I. Agency Law



Table of Contents – Business Associations TOC \o "1-3" \h \z \u I. Agency Law PAGEREF _Toc309291642 \h 3A. The Agency Relationship / Formation PAGEREF _Toc309291643 \h 3Gorton v. Doty PAGEREF _Toc309291644 \h 4A. Gay Jenson Farms Co. v. Cargill, Inc. PAGEREF _Toc309291645 \h 4B. Consequences of Creating an Agency Relationship: The Agent’s Authority and Contract Liability PAGEREF _Toc309291646 \h 4Mill Street Church of Christ v. Hogan PAGEREF _Toc309291647 \h 5370 Leasing Corp. v. Ampex Corp. PAGEREF _Toc309291648 \h 5Udall v. T.D. Escrow Services PAGEREF _Toc309291649 \h 5Watteau v. Fenwick PAGEREF _Toc309291650 \h 6Botticello v. Stefanovicz PAGEREF _Toc309291651 \h 6Hoddeson v. Koos Bros. PAGEREF _Toc309291652 \h 7Atlantic Salmon A/S v. Curran PAGEREF _Toc309291653 \h 7C. Consequences of Creating an Agency Relationship: Tort Liability PAGEREF _Toc309291654 \h 7Humble Oil & Refining Co. & Sun Oil Company PAGEREF _Toc309291655 \h 9Bushey v. United States PAGEREF _Toc309291656 \h 10Manning v. Grimsley PAGEREF _Toc309291657 \h 10D. Fiduciary Duties in the Agency Relationship? PAGEREF _Toc309291658 \h 10Reading v. Regem PAGEREF _Toc309291659 \h 11General Automotive Manufacturing Co. v. Singer PAGEREF _Toc309291660 \h 11E. Termination of Authority and the Agency Relationship PAGEREF _Toc309291661 \h 12II. General Partnerships PAGEREF _Toc309291662 \h 13A. Partnership Formation (Definition and Distinction from Other Relationships; Partnership by Estoppel) PAGEREF _Toc309291663 \h 13Fenwick v. Unemployment Comm’n PAGEREF _Toc309291664 \h 13Martin v. Peyton PAGEREF _Toc309291665 \h 14Southex Exhibitions v. Rhode Island Builders Association PAGEREF _Toc309291666 \h 15Young v. Jones PAGEREF _Toc309291667 \h 16B. Rights of Partners in Management; Partnership Liability PAGEREF _Toc309291668 \h 16NABISCO v. Stroud PAGEREF _Toc309291669 \h 19Summers v. Dooley PAGEREF _Toc309291670 \h 20C. Financial Interests in Partnership (Sharing of Profits and Losses; Partnership Property) PAGEREF _Toc309291671 \h 20Kovacik v. Reed PAGEREF _Toc309291672 \h 22D. Fiduciary Duties in Partnership Law? PAGEREF _Toc309291673 \h 23Meinhard v. Salmon PAGEREF _Toc309291674 \h 24Meehan v. Shaughnessy PAGEREF _Toc309291675 \h 25E. Partnership Dissociation and Dissolution? PAGEREF _Toc309291676 \h 25Owen v. Cohen PAGEREF _Toc309291677 \h 27Collins v. Lewis PAGEREF _Toc309291678 \h 27McCormick v. Brevig PAGEREF _Toc309291679 \h 28F. Partnership Agreements PAGEREF _Toc309291680 \h 28G. Other Partnership Forms (e.g., LPs and LLPs) PAGEREF _Toc309291681 \h 28III. Corporations PAGEREF _Toc309291682 \h 29A. General Background; Formation; Limited Liability PAGEREF _Toc309291683 \h 291. Introduction PAGEREF _Toc309291684 \h 292. Promoter Liability PAGEREF _Toc309291685 \h 333. Formation of a Corporation? PAGEREF _Toc309291686 \h 344. Defective Formation (De Facto Corporations and Corporation by Estoppel) PAGEREF _Toc309291687 \h 355. Background Information on Stock and Dividends PAGEREF _Toc309291688 \h 366. Limited Liability and Piercing the Corporate Veil PAGEREF _Toc309291689 \h 38B. The Role of Directors and Officers; Fiduciary Duties to Shareholders? PAGEREF _Toc309291690 \h 401. introduction to Director Fiduciary Duties & The BJR PAGEREF _Toc309291691 \h 402. The Duty of Care and the Business Judgment Rule PAGEREF _Toc309291692 \h 433. The Duty of Loyalty PAGEREF _Toc309291693 \h 454. Good Faith (Compensation and Oversight) PAGEREF _Toc309291694 \h 51C. Role, Duties, and Rights of Shareholders PAGEREF _Toc309291695 \h 531. Shareholder Derivative Actions PAGEREF _Toc309291696 \h 542. Shareholder Voting, Proxy Fights, and Proposals PAGEREF _Toc309291697 \h 593. Shareholder Inspection Rights? PAGEREF _Toc309291698 \h 644. Shareholder Voting Control; Control in Closely Held Corporations PAGEREF _Toc309291699 \h 65IV. Securities Fraud and Insider Trading PAGEREF _Toc309291700 \h 66A. Securities Fraud and Rule 10b-5 PAGEREF _Toc309291701 \h 66B. Insider Trading? PAGEREF _Toc309291702 \h 691. Rule 10b-5 and Classic Insider Trading PAGEREF _Toc309291703 \h 702. Tipper/Tippee Liability? PAGEREF _Toc309291704 \h 713. Misappropriation Theory PAGEREF _Toc309291705 \h 73C. Section 16(b) Liability for Short Swing Trading PAGEREF _Toc309291706 \h 74Reliance Electric v. Emerson Electric PAGEREF _Toc309291707 \h 76Foremost-McKesson v. Provident Securities PAGEREF _Toc309291708 \h 76V. Limited Liability Companies (LLCs)? PAGEREF _Toc309291709 \h 78VI. Social Enterprise (e.g., Benefit Corporations) PAGEREF _Toc309291710 \h 82I. Agency LawA. The Agency Relationship / FormationRest. 3d of Agency - § 1.01 Agency Defined: Agency is the fiduciary relationship that arises when one person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act on the principal's behalf and subject to the principal's control, and the agent manifests assent or otherwise consents so to act.Rest. 3d of Agency - § 1.03 Manifestation: A person manifests assent or intention through written or spoken words or other conduct.Rest. 3d of Agency - § 1.02 Parties' Labeling and Popular Usage Not Controlling: An agency relationship arises only when the elements stated in § 1.01 are present. Whether a relationship is characterized as agency in an agreement between parties or in the context of industry or popular usage is not controlling.Rest. 3d § 1.01: Agency is a fiduciary relationship that results from:The manifestation of assent by P to A that A shall acton P’s behalfsubject to P’s controlAnd A manifests assent or otherwise consents so to actExpress Agency:An agency that occurs when a principal and an agent expressly agree to enter into an agency agreement with each other.Exclusive agency contractPower of attorneyExpress agency contracts can be either oral or written unless the Statute of Frauds stipulates that they must be written.Implied Agency:An agency that occurs when a principal and an agent do not expressly create an agency.The agency is implied from the conduct of the parties.The extent of the agent’s authority is determined from the particular facts and circumstances of the particular situation.The Question of Control:“Control is a concept that embraces a wide spectrum of meanings, but within any relationship of agency the principal initially states what the agent shall and shall not do, in specific or general terms. Additionally, a principal has the right to give interim instructions or directions to the agent once their relationship is established.” Rest. 3d § 1.01 (comment f)A “principal need not exercise physical control over the actions of its agent” so long as the principal may direct “the result or ultimate objectives of the agent relationship.” Green v. H & R Block, Inc., 735 A.2d 1039, 1050 (Md. 1999)“when one ... asks a friend to do a slight service for him, such as to return for credit goods recently purchased from a store,” an agency relationship exists even though no compensation or other consideration was contemplated. Rest. 2d § 1(1) cmt. B “an emancipated child is no longer under its parent’s control. Nor can it be said that the Cox children were acting for their mother and father by simply living on the disputed property. There were no obligations imposed on the children. The Coxes merely allowed their children to live on land which they claimed.” Norris v. Cox, 860 So.2d 319 (Miss. App. 2003)Gorton v. DotyFormation of Agency Relationship – far reaching example likely influenced by the fact that Doty was the owner and insurance carrier and therefore the best person to be able to account for the losses“The relationship of principal and agent does not necessarily involve some matter of business, but only that where on undertakes to transact some business or manage some affair for another by authority and on account of the latter, the relationship of principal and agent arises.”Doty was directing Garst’s efforts, and Garst impliedly consentedA. Gay Jenson Farms Co. v. Cargill, Inc.Creditor/Debtor v. Principal/Agent & The Question of ControlCargill managed its risk by:Implementing a security agreementBusiness improvement requirementsVeto rights over borrowing and distributionInspection and audit rightsCriticism of financesStrong paternal guidance statementRest. 2d of Agency - § 14O Manifestation: A creditor who assumes control of his debtor's business for the mutual benefit of himself and his debtor, may become a principal, with liability for the acts and transactions of the debtor in connection with the business.Note: This is the Restatement Second, there was a change in the Restatement Third. Now creditor/debtor relationships rarely are considered an agency/principal relationshipHolding - We conclude that Cargill, by its control and influence over Warren, became a principal with liability for the transactions entered into by its agent Warren.Note: Similar to Doty, Cargill was in the best position to avoid the problem.B. Consequences of Creating an Agency Relationship: The Agent’s Authority and Contract Liability Rest. 2d § 144: a principal “is subject to liability upon contracts made by an agent acting within his authority if made in proper form and with the understanding that the principal is a party”Actual Authority (Express & Implied)Rest. 3d - § 2.01 Actual Authority: An agent acts with actual authority when, at the time of taking action that has legal consequences for the principal, the agent reasonably believes, in accordance with the principal's manifestations to the agent, that the principal wishes the agent so to act.Rest. 3d - § 2.02 Scope of Actual Authority: (1) An agent has actual authority to take action designated or implied in the principal's manifestations to the agent and acts necessary or incidental to achieving the principal's objectives, as the agent reasonably understands the principal's manifestations and objectives when the agent determines how to act.(2) An agent's interpretation of the principal's manifestations is reasonable if it reflects any meaning known by the agent to be ascribed by the principal and, in the absence of any meaning known to the agent, as a reasonable person in the agent's position would interpret the manifestations in light of the context, including circumstances of which the agent has notice and the agent's fiduciary duty to the principal.(3) An agent's understanding of the principal's objectives is reasonable if it accords with the principal's manifestations and the inferences that a reasonable person in the agent's position would draw from the circumstances creating the agency.Mill Street Church of Christ v. HoganActual Implied Authority – This case is mostly about Bill’s (the hiring brother) belief in whether the church had given him the authority to hire Sam (who fell off the ladder and broke his leg). Sam’s belief is only tangentially relevantAnalysis: (1) Bill had been allowed to exercise his discretion when hiring workers in the past; (2) Bill needed a helper to complete the jobPast specific conduct is highly relevantApparent AuthoirtyRest. 3d - § 2.03 Apparent Authority: Apparent authority is the power held by an agent or other actor to affect a principal's legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principal's manifestations.370 Leasing Corp. v. Ampex Corp.Apparent Authority – Salesman bound the company to a contract because he had the apparent authority to agree to a sale with a third party.“An agent has apparent authority sufficient to bind the principal when the agent acts in such a manner as would lead a reasonably prudent person to suppose that the agent had the authority he purports to exercise.”Udall v. T.D. Escrow ServicesApparent Authority – Apparent authority may exist in agents who act beyond the scope of their actual authorityDon’t focus on whether ABC was right in opening up the bid so low, they weren’t. Instead, “the appropriate analysis focuses on whether Udall believed, based on T.D.’s manifestations, that ABC had ‘authority to act for’ T.D. to sell the property on T.D.’s behalf, and whether that belief was ‘objectively reasonable.’Undisclosed PrincipalsHistory of “inherent agency power” or “inherent authority” in Rest. 2d as a catch-all for the rare cases where the P was bound, but didn’t fit into the other categories of cases. E.g., Watteau.These cases tend to involve undisclosed principals – Rest. 3d has gotten rid of “inherent agency power” and now just retains a vestige of that with “undisclosed principals.” (§ 1.04)Rest. 3d - § 1.04 Terminology: Undisclosed principal. A principal is undisclosed if, when an agent and a third party interact, the third party has no notice that the agent is acting for a principal.Agent acting with actual authority?Rest. 3d - § 6.03 Agent for Undisclosed Principal: When an A acting with actual authority makes a contract on behalf of an undisclosed P, both P and A are bound. Agent acting without actual authority?Rest. 3d - § 2.06 Liability of Undisclosed Principal: An undisclosed principal is liable for its agent’s actions–acting without actual authority – if a third party detrimentally relies on the agent and the principal has notice and does not take reasonable steps to notify the third party of the facts.An undisclosed principal can’t rely on narrowing an agent’s authority to less than what a third party would reasonably believe the agent to have under the same circumstances if the principal had been disclosed.Watteau v. FenwickUndisclosed Principals – There was no actual authority in this case (Fenwick expressly told Humble not to buy anything except ales and water) and there was no apparent authority in this case because Watteau didn’t even know there was a principal.Holding – Fenwick was liable for the acts of Humble in purchasing whatever he was purchasing from WatteauRatificationRatification is the affirmance of a prior act done by another, whereby the act is given effect as if done by an agent acting with actual authority.A person may ratify an act if the actor acted or purported to act as an agent on the person’s behalf.Ratification can occur by (a) manifesting assent that the act shall affect the person’s legal relations; or (b) conduct that justifies a reasonable assumption that the person so consents. (Express / implied)At the time of ratification, the purported P must have knowledge of all material facts (or not unaware of lack of knowledge), and T must not have already withdrawn from the transaction. Ratification is not effective if there has been a material change in circumstances that would make it inequitable to bind T, unless the T chooses to be bound.Ratification creates the effects of actual authority. (Both P and T are bound by the contract and the purported A is discharged.)No partial ratification. Botticello v. StefanoviczRatification – Husband and Wife are 50/50 TIC in their property. Wife said that she would take “no less than” a certain amount to lease/sell the farm. Husband went and executed the lease and when the lessee tried to exercise his option to buy, Wife refused.Holding – Wife doesn’t have to give her interest in the property, but there will be a new trial in order to determine damages as far as Husband’s interest is concerned.Neither marital status nor TIC creates an agency relationshipThe Wife had no intent to ratify, she didn’t have knowledge of all the material circumstances.EstoppelRaised where purported agent didn’t have actual or apparent authority, but a court may hold the defendant liable due to some fault. The defendant is “estopped” from raising the lack of authority defense.Estoppel is a one-way street. Only the defendant is liable (and it is generally for damages rather than making the defendant a party to the contract). (In other types, subject to some minor exceptions, the contract is binding on and can be enforced by both P and T.)Rest. 3d of Agency - § 2.05 Estoppel to Deny the Existence of Agency Relationship: A person who has not made a manifestation that an actor has authority as an agent and who is not otherwise liable as a party to a transaction purportedly done by the actor on that person's account is subject to liability to a third party who justifiably is induced to make a detrimental change in position because the transaction is believed to be on the person's account, if(1) the person intentionally or carelessly caused such belief, or(2) having notice of such belief and that it might induce others to change their positions, the person did not take reasonable steps to notify them of the facts.Hoddeson v. Koos Bros.Estoppel – The court’s rule: Koos can’t deny agency when reasonable surveillance and supervision would’ve stopped the imposter on which Hoddeson detrimentally relied.No Actual AuthorityNo Apparent Authority – Koos Bros. never made any suggestion that the mystery man had any authorityCan’t be formed solely by the purported agentNo Undisclosed Principal – Koos Bros. and the mystery man had no underlying agency relationshipNo Ratification – Koos Bros. had no intent or knowledge of the circumstancesOn remand, what will Hoddeson have to prove to make out a case of estoppel?Acts or omissions by the principal, either intentional or negligent, which create an appearance of authority in the purported agentThe third party reasonably and in good faith acts in reliance on such appearance of authorityThe third party changed her position in reliance upon the appearance of authorityAgent’s Liability in ContractFully Disclosed Agency Within Scope of AuthorityWhen the P is fully disclosed and A is acting within the scope of authority, P is liable to the T. A is not liable.Exception: If A intends/agrees to be bound to the contract. (The rules on contract liability are default rules that can be overridden by express or implied agreement between A and T.)Undisclosed or Unidentified PrincipalWhen the P is undisclosed, both the P and A are liable on the contract (unless excluded/otherwise agreed).Almost always the same when the P is unidentified.Agent Exceeding the Scope of AuthorityAn A who enters into a contract on behalf of another impliedly warrants that he or she has the authority to do so (unless A gives notice that no warranty of authority is given, or T knows that A acts without actual authority).If the A acted without authority or exceeded the scope of authority, and P did not ratify, A is liable to T for breaching the implied warranty of authority.A may also be liable for fraud if intentionally misrepresented his or her authority.Atlantic Salmon A/S v. CurranAgent’s Liability in Contract – Partially disclosed or unidentified principalAgent was liable in this case. If he didn’t want to be liable, he should have disclosed his principle.C. Consequences of Creating an Agency Relationship: Tort Liability Rest. 3d § - 7.01 Agent’s Liability to Third Party: An agent is subject to liability to a third party harmed by the agent’s tortious conduct. Unless an applicable statute provides otherwise, an actor remains subject to liability although the actor acts as an agent or an employee, with actual or apparent authority, or within the scope of employment.Principal’s Liability to Third Party for Agent’s Tort (Overview)Direct liability when:A acts with actual authority to commit tort or P ratifies A’s conductP is negligent in selecting, supervising, or otherwise controlling AP delegates performance of a duty to use care to protect persons or property and A fails to perform duty (aka “nondelegable duty”)Vicarious liability when:A is an employee who commits a tort while acting within the scope of employment [§ 7.07]A commits a tort when acting with apparent authority in dealing with T on or purportedly on behalf of P [§ 7.08]Vicarious LiabilityRest. 