the shareholders; (3) solicitation of proxy w/proxy statement. [soliciting: (1) you will authorize me to vote on your behalf ; (2) you will allow me to hire/re-hire accounting firm; (3) any other business that comes before the shareholder meeting] The majority of shareholders don’t even know what they own b/c they own what they own through mutual funds and 401K plans-( they rely on investment companies to control their assets, so sometimes the investment companies own the proxies (and you may have given them rights to that proxy when you sign up w/that sort of institution).

• The process can be daunting and some large companies hire solicitors to collect and process the proxies.

• Can you rescind your proxy?? Yes.

o If the solicitor lies on the proxy statement, the shareholder can sue (this is a federal security law—disclosure)

Shareholder Informational Rights and Proxy Voting [264-337]

▪ Shareholder: includes a beneficial owner whose shares are held in a voting trust or by a nominee on his behalf.

▪ Record owners: persons listed as shareholders on the corporation’s records; rights are conferred on record owners, not beneficial owners (example: only record owners have the right to notice of a meeting and the right to vote)

▪ Beneficial owners: persons who actually own shares

▪ Record date: reason ( b/c in publicly held corporations the shareholders are always changing so sometimes those entitled to vote may not receive notice; so, corporations are allowed to create a cut off date for voting called the record date.

▪ Street name shares ( shares registered in the name of a bank or broker; or bank nominee name ( this is the most common way of registering your stock b/c it expedites stock transfers and subsequent re-registration

▪ Depository: holder of record for the majority of shares in the market (there are 4 major ones); the number of shares held by the depositories represents more than 70% of all shares outstanding in the US

▪ Inspection rights require shareholders to take affirmative action and incur costs to obtain information; the Securities Exchange Act, applicable to corporations that have at least 500 record holders of a class of equity securities requires the corporation to report certain information to all shareholders w/o specific shareholder requests. §16.20 solves the problem for the smaller ones or the ones not covered by the SEC ( it requires that every corporation must furnish to its shareholders annual financial statements, including a balance sheet and an income statement.

▪ Capital Markets and the Corporation

o Advantages of corporation ( (1) ownership can be transferred more quickly and easily; (2) money can be raised more readily

o Primary market: the original sale of securities by governments and corporations. The corporation is the seller and the transaction raises money for the corporation. There are 2 types: public offerings (selling securities to the general public) and private placements (negotiated sale involving a specific buyer). Public offerings have to be registered w/SEC which requires a great deal of disclosure on part of the corporation. Private placements don’t have to be registered w/SEC.

o Secondary market: those in which the securities are bought and sold after the original sale. Involves one or more creditor selling to another.

o Dealer vs. Auction markets: Dealer markets are called OTCs (over the counter); today many dealers are connected electronically. Auction markets have a physical location; anyone who wants to buy or sell can do so in an auction market—that is the purpose.

▪ New York Stock Exchange (NYSE) is an auction market which accounts for more than 85% of all the shares traded in auction markets.

▪ American Stock Exchange (AMEX) and Pacific Stock Exchange are other auction markets.

▪ National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system (Nasdaq); this is an OTC market. Usually the companies in the dealer market are smaller and trade less actively w/a couple of exceptions such as Microsoft and Intel.

o Listing: in order to be listed, the firm must meet certain standards (# of shareholders, etc.). NYSE has the most stringent listing requirements (company has to have a market value for its publicly held shares of at least $18 million and a total of 2000 shareholders w/at least 100 shares each.)

▪ SEC: function is to administer federal securities laws and issue rules and regulations to provide protection for investors and to ensure that the securities markets are fair and honest (by promoting adequate and effective disclosure of information to the investing public). The commission (5 members) is appointed by President for a 5 year term; not more than 3 may be of the same political party. Required disclosure is sometimes called structured disclosure b/c what must be disclosed and how it must be disclosed is structured by the relevant SEC rules.

Security First Corp. v. US Die Casting and Development Co (1997)

▪ Rule:

o A shareholder may demonstrate a proper demand for the production of corporate books and records upon a showing, by the preponderance of the evidence, that there exists a credible basis to find probably corporate wrongdoing.

o The stockholder need not actually prove the wrongdoing itself by a preponderance of the evidence.

The Proxy Rules

▪ Proxy holder: a person authorized to vote shares on a shareholder’s behalf.

▪ Proxy, form of proxy: the written instrument in which such an authorization is embodied.

▪ Proxy solicitation: the process by which shareholders are asked to give their proxies.

▪ Proxy statement: a written statement sent to shareholders as a means of proxy solicitation.

▪ Proxy materials: the proxy statement and form of proxy.

▪ Proxy voting is the dominant mode of decision making in publicly held corporations. SEC now regulates proxy solicitation. Importance of the rules: to require full transactional disclosure

JI Case Co. v. Borak (1964)

▪ Court held that a shareholder could bring a private action for violation of the Proxy Rules.

Wyandotte v. US (1967)

▪ Court held that criminal liability was inadequate to ensure the full effectiveness of the statute which Congress intended; civil actions to seek remedy are proper.

