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Business Associations – Spring 2009 –Professor GuttentagPRINCIPAL/AGENT – THE LAW OF AGENCYGenerallyWhy do we Create Agency Relationships?Because you cannot do everything yourself. In order to gain from economies of scale, we have to get additional manpower together. What is the Main Issue of Using Agents Instead of Your Own Efforts?AGENCY COSTS – Others are not nearly as inclined to watch after your interests as you are. This loss in efficiency or effort is the “cost” associated with hiring agents to perform a task. CURE: Give the agent a piece of the action – performance incentives to align their incentives with the corporation’s incentives. OTHER PEOPLE’S MONEY PROBLEM: When someone is dealing with another person’s money, they tend not to be as careful as they would if they were dealing with their own money. SPECIES OF: Agency costs. This concept appears in all business entities where you have principal/agent relationships. FormationLegal Definition – RSA 1: Agency is the label the law applies to a relationship in which:By Mutual Consent (formal or informal, express or implied);One person or entity (called the “agent”);Undertakes to act on behalf of another person or entity (called the “principal”);NOTE: Has to be something the principal actually wants. EXAMPLE: Gorton v. Doty: Majority assumed that Doty wanted Coach to drive because she could not drive herself. This assumption was required to find the agency relationship. However, more likely it was merely generosity, not Doty’s desire to have someone drive for her because she could not. Subject to the principal’s control.TEST for Determining if an Agency Relationship ExistsPRONG 1: Manifestation of consent by P to A that A shall act on P’s behalf;FACTUALLY SENSITIVE INQUIRYNo magic words to create a relationship, must examine the facts and circumstances of the situation. CAUTIOUS APPROACH: For example, in Gorton, if Doty had specified she was loaning the car, would likely have resulted in finding no principal-agent relationship. AGENCY RELATIONS ARE EASY TO CREATE!Consideration Required? None. Agency relationship can develop out of a gratuitous favor to another if the conditions precedent exist. THUS: Favors or requests, if met by the requisite control requirements, can create principal/agent relationships.Is Intent Required?NO INTENT NEEDED: To form a principal-agent relationship.RATHER: Objective inquiry of the facts and circumstances have to support each prong of the test. OBJECTIVE FACTUAL INQUIRY!What Relationship is Being Created?Cargill RULE: Being an agent in one capacity does not mean you are an agent in every capacity you have with that principal. EXAMPLE: Cargill was a lender and a dealer. Because they were an agent in the dealer capacity does not mean they were an agent in the lender capacity. BE CAREFUL! Do not aggregate all of the actions together!PRONG 2: Subject to P’s control;Physical Control?NOT REQUIRED: Merely specifying a condition precedent will be enough to satisfy this prong.EXAMPLE: Can you please make me a burger – but make sure that you only put pickles and onions on it. Specifying the ingredients is enough to show control!ESSENTIALLY: Anything that comes down to “I want something done this way” is enough to establish the requisite control!SLIGHT SERVICE ENOUGH!Doty EXAMPLE: Asking for a particular person to drive your car is sufficient. PRONG 3: A so consents to so act. ESSENTIALLY: Agent has to agree to the condition and to act for P’s behalf. DOES NOT TAKE MUCH: Did the agent do what the principal asked? Pretty clear evidence of consent. Exceptions: Common Relationships that Don’t Create Principal/Agent RelationshipsPOLICY: Certain relationships are simply too commonplace to force principal/agent liability on the parties. Creditor Relationships – RSA 14(O)RULE: A creditor becomes a principal when he assumes de facto control over the conduct of a debtor. ESSENTIALLY: Would have to be where the lender is dictating the day to day affairs of the borrower. Standard K clauses will not lead to a finding of control. EXAMPLE – NO CONTROL: Company shall not enter into any mortgages or pay any dividends without consent of lender. Such a term is standard in creditor contracts and would not lead to a finding of agency. EXAMPLE – CONTROL: Company defaults on its debt covenants and creditor installs its own board of directors and takes possession of corporate assets. HAS TO BE PRETTY MUCH TOTAL CONTROL!Supplier Relationships – RSA 14(K)RULE: One who contracts to acquire property from a third person and convey it to another is the agent of the other only if it is agreed that he is to act primarily for the benefit of the other and not for himself.BASICALLY: Chevron sells oil to Bob the reseller and I buy oil from Bob. Bob sells me oil he never paid Chevron for. Chevron cannot sue me under agency theory unless Bob agreed to act primarily for my benefit and not his own benefit as a supplier. WHY? These transactions are simply too routine. If everyone who purchased from a party could be liable for that’s parties screw ups, it would play havoc with our economic system. Therefore, law recognizes an ECONOMIC CARVE-OUT. How to Avoid Principal/Agent RelationshipsUse separate entities;Set clear boundaries of what conduct you will engage in;Draft your contracts carefully specifying in an objective fashion who is consenting to what. CasesGorton v. DotyFACTS: D loans car to Coach to drive kids to game. D specifies only coach is to drive the car. School pays for the gas. C wrecks the car and kids are injured. Plaintiffs sue D on theory she was the principal and liable for C’s acts as an agent. ISSUE: Was a principal/agent relationship formed?RULE: Principal/agent relationship arises when the three prongs are met.HELD: D asked for Coach to drive car on her behalf subject to her stipulation that only he drive. Coach consented by driving car. Therefore, principal agent relationship found. PROBLEM: A real stretch of objective manifestation here. More likely this was D being generous and offering her car, not asking Coach to do something on her behalf because she could not otherwise do it. Jenson Farms v. Cargill FACTS: Cargill loans W money and sells him lots of random inventory. Cargill continues to extend W’s credit line and provided several limitations in the loan agreements regarding what W could and could not do. Cargill also contracted with W to be its seed agent. W ended up owing $2M to farmers and $3.6M to Cargill.ISSUE: Was Cargill liable as principal for W’s debts to the farmers?RULE: Same as above. Can derive the relationship from circumstantial evidence.HELD: Principal agency relationship existed due to Cargill’s “paternalistic” relationship with W.PROBLEM: It seemed as if Cargill was acting more as a supplier and a creditor here, and not as a principal. In addition, the court conflates the analysis and takes multiple roles and mashes them together to find a relationshipBE CAREFUL! SEGREGATE YOUR AFFAIRS BY ENTITY!Relating to Third PartiesGENERALLYPrincipal’s Perspective on Liability for Acts of AgentPrincipal only wants to be bound by the acts he specifically requests of his agent. If the Agent does something the principal does not agree with, the principal should not be bound. PROBLEM: This would prohibit an agent from ever entering into contracts without first consulting with the principal. There needs to be some room for flexibility here. Third Party’s Perspective on Principal’s Liability for Acts of AgentIf it appears the agent is working on behalf of the principal, the principal should be bound by the agent’s acts. Third party should be able to rely on the agent. Why do we even need liability for acts of the agent?Need a mechanism to avoid having the principal ratify every single decision of agents. If this were the case, there would be no reason to have agents in the first place! Types of Principals – RSA 4Disclosed Principal – When third parties are aware who the principal is. PROPERLY FORMED ENTITY: Is considered a disclosed principal. Partially Disclosed Principal – When third parties know there is a principal but are unaware of his identity.Undisclosed Principal – Where third parties are unaware a principal exists and believe the agent is the principal. INCORRECTLY FORMED ENTITY: Is considered an undisclosed principal. Atlantic Salmon. The CorporationKeep in Mind: The corporation itself is the principal. As a result, because a corporation is merely a legal entity, it must carry out ALL of its acts through its agents. Liability of Principal for Agent’s ContractsNOTE: All principal liability for acts of an agent are time and situation specific!ORDER OF PROOF: Must show:Agency relationship existed; andThere was a kind(s) of authority to bind principal through contract. STEP 1: General RULE – RSA 144: A principal is subject to liability on upon contracts made by an agent acting within his AUTHORITY if made in proper form and with the understanding the principal is a party. STEP 2: When does an Agent have Authority?Actual Express Authority (AEA)Actual Implied Authority (AIA)RULE – RSA 35: Unless otherwise agreed, authority to conduct a transaction includes authority to do acts which are incidental to it, usually accompany it, or are reasonably necessary to accomplish it. NOTE: Focus on the agent’s authority and not on 3rd party’s impression of the agent’s authority (that situation is dealt with in apparent authority). THIRD PARTY’S BELIEF IRRELEVANT HERE!Mill Street ChurchFACTS: Church asks Bill to paint church. Church was aware it was a high and difficult job and may require an assistant. Bill asks Sam to help. Sam falls and is injured. Church claims no liability under worker’s comp. ISSUE: Did Bill have apparent authority to hire Sam?RULE: Restatement 35HELD: Actual implied authority existed here because it was a two person job, reasonably necessary to hire an extra person to do so, and on numerous prior occasions, the church knew that Bill had hired someone to help. Bill had implied authority to hire Sam.Apparent Authority (AA)RULESApparent Authority Defined RULE – RSA 8: Apparent authority is the power arising from the principal’s manifestations to third personsCreation of AA – RSA 27: AA is created by the written or spoken words or other conduct of the principal, which reasonably interpreted, causes a third person to believe the principal consents to have the act done on his behalf by the person purporting to act on the principal’s accountTENSION: Between 8 and 27. 8 Suggests that only direct manifestations from the principal to the third party would qualify here. However, 27 seems broader and is more likely the better rule especially in context of corporations. Don’t need direct communications between P and third party.Liability RULE – RSA 159: A disclosed or partially disclosed principal is subject to liability upon contracts made by an agent acting within his apparent authority.Why Not Undisclosed Principals? Because in those cases the third party believes they are dealing directly with the principal! See 195 Under IAP for Disclosed. LindFACTS: Lind told by VP – H that he was being sent to NY for new job and salary and to speak with K about details. K stated salary and terms including 1% sales commission on gross sales. Based on these terms, L would be the second highest paid employee in the organization.ISSUE: Did K have the inherent authority to make the contract with L?RULE: ReasonablenessHELD: Terms seemed reasonable enough given that other managers had been given that same sort of deal. Clearly as H told L to see K, was reasonable to expect K to know the details of the salary arrangement.HOWEVER: If he was getting paid more than the CEO, maybe the terms would have been held unreasonable. Very much a borderline case. NEXT TIME: Get the employment agreement in writing or put something in the handbook that says salary decisions can only come from certain specified individuals. Inherent Agency Power (IAP)General RULE – RSA 8A: Inherent agency power is a term used to indicate the power of an agent which is derived NOT from authority, apparent authority, or estoppel and exists for the protection of persons harmed by or dealing with a servant or other agent. BASICALLY: When other stuff does not fit, it falls into this category. POLICY: Sometimes acts that seem like they should lead to liability out of social policy reasons do not under traditional authority theories. Therefore, the law has a catch-all category for those situations. Two SituationsDisclosed/Partially Disclosed Principal - Agent Exceeds Authority – RSA 161RULE: Agent subjects his principal to liability for acts done on his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, while forbidden by the principal, third party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized.NOTE: Extraordinarily rare where third party will be aware of a principal’s existence and be subject to agent’s commands that are reasonable.Undisclosed Principals – RSA 195RULE: An undisclosed principal is subject to liability to third persons with whom the agent enters into transactions usual in such business. POLICY: Otherwise, Principals would always try to hide their identity to avoid liability for any contracts entered into by their agents. WatteauFACTS: F owns bar. H works as manager and H’s name is on the walls of the place. Watteau sells goods to bars. F says H can only buy mineral waters and bottled ales. H ends up buying some cigars and Bovril. No apparent authority here because no conduct by principal. W does not know F exists.ISSUE: Should F be bound by H’s cigar contracts?RULE: RSA 195HELD: Reasonable expectation was that W was dealing with the entity that owned and operated the bar. Not just a lone bartender. Therefore, held liable. Ratification (R)General RULE – RSA 82: Ratification of an otherwise unauthorized contract exists when:Principal exists at the time of the initial contact;MEANING: Agent does not have to be an agent at the time of initial contact – but principal must exist (RTA). Principal manifests choice to treat unauthorized act as authorized. CAVEAT – RSA 89: Where there is a material change in circumstances that it would be unjust to hold third party liable on the contract. EXAMPLE: A tells P he sold P’s property Blackacre to T. House then burns down. P ratifies the agreement. Unjust to hold T to the contract and will be voidable at T’s option. Estoppel (E)POLICY: Proprietor’s duty extends beyond removing banana peels from the aisles! Hoddeson. General RULE – RSA 8B: A person who is not otherwise liable as a party to a transaction purported to be done on his account subject to liability to persons who have changed their positions,ifHe intentionally or carelessly caused such belief; orKnowing of such belief, he did not take reasonable steps to notify them of the facts.Changed Position Defined: Payment of money, expenditure of labor, suffering a loss or legal liability. ESSENTIALLY: Third party changed position in reliance; and principal could have prevented this change.NOTE: Unlike apparent authority, no conduct of the principal is required here. Principal basically just has to sit back and let something happen. HoddesonFACTS: H walks into furniture store and wants to buy some pieces. Walks into D’s store where X takes down her order and proclaims the price of $168.50. H hands over the money and does not get a receipt. Furniture never delivered and no record of the sale taking place. ISSUE: Is D liable for the sale of the rouge agent?RULE: Estoppel rule. HELD: No apparent authority as D did not manifest anything to H (no conduct is not a manifestation!). No holding out that this rouge agent was representing D. REMAND – to determine whether D’s acts or omissions led to H to reasonably rely on imposters representations and she changed positions on such relianceVOCAB WORD: Mountebank = Charlatan.Enforcement of Contracts Made by AgentsWhen can P enforce against Third Party?RULE: In every authority situation EXCEPT for estoppel. When is the Agent Liable on the Contract?Disclosed Principal RULE – RSA 320: No agent liability on the contract EXCEPT in the 2 following situationsClear intent of all parties that the agent be bound by the L; orNOTE: Can contract around this situation and make Agent liable. Agent made contract but without authority. Partially Disclosed Principal RULE – RSA 321: Person purporting to make a contract with another for a partially disclosed principal is a party to the contractNOTE: Can contract around this situation and make agent a non-party.ELECTION: Third party must elect who to sue – either agent or principal. Undisclosed Principal RULE – RSA 322: Agent purporting to act on his own account but in fact is making a contract on account of an undisclosed principal is a party to the contractCANNOT CONTRACT OUT OF THIS ONE!ELECTION: Third party must elect who to sue – agent or principal. Avoiding Liability on the Contract Atlantic Salmon RULE: It is the duty of the agent, if he would avoid personal liability on a contract entered into by him on behalf of his principal, to disclose not only that he is acting in a representative capacity, but also the identity of his