3d - § 7.07 Employee Acting Within Scope of Employment:(1) An employer is subject to vicarious liability for a tort committed by its employee acting within the scope of employment.(2) An employee acts within the scope of employment when performing work assigned by the employer or engaging in a course of conduct subject to the employer's control. An employee's act is not within the scope of employment when it occurs within an independent course of conduct not intended by the employee to serve any purpose of the employer.(3) For purposes of this section,(a) an employee is an agent whose principal controls or has the right to control the manner and means of the agent's performance of work, and(b) the fact that work is performed gratuitously does not relieve a principal of liability.2 Big Questions:How do the classifications work (e.g. “employee”)? – 7.07(3)Agent or Non-AgentExtent of Control (Employee or not)What counts as “within the scope of employment”?Rest. 3dEmployeeNon-Employee AgentNon-Agent (Service Provider)Rest. 2dServantIndependent Contractor (agent-type)Independent Contractor (non-agent)Description and ConsequenceA has power to act on P’s behalfP controls results and physical conduct= P liable if within scope of employmentA has power to act on P’s behalfP sets forth desired results but does not control physical conduct=P not liable except in special casesA does not have power to act on P’s behalfP may have less control over results and does not control physical conduct= P not liable in agency lawExceptions:P is not liable for tort of non-employee agent except in these special cases:Principal retains control over the aspect of the work in which the tort occurs (e.g., treated as employee with respect to some limited part of work)Principal hires an incompetent contractorNondelegable duty (e.g., a land occupier has a duty to keep land safe for business invitees)Activity contracted for is inherently dangerous (e.g., demolition, blasting)Criteria for Determining Employee StatusRest. 2d - §202 Scope of Actual Authority: Pollman’s List:Extent of control which P may exercise over details of the workIs A engaged in a distinct occupation/business?The kind of occupation and whether the work is usually done in that locality under P’s direction, or by a specialist w/o supervision?Skill required in the particular occupationWho supplies the instrumentalities, tools, and place of work for A?Length of time for which A is employedMethod of payment, whether by the time or by the jobIs the work a part of the regular business of P?Do the parties believe they are creating an employment relationship?Whether the P is in businessHumble Oil & Refining Co. & Sun Oil CompanyEmployee v. Independent Contractor – Apply §202 – (X not indicative of employee; √ Indicative of Employee)Humble (Held Liable)Sun Oil (Not Held Liable)Extent of control which P may exercise over details of the work - √Extent of control which P may exercise over details of the work - √Is A engaged in a distinct occupation/business? - √Is A engaged in a distinct occupation/business? - √The kind of occupation and whether the work is usually done in that locality under P’s direction, or by a specialist w/o supervision? - √The kind of occupation and whether the work is usually done in that locality under P’s direction, or by a specialist w/o supervision? - √Skill required in the particular occupation - √Skill required in the particular occupation - √Who supplies the instrumentalities, tools, and place of work for A? - √Who supplies the instrumentalities, tools, and place of work for A? - √Length of time for which A is employed - √Length of time for which A is employed - √Method of payment, whether by the time or by the job - XMethod of payment, whether by the time or by the job - XIs the work a part of the regular business of P? - √Is the work a part of the regular business of P? - √Do the parties believe they are creating an employment relationship? - XDo the parties believe they are creating an employment relationship? - XWhether the P is in business – X (only by design)Whether the P is in business - XScope of Employment - § 7.07(2)1. Was the conduct of the same general nature as, or incidental to, the task the agent was employed to perform?2. Was the conduct substantially removed from the authorized time and space limits of employment? (“frolic”?)3. Was the conduct motivated at least in part by a purpose to serve the principal?Bushey v. United StatesScope of Employment – Did the court replace the “motive test” with the “characteristic activities” test?Was Lane’s conduct foreseeable enough to hold the government responsible? – YES“The risk that seaman going and coming from the Tamaroa might cause damage to the dry-dock is enough to make it fair that the enterprise bear the loss.”Manning v. GrimsleyScope of Employment – Was throwing the ball at the hecklers within Grimsely’s scope of employment – YesAgain, which enterprise is best suited to insure against the loss and take preventative measuresApparent Agency Rest. 3d - § 7.08 – Agent Acts with Apparent Authority:A principal is subject to vicarious liability for a tort committed by an agent in dealing or communicating with a third party on or purportedly on behalf of the principal when actions taken by the agent with apparent authority constitute the tort or enable the agent to conceal its commission.HypoP Nusimatics Co. urges its customers to seek investment advice from its retail sales people, including A.T, who wishes to invest in gold coins, seeks A’s advice at an office of Nusimatics Co.A encourages T to buy a particular set of gold coins, falsely representing material facts relevant to their value.T reasonably relied on A’s representations and bought the gold coins.P is subject to liability for A’s actions.D. Fiduciary Duties in the Agency Relationship?Agent’s Duty to the Principal - Rest. 3d §§ 8.01-8.11Duty of loyaltyDuty not to acquire a material benefit from a T for actions taken on behalf of P or through A’s use of positionDuty not to act as adverse party to PDuty to refrain from competing with P during agency relationshipDuty of confidentiality; duty (during and after agency relationship); duty not to use P’s property for A’s own purposesDuty to act in accordance with any contract with PDuty of care, competence, diligenceDuty to act only within scope of actual authority and duty to obeyDuty of good conductDuty to notify P of info that A knows or has reason to know P would want to knowPrincipal’s ConsentRest. 3d - § 8.06 Principal’s Consent: Conduct by A that would otherwise breach the below-listed duties does not constitute a breach if P consents, provided that A acts in good faith and discloses all material facts in obtaining the consent.Duty of loyalty, duty not to acquire material benefit from a T, duty not to act adverse or compete, duty of confidentialityReading v. RegemFiduciary Duties – Did Reading’s agency relationship with the RAMC create a fiduciary obligation to forfeit money earned illicitly while serving abroad? – YESDisgorgement – Forfeit the profits made through unauthorized actsRest. 3d - § 8.02 – Material Benefit Arising Out of Position: An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agent's use of the agent's position.General Automotive Manufacturing Co. v. SingerFiduciary Duties – Questions from SlidesHolding? How did the court describe Singer’s legal duty? How did Singer violate these duties?Singer violated his fiduciary dutyHe had a duty to devote his efforts to the company and keep their confidentialityHe violated this by working on side deals using information he acquired as an agent to broker the dealsHow did contract interact with fiduciary duty law here? Note that they sued under an agency theory, because under a contractual theory they would only get 3% of the deal that Singer made, whereas under agency they get disgorgement (all of Singer’s ill-gotten earnings)He had already clearly violated his employment contractWhat remedy does GA get from Singer?DisgorgementWhat if it was wholly unrelated to the business?The more distant the relationship between the principal’s business and agent’s side business the less likely it is a court will find a fiduciary relationship exists.Principals’ Duties to AgentsRest. 3d - § 8.14 Duty to Indemnify – A principal has a duty to indemnify an agent(1) in accordance with the terms of any contract between them; and(2) unless otherwise agreed,(a) when the agent makes a payment(i) within the scope of the agent's actual authority, or(ii) that is beneficial to the principal, unless the agent acts officiously in making the payment; or(b) when the agent suffers a loss that fairly should be borne by the principal in light of their relationship.Rest. 3d - § 8.15 - § 8.15 Principal’s Duty to Deal Fairly and in Good Faith - A principal has a duty to deal with the agent fairly and in good faith, including a duty to provide the agent with information about risks of physical harm or pecuniary loss that the principal knows, has reason to know, or should know are present in the agent's work but unknown to the agent.E. Termination of Authority and the Agency Relationship Terminating Actual Authority - Rest. 3d §§ 3.06-3.10, 3.12Agreement of parties:The contract between principal and agent states when it will end or upon the happening of a specified event.By lapse of time:At end of specified time, or if none, then within a reasonable time periodAny time by either party after notice:At common law, presumed “at will” relationship so either party may terminate (terminology is a “revocation” by P or “renunciation” by A). Note this power exists even though the party exercising the power may be in breach of the agency contract, if one.Exception where “power given as security”By change of circumstances that should cause A to realize P would want to terminate authority:E.g., destruction of subject matter of the authority, drastic change in business conditions, change in relevant laws.Fulfillment of the purpose of the agency relationship:i.e., completion of task By operation of law:Termination occurs automatically; e.g., upon death or loss of capacity of either A or P, such as dissolution of a corporation or insanity of a person.Terminating Apparent Authority - Rest. 3d § 3.11The termination of actual authority does not by itself end any apparent authority held by an agent.Apparent authority ends when it is no longer reasonable for the third party with whom an agent deals to believe that the agent continues to act with actual authority.II. General Partnerships“[A]n association of two or more persons to carry on as co-owners a business for profit…”A general partnership can be formed without any filing with the state. Once such association occurs, general partnership law determines the parties’ relative rights and duties. Sources of law: model statutes adopted by states = UPA (1914) or RUPA (1997), and case law interpreting the statute.Most RUPA provisions are default rules the partners can alter by agreement (written, oral, or implied unless SOF requires otherwise). RUPA 103(a) states this; 103(b) tells you which provisions are mandatory and cannot be altered by agreement. Some notable characteristics: Partnership pays no federal income tax, instead any profits or losses “pass through” to the partners; Joint and several liability of partnersA. Partnership Formation (Definition and Distinction from Other Relationships; Partnership by Estoppel) RUPA - § 202 Formation of Partnership(a) Except as otherwise provided in subsection (b), the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.(b) An association formed under a statute other than this [Act], a predecessor statute, or a comparable statute of another jurisdiction is not a partnership under this [Act].(c) In determining whether a partnership is formed, the following rules apply:(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or part ownership does not by itself establish a partnership, even if the co-owners share profits made by the use of the property.(2) The sharing of gross returns does not by itself establish a partnership, even if the persons sharing them have a joint or common right or interest in property from which the returns are derived.(3) A person who receives a share of the profits of a business is presumed to be a partner in the business, unless the profits were received in payment:(i) of a debt by installments or otherwise;(ii) for services as an independent contractor or of wages or other compensation to an employee;(iii) of rent;(iv) of an annuity or other retirement or health benefit to a beneficiary, representative, or designee of a deceased or retired partner;(v) of interest or other charge on a loan, even if the amount of payment varies with the profits of the business, including a direct or indirect present or future ownership of the collateral, or rights to income, proceeds, or increase in value derived from the collateral; or(vi) for the sale of the goodwill of a business or other property by installments or otherwise.Path of Analysis: (1) Written Partnership Agreement – Sidley Austin; (2) 202(a) for definition of partnership; (2) 202(c) for specific exceptions; (3) Court developed factorsFenwick v. Unemployment Comm’nPartnership Formation – No partnership has been establishedCourt’s Factors:Intention of PartiesProfit Sharing Sharing of Losses (Risk)Management (Control)Ownership of Property (Control)Rights of Parties on Termination/DissolutionConduct/Holding Out to Third PartiesFactorsPartnershipEmploymentIntention of PartiesExpress/WritingProfit SharingYes (RUPA § 202(c)(3))But might be wages (RUPA § 202(c)(3)(ii))Sharing of LossesNo – Fenwick has all the risk; Chesire did not invest $ManagementNo – Fenwick has all the control/managerial powerOwnership of PropertyOnly Fenwick had ownership rightsRights of Parties on Termination/DissolutionLooked like simple employment termination, 10 days’ noticeConduct/Holding Out to Third PartiesWith limited exception, not held out as partnersMartin v. PeytonPartnership Formation – Partners v. Lenders – Found to be Lenders, not partnersAlso Cargill – Difference is that Cargill actually exercised controlFactorsPartnershipLendersIntention of PartiesExpress/WritingProfit SharingYes (RUPA § 202(c)(3))But might be interest on loan (RUPA § 202(c)(3)(v))Sharing of LossesNo- fixed amount to be returned by deadlineManagementSome evidence of control by PPFBut is it consistent with “ordinary caution” of a worried lender?Ownership of PropertyNo – only security for loanRights of Parties on Termination/Dissolution Loan due in full after 2 year term?Conduct/Holding Out to Third PartiesNot held out as partnersA Note on Control – Typical Lender ProtectionsPermission re change in ownership/leadershipInspection rightsExpress limit on specific risky actionsCounseling on discrete matters and/or recommend consultantsDanger ZoneConstant advisingVeto power over business decisionsResignations/designating managementAssurances to other creditors (recall Cargill)Southex Exhibitions v. Rhode Island Builders AssociationPartnership Formation – Had Southex acquired SEM’s interest in an alleged partnership with RIBA? – No P’ShipFactorsPartnershipOtherIntention of PartiesPreamble of contract used word “partners”SEM initially rejected ownership offerProfit SharingYesBut is there an exception or not limited to listed ones?Sharing of LossesOnly SEM had riskManagementSharedBut SEM had most operational responsibilityOwnership and Control of PropertyNo tangible property. Intangible?Rights of Parties on Termination/Dissolution5 year term; defined by contractConduct/Holding Out to Third PartiesNo holding out for contract purposes; no mutual name Partnership by Estoppel - how third parties can sometimes hold non-partners liable as though they were partnersRUPA § 308 – Liability of a Purported PartnerThe third party plaintiff must establish that:The person sought to be charged as a partner made a representation, either by words or conduct, purporting to be a partner, or consented to being represented by another as a partner; andThe third party relied on this representation in entering into a transaction with the actual or purported partnership (= a change of position with consequent injury in reliance on the representation).Young v. JonesParntership by Estoppel – No Partnership by Estoppel HereGive Credit – The statute speaks only to the creation of liability to third persons who, in reliance upon representations as to the existence of a partnership, “give credit” to that partnership. Here, there is no evidence that credit was extended on the basis of any representation of a partnership existing between PW-Bahamas and South Carolina members of the PW-US partnershipB. Rights of Partners in Management; Partnership Liability See Handout: Overview of Rules on Partnership Management Rights and Liabilities (Copied Here)RUPA § 401(f): “Each partner has equal rights in the management and conduct of the partnership business.” This means the default = 1 partner/ 1 vote (a “per capita basis”).For example: A contributes 70% of the partnership capital, B contributes 20% of the partnership capital, and C contributes 10%. A, B, and C each have 1 equal vote.This is a default rule that can be altered by agreement. E.g., the partners could agree that A gets 7 votes, B gets 2 votes, and C gets 1 vote, in accordance with their economic contributions.RUPA §401(j):“A difference arising as to a matter in the ordinary course of business may be decided by a majority of the partners.An act outside the ordinary course of business of a partnership and an amendment to the partnership agreement may be undertaken only with the consent of all of the partners.”This is a default rule that can be altered by agreement. RUPA § 103(a). E.g., in a large partnership setting such as a large national law firm where it may be unworkable for decisions to be made by majority rule or unanimity. Large firms will often have executive committees because of the high costs of communication and negotiation between all partners, collective action problems, and the risk of hold-outs. An executive committee can provide centralized law firm administration.See Sidley & Austin v. Day (illustrating how partnership agreements may modify the default statutory rules, such as by delegating decisionmaking authority to an executive committee or using majority approval for matters requiring unanimity per statute).If partner’s act is not in the ordinary course of the partnership business or a partner desires to amend the partnership agreement or act contrary to its provisions, then a unanimous vote is required. E.g., unless the agreement provides otherwise, no one can become a partner in the partnership without the express or implied consent of all partners.RUPA § 301(1): “Each partner is an agent of the partnership for the purpose of its business. [A partner’s act] for apparently carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership binds the partnership, unless the partner had no authority to act for the partnership in the particular manner and the person with whom the partner was dealing knew or had received a notification that the partner lacked authority.”This provision addresses the partnership’s liability in contract.