Mills v. Electric Auto-Lite Co (1970)

▪ Issue: is there an implied private right of action for violation of the proxy rules in the SEC as established by Borak?

▪ Petitioners charged that the proxy statements were misleading; it didn’t inform them of the huge conflict of interest. Board (and lower courts) argued/held that if the merger was fair to the shareholders, then the deficient proxy wouldn’t matter, but this would mean that a “judicial appraisal of the merger’s merits could be substituted for the actual and informed vote of the stockholders”—a holding that would frustrate Congress’ intentions.

▪ R: where there has been a finding of materiality, a shareholder has made a sufficient showing of causal relationship if he proves that the proxy solicitation itself, rather than the particular defect in the solicitation materials, was an essential link in the accomplishment of the transaction.

▪ “materiality” TSC Industries v. Northway, Inc (1976): an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

Notes/Rules:

▪ Mills:

o A materially false or misleading proxy statement must be deemed to be the cause of a shareholder vote the proxy statement solicits; shareholder needs to do nothing more than prove causation than to prove materiality.

▪ Borak & Mills:

o Shareholders have standing to bring an action under Rule 14a-9, which prohibits false or misleading proxy statements.

The Proxy Rules: Shareholder Proposals

▪ No-action letters: letter stating that if the shareholder proposal is omitted, no action will be taken by the SEC. SEC sends this letter after management sends statement of reasons to SEC explaining why it believes a shareholder proposal should be excluded from the proxy statement. ( basically, the letters implicitly threaten legal action if management omits the shareholder proposal.

▪ Rule 14a-8(c)(7): exempts proposals relating to the conduct of “ordinary business operations” from inclusion in proxy materials. (management tries to use this rule to omit shareholder proposals).

▪ Common-benefit rule: permits a prevailing party to obtain reimbursement of attorney’s fees “in cases where litigation has conferred a substantial benefit on the members of an ascertainable class” and where it is possible to spread the costs proportionately among the members of the class. (Mills)

The Proxy Contests

▪ Courts have held that management may look to the corporate treasury for the reasonable expenses of soliciting proxies to defend its position in a bona fide policy contest.

▪ In a contest over policy, as compared to a purely personal power contest, corporate directors have the right to make reasonable and proper expenditures, subject to the scrutiny of the courts when duly challenged, from the corporate treasury for the purpose of persuading the stockholders of the correctness of their position and soliciting their support for policies which the directors believe, in all good faith, are in the best interests of the corporation.

Special Problems of Close Corporations

▪ Generally: close corporation is one whose shares are held by a relatively small number of persons; it resembles the partnership b/c of this, courts look to partnership law to rule on cases dealing with these types of corporations.

▪ Aspects of partnership law:

1. Contractual in nature; UPA and RUPA operate absent agreement by the partners

2. internal governance:

3. authority: any partner has power to bind partnership on a matter of ordinary course of business

4. distributive shares: profits shared per capita, no partner entitled to salary.

5. transferability: no one can be a member w/o the consent of all the partners.

6. term: limited term; dissolution is easy

7. fiduciary duties: partners stand in fiduciary relationship

8. liability: partners are individually liable for partnership’s obligations

▪ Aspects of corporation law:

1. authority: shareholders have no right to participate in the management & no authority to bind the corporation

2. distributive shares: corporate distributions are not shared per capita, but in proportion to stock ownership

3. transferability: shares of stock and shareholder status are freely transferable.

4. term: perpetual term; dissolution is relatively difficult

5. fiduciary duties: shareholders do not stand in a direct fiduciary relationship to each other

6. liability: shareholders are not individually liable for a corporation’s obligations

Donahue v. Rodd Electrotype Co. (1975)

▪ D and R were the major players in the corporation; R owned 80%, D the rest; when R retired, there a board meeting to buy his shares at $800 a share; when D learned of this, she wanted the same opportunity to sell her shares to the corporation, but it gave her a much lower rate of $200 a share.

▪ D alleged the distribution of corporate assets to controlling shareholders constituted a breach of fiduciary duty to her as a minority shareholder b/c they/it failed to accord her an equal opportunity to sell her shares to the corporation. R’s claim that the distribution was w/in the corporate powers, met the requirements of good faith and inherent fairness, etc.

▪ This case looks closely at close corporation & notes the similarity b/w it and the partnership: relationship among the stockholders must be one of trust, confidence and absolute loyalty if the enterprise is to succeed.

▪ R: stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another (utmost good faith and loyalty)

▪ R: the rule of equal opportunity in stock purchases by close corporations provides equal access to these benefits for all stockholders.

Special Voting Arrangements at the shareholder level

▪ §7.22 ( an appointment of proxy is revocable unless the appointment form or electronic transmission conspicuously states that it is irrevocable and the appointment is coupled w/an interest.

▪ Voting or pooling agreements: contracts among shareholders concerning the manner in which their shares will be voted. Courts generally hold that voting agreements are normally valid; however, the agreement is invalid if it is based on a “private benefit” (side payment) given by one party to the other in exchange for the vote (principle that a shareholder may not sell his vote).