principal. NOTE: This is the AGENT’S OBLIGATION! NOT THE THIRD PARTY!Test for Disclosure of Principal RULE: Actual knowledge is the test. Other parties are not required to discover the identity of the principal. Must deliver to third party actual knowledge or what would be reasonable construed as reasonable knowledge. Entities: Be careful, an improperly formed corporation is considered an undisclosed principal and will bind the agent to the contract as in the case of Atlantic Salmon. Liability of Principal for Agent’s TortsGeneral PolicyFrom Principal’s Perspective: Principal does not want to be liable for any of his agent’s torts. Third Party’s Perspective: Principal should be liable for all torts committed by his agents. Economic Rationale: Principal’s should be liable for torts caused by agents which occur during the scope of business operations. You profit, you pay – cost of doing business. Order of ProofDetermine if there is a principal/agent relationship;Determine if there was a master/servant relationship;NOTE: scope of master/servant relationship is narrower than principal/agent. Determine if the servant’s acts were within the scope of employment. THUS: Tort liability is must narrower than contract liability – much criteria has to be met. If none of the above are applicable, check to see if it is an apparent agency situation. TerminologyArchaicServantIndependent Contractor (Agent-Type)Independent Contractor (Non-Agent)ModernEmployeeNon-servant AgentNon-Agent Independent ContractorRestatement (Third)EmployeeNon-Employee AgentNon-Agent Service ProviderAGENT’S LIABILITY RULE – RSA343: An agent who does an act otherwise a tort is not relieved from liability by the fact that he acted at the command of the principal or on account of the principal.Agent’s Are Liable for Their Torts as Well!HOWEVER: They are not typically the deep pocket – the principal is the deep pocket!PRINCIPAL’S LIABILITY RULE – RSA 219: A master is subject to liability for the torts of his servants committed while acting in the scope of their employment. RATIONALE: Should only be liable for things you had control over. If you have physical control over the employee, you should be liable.BETTER RULE: If you make money from it, you should pay for all harm incidental to your profit seeking venture. Master/Servant RULESServant DEFINED: RSA 2(2): A servant is an agent who whose physical conduct is controlled or subject to the right of control by the master.NOTE: All servants are agents!COMPARE: Independent Contractor – RSA2(3): An independent contractor is a person who contracts with another but who is not controlled or subject to control of physical conduct. He MAY OR MAY NOT BE AN AGENT. Agent Type Independent Contractor: Subject to limited control by P with respect to the chosen result.ONLY LIABILITY: Is in contract (presuming there is authority). P has limited control;A has power to act on P’s behalf;Amount of control can change making this a master-servant relationship. Non-Agent Independent Contractor: Perhaps less control on P’s part but A has no power to act on P’s behalf. NO LIABILITY! This relationship is established via an arm’s length transaction. P has little control over AA has no power to act on P’s behalf. Includes: Suppliers and lenders with the exceptions noted above. 10 Factors Indicating when Agency Rises to Master-Servant – RSA220(2)Extent of control the P may exercise over the details of the work;Is A in a distinct occupation or business?;In the locality, typically done under supervision by P or by specialist without supervision?;Skill required;P supply the instrumentalities, tools, and place of work?Length of employment?Method of payment – by time or by the job?Part of the regular business of P?Do parties believe they are creating master-servant relationship?Is the principal in business?COMPARE – Humble Oil & HooverKEY FACTORS: Of business relationships includeDuration;Control;Risk of Loss;Return. BOTH: Cases involved oil companies setting up locations that sold their products via contract. Agreements and services were similar with some notable exceptionsHumble Oil: Master-Servant relationship found:Servant Factors: WINHumble could control day to day functions of the station;Humble controlled all advertising;H required station owner to make reports, strict financial reporting, provided capital, and agreement was AT WILL with HRent connected to sales of the storeNon-Servant Factors: LOSSNo one viewed Humble as masterEmployees paid directly by Station managerK specifically repudiated master/servant relationship. Hoover: No master-servant relationship found:Servant Factors – LOSSSun Oil owns the stock but not the property.Non-Servant Factors – WINSun Oil reps make recommendations but not binding;Allows service stations to sell other products;Rent is based on sales but there is a minimum and a maximum amount;Contract can only be terminated with notice;CLEARLY: Lawyers gaming the system to avoid economic reality. Wouldn’t the better rule be that you have to pay for torts incidental to your economic conduct?CLEVER LAWYERING: Draft a K with all the effective control you want but without the indicia of physical control over affairs. Scope of Employment RULESScope RULE – RSA228: Conduct of a servant is within the scope of employment if and only if:It is of the kind he is employed to perform;ESSENTIALLY: No liability while on frolics or detours. It occurs substantially within the authorized time and space limits;It is actuated, at least in part, by a purpose to serve the master; andIf force is intentionally used by servant against another, the use of force is not unexpected by the master. ESSENTIALLY: Hiring a bouncer. NOT IN SCOPE IF – RSA228(2): Different in kind from that authorized, far beyond the authorized time or space limits, or too little actuated by a purpose to serve the master. 10 Factors Indicating Whether Act is Within Scope – RSA229: Either authorized or not authorized but determined by:Whether or not act is commonly done by such servants;Time, place and purpose of the act;Previous relations between master/servant;Extent to which the business of the master is apportioned between different servants;Whether or not the act is outside the enterprise of the master or, if within, has not been entrusted to any servant;Whether or not the master has reason to expect that such an act will be done;Similarity in quality of the act done to the act authorized;Whether or not the instrumentality by which the harm is done has been furnished by the master or servant;Extent of the departure from the normal method of accomplishing an authorized result; andWhether o not the act is “seriously” criminal. Example of Scope – ArguelloFACTS: Minority groups argue that they faced discrimination in Conoco owned and Conoco branded stores. Conoco-branded stores are independent contractors and not agents of Conoco. Three incidents took place:Conoco-owned store S racially insults customers. Two other incidents occurred at branded stores. Conoco service reps state to customers that they are powerless over branded stores’ conduct.Owned Stores: Actions occurred while employee on duty, interacting with customer during sale, used store equipment and machines during insult, - all customary functions, thus within scope of employment.Branded Stores: Contracts provided for standards and bi-annual inspections but Conoco did not control details. Thus, independent contractors and not liable in tort. HOWEVER – Possible there is a 267 argument here. Where Agent’s Acts are Outside Scope But P Still Liable – RSA 219RULE: A master is liable for a servant’s torts if:Master intended the conduct or the consequences; orEXAMPLE: Bouncer breaks a guys ribs. May not have intended the broken ribs, but you did expect the guy to be roughed up. Master was negligent or reckless; orConduct violated a non-delegable duty of the master; orServant purported to act on behalf of the principal and there was reliance upon apparent authority. Apparent Agency – ONLY IN TORT CONTEXT – NOT CONTRACT LIABILITYGenerallyDistinct concept from apparent authority. Apparent agency creates an agency relationship that does not otherwise exist while apparent authority expands the authority of an actual agent. THUS: Apparent authority is used even when there is no agency relationship. Mainly used to go after franchisors.CREATES AN AGENCY RELATIONSHIP WHERE NONE EXISTS! Differs from Estoppel for Two ReasonsEstoppel occurs where there is already a principal/agent relationship; andApparent Agency does not occur in the contract context! General RULE – RSA267: One who represents that another is his servant or other agent causing a third person justifiably to rely upon the care or skill of such apparent agent is subject to liability to the third person for harm caused by the lack of care or skill of the one appearing to be a servant or other agent . ESSENTIALLY: Did the putative principal hold the alleged agent as an agent and whether the third party relied on that holding out. Example – Miller v. McDonald’s CorporationFACTS: McDonalds has franchise agreement with A. Agreement specifies that there is no principal-agent relationship between the parties and McDonalds exercises no physical control over A’s affairs. T bites into a BigMac at one of A’s stores and breaks something. T sues McDonalds.ISSUE: Is A an agent of McDonalds Corporation?RULE: Apparent Agency Rule from 267HELD: Issue for jury to determine. Courts have gone back and forth as to whether there is actual agency here but there is definitely an issue of apparent agency. Have to determine if the sign saying it was an independent McDonalds was enough to break justifiable reliance by T!Roles and DutiesAgent’s Duty to his PrincipalFiduciary RULE – RSA13: An agent is a fiduciary with respect to matters within the scope of his agency. Agent’s Fiduciary Duties to PrincipalDefault RULES- RSA376: Fiduciary duties are modifiable by contract. The rules provided in the RSA are default rules. Duty of Care and Skill – RSA379: Agent is subject to the standard of care and skill which is standard in the locality for the kind of work and to exercise any special skill that he has. Duty to Give Information – RSA381: Agent is subject to a duty to use reasonable efforts to give his principal information which is relevant to affairs entrusted to him and which, as the agent has notice, the principal would desire to have. Duty of Loyalty – RSA387: Agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency. General Auto Manufacturing v. SingerFACTS: D signs agreement with employer to be their agent. D then does some side work that he feels employer cannot fill. Generates $64,000 in profits. D demonstrated loyalty by fronting costs for the business out of his own pocket. ISSUE: Did D breach his duty of loyalty?RULE: Good faith and loyalty.HELD: Should have disclosed information to Principal before engaging in this business.NOTE: Sued on fiduciary duties here because D did not appear to be violating K. DON’T FORGET TO DRAFT AROUND FIDUCIARY DUTIES IF YOU NEED TO!REMEDY: Must disgorge any ill-gotten profits. COMPARE: K is limited to actual damages. Other Duties OwedAccounting for Profits – RSA388: Agent who makes a profit in connection with transactions conducted by him on behalf of the P us under a duty to give such profit to P;Not to Deal with Principal as Adverse Party – RSA389 & 391: Agent is subject to a duty not to deal with his principal as an adverse party in a transaction connected with his agency;If Agent is Adverse – RSA390: Agent has to disclose all facts that the agent knows or reasonably should know would affect principal’s judgment.Duty Not to Compete – RSA393: Agent is subject to a duty not to compete with the principal concerning the subject matter of his agency.Avoiding Conflicts of Interest – RSA394: Agent is subject to a duty not to act or to agree to act during the period of his agency for persons whose interests conflict with those of the principal in matters in which the agent is employed.Not to Use/Disclose Confidential Information – RSA395-96: During and after agency. TerminationRULESRevocation and Renunciation – RSA118: Authority terminates if the principal (by revocation) or the agent (by renunciation) manifests to the other dissent to its continuance.Effect of Termination of Authority on Apparent Authority – RSA124A: The termination of authority does not terminate apparent authority. Notification Terminating Apparent Authority – RSA136: Apparent authority terminated when third party has notice of termination. Agent’s Duties to Principal After TerminationUsing Confidential Info after Termination of Agency – RSA396: Unless otherwise agreed, after the termination of agency, the agentHas NO DUTY to not compete with the principal;Has a duty to the principalNot to use or disclose to third persons in competition with the principal or to his injury, trade secrets, written lists of names, or other confidential information. HOWEVER: Entitled to use general information concerning the method of business of the principal and the names of customers retained in his memory, if not acquired in violation of his duty. Has a duty to account for profits made by the sale or use of confidential information, whether or not in competition with principal;Has a duty to the principal not to take advantage of a still subsisting confidential relation created during the prior agency relation. THE LAW OF PARTNERSHIPSWHY A PARTNERSHIP?Partners are Equal Principals: Sometimes there needs to be more than one owner. Partnership facilitates this business format. Advantages: Brings different people’s resources together in a way that cannot be done in agency and creates economic leverage and incentive to perform.Disadvantages: May result in personal liability; ego clashing; and default rules can be ruinous if you are not careful. UPA v. RUPAUPA: Uniform Partnership Act of 1914 – uses the aggregate view of partnerships. Essentially partnerships are the aggregate of the partners’ stakes. Fiduciary duties are mandatory.RUPA: Revised Uniform Partnership Act of 1997- uses the entity view. There is a separate entity known as the “partnership.” Fiduciary duties are modifiable but exist by default. FORMATIONFORMATION RULE-UPA6(1): A partnership results when an association of two or more persons associate to carry on as co-owners of a business for profit.VERY EASY TO FORM: Does not require any sort of written agreement or filings. Rather, simply acting in a particular fashion will create a partnership. TRYING TO MAKE MONEY: Is sufficient to form a partnership – the enterprise does not actually have to be profitable. AS A RESULT: Partnership is the default business association!NAME: However, simply calling yourself a partnership is insufficient proof of partnership. Fenwick. When are you Carrying on as Co-Owners?PROCESS: ExamineAny agreements?How are the profits distributed?REMEMBER: UPA does not provide much guidance here. Mostly a function of agreements between the parties. OTHER FACTORSRisk; Return; Duties; Duration;Intention of the parties;Sharing in losses;Ownership and control of partnership property;Ability to contract in debts;Conduct towards third parties;Rights on dissolution. ESSENTIALLY: Does it look like this person is the pig or the chicken?RULE – UPA(7): In determining whether a partnership existsGross Returns (Revenues, Sales, Receipts): The sharing of gross returns does not itself establish a partnership. WHY? Not committed to the success of the enterprise. You are merely one more expense that needs to be paid out of the gross revenues of the business.Revenue is more steady than profit. ANALOGY: The chicken who gives an egg to breakfast. Interested, but not committed. Profits (Net, Net Income): The receipt of profits of a business is prima facie evidence that he is a partner in a business unless payments are a result of:Debt by installment;Wages of an employee or rent to a landlord;THINK: FenwickAnnuity to a widow or deceased partner;Interest on a loan even though the amount varies with profits;THINK: Martin v. Payton. Consideration for the sale of goodwill or other property by installments.WHY?Interested in the success of the enterprise. Now you need to ensure that expenses are minimized and profitability it maximized. Profits are more variable than gross revenue.ANALOGY: The pig. You are not committed by giving up a piece of bacon to the breakfast. Basically: Are you both carrying on as co-owners of a business?Case Examples of Partnership FormationFenwick – Wages Instead of ProfitsFACTS: To avoid paying worker’s comp, A needs to have less than 7 employees. A opts to have B sign an agreement stating B is a “partner” who is to receive 20% of the net profits “if the business warrants it,” that B contributes no capital, that B will not share in any losses, and that A had sole control.ISSUE: Are A & B partners?RULE: UPA 6HELD: Not a partner, while there was intent to create a partnership evidenced by the agreement, in reality there was no partnership. B did not participate in the profits (was at the option of A); B did not share in losses, B did not have any control over partnership property; B had no control or say in management; B never held out as a partner and when B left, she had no rights on dissolution.Martin v. Peyton – Interest on Loan Instead of ProfitsFACTS: Ds allege that they are creditors and not partners of KN&K. Ds loan KN&K 2.5M in exchange for 40% of profits and option to buy equity, inspection and veto rights.ISSUE: Are Ds partners in the business and therefore liable for its debts?RULE: UPA 6HELD: While they are getting a share of the profits, this is really more akin receiving interest or return of capital on the loan of 2.5M. Not an outrageous rate of return – between 4 and 20% depending on duration. Therefore not partners and not liable. Proper Contracting – Avoiding Implications of Default Rules While Maintaining “Partnership”Generally: Can avoid the Fenwick result if agreement is drafted to look superficially like the rules governing a partnership while in reality bestow all the control onto one party. BASICALLY: Start with the default rule and play around with it. 18a – partners share losses pro rata according to capital contribution, could change to say “share losses regardless of contribution”18e – partner gets one vote, except me who gets 26. 