“The effect of § 301(1) is to characterize a partner as a general managerial agent having both actual and apparent authority co-extensive in scope with the firm’s ordinary business, at least in the absence of a contrary partnership agreement.” RUPA § 301 cmt. 2.By default, a partner has actual authority to enter into contracts in the ordinary course of the partnership business. Without a partnership agreement otherwise, any limit on the actual authority of a partner to act in the ordinary course must be decided by a majority of partners. (see RUPA § 401(j) above.)In partnerships with an even number of partners, especially those with just 2 members, deadlock is a potential problem.In the case of a 2-person partnership, a majority vote to limit one partner’s actual authority is impossible if the other partner disagrees. This rule effectively provides each partner in a 2-person partnership with a veto right over the other. Thus, before a change can occur, both parties have to agree. This dynamic may result in deadlock.See National Biscuit v. Stroud; Summers v. Dooley.A partner has apparent authority to enter into contracts in the ordinary course of the partnership business or business of the kind carried on by the partnership, unless the partner’s actual authority was limited in that regard and the third party knew or had received a notification that the partner lacked authority. (The logic here seems to be that the agency law requirement of a holding out by the principal is effectively satisfied by the mere fact that the person is a partner.)Example: A, B, and C form a partnership to run a pet hospital. All agree that A shall have the exclusive authority to order supplies, B shall have exclusive authority to handle advertising, and C shall have exclusive authority to hire help. Although A does not have actual authority to handle advertising or to hire help, he does have apparent authority to do these things because, from a third party’s perspective these all appear to be acts carried on in the ordinary course of the partnership’s business.Note that apparent authority extends to any transactions that would be apparently for carrying on business of the kind run by the partnership. Thus, in the example above, if most pet hospitals around also provide boarding or kennel services, a good argument could be made that A, B, and C each have apparent authority to enter into transactions for carrying on such activities regardless of whether the partners had agreed to do that as part of their business. What does it mean that “that the third party knew or had received notification”? Knowledge here means subjective knowledge—what the third party actually knew. A notification is effective either when it comes to the person’s attention or when it is duly delivered. RUPA § 102(d). Thus, if a notification limiting a partner’s authority is duly delivered to a third party (e.g., at the third party’s place of business), the third party cannot rely on apparent authority with regard to the limitation even if the third party has not actually read the notification.RUPA § 303: This provision allows a partnership to centrally file, such as with the secretary of state, a “statement of partnership authority” that states the authority or limitations of authority, of some or all of the partners to enter into transactions on behalf of the partnership. Subsections 303(e) and (f) restrict the effectiveness of those limitations to real estate transactions. That is, a third party is not deemed to know of a limitation of a partner merely because the limitation is contained in a filed statement, unless it concerns the limitation of a partner to transfer real property.RUPA § 305(a):“A partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership.”This provision addresses the partnership’s liability in tort.Note that you do not have to engage in the vicarious liability (aka “respondeat superior”) analysis from agency law of analyzing whether the actor is an “employee.” It suffices that the actor is a partner of the firm. To determine the partnership liability you look to whether the partner was acting “in the ordinary course of business of the partnership or with the authority of the partnership.” The “ordinary course of business of the partnership” is not defined, but seems to roughly mean that the partner’s overall course of conduct was within the scope of the partnership business or of the type broadly authorized for that type of business (e.g., would take into account evidence of customary practice in the community or relevant industry). If it is outside the ordinary course of business of the partnership and was not authorized by the partnership, then the partnership is not liable (but the individual partner may be personally liable).Note that subsection (b) provides that a partnership is liable in certain circumstances if a partner misapplies money or property of a third person.RUPA § 306:“Except as otherwise provided in subsections (b) and (c), all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.A person admitted as a partner into an existing partnership is not personally liable for any partnership obligation incurred before the person’s admission as a partner.An obligation of a partnership incurred while the partnership is a limited liability partnership (LLP), whether arising in contract, tort, or otherwise, is solely the obligation of the partnership. . .”Joint and several liability means that a claimant/creditor may sue the partners jointly as a group or separately as individuals for the full amount of the relevant obligation. This rule means that partners have personal, unlimited liability for the liabilities of the partnership. This is one of the major consequences of operating as a general partnership, and one of the key reasons for choosing to operate instead as a limited liability entity such as an LLP, LLC, or corporation (which, unlike general partnerships, requires filing organizational documents with a state agency). We’ll discuss these other forms of business associations later in this course.Note that as between partners and outside creditors, an individual partner has unlimited personal liability for the obligations of the partnership, but that between the partners, each partner is only responsible for his share of the partnership obligation. If one partner pays off a partnership obligation, he is entitled to indemnification from the partnership. If the partnership lacks the funds to indemnify the partner, the partners are required to contribute according to their loss shares. (RUPA §§ 401(b), 401(c), 807(b), 807(c)).Regarding subsection (b), a partner is not personally liable for transactions or partnership conduct that predates the partner’s arrival, but any investment they’ve made in the partnership is at risk, since partnership assets are the first source to satisfy outstanding obligations. After a partner leaves, she is liable only for obligations incurred by the partnership while she was part of it.RUPA § 307:This provision concerns actions and judgments against the partnership vs. an individual partner. RUPA 307(d)(1) is an “exhaustion rule” requiring a judgment creditor to seek to recover from partnership assets before proceeding against an individual partner’s assets.RUPA § 308:This is the “partnership by estoppel” provision. See our class discussion of this topic.NABISCO v. StroudPartnership liability – compare with Summers (similar facts, opposite outcome)Explain the basis for deciding in favor of National Biscuit.“Freeman as a general partner with Stroud, with no restrictions on his authority to act within the scope of the partnership business so far as the agreed statement of facts shows, had equal rights in the management and conduct of the partnership business.”Stroud could not restrict the power and authority of Freeman to buy bread for the partnership as a going concern, for such a purchase was an “ordinary matter connected with the partnership business,” for the purpose of its business and within its scope.Why wasn’t Stroud’s notification to National Biscuit enough for him to restrict Freeman’s ability to bind the partnership?“Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners”It was in the ordinary course of businessCan’t have a majority in a two person partnershipSummers v. DooleyPartnership liability – compare with Nabisco (similar facts, opposite outcome)In the case at bar one of the partners continually voiced objection to the hiring of the third man. He did not sit idly by and acquiesce in the actions of his partner. Under these circumstances it is manifestly unjust to permit recovery of an expense, which was incurred individually, and not for the benefit of the partnership but rather for the benefit of one partner.The only reasonable interpretation of the pertinent statute is that business differences must be decided by a majority of the partners provided no other agreement between the partners speaks to the issues.NabiscoSummers“Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners”“business differences must be decided by a majority of the partners provided no other agreement between the partners speaks to the issues”Contract binding on partnership: “Stroud was not, and could not be, a majority of the partners”Contract not binding on partnership: “a majority of the partners did not consent to the hiring of the third man”Suit was brought by a third party seeking to hold liable the partnership for the acts of one of the partners.Suit was brought by one partner against the other for contribution towards an alleged partnership expense.All partners are agents of the partnership with power to bind the partnership. As a partner, Freeman had actual authority to conduct affairs in the ordinary course of business. The partnership could have restricted that authority, but not without a majority vote and Stroud did not control a majority.All partners have equal rights to participate in the management of the partnership, and it takes a majority to change the status quo if partners disagree as to a matter in the ordinary course of business. If Summers wants to be reimbursed for an act changing the status quo, he needs a majority vote, even if the act would have bound the partnership to a third party under the apparent authority principle.In a deadlock, the partner proposing the change loses.C. Financial Interests in Partnership (Sharing of Profits and Losses; Partnership Property) RUPA § 401(a) – Partner’s Rights and DutiesEach partner has an account that is a running balance reflecting: their contributions (money plus the value of any other property), their share of profits, any distributions (taking a “draw”), and their share of losses.Capital ContributionsAs a matter of default, initial capital contributions are not required from partners.Some or all partners may contribute only services.Vocab: a “service partnership” or “K-and-L partnership” = where one partner provides all the capital and another provides all the labor.The basic default rule is that each partner is credited with an amount equal to the money plus the value of any other property contributed. The contributed capital itself belongs to the partnership and can be any property (real, intangible, etc.). RUPA § 401(a).Profits and LossesUnless otherwise agreed (and a limited exception during winding up), a partner is not entitled to compensation for services. RUPA § 401(h).By default, a partner “is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner’s share of the profits.” RUPA § 401(b).So the default = equal share of profits and losses in proportion. Does it make any difference if the partners contributed unequal amounts of capital or labor?If A and B agree to split profits 60/40 but say nothing about losses, how would losses be split?Statute is silent on when profits are distributed. A well-drafted partnership agreement will address this. If not, the default is to take draws by consensus on ad hoc basis.Partnership Account ExamplesProfit Allocated ExampleAliceBobInitial Contribution$10,000$1,000Year 1 Profit$1,000$1,000Year 1 Account Balance$11,000$2,000Loss Allocated ExampleAliceBobYear 1 Account Balance$11,000$2,000Year 2 Loss($2,000)($2,000)Year 2 Account Balance$9,000$0Profit Allocated and Draw Taken ExampleAliceBobYear 1 Account Balance$11,000$2,000Year 2 Loss($2,000)($2,000)Year 2 Account Balance$9,000$0Negative Account ExampleAliceBobYear 3 Account Balance$10,000$1,000Year 4 Loss($2,000)($2,000)Year 4 Account Balance$8,000($1,000)Settlement of Accounts and Contributions in Winding UpRUPA § § 401(a), 807A partnership must apply its assets to discharge the obligations of creditors (including partners who are creditors).If there is any surplus, that is divided among the partners in accordance with their right to distributions. Partner accounts make no distinction between capital contributions and profits.QuestionsAmos contributed $100,000 in capital and agreed to lend the partnership $25,000. He therefore has a status of both partner and creditor. What are his rights as against other general creditors with respect to his loan if the partnership goes under?Amos gets 25k at the same time as the other creditors, unless they agree otherwiseCan a general partnership be formed if there is no agreement about how losses will be shared?If all the indicators of a partnership existKovacik v. Reed“Service Partner” Exception (Minority Rule – California Rule)Kovacik – FinancierReed – Superintendent and EstimatorFacts – Kovcik approached Reed to be a superintendent and estimator and that Kovacik would finance the projects and the two would share the profits 50/50. Kovacik did not ask Reed to share any losses that might result and Reed did not offer.General Rule – absence of an agreement to the contrary the law presumes that partners and joint adventurers intended to participate equally in the profits and losses of the common enterprise, irrespective of any inequality in the amounts each contributed to the capital employed in the venture, with the losses being shared by them in the same proportions as they share the profits. (Reinforced by RUPA)Minority Rule – Service Partner – Where one party contributes money and the other contributes services, then in the event of a loss each would lose his own capital the one his money and the other his labor.RUPA’s Response to Kovacik:Comments to UPA (1997) § 401:“The UPA § 18(a) rules that profits are shared equally and that losses, whether capital or operating, are shared in proportion to each partner’s share of the profits are continued. The default rules apply, as does UPA § 18(a), where one or more of the partners contribute no capital, although there is case law to the contrary. [Citing, inter alia, Kovacik]”Partnership PropertyRUPA §204:Property purchased with partnership funds is presumed to be partnership property.Partnership property also includes property that is either:Acquired in the name of the partnership. Acquired by one or more partners with a document transferring title that indicates the partner was acting in his capacity as a partner.RUPA § 401(g): “A partner may use or possess partnership property only on behalf of the partnership.”RUPA § 501: “A partner is not a coowner of partnership property and has no interest in partnership property which can be transferred, either voluntarily or involuntarily.”RUPA § 502: “The only transferable interest of a partner in the partnership is the partner’s share of the profits and losses. . . and the partner’s right to receive distributions. The interest is personal property.”RUPA § 503: Transfer of partner’s transferable interest. RUPA § 504: Partner’s transferable interest subject to charging order.Partnership Property HypoLawyer Jean-Paul wants to sell his share in a law firm partnership to Maria. If he enters into an agreement in which he purports to sell membership in the firm to Maria, does Maria thereby become a member in the firm? – No, §202If he enters into an agreement by which he purports to sell his share of the partnership assets to Maria, does Maria take title to those assets? – No, §501Does Jean-Paul have any right he can assign to Maria? – Yes, §502New scenario: What if a personal creditor of Jean-Paul’s wants to go after his interest? – Yes, §504D. Fiduciary Duties in Partnership Law?Fiduciary Duties in Partnerships:RUPA § 404(a): “The only fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth in subsections (b) and (c).” RUPA § 404(b): Duty of Loyalty“(b) A partner’s duty of loyalty to the partnership and the other partners is limited to the following:(1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity;(2) to refrain from dealing with the partnership . . . as or on behalf of a party having an interest adverse to the partnership; and(3) to refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership.”RUPA § 404(c): Duty of Care“(c) A partner’s duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.”RUPA § 404(d): Good Faith“(d) A partner shall discharge the duties to the partnership and the other partners under this [Act] or under the partnership agreement and exercise any rights consistently with the obligation of good faith and fair dealing.”RUPA § 404(e)-(g):“(e) A partner does not violate a duty or obligation under this [Act] or under the partnership agreement merely because the partner’s conduct furthers the partner’s own interest.