▪ Proxy coupled w/an interest: the safest way to ensure that a proxy will be irrevocable is to confer it upon a proxyholder who has an “interest” in the shares to which the proxy relates; examples are where the proxy holder is a pledge of the shares, or has agreed to purchase the shares.

▪ Voting trust: a device by which shareholders separate voting rights in, and legal title to, their shares from beneficial ownership, by conferring their voting rights and legal title on one or more voting trustees, while retaining the ultimate right to distributions and appreciation. Usually, 2 or more shareholders are involved so that the voting trust is a type of pooling arrangement.

o It requires:

▪ The execution of a written trust agreement b/w participating shareholders and the voting trustees

▪ A transfer to the trustee, for a specified period, of the shareholders’ stock certificates and the legal title to their stock.

▪ The voting trustee then registers the transfer on the corporations’ books so that during the term of the trust the trustee is the record owner of the shares, entitled to vote in the election of directors and often on other matters as well

▪ In close corporations, voting trusts may sometimes be used, like voting agreements, to allocate voting control in other than a pro rata manner, or to preserve the solidarity of a faction consisting of less than all the shareholders.

▪ Voting trusts/agreements are instruments to control matters decided on a shareholder level (fundamental changes; policies, etc); the management is dealt with by the board.

o In the issue spotting process: if A, B, and C are shareholders and directors and have entered into a voting agreement to vote a certain way & C decides to contradict the agreement that he signed, how might you analyze that situation? If he is voting as a shareholder, he cannot violate the contract. If he is voting as a director, the agreement is not valid. At the directors level the agreement is invalid b/c you cannot place limitations on directorship and management. Fiduciary duty has to come before contractual obligations.

▪ Imagine that A, B, and C make a decision that benefits themselves. But, there are still other constituencies involved that could be hurt by the existence of voting agreements ( creditors, banks, vendors, employees, etc. Thus, you can breach your fiduciary duty to the corporation even if you’ve taken great care of your shareholders.

Galler v. Galler

▪ Issue: are there circumstances where a shareholder agreement limiting the discretion of the board of directors of a close corporation will be upheld?

▪ Yes. We think that special rules, not applicable to a publicly held corporation, should apply to shareholder agreements in a close corporation context.

o A shareholder of a publicly held corporation generally has a ready market for his shares and can sell them if he disagrees with the way management is operating the business. A minority shareholder in a close corporation, however, has no ready market for his shares, and may find himself at the mercy of an oppressive or unknowledgable majority, if he cannot rely on a shareholder agreement to protect his interest.

o In this case, the shareholders of a close corporation are often also the directors and officers of the corporation. Thus, unlike a publicly held corporation, in a close corporation, with the directors and officers often having a major financial interest in the company, it is often impossible to obtain a truly neutral, independent judgment of the board of directors.

o So, agreements where no minority shareholder is prejudiced, there is no fraud or injury to a corporate creditor or the public, and no clearly prohibitory statutory language is violated by their enforcement are going to be upheld.

▪ Analysis:

o The SC adopts the modern view that close corporations are special entities requiring special rules that may differ from the regular rules applicable to a publicly held corporation. Public investors typically expect that the board they elect will exercise its best independent business judgment. Shareholders in a close corporation generally recognize that there will be a blurring of the lines b/w the shareholders, the board, and the corporate officers. Understanding that close corporations usually involve “close” personal relationships and that the shareholders of such companies often have their blood, sweat, and tears wrapped up in the business, this court goes out of its way to offer some protection to such shareholders from a potentially oppressive majority. A stockholders’ agreement in a close corporation is usually the result of careful deliberation and negotiation by all of the initial investors. In the absence of a state statutory scheme protecting such shareholders, this court gives the minority shareholder in a close corporation a chance to protect himself, by developing judicial rules that will uphold certain protective agreements where they can be negotiated by the shareholders and no other minority shareholder is prejudiced by their enforcement.

Sutton v. Sutton (NY court of appeals finds it takes a shareholder unanimity to strike a unanimity provision from a corporation’s certificate of incorporation)

▪ F: the controlling shareholders of a closely held corporation sued to compel a minority shareholder/director of the corporation to sign an amendment to the corporation’s certificate of incorporation striking a provision requiring unanimous shareholder approval, including for any amendment of the certificate.

▪ Rule: A unanimity provision of a corporation’s certificate of incorporation may not be amended by a less than unanimous vote of the shareholders of the corporation.

o NY’s corporations statute provides that supermajority provisions (a provision in a corporations’ certificate of incorporation requiring more than the usual fifty percent majority vote to constitute shareholder approval of a corporate resolution) may be amended by a 2/3 vote unless the certificate “specifically” provides otherwise

▪ Analysis:

o As the court in this case notes in going through the history of the statutory provision at issue, traditionally, courts refused to enforce supermajority voting requirements, taking the view that they impeded the basic concept that the will of the majority should govern in a corporate setting. By statute, most states today permit supermajority voting requirements, including provisions of a certificate of incorporation requiring a unanimous vote of the shareholders in order to alter corporate policies. This case shows both sides of the issue. A minority shareholder should be able to protect himself against an oppressive majority. However, a unanimity provision which effectively gives a minority shareholder a veto over all corporate business transactions could create an oppressive minority. Perhaps one reason that the court ruled as it did was its effort to protect the minority shareholder. While it is not claimed in the facts that the “majority” shareholders intended to pursue oppressive tactics, clearly, once the unanimous provision was gone, the “majority” could take advantage of the “minority”. In the close corporation context, most courts and state legislature would err on the side of the minority, figuring that a minority shareholder is more likely in need of protection and that an “oppressed” majority could more easily seek dissolution of the corporation. As this case shows, there is a legislative policy against supermajority provisions unless they are made explicit in the certificate of incorporation. Such a view is based on the belief that the more supermajority provisions there are, the more likely it is a corporation will become deadlocked.