18h – Differences of opinion in governing partnership subject to majority vote, change to subject to what Guttentag had for breakfast.18f – no partner draws salary for carrying on partnership business, modify to give yourself a salary. Why Does “Partner” Classification Matter?LIABILITYRULE – UPA15: All partners are liableJointly AND severally for everything chargeable to the partnership under sections 13 and 14 (essentially all torts and breaches for fiduciary duty); andJOINTLY for all debt and obligations of the partnership (essentially all contracts). Can look to any solvent partner to collect on a debt. RUPA306 RULE: Procedural distinctions removed and all partners are jointly and severally liable. Go after anyone and let them collect from the rest of the partners. ORDER OF LIABILITY PAYMENTS – UPA40Generally: Partners are behind non-partner creditors when liabilities are being paid off from proceeds of the partnership. Details: Are in the termination section below. LIABILITY TO THIRD PARTIESPartners are AgentsRULE – UPA9: Every partner is an agent of the partnership for the purpose of its business.Act of every partner for apparently carrying on in the usual way the business of the partnership binds the partnership.UNLESS: Partner has NO AUTHORITY AND person with whom he is dealing has knowledge he has no authority!Act of a partner which is not for carrying on the business of the partnership in the usual way DOES NOT BIND the partnership unless authorized by the other partners. Partners’ TortsRULE – UPA13: Any wrongful act or omission of any partner acting in the ordinary course of the business of the partnership will make the partnership liable for any resulting harm or penalty incurred. Partnership by EstoppelGenerally: Liability is created as if there is a partnership even if one does not exist. Essentially a way to deal with negligence.Rouge Representative – UPA16(1): When a person represents himself as a partner he is liable to the other party who has given credit to the actual or apparent partnership based on that representation.LIABILITY: That person is liable as if he were an actual member of the partnership. NOTE: Must be a reasonable representation. Makes the alleged partner liable on the contract. Representative of Partnership – UPA16(2): A person represented to be a partner is an agent of a partner who consents to this representation. Such a person can bind the consenting partner (or partnership if all partners consent) as if that person was a partner.If All Partners Consent: Then the partnership is bound. ROLES AND DUTIESGENERALLY: Similar to agency law but less flexible. UPA ROLES AND DUTIESNON-MODIFIABLE MANDATORY DUTIES UNDER UPADuty to Inform – UPA20: Partners shall render ON DEMAND true and full information of all things affecting the partnership to any partner.NOTE: Only on demand! No obligation to volunteer information!WHEN ASKED: For information, partner has an affirmative obligation to give true and full information.Duty to Account – UPA21: Every partner must account to the partnership for any benefits or profits derived by him without the consent of the other partners for anything connected with the partnership. NOTE: Only real mandatory substantive provision. Other provisions are informational. Right to Accounting – UPA22: Any partner shall have the right to a formal accounting whenever just and reasonable. MODIFIABLE DUTIES UNDER UPANOTE: These are all default rules and can be modified via agreement. Agency RULE – UPA9: Every partner is an agent of the partnership for the purpose of its business. RSA RULES – 376-96: The following duties applie:Duty to DiscloseMeinhard: Disclosure would have cured any breach of loyalty. Meehan: When partner asks if you are leaving, have to answer truthfully!Duty of CareGeneral RULE – RSA379: Unless otherwise agreed, agent is subject to a duty to the principal to act with standard care and with the skill which is standard.ESSENTIALLY: Negligence standard. Duty of LoyaltyGeneral RULE – RSA387: Unless otherwise agreed, agent is subject to a duty to act solely for the benefit of the principal.THUS: Duty of loyalty is implicated anytime there is self-interest involved. Example – Meinhard v. SalmonFACTS: A &B enter into real estate partnership to run for 20 years. Toward the end of the partnership, B enters into a lucrative agreement to take place after the 20 year period is over. Does not disclose anything to A. ISSUE: Breach of duty of loyalty?RULE: Not honesty alone, but the punctilio of an honor most sensitive is the standard of behavior.HELD: Learned of the opportunity through the partnership. He had an obligation to at least disclose so that they could compete on even ground. REMEDY: 51/49 split to maintain control as it was before. RUN FROM THE BEAR AT THE SAME TIME!Competing With Former PartnersMeehan RULES: Both agents and partners can prepare to compete;Partners can grab and leave because they have equal rights to customers; HOWEVER: Must solicit in a fair way and let clients know they have an option to stick with old partnership. Otherwise, violation. DISCLOSURE: Also have to disclose to partners you are leaving when they ask!RUN FROM THE BEAR AT THE SAME TIME!Meehan v. SFACTS: Old partners leave firm and take clients and associates. They use devious letters and lie to old partners about leavingHELD: Breach of loyalty (taking old clients without giving fair chance) and breach of duty to inform (lied about leaving). NOTE: Associates are agents while partners are partners!BE CAREFUL! In the law firm context, most partnership agreements explicitly ban preparation to compete. RUPA ROLES AND DUTIESMODIFIABILITYGenerallyThe RUPA takes the freedom of contract approach to partnerships and allows them to extensively modify any of the default rules that govern partnerships. RATIONALE: Better to have the parties interpret their duties than have the Court do the guesswork. RULE – RUPA103: Except as otherwise provided, the relations among partners are governed by the partnership agreement.EXCEPTIONS:Cannot unreasonably restrict the right of access to books and records under 403b;Cannot eliminate the duty of loyalty under 404bHOWEVER: Can specify situations where it will not apply so long as it is not manifestly unreasonable;BLANKET DROP: Of the duty of loyalty will not be upheld in court. Need to make specific carve outs. ESSENTIALLY: Can specify circumstances where partners can compete with each other.Cannot unreasonably reduce the duty of care.NOTE: Duty of care is already pretty low. So not much left to take away here without getting into the “unreasonable” category. MANDATORY INFORMATION DUTIES UNDER RUPARULES – RUPA403: Partner’s Rights and Duties with Respect to Information403(a): Partnership shall maintain books and records;403(b): Partnership shall provide partners and their agents/attorneys with access to its books and records.FORMER PARTNERS: Shall have access to books and records pertaining to their period of their partnership. 403(c): Each partner shall furnish to a partner:WITHOUT DEMAND: Any information concerning the partnership’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties. AFFIRMATIVE OBLIGATION! No request required here! Broader than UPA20!ON DEMAND: Any other information concerning the partnership’s business and affairs unless unreasonable or improper. NOTE: Some information does not have to be disclosed even when asked if it is unreasonable or improper. Some discretion here to the partner. MODIFIABLE DUTIES UNDER RUPAGENERAL RULE – RUPA404: The only fiduciary duties a partner owes to the partnership and other partners are the duty of loyalty (b) and the duty of care (c).Duty of Loyalty – 404B: Partner’s duty of loyalty to the partnership and other partners is limited to:B1 - Profits: Account to the partnership any property or profit derived by the partner related to the partnershipB2 – Double Dealing: Refrain from dealing with the partnership as an adverse party;B3 - Competing: Refrain from competing with the partnership in the conduct of the partnership business before dissolution.SCOPE: The list is exclusive. Unlike UPA which covers a whole myriad of things. Duty of Care – 404C: Partner’s duty of care is limited to refraining from engaging in:Grossly negligent or reckless conduct;Intentional misconduct; orA knowing violation of the law.NOTE: Much lower threshold than UPA which specifies any negligence. Self-Interest – 404E: Partner does not violate a duty of loyalty/care or agreement merely because the act furthers the partner’s own interest.NOTE: Cardozo would likely disagree based on his decision in Meinhard. ROLE OF PARTNER AS MANAGERRemember – Agency Rules ApplyRULE – UPA9: Every partner is an agent of the partnership for the purpose of its business.Act of every partner for apparently carrying on in the usual way the business of the partnership binds the partnership.UNLESS: Partner has NO AUTHORITY AND person with whom he is dealing has knowledge he has no authority!Act of a partner which is not for carrying on the business of the partnership in the usual way DOES NOT BIND the partnership unless authorized by the other partners. Rules Determining Rights/Duties of Partners – UPA18: Rights and duties of the partners in relation to the partnership are determined, subject to any agreement, to the following rules:18(a): Each partner shall share equally in the profits and surplus and must contribute toward the losses, whether capital or otherwise, sustained by the partnership according to his share in the profits. 18(b): Every partner can spend partnership money if reasonably incurred in the ordinary and proper conduct of the partnership’s business. THINK: The bread in the Nabisco case. 18(e): All partners have equal rights in the management and conduct of the partnership business.National Biscuit Co. v. Stroud: partners Stroud and Freeman sell groceries. Stroud tells NBO no more bread but Freeman orders more; NBO ships. Purchase and sale of bread was ordinary and legitimate business of Stroud’s Food Center.Stroud is more powerful partner – in his name; when partnership dissolves everything goes to Stroud Freeman created liability for partnership and Stroud b/c no restrictions on Freeman’s authority; “equal rights in management;” buying bread ordinary & proper conduct of business; two of them so no majority to resolve diff.Recourse: Stroud should have given himself more power in the contract.YOU CAN MODIFY THESE CONTROL RULESEXAMPLE – Day v. Sidley & AustinRULE: Proper to transfer power to an executive committee that makes most important decisions of the partnership. 18(f): No partner is entitled to a salary for acting in the partnership business. 18(h): Any difference on ordinary matters connected with the partnership may be decided by a majority of the partners; but no act may be done in contravention of the agreement unless all partners consent.NO MAJORITY?: If there are only 2 partners and there is a disagreement, they can both still bind the partnership! PARTNERSHIP PROPERTYProperty Rights Under UPA24: Partnership rights of a partner arePartner’s rights in specific partnership property;Nature of Partner’s Right in Specific Property – UPA25: Partner is a co-owner with his partners of specific partnership property as a tenant in partnership. Incidents of this tenancy are such that:Partner has an equal right to possess specific partnership property for partnership purposes but not otherwise;Partner’s right in specific partnership property is not assignable except in connection with the assignment of rights of all the partners in the same property;CAN ONLY ASSIGN YOUR RIGHTS TO PROFITS!Partner’s right in specific property not subject to attachment unless it is a partnership debt.ESSENTIALLY: Cannot recover partnership assets to settle personal debts. His interest in the partnership; andInterest Defined – UPA26: Partner’s interest is his share of the profits and surplus, and the same is personal property;THEREFORE – Assignment of Interest – UPA27: Conveyance by a partner of his interest in the partnership does not dissolve the partnership;RATHER: Entitles assignee to receive the profits the assigning partner would otherwise be entitled. THUS: You can transfer your interest but that only sends the rights to the profits NOT management, claims etc. DISSOLUTION: Assignee is entitled to receive the assignor’s interest. Putnam v. ShoafFACTS: A & B are partners in a cotton gin business. B assigns her interest in the partnership via quitclaim deed to C. Later, C discovers that bookkeeper is embezzling funds. B sues C saying she is entitled to the judgment against the bookkeeper.ISSUE: Did the assignment of B’s partnership interest include the inchoate claim?RULE: Transfer of partnership interest includes inchoate claims.Inchoate Claim: Undiscovered chose in action. Becomes a valid property right once discovered. AKIN TO UNDISCOVERED RESOURCEChose in Action: Personal right not reduced to possession. Capable of such reduction via a claim in a suit of law. HELD: Partnership claim belongs to the partnership, not to any individual. Akin to undiscovered oil. B has no specific interest in the fraud claim to conveyNOTE: Partnership interest was improperly transferred here. Proper way would be to dissolve the partnership, distribute the assets and liabilities to the partners, and then quitclaim B’s portion of the assets and liabilities to C, and allow A & C to form a new partnership. TAKEAWAY: Co-partners cannot sell specific pieces of partnership property! They have no rights to convey in such property. His right to participate in the management. Property Rights Under RUPAGenerally: The real difference between RUPA and UPA is the aggregate versus the entity view of partnership. Reality is that there is little substantive difference as the rules effectively end up operating the same way. Entity (RUPA) View: Partnership is a distinct entity with ownership of assets.Aggregate (UPA) View: Partnership is a collection of partners’ assets and liabilities. Rights in Specific PropertyRUPA 501: A partner IS NOT a co-owner of partnership property and has no interest in partnership property which can be transferred, either voluntarily or involuntarily. COMPARE: UPA claims partners are co-owners of specific property. However, effectively the same rule as partners cannot assign their rights in specific property under UPA. Rights in Partnership InterestRUPA502: A transferable interest of a partner is the partner’s share of profits and losses. The partnership interest is personal property. THUS: Rule is same as UPA. TERMINATIONTERMINATION UNDER UPAGenerallyNOTE: Partner always has the POWER to dissolve the partnership, but not necessarily the RIGHT to dissolve the partnership.If done by right – dissolution proceeds under UPA31(1);If done without right – dissolution proceeds under UPA31(2);Three steps to terminating a partnership:DissolutionWinding Up;Termination.Events Triggering Dissolution Under UPADissolution Defined – UPA29: Dissolution of a partnership is the change in the relation of the partners caused by any partner ceasining to be associated in the carrying on.Dissolution Without Violation of Agreement – UPA(31(1): Dissolution is caused without violation of the agreement between the partners if:Term of undertaking is over;Explicit Term: Fixed term or specified objective of partnership achieved.NOTE: :”Permanent” is an explicit duration. Pav-Saver. Implicit Term: When partner loans money to partnership, with understanding that money advanced is a loan that is to be repaid as soon as feasible from prospective profits, partnership is for a term reasonably required to pay the loan.DISTINGUISH: Seed capital used to start up a business. One hopes to recoup this money and hope alone is not enough to generate implicit termESSENTIALLY: DEBT generates implicit terms, EQUITY does not generate an implicit term.DEBT = OWENEQUITY = PAGEExpress will of ANY partner when no definite term or particular undertaking is specified;Express will of ALL partners who have no assigned their interests;Expulsion of