(f) A partner may lend money to and transact other business with the partnership, and as to each loan or transaction the rights and obligations of the partner are the same as those of a person who is not a partner, subject to other applicable law.(g) This section applies to a person winding up the partnership business as the personal or legal representative of the last surviving partner as if the person were a partner.”Information Disclosure in PartnershipRUPA § 403(c):“Each partner and the partnership shall furnish to a partner…:(1) without demand, any information concerning the partnership’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties under the partnership agreement or this [Act]; and (2) on demand, any other information concerning the partnership’s business and affairs, except to the extent the demand or the information demanded is unreasonable or otherwise improper under the circumstances.”Nonwaivable ProvisionsRUPA § 103: “(b) The partnership agreement may not:…(2) unreasonably restrict the right of access to books and records under § 403(b);(3) eliminate the duty of loyalty…, but:(i) the partnership agreement may identify specific types of categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable; or(ii) all of the partners or a number or percentage specified in the partnership agreement may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty;(4) unreasonably reduce the duty of care…;(5) eliminate the obligation of good faith and fair dealing…, but the partnership agreement may prescribe the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable;”….Meinhard v. SalmonDid Salmon breach his fiduciary duty by not informing Meinhard of the opportunity for the 2nd lease – YesCardozo’s Take:“Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of finest loyalty. Many forms of conduct permissible in a workday world are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor most sensitive, is then the standard of behavior.”Because Salmon undertook the 2nd lease’s negotiations while the partnership was in effect, he violated his fiduciary duty.Andrew’s Take:Partnership was taken up for a fixed period and ended at the end of the first lease. The dissent felt that deals involving events to occur after the expiration of that term were no matter to the mon Law – It is unclear whether disclosing the opportunity to Meinhard would have been sufficient to eliminate Salmon’s breach of fiduciary dutyMeehan v. ShaughnessyFactsMeehan and Boyle were partners at PC and eventually grew displeased with the partnership. They basically hatched a 6 month scheme to leave the firm and take some partners and associates with them.They ended up removing approximately 142 cases to MBCPC’s Three Different Claims for breach of fiduciary duty:By improperly handling cases for their own, and not the partnership’s benefit - XIt’s a factual questions and just because certain conversations occurred, that doesn’t mean improper actions took placeBy secretly competing with the partnership – XThe logistical arrangements that MBC made (leasing office space, preparing client lists, and obtaining financing) were permissible given the situationBy unfairly acquiring from clients and referring attorney consent to withdraw cases to MBC - √MB continued to use their position of trust and confidence at PC to the disadvantage of PC, and the contents of the letter MB sent to the clients was unfair (THEY LIED and THEY CONTACTED CLIENTS IN AN INAPPROPRIATE WAY)E. Partnership Dissociation and Dissolution?Dissociation is a change in the relationship of the partners caused by any partner ceasing to be associated in the carrying on of the business.Dissociation does not necessarily cause a dissolution and winding up of the partnership business.NOTE:“At Will” – Default“Term” – By Specific ElectionA partner is dissociated from the partnership upon … RUPA § 601 – Event’s Causing Partner’s Dissociationthe partnership's having notice of the partner's express will to withdraw as a partner or on a later date specified by the partner;an event agreed to in the partnership agreement as causing the partner's dissociation;the partner's expulsion pursuant to the partnership agreement;the partner's expulsion by the unanimous vote of the other partners if:(i) it is unlawful to carry on the partnership business with that partner;(ii) there has been a transfer of all or substantially all of that partner's transferable interest in the partnership, other than a transfer for security purposes, or a court order charging the partner's interest, which has not been foreclosed;(iii) within 90 days after the partnership notifies a corporate partner that it will be expelled because it has filed a certificate of dissolution or the equivalent, its charter has been revoked, or its right to conduct business has been suspended by the jurisdiction of its incorporation, there is no revocation of the certificate of dissolution or no reinstatement of its charter or its right to conduct business; or(iv) a partnership that is a partner has been dissolved and its business is being wound up;on application by the partnership or another partner, the partner's expulsion by judicial determination because:(i) the partner engaged in wrongful conduct that adversely and materially affected the partnership business;(ii) the partner willfully or persistently committed a material breach of the partnership agreement or of a duty owed to the partnership or the other partners under Section 404; or(iii) the partner engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with the partner;the partner's:(i) becoming a debtor in bankruptcy;(ii) executing an assignment for the benefit of creditors;(iii) seeking, consenting to, or acquiescing in the appointment of a trustee, receiver, or liquidator of that partner or of all or substantially all of that partner's property; or(iv) failing, within 90 days after the appointment, to have vacated or stayed the appointment of a trustee, receiver, or liquidator of the partner or of all or substantially all of the partner's property obtained without the partner's consent or acquiescence, or failing within 90 days after the expiration of a stay to have the appointment vacated;in the case of a partner who is an individual:(i) the partner's death;(ii) the appointment of a guardian or general conservator for the partner; or(iii) a judicial determination that the partner has otherwise become incapable of performing the partner's duties under the partnership agreement;in the case of a partner that is a trust or is acting as a partner by virtue of being a trustee of a trust, distribution of the trust's entire transferable interest in the partnership, but not merely by reason of the substitution of a successor trustee;in the case of a partner that is an estate or is acting as a partner by virtue of being a personal representative of an estate, distribution of the estate's entire transferable interest in the partnership, but not merely by reason of the substitution of a successor personal representative; ortermination of a partner who is not an individual, partnership, corporation, trust, or estate.RUPA § 602 – Wrongful DissociationA partnership is either “at will” or “term.”A partner will be deemed to have wrongfully dissociated if: the dissociation is in breach of an express term of the partnership agreement; orthe partnership is for a definite term or particular undertaking and the partner withdraws, is expelled, or becomes bankrupt before the end of the term or completion of the undertaking (with limited exception).A partner who wrongfully dissociates is liable to the partnership for any damages caused by the dissociation. RUPA § 603 – Effect of DissociationDepending on the act of dissociation, 1 of 2 consequences will occur:If the event is listed in RUPA § 801, then dissolution and winding up will occur. If the event is not listed in RUPA § 801, then a buyout will occur pursuant to RUPA § 701.Consequences of DissociationRight to management ceases; duties of care and loyalty generally also terminated, except for matters arising before dissociation. RUPA § 603(b).Purchase of dissociated partner’s interest. RUPA § 701(a)-(c).Deferred payment if wrongful dissociation. RUPA § 701(h).Indemnification of dissociated partner. RUPA § 701(d).Dissociated partner’s power to bind partnership. RUPA §§ 702, 704.Dissociated partner’s liability to other parties. RUPA § 703.Dissolution, Winding up, TerminationA partnership is dissolved and its business must be wound up when any of the following occurs… RUPA § 801.A partner’s power to bind the partnership after dissolution. RUPA § 804.Dissolution causes the partnership to “wind up,” absent agreement to continue (e.g., buy-out and continuation agreements), or by unanimous vote (including any dissociating partner other than a wrongfully dissolving partner). RUPA § 802(b).“Winding up” = Shutting down the business by selling off the assets (either as separate assets or of the business as a going concern), paying the partnership liabilities, settling partner accounts. Actual authority of partners to act on behalf of partnership terminated except in connection with winding up of partnership business. Once winding up is finished then the partnership is “terminated”; no filing or magic words required. RUPA § 802(a).1 Person PartnershipsA one person partnership is not possible in CA, so if one partner leaves a 2 person partnership, it go into dissolutionOwen v. CohenAllowed DissolutionNot an at will partnership – they signed a 30 year lease with the intention of carrying on the bowling alley business for the durationCollins v. LewisDidn’t Allow DissolutionNot an at will partnership – had signed a lease for the operation of a cafeteria that went way over budgetWhat’s the Difference between Owen and Collins? – The partner seeking judicial resolution can’t be the bad actor (also look at the nature of the relationship – is it actually impractical to continue?)McCormick v. BrevigBrother and Sister’s Partnership in their family FarmIssue – Should the brother have been able to buyout the sister, or should the property have been liquidated?Holding – the property should have been liquidated under RUPA Art. VII.F. Partnership AgreementsPartnership AgreementsCan:Change governance rules (voting rights; duties; limits)Define scope of fiduciary duties, so long as “not manifestly unreasonable”Establish financial rights between partners (during, at dissolution, or upon termination)Often forget to address:Buy-outValuationContinuation Cannot:Completely eliminate fiduciary duties/right to accountingAlter third parties’ rightsG. Other Partnership Forms (e.g., LPs and LLPs) Limited PartnershipsA type of partnership with 2 types of partners:General partners: General partners manage the business and have the power to bind the partnership. They are personally liable for the partnership debts. Limited partners: Silent/passive partners without management rights. Not personally liable except in extraordinary circumstances.The partnership must have at least one general partner and one limited partner. The name must have a signifier – i.e., “LP”Default rule is that partners in a LP share profits and losses in proportion to their respective capital contributions.Requires a formal filing (a “certificate of limited partnership”) to create a LP; each state has a LP statute.Most states either have some version of RULPA or ULPA (2001). California has enacted ULPA (2001).Typically only used in venture capital organizational structure – the LPs invest into a GP and then the GP invests the money in portfolio start-up companiesLLPs and LLLPsLLP = the limited liability form of the general partnership (check out Article 10 of RUPA)LLLP = the limited liability form of the limited partnership (the GPs get limited liability)These require filing a form with the secretary of state.The effect is to shield partners from personal liability for some or all partnership debts (varies by state). III. CorporationsA. General Background; Formation; Limited Liability 1. IntroductionIntroduction to CorporationsThe founders of a corporation create the corporation (they “incorporate”) by filing certain documents with the appropriate state agency and may choose to do so in any of the states.The corporation - A “legal person” typically possessing the following attributes:Separate entityLimited liabilityIndefinite durationSeparation of share ownership and controlDivisible ownership (shares of stock)Transferable shares and debt obligations (unless limitations imposed)Corporate law primarily focuses on the relationship between: the stockholders (aka “shareholders”)Are entitled to the residual value of the corporation after it has paid its creditors. Do not participate in the management of the corporation; they merely elect the board of directors, vote on certain fundamental issues (amendments of articles, acquisitions and mergers, etc.)the board of directors, andAuthority to act for (and to bind) the corporation originates in the board.Directors have fiduciary duties to the corporation and the body of shareholders.Elected by the shareholders and serve for a set termRun the corporation – make the major decisionsAppoint the officersthe officers (aka “managers” or “executives”)They handle the day-to-day affairs of the corporationsThe officers are appointed by the board.They are agents of the corporation.E.g., CEO, CFO, etc.Critiques of Limited Liability & Unlimited Liability Critiques of Limited LiabilityTort Creditors – Limited liability is particularly troublesome in the context of tort victims, who never had a chance to decide whether to assume the risk entailed in extending credit to a corporation.The poor are more likely to be affected by corporate bad actors in the tort context (hazardous waste disposal, etc.), so some view it as the rich versus the poor.Making corporations liable would cause them to pass the costs on, therefore affecting the poorest at a disproportionately higher rate – so there is no winningContract Creditors – Contract creditors might effectively contract for either liability regime, by negotiating a shareholder guarantee or by agreeing to limit claims to corporate funds.Because a contract creditor willingly enters into an agreement with a corporation, critics have been less critical of their relationship and fairness argumentsCritiques of Unlimited Liability – There are two main arguments against unlimited liability: (1) Efficiency and (2) Logistical/proceduralThe efficiency argument stems from the notion that unlimited liability would be socially costly because it would impede investment of capital in businesses to such an extent that its costs outweigh its benefits.Exposure of one’s last dollarProblems with diversificationWeaker shareholder monitoring of corporate managementNeed for inter-shareholder monitoringReduction in clarity of stock pricesShare transfer restrictions would be neededThe procedural argument is that even if the costs of unlimited liability were worth bearing in order to eliminate the costs associate with limited liability, unlimited liability is unworkable as a practical matter.Sources of LawEach state has its own corporation code (statutes), which sets out how to incorporate and the laws governing corporations; courts interpret and apply the state corporation code through case law.While there is no federal law of corporations per se, federal statues add a significant layer of corporate regulation (e.g., securities laws, Sarbanes-Oxley, Dodd-Frank).Choice of LawChoice of law: Once a firm is incorporated in a particular state, it is the law of that state that controls as to the matters covered in the corporations code (this is known as the “internal affairs doctrine”).The Ultra Vires DoctrineAt common law, a corporation was limited to the powers enumerated in the purpose clause of its charter.The “purpose clause” is a statement describing the business the corporation is to conduct.The term “corporate powers” refers to methods the corporation may use to achieve its purpose (e.g., power to contract and power to borrow money). Historically, if a corporation engaged in conduct that was not authorized by its express or implied powers, the conduct was deemed “ultra vires” and void. Whenever a transaction was beyond the corporation’s limited purposes or powers, either party to the contract could disaffirm it. That is what is known as the “ultra vires doctrine.”Over time, courts began to interpret corporate powers more