Wilkes v. Springside Nursing Home, Inc. (Massachusetts SC creates a balancing test for determining a breach of fiduciary duty in a close corporation)

▪ F: After being removed as an officer and director of a close corporation and having his weekly salary discontinued, a founding investor in the corporation sued the controlling shareholders for breach of their fiduciary duty to him as a minority shareholder.

▪ R: in deciding if the controlling shareholders of a close corporation have breached their fiduciary duty to a minority shareholder, a court must weigh any legitimate business purpose the controlling shareholders can demonstrate for their action against the feasibility of an alternative course of action that is less harmful to the minority shareholder.

▪ A:

o This case is a classic example of a “freeze out” of a minority shareholder by a controlling group in a close corporation. The minority shareholder Wilkes (P) got in a fight w/the other shareholders. Instead of buying Wilkes out at a fair price, however, the other shareholders tried to use their majority voting power to prevent him from getting any return on his investment. The court rightfully finds their actions to constitute a breach of their fiduciary duty of the utmost good faith and loyalty. Expressing its concern that a majority shareholder not be completely hampered in its ability to manage a close corporation, however, the court goes on to set down a balancing test that weighs the majority’s right of self-interest against the fiduciary duty it owes to the minority. Thus, if a minority shareholder asserts a breach of fiduciary duty, the majority is entitled to explain its conduct by offering a legitimate business purpose for its action. If the majority can offer such a purpose, the court permits the minority shareholder to show that an alternative course of action that would have been less harmful to his interests was possible. Under this case by case approach, the court sought to give controlling shareholders in a close corporation some flexibility in setting corporate policy, while also continuing to offer some protection to minority shareholders at risk from potential majority oppression.

Smith v. Atlantic Properties, Inc. (Court finds unreasonable use of veto power by minority shareholder to constitute a breach of fiduciary duty)

▪ F: three of four equal shareholders in a close corporation sued to remove the fourth shareholder from the board of directors, after he used a supermajority veto power contained in the corporation’s articles of organization to prevent the company from declaring any dividends.

▪ R: a minority shareholder in a close corporation, whose conduct is controlling on a particular corporate issue, is held to the same fiduciary duty to which a majority shareholder would be held.

▪ A:

o This case shows that fiduciary duty standards can be applied to more than just the nominal majority shareholders in a close corporation. When any shareholder in a close corporation has the ability to control the actions of the corporation, this court would require that shareholder to exercise his power in a manner consistent with the duty of the utmost good faith and loyalty. Applying the reasoning of the court in Wilkes, this court would have weighed any legitimate business purpose for the shareholder’s action against the practicality of achieving that purpose through means less harmful to the other shareholders. Here, the minority shareholder had no legitimate business purpose for his actions and so his action was unjustified. This case also shows the willingness of courts to involve themselves directly in the corporate business decisions (here, the timing and amount of a dividend) of closely held corporations. In general, courts are much less willing to take such an active role in the business decisions of publicly held corporations.

Merola av. Exergen Corp. (At will employee who was also a shareholder of a close corporation could not assert a breach of fiduciary duty claim for his termination)

▪ F: an at will employee and minority shareholder of a closely-held corporation sued the corporation and its majority shareholder, alleging a breach of fiduciary duty for terminating the minority shareholder’s employment without cause.

▪ R: the mere fact that a close corporation, without cause, terminates the employment of a minority shareholder who is an employee in the corporation will not automatically constitute a breach of fiduciary duty to the minority shareholder.

▪ A:

o This court draws a line indicating a limit on the ability of an employee who is a minority shareholder in a closely held corporation to bring a suit for breach of fiduciary duty by the controlling shareholders of the corporation. Emphasizing that the controlling shareholders need room to maneuver in making policy decisions for the corporation, the court finds this especially true for employment decisions. Here, Merolas (P) employment was terminated through the action of the majority shareholder Pompei. While no legitimate business purpose existed for the termination, there was no breach of fiduciary duty b/c the termination was not for the financial gain of the controlling shareholder. The court correctly contrasted this case with the situation existing in the Wilkes case. There, the controlling shareholders froze out Wilkes for their own financial benefit, ensuring that he would get no fair return on his investment for the company. Here, Pompei had no direct financial gain from the termination of M and M was able to obtain a significant return on his stock when he sold it. Recognizing the legitimate business needs and rights of controlling shareholders, this court sets forth a rule allowing a controlling shareholder in a close corporation to tailor his treatment of the minority shareholders w/in a legally permissible range of action.