any partner from the business in accordance with the partnership agreementNOTE: This is dissolution with the power and the right.EXAMPLESPage v. PageFACTS: Brothers go into laundry business together as partners. Agreed profits would be retained until debts paid off. No contingencies for losses. After a string of losses, partnership begins to turn a profit. Nonetheless, the capital partner wishes to dissolve.ISSUE: Partnership at will?RULE: Hope does not establish a definitive term. Seed capital is simply equity and creates a partnership at will. NOTE: “For Profit” IS NOT A TERM! Unless there is an implied term or other explicit term, any partnership “for profit” will be a partnership at will.HELD: At will partnership. HOWEVER – if P was using his superior financial position to gains ole control and all future expected profits in bad faith, liable for breach of loyalty to his brother.HAVE TO START RUNNING FROM THE BEAR AT THE SAME TIME. Prentiss v. SheffelFACTS: Two partners in a three man partnership freeze out the third partner. The 2 partners sue for dissolution and liquidation. ISSUE: Improper dissolution?RULE: A freeze out not conducted in bad faith to obtain the partnership assets without the frozen partner is grounds for judicial dissolution.HELD: Appropriate dissolution. Not in bad faith as the third man was not contributing his share of losses.NOTE: No financial injury demonstrated to P. Dissolution in Contravention of Agreement – UPA31(2): In this case, 38(2) applies. This result can be avoided through seeking judicial dissolution.NOTE: This is dissolution with the power bu NOT the right.Pav-Saver v. VassoFACTS: Parties create a partnership intended to be “permanent” and is not to be dissolved without mutual approval. CP then dissolves without consent of other parties. ISSUE: Dissolution in contravention of agreement?RULE: “Permanent” duration is an explicit duration and creates a partnership with an explicit termHELD: Dissolution was in contravention of agreement.Dissolution by Court – UPA32: Court shall decree dissolution wheneverPartner is of unsound mind;Partner becomes incapable of performing his part of the agreement;Partner is guilty of prejudicing the business;Partner willfully or persistently commits a breach of the partnership agreement;ESSENTIALLY: Can you guys just not get along?Business can only be carried on at a loss;Other circumstances make dissolution equitable.EXAMPLESWhy Pick Court Dissolution?AVOID WRONGFUL DISSOLUTION!Received may be appointed for orderly liquidation;Judicial determination of loan status;CAUTION! Dissolution is an EQUITABLE remedy. Therefore, you may not get it if you are the at fault party and also petitioning for dissolution. Owen v. Cohen – Successful Judicial DissolutionFACTS: O&C enter into partnership to run bowling alley. C continued to torment O, stealing money and running around the agreement. O seeks dissolution.ISSUE: Dissolution by court proper?RULE: If they just can’t get along – court may order. HELD: Dissolution granted. Helped the part petitioning was not the party at fault.Collins v. Lewis – Unsuccessful DissolutionFACTS: C and L open a cafeteria together where C provides the money and L operates the place. Agreement says C will provide all the funds needed. Costs go way over to C tells his bank to call the loan early to get out of the partnership. He then goes to court to dissolve it.ISSUE: Judicial dissolution appropriate?RULE: Mere bad blood is not enough to dissolve a partnership.EQUITABLE: Collins was trying to get out of the obligation by being an asshole to avoid damages for breach of agreementBETTER REMEDY: Draft your agreement with a funding cap.Wining Up Under UPALiquidation – Sale of Assets/BusinessSale to Former PartnersPrentiss RULE: Former partners may bid on the assets of the partnership at liquidationNOTE: Essentially allows a forced sale. If 2 of three partners own 90% of the partnership, they can band together and enter the high bid and effectively only pay the 10% share to the partner they want to buy out.HOWEVER: Cannot be done in bad fait as this will trigger fiduciary breaches.EFFECT: Forced sale of minority partner’s interests. Distribution RulesGeneral RULE – UPA38(1): Each partner, unless otherwise agreed, may have his partnership property applied to discharge partnership liabilities.SURPLUS: Applied to pay in cash the net amount owing to the respective partners. Order of Liability Payment – UPA40BSubject to agreement, the liabilities of the partnership shall rank in the order of payment as follows:Those owing to creditors other than partners;Those owing to partners other than for capital and profits;Those owing to partners in respect of capital;Those owing to partners in respect of profit. Loss RulesREMEMBER! These are default rules. The parties can contract around them to specify their own loss and profit provisions.DEFAULT RULES WILL PENALIZE SOMEONEUPA JX: Service partner penalized for losses.Kovacik JX: Capital partner penalizedGeneral RULE – UPA18A: Each partner must contribute toward the losses, whether capital or otherwise, sustained by the partnership according to his share of the profits.Loss Contribution: Partners shall contribute the amount necessary to satisfy the liabilities listed in 40b. Capital Account: Initial contributions by partners. These amounts are paid before profit distributions. Kovacik RULE(CA/MIN): Upon the loss of money by a partnership, the party who contributed the money is not entitled to recover any part of it from the party who ONLY contributed services.DOES NOT FOLLOW THE UPA/RUPA SCHEMERATIONALE: Both parties have shared in the loss equally. The capital partner lost his money and the service partner lost his time. Further, capital party was more sophisticated individual and should have protected his interest (assumes service partner less sophisticated).HOWEVER: Rule foes not apply if the service partner contributes even a nominal amount of capital.RESEMBLES: An option payoff for the service partner. Maximum loss is $0 (and time). All the upside however. NO LONGER THE PIG!Everything below the trike price is other people’s money and ruins incentive!CAUTION! CA has since adopted RUPA which explicitly rejects the Kovacik approach. Current law is uncertain.FACT RECAP: Partners remodel kitchens. One contributed $10K and the other did the work. Venture ends up losing $8K and capital partner sues service partner for contribution.Continuation Following Wrongful DissolutionNOTE: Partnership assets are in a new partnership here. RULE – UPA38(2): When dissolution is caused in contravention of the partnership agreement, the rights of the partners shall be as follows:Partners Who DID NOT Wrongfully DissolveAll rights specified in 38(1); andRight against each partner who wrongfully dissolved for damages for breach of agreement.If Business ContinuesNon-breaching partners can carry on the business as a partnership so long as they secure the payment by bond or pay the wrongfully terminating partner and indemnify him from future liability.The value of his interest (WITHOUT goodwill) LESS any damages recoverable. See below for precise calculation.Pav-Saver RULE: Election for non-breaching partners to continue business may entitle them to use intellectual property that otherwise was to be returned to the other party under the agreement.LESSON? Contract around the default rules CAREFULLY to avoid adverse interpretation by the court.USE: Carefully drafted liquidated damages clauses specifying that they supersede any other rights on dissolution.Partners Who WRONGFULLY DissolvedBusiness Liquidated: All rights for partner under 38(1) less damages for breach of agreement. Business Carried On: Value of the interest in the partnership, less any damages, paid to him by cash or secured by bond. HOWEVER: Value of the partnership stake EXCLUDES GOODWILL!BIG DIFFERENCE FROM RUPA: RUPA includes the value of goodwill when making payouts. UPA double kicks wrongfully terminating partners with damages and with mere book value.Continuation per AgreementNOTE: Partnership assets are in a new partnership here.Termination Under UPAOnce the dissolution and wind up take place – the partnership has been terminated.TERMINATION UNDER RUPADissolution versus DisassociationGeneral RULE: Disassociation under 601 or 602 only leads to dissolution in certain circumstances specified in 801.If Dissolution Falls Under RUPA801: Then the business is dissolved and the winding up period beings. Otherwise: Business continues and buyout of disassociated partner calculated under 700.701(b) – Buyout of disassociated partners’ interest is the greater of liquidation value OR sale of entire business as a going concern INCLUDING goodwill value.701(c) – Damages for wrongful dissolution are deducted against the buyout amount.701(h) – Buyout can be delated until the xpiration of the term of the partnership unless the disassociated partner can show payment would not cause undue hardship to the business. CORPORATIONSIntroductionAdvantages of Corporate FormMore permanent;BECAUSE: Ownership is easily transferred. Able to handle larger tasks;Sources of Corporate LawStateRULE: Can choose whichever state to incorporate. Generally governed by either DE law or Model Business Corporation Act (MBCA). Paul v. Virginia RULE: State cannot discriminate against foreign (out of state corporations) that operate in interstate commerce. Why is DE So Popular? Two TheoriesRace to the Top: Regulatory competition ensures that only rules that are efficient and demanded by shareholders will persist. ESSENTIALLY: States compete for the “best” corporate law to attract investors. Race to the Bottom: States keep shedding rules and regulations to make their states more attractive to businesses. ESSENTIALLY: States simply deregulate and drop taxes until they all get to zero!Who Uses the MBCA?About 30 states including California. CA: While adopted by CA, CA looks to DE for substantive law when it has questions of interpretation. FederalGenerally: Corporations are federally regulated when their shares are publically traded. Subjects corporations to:SEC Act of 1933 – The Disclosure ActSEC Act of 1934 – Regulates the sale of securitiesSarbanes Oxley Act of 2002 – Federalizes corporate governance standards. ExchangesGenerally: Stock exchanges will impose their own private rules on corporations that wish to have their stock listed there. Corporations can choose which exchange they want to be listed on. Typical Types of CorporationsClosely Held Corporation: Generally: A corporation with very few shareholders and heavy restrictions on the transfer of its stock. No public market exists for their stock.Private CorporationGenerally: A corporation with a limited number of shareholders and a limit imposed on trading in the shares under federal law. NOTE: Several very large corporations are private corporations. Cargill;Bechtel;Chrysler;How to Take PublicIPO: Through an initial public offering of shares, a private corporation can offer its shares for sale to the public at large assuming it complies with all the necessary federal guidelines. Public CorporationGenerally: Trading of shares is of sufficient volume that they are conducted on markets. Essentially when you have more than 500 shareholders and more than $10M in assets.Shares: Are freely tradable.Subject to: All of the various federal regulations. Key Attributes of Corporations Legal Personality and Perpetual Duration – MBCA 3.02RULE: Corporation is an entity with separate legal existence from its owners. Has all the powers and rights of an individual to carry on its business affairs.Possesses some constitutional rights;Separate taxpayer;Requires formal creation. Limited Liability – MBCA6.22RULE: Unless the articles of incorporation provide otherwise, a shareholder of a corporation is not personally liable for the acts or debt of the corporation except that he may become personally liable by reason of his own acts or conduct. NOT LIKE PARTNERSHIP: Shareholder is immune from liability unless he affirmatively does something. LiquidityShares can be traded on exchanges or individually.HOWEVER: Must be cautious of Federal rules here.Allows: More liquid capital markets and the ability to raise capital without having to involve people in the day to day affairs of corporate governance. Separation of Ownership and Control – MBCA 8.01(b)RULE: ALL corporate powers shall be exercised by or under the authority of the board of directors of the corporation and the business and affairs of the corporation shall be managed by or under the direction and subject to oversight of its board of directors. ESSENTIALLY: Allows dedicated management by a group and separate capital funding by another group. PRACTICAL CONSEQUENCE: Of having liquid ownership structure because the ownership of the corporation will change day to daySOURCE OF FRICTION: Between whether the shareholders thoughts should rule or the managers’ thoughts should rule. Formal Capital StructureGenerally: A firm has a lot of flexibility in the type of claims it can issue against its future revenues and profits. Securities = Any claim on future revenues or profits based on a contractual agreement. Capital Structure = Debt + EquityEquity: Represents ownership interest and can rise and fall depending on the success of the corporation. It’s the pig.Voting Rights: Get to select the board of directors.Limited Liquidation Rights: Only get whatever is left after everyone else has been paidEntitled to: Profits of the corporation. Unlimited upside and unlimited downside to the extent of the equity investment. Preferred v. Common StockPreferred: Preferred as to dividends and liquidation rights. Usually no voting power. Hybrid form of mon: Voting rights. Back of the line claims. Debt: Fixed claims on future revenues that do not change with the value of the firm. This is the chicken. Usually: Interest payments are made and the principal is due at the maturity date. Secured: Secured debt is backed by an asset of the corporation. E.g. C Corporation can have $10M dollars so long as in the event of default Lender gets the factories. Financial StatementsBalance Sheet (The Stock)– Snapshot of assets, liabilities and shareholder equity at a given point in time.GAAP: Done via generally accepted accounting principles. COST BASIS: Assets and liabilities are recorded at their historical cost. Fundamental Accounting EquationAssets = Liabilities + Shareholder EquityTHEORY: Everything a corporation owns has to be paid by either debt or shareholder contributions. Ratio AnalysisMarket Value/Book ValueIncome Statement (The Flow) – Provides the profit and loss statement for operations over a certain period of time. Lists out all revenue sources and all expenses. RATIO ANALYSIS: Price of Stock/EarningsExample from Dodge v. Ford: Dodge brothers offered to sell their 10% shares back to Ford for $35 million. This implies a firm market value of $350 million. $350 million is almost 3x the book value of $132 million listed in the case. But better indicator is the price/earnings ratio. Profits were $60 million per yr, so 350/60 is almost 6x (offer was six times what the company is earning each year). Meaning, someone buying the firm would have their investment back in 6yrs. This is a low number and good deal for the buyer according to NY Times article by David Leonhardt, which shows that since 1937, price/earning ratios are generally between 10-20.Valuing a Corporation and Its StockTypes of SharesAuthorized SharesNumber of shares a corporation can issue as per its articles of incorporation. Outstanding SharesNumber of shares the corporation has sold and not redeemed. Authorized But Unissued Shares: Shares that are authorized, but have not yet been sold. Enterprise ValueOne Share of Stock * # of authorized Shares + Value of Firm’s Debt = Value of the AssetsBook Value or Market ValueBook Value: Value based on balance sheet figures using historical cost.Book Value = Shareholder EquityMarket Value: Value based on trading price of a stock. Efficient Capital Market Hypothesis: The price of an asset reflects all available information. Market Value = Shareholder Equity Based on Market Prices Determining the Value of a Share of Stock Using Book ValueStep 1: Determine a firm’s total value using eitherLiquidation Value: What you can get from selling the various assets of the firm after paying off its liabilities; orValue of Future Cash Flows: Discount to find the present value of the cash flows of the corporation into perpetuity. ESSENTIALLY: Take all future revenues; subtract all future costs; find discount rate; discount and find present value.Step 2: Determine the Firm’s Equity ValueSubtract the obligations (liabilities) of the firm value. Step 3: Calculate equity value per shareEquity value/# of shares outstanding. TaxationGENERALLY: Corporations pay tax on their earnings and then when those earnings are distributed to shareholders they also pay tax.THE DOUBLE TAXATION.LOSSES: Can only be taken at the corporate level. Individual shareholders do not get to use PARE: Partnerships where you can take the venture’s losses against your own profits. FormationProcess of FormationFirst: Pick a StateInternal Affairs DOCTRINE: Corporations are governed by the state in which they are incorporated. Reserved Powers DOCTRINE: A corporation is bound by changes in the State’s substantive law regardless of what is in its corporate charterNOTE: Corporation viewed as a mixture of private and public interests. Second: Draft the Articles of Incorporation & BylawsArticles of Incorporation – MBCA2.02: Essentially the corporation’s constitution.MUST INCLUDE: Name, # of authorized shares, address, name of each incorporator. MAY INCLUDE: Name of initial directors; management; limits on rights; shareholder liability. Bylaws – MBCA2.06: Essentially the statutes of the corporation. Easier to change than the articles of incorporation. Incorporators or Board: Shall adopt initial bylaws.MAY INCLUDE: Provisions for managing the business and regulating the affairs of the corporation. Third: File Articles with Secretary of StateRULE MBCA2.03: Corporate existence begins when the articles of incorporation are filed. Secretary’s Filing: Conclusive proof that all conditions precedent were satisfied.THUS: Don’t screw this step up. Limited liability depends on a proper incorporation. Fourth: Final Steps After FormationRULE MBCA2.05: After incorporationFinalize Directors: Initial directors should hold an organizational meeting or shareholders should appoint them if they don’t exist;Appoint Officers: Elect directors.Adopt Bylaws: Under 2.06. Members of the Corporate CastPromoters – Solicit fundsShareholders – Vote, sue, sell (majority duty to minority shareholders otherwise do not owe one another fiduciary duties)Board of Directors – Manage business, fiduciary duties to shareholders Officers – Work for directors, similar fiduciary duties; third party liability determined by agency law. Issues With FormationDefective Formation DoctrinesDe Facto IncorporationRULE: An improperly organized corporation will be treated as an incorporated entity if the organizers:Tried to incorporate in good faith;Had a legal right to incorporate; andActed as if they were a corporation. Incorporation by EstoppelRULE: An improperly formed corporation will be treated as an incorporated entity if a third person dealing with the firmThought the firm was a corporation; andA windfall to the third party would result if not allowed to argue firm was not a corporation. POLICY: Prevent getting around limited liability due to some paperwork error. Promoter Liability for Pre-Incorporation ActivityNOTE: Archaic area of law now that incorporation is so easy to perform. Promoter Defined: Someone who claims at act as an agent prior to incorporation to solicit fundsDoes the corporation become party to the K?RULE: Yes, if the contract is adopted by the corporation. Note: this requirement will often be satisfied because the job of the promoter is generally to go out and get money, so person willing to invest generally executes agreement w/ corporation so that they will adopt the KIs the promoter liable if the corporation breaches the K?RULE: Yes, unless both corporation AND investor release promoter from liability. Is the promoter liable if the corporation is not formed?RULE – MBCA2.04: Yes, promoters are jointly and severally liable for all liabilities created while a promoter. Shareholder Liability to Third PartiesGeneral – Avoiding Personal LiabilityDark Side: Business can be incorporated for the express purpose of avoiding personal liability!RATIONALE: Makes investors willing to put capital into markets and encourage economic development;Shareholders are not the managers of the business so it seems unjust to make them personally liable;THUS: When a shareholder is also a director, there may be liability!Enterprise Splitting: A single enterprise can be split into multiple corporations to limit the liability exposure of each part of the business!General RULE – MBCA6.22(b): A shareholder of a corporation is not personally liable for the acts or debt of the corporation except that he may become personally liable by reason of his own acts or conduct. THUS: Shareholder’s can only lose his investment into the firm and nothing more.CORPORATION IS LEGAL ENTITYIt is responsible for its own debts and torts. EXCEPTION – PIERCING THE CORPORATE VEIL (PCV)GENERALLYThis is the “except that he may become personally liable by reason of his own acts or conduct” exception.Suing the shareholder to collect from him personally. Walkovsky RULE: P must show that shareholder and his associates are doing business in their individual capacities, shuttling their personal funds in and out of the corporation without regard to formality and to suit their immediate convenience.WARNING! The corporate form is not disregarded merely because it has insufficient assets to pay claims. ESSENTIALLY: So long as a corporation follows the required formalities, shareholders can avoid liability!LESSON: Don’t mingle funds!Van Dorn TEST for PCV: Must demonstrate two factorsUnity of Interest: Examine the following factors to determine if the separate personalities of the corporation and the shareholder no longer exist:Lack of corporate formalities;Comingling of funds and assets;Severe under-capitalization;Business does not have sufficient capital to support operations. Treating corporate assets as one’s own. Refusal Would AllowSanction fraud; orEXAMPLE: Promising to pay a debt knowing you will shift assets to avoid ever having to pay the debt. Promote injusticeE.g. unjust enrichment. NOTE: Must be more than mere inability to collect on a debt or judgment. Reverse Piercing of the Corporate VeilGenerallyReverse piercing the corporate veil is the act holding a shareholder personally liable for the debts of the corporation and then (when taking his assets as damages) reaching into the assets of other corporations to which he is a shareholder.Like being struck by lightning!Sea-Land RULE: The court may reverse pierce the corporate veil only after the corporate veil has been pierced.NOTE: Generally used when the shareholder’s assets are primarily stock of other corporations that do not have much value. Allows access to those corporations assets ahead of creditors. Sea Land v. Pepper Source – Sea Land shipped peppers on behalf of Pepper Source. PS then failed to pay for the freight bill. When judgment entered against PS, had dissolved & no assets. PS had one shareholder (Marchese), who was also sole shareholder in 5 other corporations and 50/50 in another. Sea Land sues wanting to pierce the corporate veil (gets personal liability) and reverse pierce to get assets of other corporations. Held: first half of test met, b/c Corporation undercapitalized, funds and assets were commingled and had been moved and borrowed w/o regard to their source. But case remanded on second part of test (on remand ct held shareholder had promised payment knowing he would shift assets to avoid payment (fraud)Corporation’s Liability to Third PartiesEnterprise LiabilityGenerallyThis is where a P will sue sister corporations in the aggregate to collect from their pooled assets. Not really a form of corporate veil piercing. General RULE: When a corporation is a fragment of a larger corporation that actually conducts business, the larger entity in the aggregate may be held liable if the shareholders did not respect the separate identities of the corporation by eitherAssignment of employees;Sharing bank accounts;Sharing supply ordersTHEREFORE: If a company commits a tort and its sister companies form has not been respected by shareholders, may be able to recover by viewing the companies in the aggregate. Roles and DutiesCorporation’s Duty with Respect to CreditorsIntroductionDebt Securities: Fixed claims that arise from funds borrowed by the firm, and that the firm agrees to pay interest on and repay in full on maturity. Holders of Debt Securities: Are the creditors of a corporation. Duties Owed to CreditorsGeneral RULE: Corporation’s duty to creditors are specified via contractLegal Analysis: Governed by the interpretation of express terms and the duty of good faith and fair dealing. THERE ARE NO FIDUCIARY DUTIES TO DEBT HOLDERS!THUS: The only rights creditors have are the rights they crafted in the debt indentures!NOTE: Creditors can do nothing to protect themselves against actions of the borrow that jeopardize borrowers’ ability to pay the debt unless rights are established through K provisions in indenture.Bond Indentures – The contract between corporation and creditorGeneralIssues in $1000 increments. Two FlavorsSecured: Backed by a particular asset that the creditor receives in the event of default.Unsecured: Not backed by a particular asset. Just superior rights in the event of liquidation. Typical ProvisionsDefault ProvisionRULE: A default by the firm will trigger acceleration of the bonds.Acceleration: Face value becomes immediately due and payable. ENFORCEMENT MECHANISM: This is the enforcement provision if any of the bond covenants are broken. Restrictive Covenants: Specifies limits on certain activities such asLimit the firm’s ability to pay dividendsLimit the use of proceeds;Specify certain financial ratios that must be keptE.g. debt to equity ratios. NOTE: This is the key way creditors protect themselves from being hosed. Negative Pledge CovenantsRestricts the firm’s ability to issue debt senior to the bond in question. Liquidation ClauseRULE: If the issuer (the corporation) is liquidated, the debt must be paid at face value. Successor-Obligor ClauseRULE: When a corporation transfers all or substantially all of its assets to a successor entity, that entity must assume the debt obligation. INTERPRETATION: Of these boilerplate clauses is a matter of LAW and not fact. For judge to determine. Sharon Steel. RATIONALE: Essentially just a change in form and therefore the mere moving of entities shouldn’t alter the obligation. Keeps merger options and such open. HOWEVER: Cannot transfer the assets piecemeal. Substantially all or all the assets must be transferred to a single entity at the same time. Sharon Steel Corp v. Chase Manhattan – UV had issued $123 million face value bonds at below market interest rate (low interest rate means market rate value less than face amount). UV adopts plan for liquidation (but if “all or substantially all” assets sold then will not be in default). Three businesses: in March sold Federal Electric for $345 million; in October sold oil and gas for $135 million. This left Mueller Brass, some mining properties, and $322 million in cash (subject to bondholders). In November, Sharon Steel bought remaining assets for $107 million cash and issued bonds with a market value of $353 million to UV equity holdersSharon Steel and UV exchange cash for cash and bonds for Mueller Brass; doing this b/c they want to leave bonds outstanding to maintain low interest rates. Bondholders want to accelerate bonds so they can reinvest to take advantage of higher interest rates existing in the market.Sharon Steel argues obligor clause applies b/c proceeds received from earlier piecemeal sales are assets meaning it purchased all or substantially all UV’s assets. Court holds that UV only transferred 51% of its book assets based on when the liquidation began (the Mueller Brass corporation) and therefore not “substantially all” and was therefore in liquidation not successor obligor.PROF DISAGREES: Should be based on the market value of the assets transferred, not the book value when the liquidation began! LACKS ECONOMIC SENSE!The Leveraged Buyout (LBO)Definition: Investor takes out debt secured by the assets of the target to acquire the outstanding shares of the corporation. Shareholders are paid to leave essentially. Acquisition: Means gaining at least 51% control of the corporation. Bondholder Concern: Issuing more debt makes market value of existing bonds worth less. As a corporation takes on more debt, its default risk increases driving down the market value for its bonds.HOWEVER: Bondholder’s rights are only secured by contract. Therefore, in the absence of any negative covenants against taking on more debt, bondholders have no recourse!RESULT: Corporate control is transferred and the corporation has a lot more debt.INCREASED “LEVERAGE” (Debt to Equity)BENEFITS More debt = more risk = more discipline (or so the theory goes). Allows purchase to be easily financed. Shareholders get to cash out (usually at a premium to market value). The “Strong” Capital Structure: A firm with lots of equity and little debt.Allows: Corporation to buy out some its equity with debt to transfer control. Similar to: A mortgage. You borrow money against an asset you do not yet actually own to buy it!Met-Life v. RJR NabiscoFACTS: Nabisco is the target of an LBO; Π’s are bondholders. Because new debt makes preexisting bonds less valuable, bondholders sue after the LBO to protect their investment (arguing they suffered multimillion dollar loss). Claimed breach of implied covenant of GFFD (duty to not dilute debt); equitable claims of unjust enrichment; breach of fiduc.; frustration of purpose; unconscionability; and fraud (10b5 fed securities and common law).RULE: Obligations with respect to creditors governed by contractHELD: All claims dismissed as none of the debt covenants were breached. 10b5 claim was not in connection with the purchase or sale of any security and therefore invalid. Common law fraud for statements saying “we would not harm the balance sheet” possible. Remand for determination. Bank DebtThese are lines of credit that a corporation can draw on to fund operations. Fiduciary Duties to CreditorsRULE: Generally all duties to creditors are governed by the security agreements. EXCEPTION - INSOLVENCY: When a firm’s debt obligations exceed its assets. Firm’s equity is essentially worthless at this point;In this situation, board of directors owes a fiduciary duty to the debt holders.THUS: Board of directors can be reckless with respect to the debt (assuming they do not breach indenture covenants) until the firm is insolvent. Then they owe fiduciary duties!Two Competing Theories on to WHOM Duties are OwedStakeholder Theory: Duty of the corporation is to all constituents who have a stake in the outcome of the community including the shareholders, the community, employees, and clients/customers. Scholarly Rationale: Keeping the shareholders interests as the exclusive interest makes corporations do evil nasty things (think Ford Pinto). FRIEDMAN’S REBUTTAL: Essentially you are spending other people’s money and making the allocation yourself instead of the market. Who pays? The shareholders in reduced returns, the employees in lower pay, or the customer in higher prices. This is the decision being made by the corporate executive. SUPPORTED BY: Warren Buffet as well. Corporation is not an eleemosynary institution.Professor’s Retort: Corporations can do things that benefit their constituents but believe in the long run they are benefiting shareholders. Example – AP Smith Mfg Co v. BarlowFACTS: Corporation gives 1500 bucks to Princeton University as a donation.ISSUE: Is this a proper corporate expenditure?RULESBoard of directors actions are eitherUltra Vires – beyond their power;Intra Vires – within their power;Under Common-Law: Board cannot make contributions unless in the Certificate of Incorporation;PERMISSIBLE, Common Law then recognized that donations that tended to promote corporate objectives were permissible.NOT PERMISSIBLE: Indiscriminate giving, pet charities, personal ends. HELD: Corporation has an interest in having a supply of talented individuals as employees. Further, as corporation has become the main store of wealth, donations necessary go through them. Shareholder Primacy: Sole duty of the corporation is to its shareholders. Rationale: They own the corporation and the corporation’s directors’ sole competence is running the company. Any social or other objectives should be left to the shareholders when they receive the fruits of the corporation’s business. UTILIZES: Specialization and market mechanisms. Allocation decisions are skewed when allocating cash other than your own!RULE: Directors must act in the best interests of the corporation to maximize shareholder profits. HOWEVER: There is considerable discretion in the means of achieving that end. SO LONG AS: Decisions are made “in the shareholder’s interest” and there is some rational basis to support, decision will be upheld.Dodge v. Ford Motor Co.FACTS: Ford decides he’s no longer going to pay special dividends to shareholders; plans to reinvest profits in the company. Π offers to sell 10% interest for $35 million; ? refuses and Π sues claiming choice not in best interest of company/shareholders. ? testifies claiming purpose of expanding was for consumers and potential employees. HELD: Decisions specifically not for the primary interests of the shareholders therefore dividend ordered paid but Ford was allowed to continue expansion.NOTE: The Dodge Brothers offer was pretty good – they were asking to be bought out for a 6 P/E compared to market averages of about 10 to 20 at the time. ESSENTIALLY: Courts will not scrutinize decisions on how to make profit but will scrutinize decisions as to whether to make profit. PRIMARY PURPOSE: Has to be for the shareholders not for others!Content of Board of