broadly. State legislatures began to allow corporations to specify in their charter that they were formed to engage in “any lawful purpose.” Corporations need not specify a single purpose, nor do they need to list their specific powers.Today, most modern corporation statutes expressly grant incidental/implied powers. In the absence of express restrictions, the board and corporate managers to whom they delegate, have discretionary authority to enter into contracts and transactions reasonably incidental to its business purpose, which may be broadly defined. (DGCL §§ 121, 122)The modern ultra vires doctrine is narrow; it applies only where the certificate of incorporation states a limitation and there are 3 exclusive means of enforcement (DGCL § 124): in a proceeding by a stockholder against the corporation to enjoin a proposed ultra vires act; in a corporate suit against directors and officers for taking unauthorized action (the directors and officers can be enjoined or held personally liable for damages); the state attorney general can seek involuntary judicial dissolution if the corporation has engaged in unauthorized transactions.An ultra vires act will be enjoined only if equitable to do so; generally means that an act involving an innocent third party (e.g., one who didn’t know the action was ultra vires) will not be enjoined.Use of the ultra vires doctrine is very rare; many legal commentators view it as a historical relic.The Internal Affairs DoctrineAs a general matter, the “internal affairs” of the corporation are governed by the law of the state of incorporation.Courts apply the law of the state of incorporation when adjudicating governance and fiduciary duties that arise within the corporation, including the rights of and relations among stockholders, the duties and obligations of the officers and directors, issuance of shares, acquisition procedures, etc.Hence, the act of incorporation also selects the law that will apply to the corporation’s internal affairs. (E.g., “a Delaware corporation,” “a California corporation”)A notable departure from the internal affairs doctrine is California’s long-arm statute, Corporation Code § 2115.It makes “foreign” corporations with half of their taxable income, property, payroll, and outstanding voting shares within California subject to certain provisions of the California Corporations Code. This is controversial and has been the subject of recent debate (Delaware courts have ruled it unconstitutional and there has been a California legislative attempt to get rid of it).Qualification of “Foreign” Corporations to Do BusinessA business incorporated in one state may conduct business in another if “qualified” to do business in that state. To “qualify” the corporation usually has to file a certified copy of its certificate, pay a filing fee, and appoint a local agent to receive service of process in that state.Why do we Study Delaware Law?The largest body of precedent interpreting its corporation code – meaning it has the most comprehensive body of corporate law in the U.S.Relatively stable and modern corporate law. Radical reform of its corporation code is unlikely as Delaware’s constitution mandates a 2/3 vote of both state legislative houses to change the corporation code. Delaware courts frequently issue unanimous opinions.A special court for business matters (the Chancery Court), which has a reputation for excellence and experience in corporate law (as well as the Delaware Supreme Court, which is similarly respected).Procedures that facilitate timely decisions (which can be especially important for some corporate issues like takeovers).Many lawyers across the country are trained in Delaware corporate law, especially business savvy lawyers.Public v. Private Corporations“Public” corporations are large firms with stock traded on public stock markets The shareholders typically do not expect to participate actively in the operation of the business; they are passive investors. (Many Americans also invest indirectly through mutual funds, etc.)There is a large amount of federal law that applies to public corporations (securities laws, etc.).“Private” corporationsNot subject to public reporting requirements under federal securities laws (Take the Securities Regulation course to learn more!)Typically, private corporations have a small number of shareholders who hold stock that is not publicly traded. The stock is generally less “liquid” and may be subject to shareholder agreements that limit its transferability.Generally (though not always) private corporations are of relatively modest economic scope, and the people in the top managerial positions may also own a substantial amount of the corporation’s stock. Partnerships v. CorporationsGeneral PartnershipCorporationFormationInformal; UPA, RUPA.Formalities required; Certificate of incorporation, bylaws, board of directors, minutes, filings, etc.Limited LiabilityNo. Unlimited personal liability.But partnership agmt can have indemnity provisions, can buy insurance, and other partnership forms offer limited liability to various extents (LP, LLP, LLLP)Yes. Limited liability for shareholders.But creditors may seek personal guarantees and there is the veil piercing doctrine.Free transferability (of interest/share)No (default rule).Just the “transferable interest” is personal property that can be transferred; but partners can negotiate and dissociate.Yes, generally.Can sometimes be restricted.PartnershipCorporationContinuityDefault is at will.Can agree to continuation agreements.Death of partner – dissociation.Default is indefinite/perpetual.But can limit.Not tied to human life.ManagementDecentralized (default).Each partner an agent and equal participation in mgmt is default; but can use exec comm. and limit authority by agreement and notice to third parties.Centralized (default).Directors and officers manage the corporation; not shareholders. Separate and specialized functions.CostZero.But often good idea to hire a lawyer.Filing fees, typically lawyer fees, franchise fees, etc.Default RulesExtensive.More extensive.FlexibilityVery malleable form for carrying on business; most rules are default. Not quite as flexible.Tax“Pass-through” (single).Losses can be passed through for use by partners.Taxed as entity, so shareholders have “double taxation” on distributed earnings; losses usable only by corporation. [Exception: S Corporations]2. Promoter LiabilityA “promoter” is a “person, who acting alone or [with others], directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer.”E.g., identify and solicit investors, arrange for space/facilities, hire employees for the entity, enter into contracts.Often referred to as the “founder” or “organizer.”Contrast with an “incorporator” who has the limited, mechanical task of preparing the incorporation documents and filing them with the state. Incorporators are often lawyers, paralegals, etc. In contrast to the rules of promoter liability, incorporators are typically not liable for their pre-incorporation acts.Promoter LiabilityPre-incorporationPromoters are liable for contracts entered into on behalf of a future corporation, absent a contrary intent. Contrary intent generally requires showing more than just signing “for a corporation to be formed.” Evidence of the parties’ intentions must be found in the contract or in the surrounding circumstances—for example, a provision in the contract stating that the parties intend the promoter to be a non-recourse agent.Post-IncorporationCorporation is liable on the contract only if the corporation adopted/ratified it.Can be express (e.g., formal board resolution) or implied (e.g. if directors or officers knew of and acquiesced in the contract).Promoter remains liable unless:Corporation is formed;Corporation adopted the pre-incorporation contract; andThe parties agreed to release the promoter from liability (either in the initial contract or through subsequent novation).It’s possible for the corporation and the promoter to both be liable on the contract.Moneywatch v. WilbersPromoter Liability? - Jeff Wilbers – Promoter of a corporation formed for a golf businessπ – Moneywatch – Landlord that leased property to WilbersFactsWilbers intended to create a corporation, but the LL advised him that he would have to remain personally liable on the lease even if a corporation was eventually created.Wilbers incorporated and submitted a request to change the name of the lease from Wilbers to the corporate identity.2 Arguments:Novation (Contracts Argument) -X“A novation occurs ‘where a previous valid obligation is extinguished by a new valid contract, accomplished by substitution of parties or of the undertaking, with consent of all the parties, and based on valid consideration.”“In order to effect a valid novation, all parties to the original contract must clearly and definitely intend the second agreement to be a novation and intend to completely disregard the original contract obligation.”Promoter (Corporate Argument) - X? argued that he is not liable because he executed the lease as a corporate promoter on behalf of a future corporation“A promoter is not personally liable on a contract made prior to incorporation which is made in the name and solely on the credit of the future corporation.”“The promoters of a corporation who execute a contract on its behalf are personally liable for the breach thereof irrespective of the later adoption of the contract by the corporation unless the contract provides that performance thereunder is solely the responsibility of the corporation.”Promoter Fiduciary DutiesPromoters of a yet-to-be-formed corporation have some fiduciary duties to the entity, the other promoters, and investors:Promoters must deal with the entity in good faith. This requires promoters to act fairly in transactions they enter into with the corporation.Promoters must disclose relevant information, like opportunities and conflicts vis-a-vis the entity, to other relevant parties. (e.g., no secret profits)3. Formation of a Corporation?The Incorporation ProcessSelect state of incorporation.Reserve the desired corporate name by application to the secretary of state or other designated state office.Arrange for a registered office and registered agent.Draft, execute, and file the certificate of incorporation (aka “charter,” “articles of incorporation”) with the relevant state agency, according to the requirements of state law (e.g., DGCL § 102 – let’s look at this in detail). Note: The role of incorporators can be purely mechanical. They sign the certificate and arrange for the filing. If the certificate does not name directors, the incorporators select them at the first organizational meeting (to serve until first shareholder meeting). After incorporation, the incorporators can fade away and do not need any continuing interest or role.Filing the certificate is a straightforward task. The DGCL requires state officials to accept certificates for filing if they meet the specifications. DGCL § 103(c). Certain filing or organization fees and any franchise tax must be paid.Properly filing the certificate brings the corporation into existence. (DGCL § 106.) Next step is to have an organizational meeting of the incorporators or of the subscribers for shares to elect the directors, if not named in the certificate. Also:Appoint officersAdopt bylaws (typically describe rules regarding shareholder and director meetings, shareholder voting, etc.) (DGCL § 109)Adopt pre-incorporation promoters’ contractsAuthorize issuance of shares, stock certificates, corporate seal, corporate account, etc. (use a checklist to be meticulous)Prepare board meeting minutes, open corporate books and records, issue shares, qualify to do business in states where business will be conducted, obtain any needed permits, taxpayer ID numbers, etc.Plan for shareholder meeting as required.4. Defective Formation (De Facto Corporations and Corporation by Estoppel) 2 Results of Defective Formation:(1) De Facto CorporationGood faith attempt at incorporation; andSome use of corporate-like power and good faith in doing so (e.g., transaction of business by the organization as if it were a corporation).(2) Corporation by EstoppelParties have dealt with each other on the assumption that a corporation existed; andUnjust to deny corporate existence.Example: Southern Gulf v. CamcraftHill v. County ConcreteDe Facto Corporation – “This case demonstrates the importance of the good faith requirement for establishing a de facto corporation.Facts – Two contractors decided to form a corporation, but they name they chose was already taken in the state. They continued to do business under the original name, even though they knew they weren’t incorporated under that name. When a creditor tried to get them to pay the bill, they argued that although there was no official corporation, there was a de facto corporation because they tried to incorporateHolding – Court rejected the ?’s argument because their conduct was not in good faith. Once they found out that incorporation under the former name was impossible, they acted in bad faith by not informing their suppliers and other known creditorsTest – Court require at least three elements to be met in order to claim protection under a theory of de facto incorporation:Authority – The state must have authorized the formation of a corporation in the jurisdiction (almost always met)Use of corporate power – There must be a transaction in which individuals must have been acting or purporting to act on behalf of the still-to-be-formed corporate entity.A good faith attempt at incorporationSouthern-Gulf v. CamcraftΠ – Camcraft – entered into a contract with southern gulf to buy a vessel, when they believed that southern gulf was incorporated in the state of Texas. Brought suit against Southern Gulf when they wouldn’t deliver the vessel they had contracted for.? - Southern Gulf – Incorporated in the Cayman Islands, not Texas. – They argued that the company did not exist at the time of the contracting; therefore there was no valid consent.Holding – Defendant could not claim lack of existence of the corporation as a defense to contracting, unless the corporation’s lack of incorporation somehow prejudiced the defendant’s rights.“The plaintiff relied upon the contract and secured financing. The defendant likewise relied on the contract and began construction of the vessel. We have no doubts that defendant would assert that plaintiff and D.W. Barrett were liable on the contract had they defaulted and enforcement was advantageous, but defendants refuse to recognize any rights they may have therein. In all likelihood, the true state of affairs is as represented by plaintiff’s counsel: the vessel appreciated in value above the contract price between the time of contract and the agreed delivery date.”General Rule – There are disagreements among the states, but it can be generally said that the parties are estopped from denying corporate existence if both parties believed they were dealing with a corporation and had no actual knowledge that the entity was not properly formed.One Important Exception to the Estoppel Doctrine:The doctrine DOES NOT apply if the parties have actual knowledge that the corporate entity was not properly formed5. Background Information on Stock and Dividends Corporations often fund their business with bank loans or with “retained earnings” (which just means income retained by the corporation instead of distributed as dividends).Corporations also raise money (“capital”) to fund their business by issuing debt and equity securities (the “capital formation” process).These securities are long-term contingent claims on the corporation’s assets and future earnings, issued pursuant to formal contractual instruments.Debt & EquityCorporations have a “capital structure,” consisting of these 2 basic types of securities:Debt 3 basic forms: bonds, debentures, and notes. Holders of debt securities are creditors of the corporationDebt represents a fixed claim on the corporation’s assets and earnings, usually with a specific duration. Typically, debt holders get periodic interest payments and ultimate repayment of the principal at maturity date. At liquidation, they would get paid before the stockholders.The relationship between the corporation and its debt holders is essential contractual. Directors and officers normally owe no fiduciary duties to debt security holders. Equity A corporation issues equity in the form of shares of stockEquity security holders have the “residual claim,” which means at liquidation they are entitled to whatever funds are left after all other claims on the corporation have been satisfiedThe law traditionally regards stockholders as “owners” of the corporation (though many corporate scholars take issue with this characterization – stock represents an economic interest in the corporation with particular rights)The relationship between the corporation and its shareholders is a major focus of corporate law. StockMany corporations divide their equity securities into multiple “classes” of stock (and there can be “series” within a class). They must be authorized and set forth in the certificate of incorporation. DGCL § 102(4).The most basic forms are common stock and preferred stock.Unless otherwise agreed, corporate shares are by default “common shares” with equal voting rights per share and equal rights per share to residual claims of the corporation.Issuing StockMuch of the law governing the issuance of stock is federal and state securities laws.At the most basic level the idea is that federal securities laws require issuers of stock to register the issuance with the SEC, unless there is an available exemption. Liability can result from false statements in the registration statement.There is also state corporate law concerning the stock issuance process. That’s what we’ll focus on (+ basic vocab).To validly issue shares, the board must authorize the issuance of shares and the corporation must receive appropriate consideration. DGCL § 152.The corporation, acting through its board, must approve the particular transaction in which the shares are sold. DGCL § 161.The appropriate number of shares must