Piemonte v. New Boston Garden Corp (Massachusetts high court accepts trial court’s use of the Delaware Block Method of stock appraisal)

▪ F: Some minority shareholders of a close corporation acquired in a merger sought a judicial determination of the value of their shares and payment for those shares under a state statute permitting them to opt out of the merger.

▪ R: the DBA is an acceptable procedure for valuing corporate stock under an appraisal statute allowing shareholders to opt out of a merger approved by the majority of the shareholders of the corporation.

o Appraisal ( the right of a shareholder of a corporation who objects to certain corporate actions to require the corporation to purchase the shareholder’s stock at its value immediately prior to the approval of the corporate action.

o Delaware Block Approach ( Valuation of a corporation through a determination of the market value of the company’s stock, the value of the company’s net assets, and the company’s “earning value”. These values are weighted based on an opinion of which method provides the best valuation estimate and then added, adjusted by their relative weights.

o Earnings Value ( a method of valuing a corporation based on its earnings, in which an average of the earnings of the corporation for the past five years is computed, extraordinary gains and losses are excluded, and a multiplier is selected and applied, reflecting the perceived future financial condition of the corporation and the risks of investment.

▪ A:

o This case shows that property valuation is an art and not a science. In practice, the appraisal of stock is difficult to perform and often results in a wide range of results. It depends greatly on the judgment of the person appraising the property. Here, the trial judge considered per share values ranging from $26.50 to $103.16. Depending on the weight accorded each of the three various components of the DBA approved by the Massachusetts Supreme Judicial Court in this case, the share valuation could vary widely. The court recognizes this fact by noting that the fact finder in a valuation case has a range of discretion w/in which to operate in valuing a property. In general, most appellate courts will rarely overturn a valuation ruling in the absence of clear error by the fact finder. While the valuation approach used in this case is called the Delaware block approach, a few years after this case, the Delaware courts actually abandoned this method in favor of an approach that would consider not just the three methods used in the DBA, but any approach that is generally accepted in financial and appraisal circles for ascertaining property value, such as the discounted cash flow method of valuation.

Allen v. Biltmore Tissue Corp (NY court of appeals upholds first-option buyback provision in corporation by-laws)

▪ F: the executors of the estate of a minority shareholder of a close corporation sued to attempt to void a provision of the corporate by-laws giving the corporation a first-option buyback right on the sale of the shareholder’s stock or in the event of the death of the shareholder.

▪ R: a first-option provision in a corporate by-law of a close corporation is generally enforceable and does not constitute an impermissible restriction on the alienability of shareholder stock.

o First option provision: a provision in a corporation’s charter or bylaws that prohibits a shareholder from transferring his shares unless he first offers the shares to the corporation, other shareholders, or both, at a fixed price.

▪ A:

o This court takes the modern view which permits restrictions on the transferability of shares. As the court notes, courts around the country are increasingly willing to enforce such provisions. The courts generally employ a contract analysis, upholder such restrictions, so long as they believe that he shareholder bought his shares with knowledge of the restriction. Some states, including Delaware, have statues expressly validating such transfer restrictions. This court recognizes that in the context of a closely held corporation, such restrictions are often a necessity. Like partnerships, where the partners depend greatly on the trust and confidence they have in each other, the shareholder of a close corporation are often closely tied to each other. As the court noted, repurchase agreements act as a preemptive right through which shareholders may veto the admission of a new corporate participant. While the court recognized that the price being offered here was quite low, the court understood that in the future, if every price formula were to be litigated, the utility of such transfer restrictions would be lost.

Gallagher v. Lambert (NY court of appeals upholds mandatory buyback provision)

▪ F: after his employment w/a close corporation was terminated, an employee/minority shareholder sued to void a mandatory buyback provision of a stockholder’s agreement giving the corporation a right to repurchase his shares at book value.

▪ R: a mandatory buyback provision of a shareholder’s agreement, permitting a corporation to repurchase an employee/stockholder’s stock in the event his employment is terminated, in generally enforceable.

▪ A:

o this court emphasizes freedom-of-contract principles, believing strongly in the efficiency of allowing paties to attempt to rationally maximize their outcomes in a transaction by freely bargaining with each other. The court reasoned that the parties had rationally and freely negotiated and understood the consequences of their bargaining when they signed the agreement in this case. The dissent was less convinced that Gallagher knew what he was signing away when he made the agreement. One important factor driving the court here may have been that Gallagher started as an employee and then later became a shareholder. Had he been a shareholder first or begun with the corporation as both a shareholder and an employee, the court might have viewed his reasonable expectations differently. Since he began as an at-will employee with no expectations beyond his salary, however, the court might have been justified in concluding that he was aware of what he was signing away when he accepted the terms of the shareholder’s agreement.

Wollman v. Littman (NY court of appeals refuses to dissolve a deadlocked close corporation)

▪ F: one of two groups of fifty percent shareholders of a closely held corporation sued for dissolution of the corporation, asserting that another lawsuit b/w the shareholder groups made it impossible to effectively conduct corporate business.