Director’s Duties GenerallyRole of the Board of DirectorsRULE – 141a/8.01: The board of directors manage the business of the corporation NOTE: As explained above, directors must generally act to maximize shareholder profits.To Whom Does the Board Owe Duties?RULE: The board’s duties are to the corporation and the shareholder. EXCEPTION: When a corporation holds money in trust, duties are owed to those for whom the money is held. Francis. THINK: Insurance companies. Duty of Care (Don’t Shirk)BUSINESS JUDGMENT RULE: Courts will defer to directors on decisions regarding substantive corporate matters. Courts will only examine the process of decision making for defects but there will be a PRESUMPTION that the decision was made properly. EXAMPLE: Dividend distribution by Amex in the Karin case. Business decision to pay dividend not reviewed. Process of making that distribution will possibly be reviewed. POLICY: Directors at the time of the decision are in the best position to make it without shareholders second guessing;SHAREHOLDERS: If they don’t like the directors they can always vote in new ones. Directors are specialists in corporate decision making, not judges;COMPETITION: Lousy management will get eaten in the marketplace. Let the market determine who is a good manager. Directors should not be held liable for a bad business call;ENCOURAGES: People to enter into corporate governance.SEPARATE OWNERSHIP/MANAGEMENT: The idea is to take the risk considerations out of the decision making to make the most efficient decisions. BJR PRESUMPTION OVERCOME (Aronson): If challenger shows eitherFraud, illegality or conflict of interest (lack of good faith);Kamin: Business judgment rule protects in this instance because only 4 of the 20 shareholders had a potential conflict of interest and it appears board was acting in good faith. KAMIN = PASS No Honest Belief: That an action is in the best interest of the corporation is a breach of good faith. THINK: Ford. Henry Ford lost because he had an honest belief it was not in the corporation’s best interest!FORD = FAILLack of a rational business purpose (waste);NOTE: Essentially impossible to meet. Virtually every corporate decision will have some rational purpose. Kamin: Shareholders alleged that distributing a stock dividend in kind as opposed to selling and taking an $8M tax benefit amounted to waste. Lost because Board contemplated and decided would look better not to take the loss MARGINAL CALL: If you believe in the efficient market hypothesis. Gross negligence in discharging duties to supervise and become informed.ESSENTIALLY: Watching the factory burn and doing nothing about it. ALMOST IMPOSSIBLE: To prevail on this claim. Relying on Director’s ReportsDGCL 141: Directors can rely on reports from other directors/employees/officers if reasonable (report construed liberally to include oral reports) in making decisions. Provides duty of care defense.Smith v. Van GorkomFACTS: CEO negotiates LBO of company. After Chief Financial Officer (CFO) determines LBO would be easy at $50/share but difficult at $60, CEO decides to sell at $55 after meeting with CFO’s assistant. CEO works behind the scenes and gets deal – eventually board has meeting on Sept 20, at which time merger is approved (10-1) based on oral testimony of management (9/20). Revised deal approved 10/8 and shareholders approved on 2/10. HELD: not informed – directors must inform themselves of all material info reasonably available prior to decision. Board uninformed as to value of the company ($55 came from nowhere). Based decision solely on management testimony in 2hrs w/o even seeing written summary of terms of merger beforehand. CFO had learned of agreement 1hr before meeting; CEO signs agreement w/o reading document. DEFECTIVE: Smith defects: couldn’t rely on officers statements under Delaware code; no adequate market test; not all material info was given to Board before decision was made; #’s came from out of nowhere – wasn’t informed. NOTE: Shareholder ratification couldn’t cure because would be uninformed (how price set was unknown – they just accepted what the directors said).Van Gorkon CuresDUE DILIGENCE: Hire Lawyers, accountants, investment bankers to go through the deal.ESSENTIALLY: You have to go through the motions!PRICE PREMIUM: Has to be conducted based on reasonable information (valuation) and not on what would be “feasible.”DGCL 141e: Directors can rely on reports from other directors/employees/etc (report construed liberally to include oral reports – must be reasonable!) in making decisions. Provides duty of care defense.Van Gorkon: There was no report and CFO’s oral report was insufficient, therefore 141 does not protect. Nothing in reports showed basis for price!Market Test PeriodCan put the bid out to market to see if anyone will bite. But has to be a reasonable market test period. The one in Van Gorkom failed because it didn’t allow bids to be solicited. No meaningful opportunity to bid!Shareholder RatificationShareholders could have cured if they were fully informed. Inaction of a DirectorCAUTION! Business judgment rule only applies to ACTIONS by the board. Inaction is not an action and therefore the rule does not apply in this context!RULE: Breach of duty of care requires showing duty, breach and proximate cause.Duty: Typically to shareholders only.HOWEVER: Directors of nonbanking corporations may owe a similar duty when the corporation holds funds of others in trust!EXAMPLE: Insurance broker/Reinsurance broker. Breach: Director has an AFFIRMATIVE OBLIGATION of:Basic knowledge and supervision;Read and understand financial statements;Object to misconduct and, if necessary, resign. Proximate Cause: The inaction must be the proximate cause of the party’s loss.STRETCH: In particularly egregious circumstances, the Court may stretch proximate cause to liability.EXAMPLE: In Francis, the fraud did not start under the drunken listless widow, it started under the late husband. She was held liable anyway to add her estate’s assets to the bankruptcy pool. Francis v. New Jersey Bank –FACTS: Husband dies and wife left w/ 48% shares and board chair (reinsurance brokerage firm); sons owned 52% and systematically embezzled large amounts of $ in the form of loans; wife was unfamiliar w/ business of reinsurance, made no effort to assure policies of corporation complied with law, missed meetings, drank heavily, listless etc. HELD: ct found directors have affirmative duties & duty was owed to customer’s b/c character of reinsurance industry, nature of misappropriation of funds, and financial condition of firm. Proximate cause met b/c son’s actions so blatantly wrongWHY LOANS: Show up as an asset on the balance sheet and do not deplete surplus, just cash. Compliance with Statutes and RegulationsNO BUSINESS JUDGMENT RULE APPLIES HEREWhy? Compliance with law is not the same policy as encouraging directors to engaging in risk taking.OLD RULE – Graham: Directors are entitled to rely on the honesty of their subordinates until something occurs to put them on notice. Failure to Act: Once the director is on notice will potential create liability for breach of a duty of care. “One Free Bite” Rule: Director gets one shot to be a buffoon. CURRENT RULE – In re Caremark: Directors have a duty to assure that a corporate information and reporting system exists and that a failure to do so MAY render a director liable for losses caused by non-compliance with legal standards. What Does an “Adequete” Compliance Program Look Like?Policy manuals;Training employees;Compliance audits;Sanctions for violation;Provisions for self-reporting of violations to regulators. Rationale:Risk taking with respect to business matters is GOODTHEREFORE: The law will encourage it by providing a level of deference through the business judgement rule.Risk taking with respect to the law is BADTHEREFORE: The law has an societal interest in deterring illegal activity and will discourage it through active oversight. In re Caremark Derivative LitigationFACTS: Corporation involved in healthcare, employees violate law and Π brings derivative suit claiming inadequate supervision (duty of care breach). Court is reviewing proposed settlement to determine if fair and reasonable. HELD: Settlement is approved. Company benefited by getting five provisions in proposed settlement but it cost $869,000 in fees to Π attorney and company cost to defendASPIRATIONAL RULES- DUTY OF CARE CODIFIED8.30(a): Each member of the board of directors when discharging the duties of a director shall actIn good faith; andIn a manner the director reasonably believes to be in the best interests of the corporation. 8.30(b): When becoming informed or devoting attention shall discharge their duties with the care a person in a like situation would reasonably believe appropriate.8.30(c): Directors shall disclose material information.CAUTION! This is a PROCEDURAL duty of care, not a substantive duty of care akin to the duty in tort law.ASPIRATION RULE! Liability does not occur based on a breach of this rule. It is simply the desired “standard” of directors. LIABILITY RULE 8.31: Directors may be found liable if:NOTE: 8.31(a)(1): Corporate charter indemnification or cleansing does not preclude liability;(a)(2)(i): Director did not act in good faith;(a)(2)(ii)(A): Director did not reasonably believe decision was in best interests of corporation;(a)(2)(ii)(B): Director was not informed to an extent the director reasonably believed appropriate in the circumstances; or(a)(2)(iii): Lack of objectivity due to director’s lack of independence (conflict of interest);(a)(2)(iv): Failure to devote attention to ongoing oversight of the business or devote timely attention when facts arise. Insulating Directors from Personal Liability GenerallyIf a challenger overcomes the business judgment rule and shows a decision was uninformed or lacked rational basis, any director who participated in the decision is liable for breaching a duty of care. INCLUDES: Directors who voted for, acquiesced in, or failed to object to an action. EXCLUDES: Those who formally objected. JOINT AND SEVERAL LIABILITY: The offending directors are jointly and severally liable for the proximately caused damages. Business Judgment RuleSee aboveIndemnificationMBCA8.51-56/145: Corporation can indemnify officers and directors against judgments and expenses associated with defending them Requires vote of disinterested directors/shareholders. Advance Fees: Corporation can advance the officer/director the money needed for defense. If Cleared on Merits: Must be indemnified for actual and reasonable costsTerminationDue to settlement does not lead to a presumption of not acting in good faith. Finding of Liability: Generally negates ability to be indemnified. THEREFORE: SETTLE!.Directors’ and Officers’ InsuranceRULE – MBCA8.57/145(g): Corporation has the power to carry insurance whether or not the corporation would have the power to indemnify the director/officer. Exculpation Statutes – MBCA2.02(b)(4); DGCL 102(b)(7). GENERALLY: After Van Gorkom, insurance premiums for directors and concern over director liability prompted statutory changes.NOT MANDATORYHOWEVER: 90% of public companies have adopted it. ALLOWS: Charter amendments to shield directors from personal liability for breaching their duty of care.DOES NOT ALLOW: Waiver of the following:The duty of loyalty or When personal benefit is derived;Fraud or misappropriation Duty of Loyalty (Don’t Steal)GeneralBUSINESS JUDGMENT RULE DOES NOT APPLY TO DUTY OF LOYALTY CLAIMS!REMEMBER: Does not apply to conflicts of interest – which is the heart of the duty of loyalty. When UsedRegulates self-dealing in transactions between directors and the corporation. OLD RULE: Flatly prohibited any transactions between the corporation and its directors. RationaleTransactions between directors and the corporation can be mutually beneficial;However, these transactions have the potential to end up looking like embezzlement;Therefore, a policing mechanism is needed.Description of the Duty of Loyalty“Essentially, the duty of loyalty mandates that the best interests of the corporation and its stockholders takes precedence over any interest possessed by a director … and not shared by the stockholders generally.” Technicolor quoting Guth v. Loft.Essence of the Duty: Don’t have a financial interest in an adverse party and act in good faith. Delaware Statutory SchemeRULE – 144: No contract or transaction between a corporation and 1 or more of its directors or officers shall be void or voidable if:INFORMED disinterested directors approve by majority vote; orINFORMED disinterested shareholders ratify; orTransaction is substantively fair to the corporation as of the time it is authorized. MBCA Statutory SchemeNOTE: DE statute was improperly drafted and cured via judicial interpretation. Model rules are substantively identical. Step 1: Is there a conflict of interest?BURDEN OF PROOF: Is on the Plaintiff. MBCA8.60 RULE: There is a conflicting interest if transaction effected or proposed to be effected by corporation has:Director is a party to the transaction; orDirector had knowledge and a material financial interest in the transaction; orDirector had a related party with an interest in the transaction. If No = No Duty of Loyalty IssueUNLESS: Corporate opportunity issueControlling shareholder. If Yes = Step 2Step 2: If there is a COI, Has it Been Properly Cleansed?BURDEN OF PROOF: On the defendant. MBCA8.61 RULE: COI will not violate duty of loyalty if:Qualified directors’ cleanse under 8.62; orEssentially: Majority vote of non-conflicted directorsNOTE: Does not work for controlling corporations. Sinclair.Independent shareholders ratify under 8.63;Essentially: Majority of disinterested and informed shareholders approve. See Below for effect. Transaction is judged to be fair to the corporation. PRACTICAL TIP: Get multiple types of approval to avoid a claim. COURT: Will examine the substance of the transaction to see if unfair. COMES UP: In controlling shareholder claims where ratification does not work. If Cleansed = No Duty of Loyalty ClaimIf Not Cleansed = Transaction Voidable by CorporationCase Law SchemesCorporate Opportunity DoctrineOperationDirector must disclose the existence of the corporate opportunity;Corporation has the right of first refusal on the project;THUS: Can pass the opportunity to the fiduciary and no violation occurs. Remedy: Gains based remedy – must remit any gains from the project to the corporation. CAUTION: Injunctive relief available in addition to punitive damages. Corporate Opportunity Exists When: Examine the following factors:Corporation is financially able to take the opportunity;NOTE: Even if corporation is not in position to take the opportunity, not dispositive.RATHER: Simply lessens the burden on defendant. Opportunity is in the corporation’s line of business;BROADER: Than simply the line of business. It also reflects on businesses that Corporation may wish to engage in. Aspirational if you will. Guth FACTORS: “Activity to which corporation has fundamental knowledge, practical experience, and ability to pursue.”“Consonant with reasonable needs and aspirations for expansion”Corporation has an interest or expectancy in the opportunity;NARROWER THAN LINE OF BUSINESS TESTInterest: Something to which the firm has a legal right.Expectancy: Something which, in the ordinary course of things, would come to the corporation but corporation has not realized. EXAMPLE: Officer took renewal rights to a lease the corporation had. Reasonable to believe the corporation would have had the right to renew in future. Embracing the opportunity would create a conflict between director’s self-interest and that of the corporation. MEANING: Seizing the opportunity creates a conflict that did not exist beforehand. REMEMBER! If there is a corporate opportunity it must be disclosed to the corporation. Safe-HarborRULE: Board approval of a director taking a corporate opportunity is not required.BOARD APPROVAL: If the board approves, creates a safe-harbor and eliminates the duty of loyalty claim against the director. Why Not Required?Considerably inefficient to present every transaction by a director to the board of a company. They both need to conduct business!CAUTION: Meeting individually with board members does not create safe harbor! Fn17 from Broz. Action of the Board Only Occurs When8.20: Board meetings are either regular or special;8.21: Action without a meeting must be through unanimous written consent. 8.22: No notice required for regular meetings; two day notice required for special meetings.8.23(a): A director may waive notice. Except as provided in (b), the waiver must be in writing. 