be authorized in the certificate of incorporation.The directors determine the price or consideration for newly issued shares. Their judgment that it is adequate is considered conclusive, in the absence of fraud. DGCL § 152.Typically Three Levels of Possession for Publically Traded Companies:Depository Trust – Provides for Central Custody of Securities (e.g., DTC)Broker – Sells Stock to Investors (e.g., Citibank)Beneficial Owner – Buys the Stock from the Brokerage (e.g., Joe Regular)Authorized, Outstanding, & Treasury StockAuthorized stock/shares: The maximum number of shares that a corporation is legally permitted to issue, as specified in the certificate of incorporation.Outstanding stock/shares: shares are outstanding when they have been validly authorized, issued, and are held by someone or some entity other than the corporation itself (aka, “issued stock/shares”).These are the shares that are entitled to vote and receive dividends. DGCL §§ 160(c), 170.Treasury stock/shares: stock that has been repurchased by the corporation. Par Value – See – Background material on stock and DividendsSubscription AgreementAn offer to purchase shares from a corporation. Subscriptions can be made to existing corporations or corporations to be formed.A subscription does not become a contract until accepted by the corporation. There can be concerns about the enforceability of subscription agreements entered into before incorporation; DGCL § 165 provides the default that they are irrevocable by the subscriber for 6 months from the date of subscription, unless otherwise provided.DividendsA dividend is a distribution of cash, stock, or property by the corporation to a class of its shareholders, decided upon by the board of directors. Most commonly it is a portion of the profits that is distributed as a dividend. The dividend is often quoted?in terms of the dollar amount each share receives (dividends per share). E.g., a corporation with 1 million shares outstanding that decides to distribute $2 million to its shareholders results in a dividend per share of $2 ($2 million dollars divided by 1 million shares).The board of directors “may” authorize the corporation to pay dividends. DGCL § 170(a).What are the constraints on the board’s discretion to declare a dividend?Can shareholders compel a corporation to declare a dividend?Stock SplitsA stock split is a division of the outstanding shares into more shares.It simply divides the pie into more slices. It doesn’t change the stockholders’ relative ownership interests. Why might a board decide to split the stock?How are stock splits commonly done?How are stock splits expressed/referred to?Stock RepurchasesWhat are possible reasons why a corporation would repurchase its own stock?Rules on repurchases?Repurchased stock = “treasury stock” (authorized, issued, but not outstanding stock that can be re-issued by default rule)6. Limited Liability and Piercing the Corporate Veil Limited Liability – the general default rule is Corporations have limited liability, which means that shareholders are not personally liable for corporate debts or torts. Shareholder losses are limited to the amount invested in the firm.This is a default rule. It is possible for a shareholder to voluntarily assume liability through a personal guaranty.It is the tort or contract creditor, not the corporation’s shareholders, that bears the loss whenever the corporation’s resources are insufficient to satisfy the claim.Tort – Harder to socially justify limited liabilityContract – Easier to socially justify limited liabilitySocial Arguments For & Against Limited Liability:For:Capital FormationManagement Risk RakingInvestment Diversification (or else every investment you make would expose the previous to liability)Trading on Stock MarketsAgainstTort creditors are not voluntaryManagement, shielded by limited liability, does not have an incentive to internalize the costs of accidents or excessive risk takingCorporations are in a better position to purchase insurance and reduce risk taking behavior than someone adversely effected by corporate actionCreditor ProtectionsPromoter LiabilityCorporate Agents (Cargill)PCVInsider Trading and Securities ViolationsPiercing the Corporate Veil – Common law exception to the default rule of limited liabilityVertical Liability – Plaintiff can get through the corporation to the shareholders in their individual capacityRegarding the liability of natural persons, veil piercing is generally only an issue for small corporations. Shareholders of public corporations do not need to worry about veil piercing claims.Horizontal Liability – Known as “Enterprise Liability,” allows the plaintiff to hold separate corporation liable (“Reverse Pierce” may accomplish similar results, but is conceptually different)States vary in their PCV tests. No single test prevails.Variants for “unity” prong include “alter ego” or “mere instrumentality” tests which we saw an example of in Walkovsky; they are similar, though often emphasize more the domination/control/active participation aspect in examining whether the shareholder treated the corporation as his alter ego. Control alone is not enough, however; courts still look for something more such as other factors, and unjust enrichment, that the corporation was used to disguise wrongs, etc.Some courts expressly state the separate prong with sanctioning fraud or promoting injustice (like Van Dorn); sometimes the analysis ends up being very similar anyway and effectively collapses into analysis of the unity factors or a holistic appraisal (more Walkovsky)California Test: F. Hoffman-La Roche v. Superior Court, 130 Cal. App. 4th 782, 796 (2005)“To invoke alter ego, two conditions must be met: [(1)] There must be such a unity of interest and ownership between the corporation and its equitable owner that the separate personalities of the corporation and the shareholder do not in reality exist; and [(2)] There must be an inequitable result if the acts in question are treated as those of the corporation alone.”Can’t reverse pierce in California, but the test is the same as Van DornPCV Factors – Generally need at least two to succeedLack of corporate formalitiesFailure to hold shareholder meetings, board meetings, and to keep minutes of meetingsFailure to keep separate booksFailure to issue stockFailure to appoint a boardFailure to adopt certificate of incorporation or bylawsIntermingling funds or assetsNot keeping separate personal/bank accountsTreating corp (other corp) assets as ownUndercapitalizationDeliberate undercapitalization: How to distinguish from legitimate business debt?Does a corp need to keep adding to capital?Insurance counts towards capitalization for PCV purposesControl is often an implicit factor]Walkovsky v. CarltonPCV – Taxi case (Carlton owned 10 corporations. He spread his fleet and assets equally throughout the corporations and then got the minimum insurance required to operate for each separate corporation) – One of his cabs hit Walkovsky. Outcome – Walkovsky lost, this was common practice and an issue for the legislature. (But according to the E&E, he won on the enterprise liability theory because Carlton held himself out as one business)New York – Two Piercing Theories Alleged“Alter Ego Test” - Vertical Liability“Whenever anyone uses control of the corporation to further his own rather than the corporations business, he will be liable for the corporation’s acts “upon the principle of respondeat superior applicable even where the agent is a natural person.”Stockholder will be personally liable“Enterprise Liability” theory – Horizontal LiabilityNone of the corporations “had a separate existence of their own.”Only the corporation will be liableDissent – “[What I would hold] is that a participating shareholder of a corporation vested with a public interest, organized with capital insufficient to meet liabilities which are certain to arise in the ordinary course of the corporations business, may be held personally responsible for such liabilities.”Sea-Land Service, Inc. v. Pepper SourcePCV – Pepper Source (owned by Marchese) contracted with πs for the delivery of peppers and didn’t pay the bill. Marchese owns five other corporations and his half owner of a sixth (Tie-Net). He basically plays shell games with his moneyChicago (7th Circuit) – Two Piercing steps, same test (have to get Marchese then “reverse pierce” his other holdings):“Van Dorn” TestA corporate entity will be disregarded and the veil of limited liability pierced when two requirements are met:First, there must be such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] no longer exist; and Second, circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.Determining whether a Corporation is so controlled by another Corporation as to justify disregarding their separate identities, the Illinois cases focus on four factors: (Part I of the Van Dorn Test)The failure to maintain adequate corporate records or to comply with corporate formalities:The commingling of funds or assets,Undercapitalization andOne corporation treating the assets of another corporation as its ownApplicationPart 1 - √All of the corporations were run out of the same officeMarchese was using the funds to pay personal expense (intermingling funds)Never had a board meeting or any other common corporate practicePart 2 – X – Didn’t meet the burden“If an unsatisfied judgment is enough for the “promote injustice” feature of the test, then every plaintiff will pass on that score, and Van Dorn will collapse into a one-step “unity of interest and ownership” test.”Πs, although it alleged in its complaint the kind of intentional asset and liability shifting found in Van Dorn, has yet to come forward with evidence akin to the “wrongs” found in these cases.B. The Role of Directors and Officers; Fiduciary Duties to Shareholders?1. introduction to Director Fiduciary Duties & The BJRFiduciary Duties - Directors are fiduciaries - They shall act in good faith and with conduct reasonably believed to be in the best interests of the corporation.Fiduciary Duties of Officers:The Delaware Supreme Court recently clarified that officers have the same fiduciary duties as directors.There is still some uncertainty about whether the standards are the same (e.g., BJR protection). By their language, DGCL §§ 102(b)(7) and 141(e) apply only to directors.Regarding California corporate law, the codified BJR (Cal. Corp. 309) refers only to directors and the majority of California courts addressing the issue thus far have held the California BJR does not apply to corporate officers.Two Primary Fiduciary Duties: (Directors owe the duty to the corporation and its shareholders)(1) Duty of Care (DOC) and;(2) Duty of Loyalty (DOL)includes a Duty of Good Faith as a subset Stemming from these duties, directors also have a Duty of Disclosure (aka, a Duty of Candor) “Standard of conduct” (aspirational)MBCA § 8.30(b): “when becoming informed in connection with their decision-making function or devoting attention to their oversight function, [directors] shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under the circumstances.”“Standard of liability” (where legal liability may arise if the corporation suffers losses from their breach of duty)MBCA § 8.31: a director shall not be liable to the corporation or its shareholders unless the challenging party establishes (1) a corporate charter indemnification or cleansing does not preclude liability; and (2) the conduct was the result of lack of good faith; lack of belief acting in best interest of corporation; not being informed; lack of independence (DOL); or failure to devote ongoing attention to oversight, or devote timely attention when particular facts arise.Business Judgment Rule - Generally, for ordinary business decisions, the relevant fiduciary duty is the duty of care, but directors are entitled to the protections of the “business judgment rule” (BJR).Presumption - The BJR presumes that the directors’ decisions were made “on an informed basis, in good faith and on an honest belief that the action is in the best interest of the corporation.”Analysis - When the BJR applies, it is the plaintiff’s burden to rebut the presumption (and establish that losses were proximately caused because of the breach).When a board decision is challenged, the burden is on the plaintiff to overcome the BJR by showing: fraud, bad faith, illegality, or a conflict of interest (DOL);failure to become informed in decisionmaking (focus on process; liability generally based on gross negligence; e.g., Van Gorkom);failure to establish a modicum of oversight of the corporation’s activities (e.g., Francis; cf. recent good faith cases regarding oversight, DOL); orthe lack of a rational business purpose (or “waste”). Focus on Process - Because of the BJR, courts generally will not second-guess directors’ decisions. The inquiry for the DOC is largely about whether the process that generated the relevant business decisions was unsound (e.g., were the directors grossly negligent in failing to inform themselves before making a decision?).Waste - There is an outer limit or exception to the BJR for substantively egregious decisions—where there is no rational business purpose or what is known as “corporate waste.”In addition, BJR protection is not available in non-feasance situations (failure to perform minimal levels of oversight or making a decision at all).Policy Justification: (1) nothing ventured nothing gained (encourages reasonable risk taking); (2) Encourages directors to serve without being afraid of liability for bold choices; (3) Avoids judicial waste; and (4) Avoids judicial substitution of judgment (no Monday morning quarterbacking)Two Views of the BJRAs an abstention doctrine– a judicial “hands off” philosophy or presumption against judicial review of DOC claims. The court abstains from reviewing the substantive merits of the directors’ conduct unless the plaintiff can rebut the BJR.As a standard of review, essentially raising the bar (e.g., from negligence to gross negligence or recklessness).Reliance on ExpertsIn discharging the DOC, directors are encouraged to seek information and advice from officers, employees, as well as outside experts, such as investment bankers, attorneys, and accountants.Under DGCL § 141(e), directors are entitled to rely on opinions and reports so long as such reliance is reasonable and in good faith.Underlying Themes/QuestionsDoes the law require directors to have a particular goal or purpose for the corporation? What is the directors’ duty to shareholders? What about social responsibilities to other stakeholders?Contrast two theories: (1) Shareholder Primacy v. (2) Stakeholder Theory (Community, Shareholders, Community, and Customers)A.P. Smith v. BarlowCorporate Charitable Donations - The most eloquent and elucidating opinion on corporate charitable contributions is in A. P. Smith Manufacturing Company v. Barlow. At issue was the propriety of a $1500 gift to the trustees of Princeton University. The plaintiff shareholder challenged the gift as a waste of corporate assets since it resulted in no direct economic benefit to the corporation.Corporation’s Justifications: (1) Fosters good will; (2) Provides properly trained employees; (3) acknowledgment of corporate responsibility; and (4) Capitalism depends on well educated employeesHolding - The court first traced the history of corporations, concluding that the corporate entity has always had a role to play as a responsible societal member. The court validated the gift not only as a donation to society but also as in furtherance of the free enterprise system on which the corporation's success was dependent.The Barlow case is especially significant because it upheld the gift as a matter of common law. The holding has won legislative confirmation as evidence by the Model Business Corporation Act's express recognition of the corporate power “[t]o make donations for the public welfare or for charitable, scientific or educational purpose. Even under such express statutory authority, however, charitable gifts are subject to challenge if clearly unconnected to the corporation's present or prospective welfare.The Delaware counterpart of the Model Business Corporation Act's provision was scrutinized in Theodora Holding Corporation v. Henderson, wherein a shareholder challenged a corporate charitable contribution in excess of $525,000. The Delaware Court of Chancery upheld the validity of the contribution, relying on both the state corporation statute and the parameters of permissible charitable deductions as established by the federal tax code. In a more recent decision, the Delaware Supreme Court reaffirmed its view that reasonable charitable gifts are proper and that the tax code provides the guide of reasonableness. These guidelines in turn support giving corporate directors great leeway in making charitable contributions.STAKEHOLDER THEORYDodge v. Ford Motor Co.Cutting Corporate Dividends - the Michigan Supreme Court ordered Ford Motor Company to pay a special dividend of about $20 million as a result of a suit by the Dodge Brothers. However, this was a most unusual case and reflects both the political, economic, and judicial philosophy of the times. Ford justified not declaring the extraordinary dividends it had declared in the past on the basis that it was the intention of Mr. Ford to plow the additional funds back into the business in order that he could employ more people and “spread the benefits of the industrial system to the greatest possible number.” The court held that Ford's obligation was to serve the shareholders and not to benefit mankind. In what has become a definitive exposition of shareholders' status in the corporation for years to come, the court said:“A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end and does not extend to a change in the end itself, to the reduction of profits or to the nondistribution of profits among stockholders in order to devote them to other purposes.”SHAREHOLDER PRIMACYShlensky v. WrigleyBusiness Judgment Rule – Night games had become increasingly common in professional baseball and widely accepted and utilized business tactic throughout the