▪ R: dissolution is inappropriate, even if shareholders are deadlocked, if the result would be to permit one shareholder group to divert the corporations business to itself.

▪ A:

o As this case shows, deadlock statutes are generally interpreted to make corporate dissolution discretionary for a court, even when actual deadlock is shown to exist among the shareholders and directors. In general, courts do not like to order a profitable corporation to break itself apart over the objections of some of the shareholders, especially where other remedies might exist to solve the difficulties b/w the shareholders. Sometimes a court will order a provisional director appointed to break the deadlock. A court might also requires the objecting party to buy out the party seeking dissolution at a fair price. Here, although one half of the shareholders and board of directors directly opposed the other half, creating a deadlock scenario, the court, as a court of equity, rightly recognized that n order of dissolution would unfairly benefit the party accused of wrongdoing. Involuntary dissolution would have made it easier for the Ps to go and sell directly to the customers found by the Ds, making it easier for the alleged wrongdoings to succeed. The true lesson to be learned from this case is the admirable insight and actions by the court of appeal. We have seen the minority being protected from the majority. We have also seen the majority being protected from the controlling minority. Here, we simply see shareholders of equal power, but the court has still taken action to prevent one shareholder from taking advantage of the other. The court was able to “see” that if the corporation were dissolved, it would effectively enable the Ps to obtain the whole business.

Matter of Kemp & Beatley, Inc (oppressive conduct by majority shareholder is grounds for dissolution of the company, where the majority does not want to buy out the minority at a fair price)

▪ F: two shareholders who were formerly employees of a close corporation sued for dissolution of the corporation after the corporation changed its policy regarding corporate distributions in a way that ensured the shareholders would not get a return on their investment.

▪ R: conduct by majority shareholders that substantially defeats the “reasonable expectations” held by minority shareholders in committing their capital to a close corporation is appropriate grounds for dissolution of the corporation, provided that the majority shareholders are first given an opportunity to buy out the complaining minority at a fair price.

▪ A:

o Historically, courts have not been willing to order dissolution of a profitable corporation, even in an instance of corporate deadlock. This case represents the more modern approach that recognizes that dissolution may be necessary when a majority shareholder has engaged in oppressive conduct that has prevented a shareholder from receiving a return on his investment or achieving the reasonable expectations from his investment that he had on entering the company. This court recognizes, however, that while some remedy is necessary in such an instance, dissolution of a profitable corporation is such a harsh remedy that it should only be granted where the majority has been given an opportunity to buy out the minority shareholder’s stock and has refused. It is a Solomon-like compromise that permits the majority to continue the profitable corporation and the minority to obtain the relief it needs to rescue its invested capital from the hands of the oppressive majority. Many states have enacted statutes which specifically provide for the remedy announced in this case. Those statutes dictate that the majority shareholders may avoid corporate dissolution by purchasing the shares of the minority for fair value.

McCallum v. Rosen’s Diversified, Inc. (court orders buy out of minority shareholder at fair market value after majority shareholders engage in unfairly prejudicial conduct)

▪ F: a minority shareholder who was the former chief executive officer of a closely-held corporation sued to require the corporation to buy back his shares for fair value after the corporation terminated his employment.

▪ R: conduct by a majority shareholder of a close corporation towards a minority shareholder can be grounds for a court to order the majority to buy out the interest of the minority when the minority’s reasonably expectations are defeated.

▪ A:

o This court adopts the “reasonable expectations” in Matter of Kemp. Recognizing that the shares were given to McCallum (P) at least in part to convince him to stay with the corporation, this court points out that, to deny him a fair price for his shares, would defeat his reasonable expectations with regard to the stock. He stayed with the company, at least in part, because he was given the stock and expected to play a major role in the corporation’s management. Once McCallum (P) was forced out of the company’s management, this court, acting under the Minnesota statute, would permit him to leave entirely, escaping with the fair value of his shares and allowing the corporation to continue w/o him. It is remarkable how far this court goes to give McCallum (P) his remedy. Note that (P) does not claim any fraud or oppression. He merely claims that his reasonable expectations were not met. It is also noteworthy that the shares were received by (P) as a gift or bonus, yet the court still provided him with the protection of a minority shareholder.

Charland v. Country View Golf Course, Inc (minority discount and lack of marketability discount should not apply when majority shareholder purchases minority’s shares to avoid dissolution of the corporation)

▪ F: a minority shareholder appealed a judicial appraisal of his shares that had discounted their value due to their lack of marketability and the fact that they were not enough shares to control corporate decisions.

▪ R: in appraising the fair market value of the stock of a minority shareholder in a close corporation who has filed for dissolution, a court should not apply either a minority discount or a lack of marketability discount to determine the value of the stock.

o Lack of marketability discount: a discount applied to the value of stock in a closely-held corporation due to the fact that there is no ready market for the shares.

o Minority discount: a discount applied to the value of the stock of a minority shareholder of a corporation due to the fact that the shareholder does not have enough voting power to control decisions of the corporation.