8.23(b): Director’s attendance at or participation in meeting waives any required notice unless he promptly objects;8.24: Default quorum is one half. Minimum allowed is 1/3rd. Vote decided by majority present. Broz v. Cellular Info SystemsFACTS: Broz was sole shareholder and President of RFB (hat 1) and was board member of CIS (hat 2); CIS was in financial difficulty but was in the process of being acquired, and ultimately was acquired by PriCellular (tender offer 11/9/94; acquired on 11/23). Opportunity had to do w/ buying cell phone franchise called Michigan 2. Broker offers M2 to Broz in RFB capacity & wearing that hat Broz buys on 11/14 (CIS not approached b/c of financial status; board didn’t formally approve but CEO informally allowed); PriCellular was also approached and reached option agreement to purchase in Sept (outbid by Broz)HELD: Not a corporate opportunity because:CSI was not financially capable of acquiring the license until the takeover was complete. Takeover considered “speculative” by court.Was in line of business however.CSI was in the process of divesting its interests, not acquiring new ones, so not an expectancy or interest.No new conflict resulted as Broz already owned adjacent cellular areasHOWEVER: Had the transaction closed earlier between PriCellular and CSI – Broz may have been in hot water. Controlling Shareholder TransactionsGenerallyRULE: Shareholders acting as shareholders owe no fiduciary duties. EXCEPTION: Controlling shareholders owe fiduciary duties to the minority. WHY? Separation between ownership and control is broken. The controlling shareholders now have control AND ownership. SOLUTION? Get rid of the minority shareholders!DUTY RULE: When there is a conflict of interest between a minority shareholder and a controlling shareholder, it will be tested under the intrinsic fairness standardCOI EXISTS IF: Parent receives a benefit to the exclusion of and at the expense of the minority shareholders. BURDEN OF PROOF: On defendants (controlling shareholder) to show that transaction was intrinsically fair. IF MET: Burden shifts to the P to show that it failed BJR (waste – no rational purpose). UNFAIR: Breach of contract that benefits the parent to the exclusion of the minority shareholders. Sinclair. RATIONALE: Ratification via directors or shareholders would be a meaningless gesture as they are not disinterested!Sinclair Oil v. LevienFACTS: Sinclair is holding company with multiple subsidiaries; each operation subsidiary functioned in one country; Sinclair is 97% shareholder of Sinven (subsidiary of Sinclair that operates in Venezuela); minority bring suit alleging thee claims:CLAIM 1: Sinven’s large dividends paid prevented developmentBut no minorities excluded = no self dealing meaning BJR applies and not intrinsic fairnessBurden shift to Π – must rebut rational business purpose (show waste)CLAIM 2: Sinven prevented from expanding – taking corporate opportunity to expandBut no business opportunity came to Sinven independently; line of business in Venezuela CLAIM 3: Contract between Sinven and International breached – Sinclair forced Sinven to K with them (sale of oil, etc); this was self-dealing b/c Sinclair receiving products produced by Sinven and Sinven minority not able to share in receipt of products. Sinclair caused K to be breached but Sinclair still received benefits (detrimental to minority). Sinclair failed to show intrinsic fairness Breached in two ways: late payment & fell below K min requirements. Must prove Sinven couldn’t have produced or obtained K minimum (contract theory – impossibility – gave everything they could). Cleansing TransactionsEffect of Shareholder RatificationNOTE: Requires majority vote of disinterested informed shareholders. Therefore, the conflicted shareholders’ votes will be ignoredDuty of Care ClaimsRULE: Extinguishes duty of care claims. Duty of Loyalty Claims against DirectorsRULE: Shifts burden of proof to plaintiff to show waste (BJR). Duty of Loyalty Claims Against Controlling ShareholderRULE: Shifts burden of proof to P to show unfairness. In re WheelabratorFACTS: Two companies Waste and WTI (Wheelabrator); Waste owned 22% of WTI (4 directors); negotiated merger in which Waste would acquire another 33% and WTI shareholder would receive low % of WTI and Waste shares. WTI board held special meeting w/o Waste – reviewed agreement, had others come in (3hrs) – 7 WTI approve. Then 4 Waste join and all approve. Next two firms distribute proxy explaining transaction to WTI shareholders; majority of WTI shareholders approve.Board has fiduciary duty to disclose fully and fairly all material facts w/in control that would have significant affect upon stockholder vote – this was met so vote of shareholders was fully informed. CAUTION! Can’t be materially misleading. DUTY OF CARE: Π duty of care claim (not fully informed) extinguished by shareholders ratification.DUTY OF LOYALTY: Π duty of loyalty claim against directors – fully informed shifts burden on Π to show waste majority. This must be proved on remand b/c when vote took place Waste was still minority shareholder. HOWEVER: If Waste had become majority holder and then another vote took place – then ratification would have effect of shifting burden to Π to show transaction was unfair.Peripheral DutiesGenerallyThese are duties that have been recognized in some places but not fully adopted quite yet.Duty to Act in Good FaithBe honest;No conflicts of interest;No illegal activity. Non-Controlling Shareholders DutiesRULE: Shareholders owe no duties to anyone!UNLESS: They are controlling shareholders. In which case they owe fiduciary duties to the minority shareholders. See above is that’s the case. Non-Controlling Roles of Shareholders LawsuitsTwo Kinds of LawsuitsDirectDefined: Suit alleging a direct loss to the shareholder.THEORY: Based on a breach of K claim. Bases for a Direct ClaimForce payment of a dividend;Enjoin activities that are ultra vires;THINK: AB Smith – Princeton donationNOTE: Shareholder ratification only cures an ultra vires act if it is unanimous. Rosenfeld.Claims of securities fraud;Protect participatory rights of shareholders.EXAMPLE: Failed to hold a shareholder meeting. Abdication by the board of their duties. HOWEVER: Large severance if the board interferes is not considered abdication! Grimes. RATIONALE: Shareholders pick the board so they should be able to do something if the board does nothing!DerivativeDefined: Two lawsuits in one. First a suit against the corporation to compel it to sue another. Second suit is by the corporation against the other person. First Suit: Shareholder sues to compel corporation to sue another (generally a director/officer).Second Suit: Suit by corporation against the party that has breached their fiduciary duty.THEORY: Based on a breach of fiduciary duty claim. Bases for Derivative ClaimsBreach of the duty of care;Breach of the duty of loyalty;Enjoin “management-retrenching” practices;Nature of HarmShareholder is suing “in right” of the corporation. Harm is more disconnected than a direct suitREMEDY: Any remedy goes to the corporation. ATTORNEY’S FEES: Corporation is required to pay shareholder attorney’s fees if the case is successful or settled. Trade-Offs for Shareholders in Derivative ClaimAdvantagesPossibly more attractive damages;Avoid having to pay legal fees. DisadvantagesDamages/remedies go to corporation. Damages are paid by corporation, thus indirectly harming the shareholder anyway. LAWYERS ARE THE REAL WINNERS HERETrade Offs for Defendants in a Derivative ActionRULE – 145: Director can be indemnified for costs and advanced costs for defending case. Settlement = Usually indemnified.Found Liable(b) = No indemnificationSuccessful on Merits = Must be indemnified.Ratification: Disinterest shareholders/directors must vote to ratify. StrategicallyVery difficult to bring these claims;If shareholder makes it past pleading – will usually settle to ensure legal fees paid;Shareholders rarely get muchHOWEVER: Essentially the sole system of discipline. Directors can’t be expected to sue themselves!The Bizarre Incentives of a Derivative ActionShareholder has no real interestP’s attorneys have extensive interest in settling claim and receiving large fees.Board of directors has interest in settling to ensure indemnification rather than risk having to pay costs personally.RESULT: Attorneys get paid in 90% of the suits. Thus why Court must approve the settlements. Half of all suits do not yield a settlement and when settlements do occur, the per share payouts are usually low. Distinguishing Between a Derivative Claim and a Direct Claim: 4 TestsNOTE: All breach of fiduciary duty claims are derivative claims. Who suffered the most immediate and direct injury?Breach of Fiduciary Duty = More derivative like;Loss of voting power = More direct like.Who did the D owe a duty to? (ALI Test)Duty to the Corporation (fiduciary) = Derivative ClaimDuty to the Shareholder (dividend) = DirectWho would benefit from a favorable verdict? (DE)Corporation gets paid by director = DerivativeShareholder = DirectIs the remedy only injunctive?If YES = DirectBringing a Derivative ClaimWho Can Bring a Derivative Claim?MBCA7.41(1) RULE: Must be a shareholder at the time of the alleged wrongdoing; andMBCA7.41(2) RULE: Named P must be a fair and adequate representative of the corporation’s interestsMEANING: No conflicted interests like bringing the suit for strategic purposes. CAUTION! Many states require that representative continue being a shareholder throughout the action. Procedural Hurdles to Bringing a Derivative ClaimWhy the Hurdles?Deter litigation. Attorneys usually make out like bandits while per share settlements are small and corporations usually indemnify their directors.Don’t want to make it a lawyer free for all. Bonding RequirementRULE: A derivative claimant with “low stakes” must post a bond securing the corporation’s legal expensesNOTE: Not in DE. Demand Requirement – DE Court of Chancery R. 23.1DE RULE: Shareholder must approach the board and demand that they pursue legal actionEXCEPTION: Unless the shareholder can claim a valid excuse. WHEN: Not required to demand before filing case. As a result, file the suit first to preserve rights!CONTRAST: MBCA: MUST FIRST make a demand and wait 90 days before engaging in litigation. RATIONALE: Recognizes that the board manages and directs the corporation’s operations. They should have first crack to see what the hell is going on. CONSEQUENCE: Of the separation of ownership and control. ENCOURAGES: Arbitration and exhaustion of non-litigation based settlement. NATURE OF THE DEMANDTypically a letter from shareholders to directors requesting the board bring suit on the alleged cause of action.MUST INCLUDE: Must be sufficiently specific as to apprise the board of the nature of the alleged cause of action and to evaluate its merits. When is Demand Excused? (in DE)RULE: Demand is deemed futile if P creates a reasonable doubt that:Directors are disinterested and independent; orNOTE: Easier claim to make.NOT ENOUGH: To sue all the directors or claim all directors were involved. The challenged transaction was the product of the business judgment rule. DISCOVERY: Limited to the “tools at hand”220: Shareholder can use his right to look at books and records to gather information. Public Info: Use public records and such to make your claims. NOTE: Even if P is successful on the excuse claim, may face a special litigation committee before further pursuing claim. What happens if Board Rejects Demand?RULE: Refusal to pursue claim is subject to business judgment ruleHOWEVER: Once demand requested, cannot challenge board’s independence!Rational Shareholder’s Approach in DE: FILE FIRSTIf No Demand Made: Trivial consequence. If it is determined that demand is not excused, delayed while demand is made.Preserves: Right to litigate the board independence issue. THUS: litigants will always file the case first alleging excuse to preserve litigation rights!ALWAYS PLEAD DEMAND FUTILITY IN DE!Grimes v. DonaldFACTS: Corporation entered employment K with CEO under which CEO could claim wrongful termination if Board interfered too much in CEO’s management; wrongful termination would lead to huge severance package; stockholder filed suit seeking (1) declaration of invalidity of employment K (board improperly abdicated its powers to management) and (2) damages to corporation (excessive compensation). HELD: Π’s made demand, which was refused and in charging documents alleged demand was futile – not allowed under Speigel.FILE FIRST!Demand Requirement in MBCAMBCA7.42 RULE: No shareholder may commence a derivative proceeding until:A written demand has been made upon the corporation to take suitable action; and90 days have expired from the date the demand was made unlessDemand rejected; orIrreparable injury to the corporation would result by waiting the 90 days. THEREFORE: Under MBCA, must make demand before filing claim!DOES NOT: Eliminate P’s right to allege director’s lack of independence. DismissalRULE: Derivative case will be dismissed if independent directors or panel find in good faith proceeding with the suit is not in the best interests of the corporation. Evaluation Determined By:Majority of independent directors; orMajority of committee of independent directors.If Rejected: Shareholder can proceed if Majority of the board is not independent; orRreview was not conducted in good faith or was not reasonable.If Board Not Independent: Board must prove act was in good faith and reasonable. Special Litigation CommitteesGenerallyProcessShareholder does not make demand;Demand is excused as futile due to conflict of interest;Board then appoints a special litigation committee consisting of the “non-tainted” directors.Board determines whether lawsuit is in the best interests of the corporation or not. Board then makes a recommendation for dismissal or pursuit of the case. Rationale for Allowing SLCsWhen demand is made, board gets to have a look to determine what is in the best interests of the corporation. This reflects the directors’ role of operating the corporation. When a demand is excused, litigation proceeds on corporation’s behalf without input from the board (the managers) themselves. THUS: There must be some balance that can allow the corporation to engage in a management role here without entirely eviscerating the shareholder’s rights. HOWEVER: Corporation alone can’t be trusted as there is likely allegiance to the tainted board (the board appoints them afterall!)Zapata Two Step Review of SLC Motions for DismissalStep 1 - PROCEDURAL: Court should inquire into:The independence and good faith of the committee; andThe bases supporting the committee’s recommendations. Step 2 - SUBSTANTIVE: Court must apply its own business judgment to determine if the case should be dismissedDoes it pass step one but seems like the spirit of independence not there?Prematurely terminate a shareholder’s grievance deserving further consideration in the corporation’s interest?Special Consideration to:Corp’s best interests;Matters of law; andPublic policy. THUS TO WIN: Shareholder simply needs to prevail on one of the steps. Zapata v. MaldonadoFACTS: Shareholders bring lawsuit; demand wasn’t made and was excused as futile. Four yrs later four defendant/directors no longer on board; directors appoint two new outside directors then created SLC composed solely of two new directors; investigate action to see if suit should continue – decide it shouldn’t and dismiss case.HELD: they could do this subject to review by Court.VotingWho VotesRULE: Shareholder of record votes. MBCA7.07: Holder of stock on the record date can vote.RECORD DATE: Can be no more than 70 days before the vote. VotesDEFAULT RULE7.21: Each outstanding share, regardless of class, is entitled to one vote on each matter.HOWEVER: Articles of incorporation can specify a different ratio When Do They Vote?Shareholder MeetingsAnnual Meetings – 7.01: Corporation holds an annual meeting based on the time specified in their bylaws. Special Meetings – 7.02: Are held either:When called for by the board; orWhen called for by at least 10% of the votes entitled to be cast (Can be lowered by AOI but not increased past 25%)Unanimous Written Consent – 7.04: Act can be accomplished without a meeting if there is unanimous written consent from all shareholders. How Do They Vote?GenerallyRule 7.25: Most matters require a majority of shares present at a meeting at which there is a quorum. Quorum: Default is one half of the eligible votes. Method – 7.22In person;By proxy.Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her shares at the meeting;Appointment effected by means of a proxy (a.k.a. proxy card). Can specify how shares are to be voted or give discretion to proxy agent discretion;Revocable. Proxy Rules – Governed by Federal LawCorporation: Will send out the official proxy statement at its own cost“Unofficial” Proxies: Firm has the option to mail out unofficial proxy materials at independent shareholders’ cost. Rule 14a-7Names: Shareholders may request names and addresses of shareholders under state law for proper purpose. CORPORATION: Will want to mail materials themselves to charge the independent shareholders a lot of money and discourage them.SHAREHOLDERS: Will want to collect the names of shareholders to mail the items themselves. What Do They Vote On? – Shareholders Entitled to Vote ONElection of Directors – 8.03-8.08Cumulative Voting – 7.28RULE: Cumulative voting will be allowed if provided in the AOI. ALLOWS: Minority members to gain board representation. OTHERWISE: Majority shareholders take every seat. Classified or Staggered Boards – 8.06MBCA RULE: AOI can provide for shareholders to be broken into groups of 2 or 3 of equal numbers to stagger the elections.RESULTS: In limited change of directors at each meeting. DE-145 RULE: Same except can be adopted via AOI or BYLAWS. Which Directors Can You Vote For?Incumbent board nominates a slate of directors;Company sends out the official proxy statement. NOTE: DE112 just changed the rules to allow bylaws to be amended for shareholder suggested candidates to come up on the company’s proxy. Competing Slate: Needs to be offered in separate proxy materials.Insurgents pay cost of mailing proxies. . Proxy CostsFroessel RULE: Incumbent’s proxy costs are paid regardless of outcome; insurgent costs may be reimbursed if they win. CONDITIONED: On a bona fide proxy dispute. REVIEW? Essentially subject to business judgment rule. RATIONALE: Corporate directors should not be at the mercy of persons seeking to wrestle control merely because they have ample funds. Proxy Contests are RAREHigh Risk: If shareholder loses, they are out all the expenses. Limited Upside: Upside is limited to one’s shareholders. Free Rider Problem: The shareholders not bringing the case are the ones who principally benefit. Rosenfeld v. Fairchild EngineFACTS: Incumbent board puts on their directors; shareholders got together and proposed competing board; incumbents $ came from corporation while competing put up their own; new slate of directors won; asked shareholders if $ should be reimbursed, they agreed, so it was; shareholder argues compensation too high for one of the guys (corporation had paid for new board and old board proxy expenses).DISSENT: Dissent argued shareholder vote not enough to approve spending of $; seems to be loyalty issue (corporate funds to reimburse personnel expenses, looks fishy); ultra vires (looks like waste); bona fide contest test is meaningless b/c so easy to meet.Amendments to the AOI and Bylaws – 10.03/10.20Modifying the Corporate Charter/AOIMBCA10.03 RULE: An amendment to the articles of incorporation must:Be adopted by the board of directors; andApproval of the shareholders at a meetin at which a quorum consisting of at least a majority of the votes is present. DGCL242b1: The directors shall adopt a resolution and holders of at least a majority of the outstanding stock must vote in favor of the amendment. THUS: More difficult to amend corporate charter in DE due to outstanding share requirement instead of quorum. NOTE: Authorized but not issued do not count as they are not outstanding. Modifying the BylawsMBCA10.20 RULE: Shareholders may amend or repeal; andDirectors may amend or repeal UNLESS pertains to director election or prohibited by bylaws. DE109 RULE: Power to adopt, amend, or repeal bylaws shall be in the shareholders entitled to voteDIRECTORS: may also have this power if provided for in the corporate charter. Fundamental Transactions – (Mergers – 11.04)Odds and Ends – “Precatory Measures” SEC RULE14a8: Allows qualifying shareholders to put a proposal before their fellow shareholders. Proxy Statements: May have proxies solicited in the corporate proxy statement. Thus, corporation bears expense of these measures. Why Only Precatory? Directors are the managers of the corporation. Therefore shareholders can only make suggestions.Federal law respects this in 14a8i. Board Fails to Act: Subject to the business judgment rule!Reasons For Excluding Proposals14a8i1: Proposal is not a proper subject of action for shareholders under the laws of the jurisdiction of the company’s organization. (2): Implementing would violate law(3): Implementing would violate proxy rules;(4): Proposal involves personal grievance or special interest. (5): Proposal is not relevant to firm’s operations;RULE: Ethical and social significance can be significantly related to firm’s operations even if small part of revenues. Lovenheim v. Iroquois BrandsShareholder meets all of the tests and wants to put up proposal to investigate the methods of foie gras production. Corporation tries to exclude.HELD: Ethical and social significance of corporation’s operations enough. NOTE: Had the proposal said the corporation should stop making foie gras, would have been excluded because it suggested how to run the business!(6): Company lacks power to implement;(7) Proposal deals with company’s ordinary business operations;(8): Relates to electing directors. Timing of ProposalsRULE: Proposal must be submitted to corporation at least 120 days before the date on which proxy materials were mailed for the previous year’s annual shareholder meeting. Eligibility to Make ProposalRULE 14a-8b1: Proponent must own at least 1% or $2000 of issuer’s securities (whichever is less) for at least one year prior to the date on which proposal submitted. Submission Rules14a-8c: Only one proposal per corporation per yearNO LIMIT: on how many companies a proponent can submit proposals to. 14a-8h: If proponent fails to show up at the meeting to present the proposal in person, proponent ineligible from using the rule for two years with that corporation. 14a-8(g): Proposal plus supporting statement cannot exceed 500 words. Website reference for more info OK so long as sites comply with proxy rules. Process for Excluding a ProposalManagement files a notice of intent to exclude with the SEC. Accompanied by an opinion of counsel if any of the stated reasons rely on legal issues.CURE: Management under 14a-8f must provide proponent with explanation of deficiency and a chance to cure. Copy of the firm’s notice and statement must be sent to proponent in addition to SEC who may (but need not) reply. SEC’s ResponseStaff determines it can be excluded, issues a “no action” letter;If staff determines it can be included, notifies the issuer of possible enforcement action if excluded. SEC Reluctantly gets involved!SellingGeneralSEC Act of 1933 – regulates sales of securities; disclosure at time of public offering; key section is 5SEC Act of 1934 – regulates trading activity; ongoing disclosure required; key sections 10b (no fraud); 14a (proxy); 14e (tender offers); 16 (insider trading)Are You Selling Securities? – If Yes – Then Federally RegulatedSecurity DefinedSEC ’33 2(a)(1): Security means any note, stock, bond, debenture, or investment contract, or in general, any interest or instrument commonly known as a security.EXCLUDES: Certain exotic instruments like credit default swaps. Is Your Sale a Public Offering?If YesBoth: Section 5 of ’33 and Section 10 of ’34 apply. If NoOnly: 10 applies to your transaction. Transaction is NOT a Public Offering If EitherShares were already registered. Sec. Act 4(1). MEANING: Secondary trading. Offering by the issuer that is a private placement. Sec. Act 4(2). NOTE: Some disclosure may still be required. Private Placement Test: Examine factors:Number of investors offered to;Size of the offering;Manner of the offering;NO: General advertising or solicitationInternet: Not private. ESSENTIALLY: Cannot broadly marketSection 5 of the 1933 SEC Act – APPLIES TO PUBLIC OFFERINGS ONLYPre-Registration Period: Prohibits an offer to buy or sell any “security” unless registration statement filed with the SEC. Waiting Period: Offers to sell are allowed, but sales cannot be closed until after the effective date (determined by the SEC, at least 20 days);Post-Registration Period: Sales can be closed, but must be accompanied by a prospectus. Section 10b-5 of the 1934 SEC Act – APPLIES TO ALL SECURITIES OFFERINGSNOTE: There are insider trading 10b5 actions and “generic” 10b5 actions. Make sure to distinguish!RULE: Unlawful for any person, directly or indirectly, to:To employ any device, scheme, or artifice to defraud;To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; orMATERIAL: Whether there is a substantial likelihood that reasonable shareholder would consider the fact important.INCLUDES: Speculators. MISLEADING: Consider meaning of statement to reasonable investor (would reasonable investor be mislead); consider relationship to truth.Would it create a false impression?To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any personIn connection with the purchase or sale of any security.SEC Standard: Would it cause a reasonable investor to rely on the information, and, in connection with it, so relying, to cause them to purchase or sell a corporation’s securities?Cotemporaneous Investor: Did they actually rely on the statements to buy or sell the security? Is your Sale Insider Trading?GenerallyWhat is Insider Trading?Buying or selling securities using inside information. “Inside Information”Information about a firm which is not publically available. HOWEVER: Buying or selling securities with non-public information is not always insider trading!When is it Insider Trading?How Information Was GatheredOverheard in public? OrGained in fiduciary role?How Was Info Used?In advance of a tender offer? OrBuying or selling on open market. RemediesSEC: Generally fines and criminal prosecution. Cotemporaneous Traders: Monetary damages. Statutory Insider Trading – Section 16Generally: Bright line prohibition: all gains within six months by statutory insiders are forfeited to the firmAPPLIES ONLY TO EQUITY INSTRUMENTS IN LISTED COMPANIESRULESStatutory Insider Defined16(a): If person Owns over 10% of the outstanding stock; orIs a director or officer (“statutory insiders”), then they mustREPORT: Report ownership stake and changes to the SEC. Violation RULE 16(b): A statutory insider who profits from purchase and sale OR sale and purchase within six months are recoverable by the firm. Must be statutory insider at both transactions. Shares are fungible.Transactions must occur within 6 months of each other.MatchingIn the six month period, the low high and the high sell will be “matched” to maximize recovery to the corporation. UNCLEAR: Whether the initial purchase that places a buyer in the statutory insider category can be “matched.” RemedyAll gains go to corporation;Courts interpret statute to maximize gains to company. PolicyOver-InclusiveCovers legitimate sales;Under-InclusiveOwn slightly under 10% (Reliance Electric)Wait six months and a day. Reliance Electric v. Emerson Elec. FACTS: June 16 Emerson acquired 13.2% at $63 per share of Dodge in a tender offer, w/ goal of taking over Dodge. Then Dodge announced merger w/ Reliance, effectively putting end to goal of taking over Dodge. Aug 28 Emerson sold shares at $68 per share and had 9.96% interest in Dodge after this sale. Sep 11, Emerson sold remaining shares at $69/per share. Emerson sold 2 parts to avoid SEC § 16b. Reliance filed suit seeking to recover profits from BOTH salesHOLD: Reliance can recover from Aug 28 sale but not Sept 11 sale; Emerson was 10%+ owner when it sold on Aug 28 but wasn’t on Sept 11. Lower court found transaction fell w/in SEC 16b b/c purchaser became 10%+ by virtue of initial purchase but SCT deflected issue. Emerson argued that transaction didn’t trigger b/c he wasn’t 10% owner when he purchased on June 16. Classic Insider TradingGenerally: Firm insiders use material information not publically disclosed to trade in their firm’s shares. HistoryTPG: Read an insider trading violation into the 10b5 rule. Based on the idea of omitting material facts in connection with the sale or purchase of a security. Applied an “abstain or disclose” rule on anyone with material information. RATIONALE: Equal informational playing field. Chiarella: SCOTUS recognized that the blanket TPG rule was too broad and limited it to fiduciaries who gained their information in a fiduciary capacity. Kept the abstain or disclose rule for these individuals. RATIONALE: Some information advantages are earned – putting in more time and effort to figure out a situation. Should be able to exploit this effort. Further there is a difference between silence and affirmative misrepresentationCAPITAL MARKETS: Without the ability to utilize your efforts in the capital markets – people would leave them lowering liquidity and driving up the cost of capital. CASE FACTS: Printer of financial reports used the info to buy and sell securities. No violation of 10b5. RULE: Insider trading is a violation of 10b-5 when a fiduciary trades shares of his or her own firm based on information gained as a fiduciary. Who is a Fiduciary?Directors and officers;Employees (agents) learning information during the course of their employment;Constructive Insiders: Anyone who Obtains material non-public information from the issuer; withAn expectation on the part of the corporation that the outsider will keep the disclosed information confidential; andThe relationship at least implies such a duty. THINK: Underwriters, accountants, lawyers, consultants, etc. Options for Fiduciaries With Information – Cady, Roberts RULEAbstain; orDo not engage in buying or selling of firm’s stock. Disclose Corporation can disclose the information After there has been a reasonable time for dissemination,Then can act on the information. When to DiscloseRULE – fn 12 TPG: Matter of the business judgment rule for the corporation. HOWEVER: Until disclosure, must abstain in securities transactions with the firm’s securities. SEC v. Texas Gulf SulphurFACTS: TGS explores in late 1950; in 63 k-55-1 drilled & looks promising; based on this TGS begins land acquisition (president commands secrecy 11/63); same day TGS insiders begin acquiring shares and call options; 3/64 land transaction complete; next month unauthorized press reports; next day misleading press release; 4 days later official statement made at 10am; news appears on Dow Jones ticker at 10:54Tippers & TippeesGenerally: Insider trading prohibition under 10b5 extends to those who use non-public material information they know was provided by a tipper for personal benefit. Dirks RULE: Tippees inherits disclose or abstain duty (Cady, Roberts) only if:Tipper receives personal benefit; ANDTippee knows or has reason to know of tipper’s breach of fiduciary duty. What Constitutes a Personal Benefit?Monetary gain;Quid pro quo;Reputational gain;Helping a family memberBUT NOT: Desire to provide a public good such as disclosing a fraud. Dirks v. SECFACTS: Dirks, officer of broker-dealer firm who specializes in providing investment analysis of insurance co securities to institutional investors, received info from Secrist, former officer of EFA that EFA has engaged in fraud. EFA diversified corporation primarily engaged in selling life insurance and mutual funds; Dirks told ppl of alleged fraud, investigated, confirmed fraud, and told more ppl; Dirks didn’t deal w/ EFA securities (which suffered); SEC argued Dirks had inherited duty to disclose or abstain and convicted him of insider trading but SCT reversed – Secrist (tipper) didn’t benefit from disclosure thus okay to disclose fraud.Misappropriation Insider TradingGenerally: Insider trading prohibition extends to those who use non-public material information in violation of a fiduciary duty. O’Hagan RULE: Insider trading prohibition under 10b5 extends to those who use non-public material information gained in a fiduciary capacity. OCCURS: When a breach of fiduciary duty to the “source” of the information occurs. Not necessary the firm the trader is working for. RATIONALE: Adds symmetry to 10b5. Makes no sense that one can use inside information obtained in a fiduciary capacity so long as it is not based about their own firm. STATUTORY BASIS: “deception” by trader in connection with the buying or selling of securities. CURED BY – ABSTAIN OR DISCLOSEDISCLOSURE: Must be to the source of the information. However, may have to disclose to multiple entities if there is a “chain” – e.g. partner must disclose to law firm and client. HOWEVER: Still liable under rule 14 – just no 10b5 violation!OTHER STATUTES: Will probably get you as well. OVERTURNS: Chiarella, as Chiarella owed a fiduciary duty to his employer and breached it by misappropriating the information in connection with the purchase and sale of securities. United States v. O’Hagan FACTS: ? was attorney at firm that represented Grand Met in planned tender offer of Pillsbury; ?, armed with info, purchased Pillsbury securities and made nice profit; when faced w/ insider charges – argued he wasn’t statutory insider and had no fiduciary duty to Pillsbury or shareholders; and that he didn’t receive info unlawfully from tipper. HOLD: Ct finds ? guilty – breached duty to law firm, which had duty to Grand Met; if ? firm was counsel to Pillsbury, he’d be guilty of insider trading;SEC Tender Offer Rule 14e-3RULE: Prohibits insider trading during a tender offer and supplements 10b5. Substantial Steps: Once substantial steps are taken toward a tender offer, rule prohibits anyone (except the bidder) who possesses material non-public information about the offer, from trading in the target’s securities. Tipping: Rule prohibits anyone connected with the tender offer from tipping material non-public information about it. NOT PREMISED ON BREACH OF FIDUCIARY DUTYO’Hagan upholds anyway. TerminationVoluntary Dissolution:MBCA 14.02b – board submits and shareholders vote on proposal to dissolveSubmit articles of dissolution to the stateCan only carry on to wind upInvoluntary Dissolution:MBCA 14.30 – if there is deadlock ................
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