▪ A:

o Like most courts around the country, this court recognizes a difference b/w the value of a minority shareholder’s stock in a close corporation to a third party buyer and the value of the shares to the majority shareholders in that close corporation. A third party buyer who purchases the shares of a minority shareholder will simply be in the same position as the minority shareholder was, lacking control over corporate decisions due to a lack of voting power and lacking a ready market in which to sell his shares. When the corporation, or really, the majority shareholder of the corporation, buys the minority shareholder’s stock, however, the majority shareholder will not have the same difficulties. Moreover, the shareholder will be ridding himself of the problems created by the minority shareholder, a clear benefit that has real value to he majority in many cases.

Restrictions on Alienability

▪ Normally, stock is freely alienable (especially in publicly held corporations). Rule 144 stock (restricted stock); transfers of restricted stock has to be recorded w/the SEC.

▪ Can’t restrictions be discriminatory? Are there constitutional issues involved in restriction of sale? An absolute restrain on alienation is probably void according to the principles of public policy. Private discrimination is allowed: restrictions that prohibit sale of stock to women, for example, are legal (it is only when the government is discriminating that constitutional amendments are invoked).

▪ Restrictions can be located on legends on the stock certificates, in the bylaws, in the corporate certificates, in agreements. Restraints are upheld due to:

o Reasonableness

o Notice

▪

▪ Some restrictions are held to be reasonable in the close corporation context:

1. First refusals: which prohibit a sale of stock unless the shares have been first offered to the corporation, the other shareholders, or both, on the terms offered by the third party. This is the lease restrictive.

2. First options: which prohibit a transfer of stock unless the shares have been first offered to the corporation, the other shareholders, or both, at a price fixed under the terms of the option. The restrictiveness of these depends on the relationship b/w the option price and a fair price at the time the option is triggered.

3. Consent restraints: which prohibit a transfer of stock w/o the permission of the corporation’s board of shareholders. This is the most restrictive and it used to be held invalid; but now the courts have become more tolerant; they are still held invalid, however, in the absence of statute or authoritative precedent.

4. Mandatory sales: these give the corporation or the remaining shareholders an option to purchase a shareholder’s stock upon the occurrence of designated contingencies, even if the shareholder wants to retain the stock (ex: buyback provisions when employment is terminated w/the corporation)

▪ Buy-sell or survivor-purchase agreement: provides that on the death or retirement of a shareholder in a close corporation, his estate has an obligation to sell its shares to the corporation or the remaining shareholders at a price fixed under the agreement, and the corporation or the remaining shareholders have an obligation (rather than an option) to purchase the shares.

▪ Getting a price:

• Book value

• Capitalized earnings

• Periodic revisions

• appraisal

Dissolution

▪ Can occur because of:

1. Deadlock

2. veto arrangement or supermajority provisions can result in a deadlock

3. Oppression

▪ Profitability is not a bar to dissolution.

Shares of Stock—Equity (look at question 2 on the extra credit assignment)

Issues:

▪ Compensation for shares

▪ Dividends and distributions (creditors)

Dividends and the issues of shares:

▪ Corporations authorize the number of shares to be issued; authorization is the simple process by which a corporation prints up a designated number of shares; when those shares are sold, they’re “issued.” Once they’ve been authorized and issued, they’re called “outstanding”. When outstanding gets repurchased by the corporation, they’re called “treasury.”

▪ §6.20: issuance: when shares are sold to the shareholders.

1. Subscription: prior to a corporations’ existence, we are, in effect, dealing out investors.

Shareholder Suits

▪ Proxy rules:

1. major source of litigation; this is the situation where information is disseminated and certified to shareholders; proxy rules allow to look past the transaction and sue the directors

2. securities laws apply to publicly traded corporations (so, there won’t be these sort of laws for closely held corporations)

3. basis on which they’re suing is the Federal Securities laws

▪ Shareholders have a right to sue the corporation/and/or the directors of the corporation. How do you know when there is a violation of a director’s duty.

▪ Shareholders can sue corporations for violations that are unique for corporate law

▪ Difference b/w direct and derivative actions;

▪ Not all actions can be both! For some, it isn’t clear which one they are.

▪ Importance of distinguishing:

1. if you bring a derivative action you have:

o procedural notification hurdles: why should the shareholder have to do this? b/c you’re supplanting the directors duty to bring that action so you need to give notice to the directors that you think there is a wrong and give them an opportunity to bring the action themselves.

o standing hurdles: sometimes hard to meet the standing requirements.

• These hurdles don’t exist in the same intensity as in direct actions.

2. if you’re suing in a derivative action, you’re really suing for damage done to the corporation.

o A corporation can be injured by a director’s wrongdoing; the shareholders are also injured by a director’s wrongdoing.

o In a derivative suit, you’re bringing it on behalf of the corporation; in a direct action, you’re bringing it on behalf of the shareholders.

o Class actions can be of a derivative or a direct nature.

▪ Plaintiff in a derivative action must be a shareholder at the time the action has begun, and must remain a shareholder during the pendency of the action.

▪ Why should we allow shareholders to sue corporations?

Alternative Forms of Business Organizations

o Limited Liability Company: these are unincorporated hybrids of partnership and corporation, with members generally participating and corporation, with members generally participating in management while receiving limited liability. They are governed by special state statutes, which differ widely between states. The following are widespread prevailing rules:

o Looks like a corporation; there are articles of organization; parallels corporate law statutes.

o One thing that hasn’t been established is how the Federal Securities laws apply; the employment issue is not limited to LLCs but partnerships; ex: are members employees?

o Formation: An LLC is formed by filing a certificate/articles of organization (listing the LLC’s name, principal place of business/registered office, and process agent) with the Sec. Of State. Many state statutes require this document to also identify the LLC’s purpose, duration, founders, management (either member-managed or manager-managed), etc. Once formed, they are generally automatically empowered to act as necessary to conduct business.

o Operating Agreement: An LLCs central agreement is usually not the articles of organization but rather the operating agreement/limited liability agreement, which details governance procedure. In some states, this may be unwritten.

For the exam:

1. know the chart

2. answer the call of the question

3. you need to know the comparative features of the different types of business organizations

4. it is possible to create a combination of entities:

• ex: why not have an LLC owned by an LLC owned by an LLC? Triple layers of liability protection might be more custom fit to the particular client.

5. agency law –

• be comprehensive; the exam is not about rushing to the right answer; you’re being asked about analytical capability, etc. The shortest route to the end point isn’t the right one. Consider the restatement and the cases in the book dealing with agency law.

• Remember that agency has 2 points of analysis:

o Relationship b/w principle and agent

o Issues of creation of the relationship (authority, duties of the two parties); do not assume that there is an agency relationship even if the two parties are called agent and partner.

o b/w the principle and/or agent as it relates to 3ps.

• Section 27 of Restatement: apparent authority ( trickiest form of authority; agency’s liability to third party in contract

6. partnership

• be comprehensive an analytical; use UPA and handout; don’t be concerned with RUPA unless you want to.

• Interrelationship of the partners to themselves and to the partnership; concerns creation issues and duties (rights/liabilities) issues.

• Partner/partnership liabilities to third parties.

• Don’t assume that a partnership exists; analyze your way; §6, 7 UPA: test for partnership. Co-ownership is not a partnership necessarily. §15 UPA;

• What does a partner own in a partnership: partner’s interest & issue of assignability of a partner’s interest.

• Process of dissolution and continuity and how retiring partners are treated/handled.

7. LLC

• Be comprehensive

• Be mindful of the language that you need to LLC; members are NOT partners!!

• Know the issues of LLCs

• Know the benefits/characteristics/detriments

8. Objectives

• Pre-incorporation transactions (know the rules to promoter liability and entity liability pre-incorporation). Also, a pre-subscription agreement are also pre-incorporation transactions; what constitutes adequate consideration? Historically, a director couldn’t get stock based on consideration constituting future contributions; now, corporations give the freedom to allow for this sort of consideration.

• De-facto incorporation agreement; doctrine has been frowned upon; the process is so easy now that if you don’t follow the formalities, you don’t get the benefits.

• Know the results of a defective incorporation: not incorporated

• Know the definition of equitable subordination: this is in a bankruptcy; court finds deep rock doctrine: gives creditors priority over shareholders in a bankruptcy situation b/c of the circumstances.

• Piercing the corporate veil: followed the formalities but there are things you are doing that the law won’t respect limited liability for and holds the owner personally liable: if you undercapitalize the entity (don’t have sufficient capital or insurance)

• Ultra Vires: not significant in real life except for exam purposes; corporations were historically created for narrow purposes, if you went beyond those purpsoses and contracted w/3Ps those contracts were typically void b/c you didn’t have the power to do it. Today, authorization of authority has broadened: any lawful purpose

• Corporate governance: concept that you need to go beyond corporate statutes to effectively govern corporate behavior. The material (supplement) on corporate governance is NOT law.

• Shareholder proposals and resolutions; no-action letter material; process by which corporations adopt or reject shareholder proposals, etc.

• Securities: what are they? How are they regulated? This is a broadly defined concept that can be synonymous w/investments; there is a laundry list of what constitutes securities. If you’re asking for investments, you’re probably selling securities. To present a sale as an investment, you are selling a security. Things that have been held not be securities (like insurance; term life insurance is not a security b/c you’re not asking anyone to invest, you’re asking someone to pay for coverage)

9. Corporations

• Publicly traded

o Directors/officers duties/liabilities

o Proxy rules

o Meeting requirements; quorum; majority vote (shareholders & board); etc.

o Business judgment rule

o Conflicted transactions §8.61 approval of conflicts

o Rights to information (shareholders and board of directors)

o Removal of directors

o Shareholders actions (derivative lawsuits)

• Closely held

o Sorbane Oxley will have an impact on closely held corporations.

o Duties of majority shareholders: B/c they look like partnership arrangements, they may be fiduciary. Fiduciary duties are a ? not a statement. Do partners have fiduciary duties to other partners? YES. Publicly traded shareholders don’t have FDs

o Freeze-outs

o Supermajority

o Cumulative voting

o Shareholder agreements; voting agreements

o Dividends and unlawful distributions: there are limitations w/how much you can give to the shareholder

o

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