league, but the Cubs refused and install lights. The cubs had also been sustaining operational losses, that the plaintiff attributed to the refusal to put lights in the stadiumHolding – Court affirmed dismissal of the lawsuit. It was a clear exercise of business judgment. This kind of seems like a transitional case between the BJR and the Stakeholder/charitable donations theory – both were used in justifying Wrigley’s decision not to light the field.STAKEHOLER THEORY / BJR2. The Duty of Care and the Business Judgment Rule Duty of Care - In general, the duty of care (DOC) requires directors to use the amount of care and skill that a reasonably prudent person would reasonably be expected to exercise in a like position and under similar circumstances (at least in Delaware).If the Directors acted within the Duty of Care, the BJR will apply (Kamin). If the Directors acted in violation of the Duty of Care, the BJR will not applyKamin v. American ExpressDuty of Care - American express bought $30 million dollars worth of Donaldson, Lufkin and Jenrette (DLJ) stock, subsequently the DLJ stock went down in value to about $4 millionThe Board, instead of taking the tax benefit ($8 million), decided to disperse the stock to the shareholders as a dividend because they didn’t want to declare a $25 million dollar loss“The crucial allegation . . . alleges: [Defendants negligently] permitted the declaration and payment of the Dividend in violation of their fiduciary duty owed by them to Amex to care for and preserve Amex’s assets in the same manner as a man of average prudence would care for his own property.”Holding – Motion dismissed because in the absence of fraud, the judgment receives the protection of the BJRSmith v. Van Gorkom – The “Trans Union Case”Duty of Care - Court held that the board of directors of Trans Union were grossly negligent in evaluating and approving a merger proposal. Specifically, the Court held that the plaintiff had successfully demonstrated that the board's decision was uninformed, thereby rebutting the “presumption that its business judgment was an informed one.” The directors were denied the protection of the business judgment rule and were held personally liable for any damages resulting from their actions ($23 Million), even though there was no evidence of self-dealing. The Court held that “a director's duty to exercise an informed business judgment is in the nature of a duty of care, as distinguished from a duty of loyalty. Here, there were no allegations of fraud, bad faith, or self-dealing, . . . [so] it is presumed that the directors reached their business decision in good faith, and considerations of motive are irrelevant to the issue before us.”Facts - Jerome Van Gorkom was the Chairman and CEO of Trans Union, a publicly traded holding company. For various reasons, Trans Union had not been able to take advantage of certain tax credits, so Van Gorkom decided to pursue a merger with a larger entity that could use those tax credits. He met with Jay Pritzker, a “corporate takeover specialist and a social acquaintance.” Without informing his board, Van Gorkom proposed to Pritzker a price of $55 per share, a price Van Gorkom thought was fair. Pritzker soon made a cash-out merger offer at $55. Senior management at Trans Union was against the proposal, but the board recommended it, and the stockholders eventually approved it.Pritzker made his offer on September 18, 1980, and insisted that the Trans Union board act on it by September 21. The board met on September 20 with no advance notice of the purpose for the meeting. Van Gorkom opened the meeting with a 20-minute oral presentation on the Pritzker proposal, but no copies of the merger agreement were available at the meeting.Van Gorkom told the board about his meeting with Pritzker, but he did not tell them that he had come up with the $55 figure or how he had come up with it. The company's regular investment banker was not asked for a fairness opinion. Trans Union's CFO said that $55 was in the range of a fair price, but was “‘at the beginning of the range.” The meeting lasted two hours, and the directors approved the proposed merger agreement based on Van Gorkom's oral presentation, the CFO's statements, and their knowledge of Trans Union's historical stock prices. The agreement was signed without any directors having read it--indeed, it did not exactly reflect what the directors had contemplated.The directors had a duty to: “inform themselves of all material information reasonably available to them” before making a decision.”The Court held that the Trans Union board “did not reach an informed business judgment” in approving the merger. Moreover, the directors, “at a minimum, were grossly negligent in approving the ‘sale’ of the company upon two hours' consideration, without prior notice, and without the exigency of a crisis or emergency.”Undue HasteLack of Board PreparationLack of Questioning or Involvement by the BoardLack of Care in Dealing with DocumentationResponse to Van GorkomAftermath of Van Gorkom: D & O insurance rates began to skyrocketMany directors quit/declined appointment to boardsDelaware legislature enacted DGCL § 102(b)(7)DGCL § 102(b)(7) – “[A corporation may include in its charter] A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; … or (iv) for any transaction from which the director derived an improper personal benefit.”Francis v. United Jersey BankDuty of Care - The defendant was a widow who, with her two sons, constituted the board of directors of a reinsurance brokerage firm. A reinsurance broker arranged the contract between the “selling” insurance company and the reinsurer and acted as intermediary for premiums going in one direction and the loss payments going in the other.Contrary to industry practice, this brokerage firm commingled insurance company funds with its own. The two sons began to take advantage of “float” by withdrawing funds from the commingled account as loans to themselves. Over a six-year period, the “loans” increased from $509,941 to $10,298,039, which was roughly equivalent to the working capital deficit. The mother, though warned by her husband that the sons “would take the shirt off my back,” was totally inattentive to her sons' conduct and never read any of the annual financial statements which would have disclosed the sons' depredations.The director's duty of care requires:Obtain at least a rudimentary understanding of the corporation's business, Obtain and read corporate financial statements, Attend meetings of the board of directors, and Make a continuing effort to keep informed regarding corporate affairs to prevent illegal conduct of officersA director is not required, however, to supervise or inspect the day-to-day operations of the corporation or to audit corporate financial statementsCourt Held – “In summary, Mrs. Pritchard was charged with the obligation of basic knowledge and supervision of the business of Pritchard & Baird. Under the circumstances, this obligation included reading and understanding financial statements, and making reasonable attempts at detection and prevention of the illegal conduct of other officers and directors. She had a duty to protect the clients of Pritchard & Baird against policies and practices that would result in the misappropriation of money they had entrusted to the corporation. She breached that duty. [That breach proximately caused the damages.]”Duty of Care AnalysisRemember to check DGCL § 102(b)(7) – Corporations can limit director liability 3. The Duty of Loyalty Duty of Loyalty - RMBCA § 8.30(a)(2) Requires that directors and officers act “in a manner the director reasonably believes to be in the best interests of the corporation.”Four Flavors of Duty of Loyalty:Interested Director TransactionsCorporate OpportunityControlling Shareholder TransactionsGood Faith (Compensation & Oversight) Delaware courts have recently classified as a subset of the DOLa. Interested Director Transactions?(AKA “Self-Dealing” or “Conflicts of Interest”)Direct v. Indirect Interested Transactions:Direct – Director in XYZ, Inc. forms a contract with XYZ, Inc.Indirect – XYZ, Inc. forms a contract with ABC, Corp. – But Director sits on ABC’s Board and is COO of XYZTraditional Common Law Rule:Late 19th century: At early common law, the corporation or its shareholders could void a conflicted interest contract, regardless of the fairness of the contract or approval by the board or shareholders.Remedies for Interested Director Transaction:enjoining the transaction, setting aside the transaction, damagesBayer v. BeranDuty of Loyalty – πs claimed that the radio advertising Celanese was engaging in had a noncorporate purpose: the radio advertising was for the benefit of Miss Jean Tennyson, one of the singers on the program, who in private life is Mrs. Camille Dreyfus, the wife of the president of the company and one of its directors; that is was undertaken to foster and subsidize her career.“The BJR yields to the rule of undivided loyalty.” – “While there is a high moral purpose implicit in this transcendent fiduciary principle of undivided loyalty, it has back of it a profound understanding of human nature and of its frailties.”Who bears the burden of proof for a claim of breach of the duty of loyalty? - ?, all the plaintiff has to show is that there is in fact a conflict of interestsWhat must that party show? – “Fairness to the Coroporation”Who wins on the duty of loyalty issue in Bayer? Why? – ?s, the amount spent was normal, they had considered radio in the past, the wife was a competent singer, wife was paid market rates (less than the other singers), and it was negotiated through her agent, the program wasn’t designed to further her career, legitimate and useful purpose for the corporation.Interested Director StatutesCommon Law - Modern Delaware common law upholds a transaction so long as the director proves it was fair to the corporation.Statutes - There are interested director statutes such as DGCL § 144 - The statute doesn’t preempt common law, but instead overturns the old common law cases deeming conflicted interest transactions voidable per se and provides a procedure by which to “cleanse” interested transactions.DGCL § 144 - (a): an interested transaction shall not be “void or voidable solely” because of the conflict or “solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director’s or officer’s votes are counted for such purpose,” provided at least 1 of 3 conditions are satisfied…(a)(1) approval by “a majority of the disinterested directors” provided there has been full disclosure of the material facts relating to both the transaction and to the director’s conflict of interest – BOT v. Benihana (a)(2) approval “in good faith by vote of the shareholders,” with full disclosure of the material facts relating to both the transaction and to the director’s conflict of interest - Fliegler v. Lawrence and In re Wheelabrator(a)(3) a transaction that is “fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders”Under § 144(a)(3), the interested director bears the burden of proving the transaction’s entire fairness to protect against invalidation of the interested transaction.Example of situations in which § 144(a)(3) would be relevant? - Where board or shareholder approval was not obtained or was obtained but in a manner inadequate for purposes of § 144(a)(1) or (2) (e.g., where the interested director failed to disclose material facts). DGCL § 122(17) – Allows a corporation to say in advance what is or is not a corporate opportunity:“Every corporation created under this chapter shall have the power to:… (17) Renounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in, or in being offered an opportunity to participate in, specified business opportunities or specified classes or categories of business opportunities that are presented to the corporation or one or more of its officers, directors or stockholders.”Benihana of Tokyo v. Benihana, Inc.Duty of Loyalty – The transaction between Benihana and BFC was Negotiated by Abdo as BFC’s principal, but Abdo was also on Benihana’s Executive Committee (indirect interested transaction)After a conflict was established, Abdo had to defend himself:He had a simple defense – 144(a)(1): A “majority of the disinterested directors” had been informed (full disclosure of the material facts) of the conflict and they approved (Majority voting requires a director to receive a majority of the votes cast or present and entitled to vote, depending upon how the provision is drafted) the transaction.Because he rebutted the plaintiff’s asserted conflict, the BJR appliedSarbanes-Oxley Act – ‘SOX’§ 402 of “SOX” bars publicly held corporations registered with the SEC from directly or indirectly lending or arranging for the extension of credit to their own officers or directors.§ 406 requires a corporation to adopt a code of ethics applicable to its CEO, CFO, controller, and chief accountant. The ethics code must provide for “the ethical handling of actual or apparent conflicts of interest between personal and professional relationships.”Interested Transactions Analysisb. Corporate Opportunities?Corporate Opportunity Doctrine: Objective is to deter appropriations of new business prospects “belonging to” the corporation by targeting: (1) Directors and officers of corporation and (2) Dominant shareholders who take active role in managing firm.Broz v. Cellular Information SystemsCorporate Opportunity Usurped by Director - The principal basis for the contention of CIS is that PriCellular, another cellular communications company which was contemporaneously engaged in an acquisition of CIS, was interested in the Michigan-2 opportunity. CIS contends that, in determining whether the Michigan-2 opportunity rightfully belonged to CIS, Broz was required to consider the interests of PriCellular insofar as those interests would come into alignment with those of CIS as a result of PriCellular's acquisition plans.Delaware’s Factors/Balancing Test To Determine If Corp. Opportunity:Is corporation financially able to take the opportunity?Is the opportunity in the corporation’s line of business?Does the corporation have an interest or expectancy in the opportunity?Would taking the opportunity result in a conflict between the director’s self-interest and that of the corporation?If result of balancing test is that it is not a corp opportunity, then director can pursue it without offering it to the corporation first.Holding – “We hold that the Court of Chancery erred as a matter of law in concluding that Broz had a duty formally to present the Michigan-2 opportunity to the CIS board. We also hold that the trial court erred in its application of the corporate opportunity doctrine under the unusual facts of this case, where CIS had no interest or financial ability to acquire the opportunity, but the impending acquisition of CIS by PriCellular would or could have caused a change in those circumstances.”In re eBay, Inc. Shareholders LitigationCorporate Opportunities Usurped by the Entire Board of DirectorsThe now-outlawed practice of spinning -- in which investment bankers lavished discount-priced early shares of hot IPO stocks on officers and directors of their clients -- was common in the dot-com stock boom of the 1990s but came under heavy fire from the Securities and Exchange Commission, shareholders and then Congress a few years later.Guth Test:Is corporation financially able to take the opportunity? - √Is the opportunity in the corporation’s line of business? - √ eBay consistently invested in securities - $550 milDoes the corporation have an interest or expectancy in the opportunity? - √ - opportunity came from the business the corporation had been doing with Goldman, but the Directors benefitedWould taking the opportunity result in a conflict between the director’s self-interest and that of the corporation? - √ they made a lot of moneyAgency Argument – Like the Redding case (can’t use your position to benefit)c. The Duty of Loyalty and Controlling Shareholders General Shareholder Rule - As a general matter, shareholders are allowed to act in their own interest in deciding how to vote their shares.Shareholder-Director Rule - Where a shareholder is elected to the board, the shareholder-director naturally assumes fiduciary obligations towards other shareholders.Controlling Shareholder Rule - Between these two extremes is the situation of a shareholder with voting control. Recognizing that a board in this context may not act independently of the controlling shareholder, courts began to extend aspects of the board’s fiduciary duties to the controlling shareholder.Note that a controlling shareholder can be a natural person, or a corporation (parent-subsidiary relationship)Determination of Controlling Shareholders - In this setting, there is not a bright-line rule for determining whether a controlling shareholder relationship exists; the determination is on a case by case basis. The notion of a controlling shareholder includes both de jure control and de facto control.De jure: If a shareholder owns more than 50% of the voting stock, then the shareholder has de jure control.De facto: A shareholder owning less than 50% of the voting stock has de facto control if a majority of the board lacks independence from the shareholder. Parent-Subsidiary TransactionsWholly-Owned Subsidiary – Parent owns 100% of SubsidiaryMajority-Owned Subsidiary – Parent owns >50% of SubsidiarySinclair Oil v. LevinControlling Shareholder - The court created the “advantage/disadvantage” test as a threshold test to be applied in parent-subsidiary transactions to determine whether the ultimate standard of review should be fairness or business judgment.Three Challenged Transactions:Distribution of Dividends (BJR should have applied because they were distributed according to interest in corporation and only prevented expansion)Contracts between Sinclair Int’l (a WOS of Sinclar) & Sinven (Intrinsic Fairness)Contracts between Sinclair & Sinven (Intrinsic Fairness)Contracts were breached by Sinclair by making payments late or not at all2 Different Standards of Review:BJR – Applies in absence of self-dealingIntrinsic Fairness – Applies where there is a showing of self-dealingSelf Dealing: “Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary.d. Ratification Ratification Deals with DGCL § 144(a)(2)DGCL § 144 - (a): an interested transaction shall not be “void or voidable solely” because of the conflict or “solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director’s or officer’s votes are counted for such purpose,” provided at least 1 of 3 conditions are satisfied…(a)(2) approval “in good faith by vote of the shareholders,” with full disclosure of the material facts relating to both the transaction and to the director’s conflict of interestFliegler v. LawrenceRatification – “A” corporation was buying an asset of “B” corporation, but B corporation was partially owned by some of the directors of A corporation.Court’s Interpretation of 144(a)(2) – “We do not read the statute as providing the broad immunity for which defendants contend. It merely removes an “interested director” cloud when its terms are met and provides against invalidation of an agreement “solely” because such a director or officer is involved. Nothing in the statute sanctions unfairness to Agau or removes the transaction from judicial scrutiny.”Does not remove the burden of proving fairness by reason of shareholder ratificationIn re WheelabratorRatification in Duty of Care v. Duty of Loyalty Claims - In In re Wheelabrator the Court distinguished between the effects of ratification in claims that a director breached his duty of care and those in which he was alleged to have breached his duty of loyalty. Facts - Waste Management (“WM”) owned 22% of Wheelabrator stock and could elect 4/11 members of Wheelabrator’s board. WM Negotiated stock-for-stock “merger” agreement in which they would acquire another 33% of Wheelabrator’s stock.Effect of approval by informed, disinterested shareholders of a transaction that does not involve a controlling shareholder?Effect of approval by informed, disinterested shareholders (a.k.a., majority of minority) of a transaction that does involve a controlling shareholder?Duty of Care ClaimExtinguished - But Gantler later clarifies/overrules and specifies that effect of SH ratification at common law is to subject challenged director action to BJR?????Duty of Loyalty ClaimBurden shifted back onto plaintiffs with BJR as the standardShifts burden onto plaintiff; standard remains entire fairness. And if did not get the vote of informed, disinterested shareholders, then burden remains with defendants to show entire fairness.Gantler v. Stephens“[W]e hold that the scope of the shareholder ratification doctrine must be limited to its so-called “classic” form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover, the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. With one exception, the “cleansing” effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to “extinguishing” the claim altogether (i.e., obviating all judicial review of the challenged action). [Fn 54]”Fn 54 - “To the extent that Smith v. Van Gorkom holds otherwise, it is overruled. The only species of claim that shareholder ratification can validly extinguish is a claim that the directors lacked the authority to take action that was later ratified. Nothing herein should be read as altering the well-established principle that void acts such as fraud, gift, waste and ultra vires acts cannot be ratified by a less than unanimous shareholder vote.… To avoid confusion about the doctrinal clarifications set forth…, we note that they apply only to the common law doctrine of shareholder ratification. They are not intended to affect or alter our jurisprudence governing the effect of an approving vote of disinterested shareholders under 8 Del. C. § 144.”Controlling Shareholders Analysis4. Good Faith (Compensation and Oversight) Examples - The concept of good faith pervades Delaware’s corporate law:Courts often refer to the BJR as “a presumption” that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company DGCL § 141(e) provides: “A member of the board of directors, or a member of any committee designated by the board of directors, shall … be fully protected in relying in good faith upon [specified documents and persons]DGCL § 102(b)(7) provides that a corporation’s articles of incorporation may (but need not) contain: “A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: … for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law….DGCL § 145(a) and (b) only authorize indemnification of a director or officer who “acted in good faith.”Development of the Concept of Good Faith - Despite the pervasiveness of the concept, it has been essentially undefined until recently. In addition, whether it is an independent fiduciary duty or subsumed in the DOC or DOL has been unclear. In Cede & Co. v. Technicolor, Inc. (Del. 1993), the Delaware Supreme Court stated: “To rebut the rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty—good faith, loyalty or due care.”Since Cede, the Court has further clarified the meaning and status of good faith in Walt Disney Co. Deriv. Litig. and Stone v. Ritter.In re The Walt Disney Co. Derivative LitigationExecutive Compensation – Ovitz got $130 Million for 14 months of work because of the “non-fault termination” (NFT) clause in his employment contract, which was triggered when Disney couldn’t eliminate him for cause.Issues – Ovitz - Did Ovitz breach his fiduciary duties of care and loyalty by negotiating for the NFT provision or by accepting payment of it upon termination? – No, he was not a de facto officer because when he executed the contract he hadn’t assumed any of the duties of his office.Directors - Were the actions of the Disney directors in approving the employment agreement, hiring Ovitz, and then terminating his employment “not for cause” made without any violations of the fiduciary duties of due care and good faith?Due Care - XWhat did plaintiff need to prove to show process due care violation? – Gross NegligenceWhat did the court suggest would be “best practice”?“In a ‘best case’ scenario, all committee members would have received, before or at the committee’s first meeting a spreadsheet prepared by a compensation expert. Making different, alternative assumptions, the spreadsheet would disclose the amounts that Ovitz could receive under the OEA in each circumstance that might foreseeably arise (including NFT). The contents of the spreadsheet would be explained to the committee members, either by the expert who prepared it or by a fellow committee member similarly knowledgeable about the subject. This spreadsheet, which ultimately would become an exhibit to the minutes of the compensation committee meeting, would form the basis of the committee’s deliberations and decision.”What actually happened? – Not the best-case scenario, but the members were ultimately informed what the compensation would be under different scenarios.Were the directors liable for breach of the duty of care? - NoHow is this case different from Van Gorkom? – They weren’t selling the company here and they were better informed.Good Faith - XIdentified two possible bases for finding that directors acted in bad faith:Conduct motivated by subjective bad faith (i.e., an actual intent to do harm)“Intentional dereliction of duty, a conscious disregard for one’s responsibilities”Gross negligence ≠ bad faithGave examples of conduct in bad faith:intentionally acting with a purpose other than advancing the best interests of the corporation, intent to violate the law, intentionally failing to act in the face of a known duty to act, demonstrating a conscious disregard for duties.The Court declined to decide whether there is a distinct fiduciary duty to act in good faith independent of the duties of loyalty and care.Corporate Waste - XConduct was not even close to the standard: “So one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.”This is the classic formulation of the waste testIn re Caremark Int’l Inc. Deriv. Litig.Caremark Claims: In dicta, the court stated that as part of its duty to monitor, the Board must make good faith efforts to ensure that a corporation has adequate reporting and information systems:“A director’s obligation includes a duty … to attempt in good faith to assure that a corporate information and reporting systems … exists, and that failure to do so …may, in theory at least, render a director liable for losses caused by non-compliance with legal standards.”The opinion described this claim as difficult to win, with liability attaching only for “a sustained or systematic failure to exercise oversight” or “[a]n utter failure to attempt to ensure a reporting and information system.”Although a number of Caremark-type claims have been filed, decisions finding a violation are rare. Most companies now have compliance programs and control systems.What Might an “Adequate” Law Compliance Program Include?Policy manualTraining of employeesCompliance auditsSanctions for violationProvisions for self-reporting of violations to regulatorsOther controls to verify compliance with laws and to give the board the ability to monitor the businessIn Stone v. Ritter, the Del. Supreme Court addressed Caremark’s validity and clarified good faith and how it fits into the fiduciary duty framework. Stone v. RitterCaremark Claim: “We hold that Caremark articulates the necessary conditions predicate for director oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or(b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.”Caremark v. StoneCaremark: “[A] sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists…will establish the lack of good faith that is a necessary condition to liability.”Stone: “[T]he Caremark standard …draws heavily upon the concept of director failure to act in good faith. That is consistent with the definition(s) of bad faith recently approved by this Court in [Disney], where we held that a failure to act in good faith requires conduct that is …more culpable than the conduct giving rise to a violation of the [DOC] (i.e., gross negligence). . . [I]mposition of [oversight] liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their fiduciary duty of loyalty by failing to discharge that fiduciary obligation in good faith.”“The failure to act in good faith may result in liability because the requirement to act in good faith ‘is a subsidiary element,’ i.e., a condition, ‘of the fundamental duty of loyalty.’ [B]ecause a showing of bad faith conduct…is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.”“[A]lthough good faith may be described colloquially as part of a ‘triad’ of fiduciary duties…, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may do so, but indirectly. The second doctrinal consequence is that the fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith.” C. Role, Duties, and Rights of Shareholders Shareholder duties: None, unless controlling shareholderShareholder Roles And Rights:Sell – the “Wall Street” RuleSueDerivative v. DirectVote (& make proposals)(plus inspection rights)1. Shareholder Derivative Actions Direct v. DerivativeDirectBrought by the shareholder in his or her own nameCause of action belonging to the shareholder in his or her individual capacityArises from an injury directly to the shareholderDerivativeBrought by a shareholder on corporation’s behalfCause of action belongs to the corporation as an entityArises out of an injury done to the corporation as an entityDetermining Whether a Suit is Direct or DerivativeWho suffered the alleged harm, the corporation or the suing shareholders individually?Who would receive the benefit of any recovery or other remedy, the corporation or the shareholders individually?ExamplesABC Corp. - DerivativeABC Corp entered into a contract with Jane JonesJones breached the contract, but ABC Corp has not sued her for that breachMay a shareholder of ABC Corp sue Jones directly? – NoABC Corp. - DerivativeABC Corp’s treasurer/CFO embezzles all its money and abscondsShareholders’ stock is now worthlessMay a shareholder of ABC Corp sue the treasurer/CFO directly? - NoXYZ Corp. – DirectThe board of XYZ Inc. agrees to sell 80 percent of its assets to an unaffiliated purchaser. Although a vote is required by state law for the sale of “substantially all” of a corporation’s assets, no shareholder vote is scheduled, because the board disputes the plaintiff’s claim that the sale amounts to a disposition of substantially all of XYZ’s assets. May a shareholder sue the board directly? - YesDirect:Claims based on disclosure req’ts of securities lawsVoting rights for SHsInspection of corporate books and recordsDerivative:Breach of duty of careBreach of duty of loyaltyBarriers to Derivative LitigationBonding RequirementsDemand Requirement Special Litigation CommitteesThen you will reach a settlement – pending judicial approvalBonding Requirement - In some states (though not Delaware), a derivative claimant with “low stakes” must post security for the corporation’s legal expenses.a. Demand Requirement?Demand Requirement - Most states require shareholders to first make demand that the board pursue legal action…unless demand is “excused” as “futile”“The demand requirement is a recognition of the fundamental precept that directors manage the business and affairs of the corporation.” Aronson v. LewisWhat is Demand?Typically a letter from shareholder to the board of directors.Must request that the board bring suit on the alleged cause of actionMust be sufficiently specific as to apprise the board of the nature of the alleged cause of action and to evaluate its merits“At a minimum, a demand must identify the alleged wrongdoers, describe the factual basis of the wrongful acts and the harm caused to the corporation, and request remedial relief.” Allison v. Gen. Motors Corp., 604 F. Supp. 1106, 1117 (D. Del.), aff’d mem., 782 F.2d 1026 (3d Cir 1985)The Complaint - FRCP 23.1/Ct of Chancery Rule 23.1“The complaint shall be verified and shall allege . . . the plaintiff was a shareholder or member at the time of the transaction of which the plaintiff complains…”“The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors … and the reasons for the plaintiff's failure to obtain the action or for not making the effort. . .”Demand Required Unless “Excused”The shareholder-plaintiff must either make demand or plead that it is “excused”If demand is made the board may accept or reject—the shareholder-plaintiff loses control All that is left for the shareholder-plaintiff is a potential argument that demand was wrongfully refused; BJR appliesIf the shareholder-plaintiff pleads that demand is excused the question is … what is the standard? Demand is excused when “futile”…The standard for demand futilityDel.: Grimes v. Donald NY: Marx v. AkersIf the standard is not met, failure to make demand is a procedural barrier and the suit will typically be dismissed or stayedNote: California courts have frequently adopted the same demand futility standard as Delaware “Demand is not excused simply because plaintiff has chosen to sue all directors.” Discovery Limitations - Discovery limited to “tools at hand” & DGCL § 220 inspection of books and recordsRales standard = whether the derivative stockholder complaint creates a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. The “Rales standard” applies: in cases not involving a business decision (e.g., failure to exercise oversight claim), where a majority of the board has been replaced since the challenged transaction with disinterested and independent members, andwhere the challenged decision was made by the board of a different corporation or a third party.Alternative Approach of ALI and RMBCA: “Universal Demand”Adopted in some statesNo demand futility test; Demand must be made in all cases. No shareholder may commence a derivative suit until 90 days after the demand, unless (i) the shareholder has earlier been notified that the corporation has rejected the demand; or (ii) irreparable injury would result to the corporation by waiting.Somewhat strict judicial review of wrongful rejectionFunctionally ends up being more or less the same as the demand futility approach—ideally filter bad cases out and good ones inGrimes v. Donald (Delaware)Demand Requirement – Grimes sued claiming breach of duty of care arising from Donald’s compensation agreementsAaronson Test - Demand is excused as futile if the plaintiff creates reasonable doubt that the board can make an independent judgment on the suit, because…Majority of board has a material financial or familial interest;Majority of board lacks independence for some other reason (such as being dominated or controlled by wrongdoers/someone with an interest); orUnderlying transaction is not the product of valid exercise of business judgmentMarx v. Akers (New York)Demand Requirement – Marx sued claiming breach of duty of care arising from director compensationBarr Test - An analysis of the Barr decision compels the conclusion that in New York, a demand would be futile if a complaint alleges with particularity (“reasonable doubt”) that:(1) a majority of the directors are interested in the transaction, or Director interest may either be self-interest in the transaction at issue or a loss of independence because a director with no direct interest in a transaction is “controlled” by a self-interested director.(2) the directors failed to inform themselves to a degree reasonably necessary about the transaction, or The “long-standing rule” is that a director “does not exempt himself from liability by failing to do more than passively rubber-stamp the decisions of the active managers”(3) the directors failed to exercise their business judgment in approving the transaction.Derivative ANalysisb. Special Litigation Committees (SLCs) Auerbach (NY): Procedural not substantive scrutiny of SLCSLC decision covered by BJRBut judicial inquiry permitted with respect to:Disinterested independence of SLC membersAdequacy of SLC’s investigation (Good Faith Standard)Burden of proof on plaintiffCalifornia has adopted an approach to SLCs similar to NYZapata (DE): In demand-excused cases, 2-step judicial inquiry into (1) independence, good faith, and a reasonable investigation, with corporation bearing burden, as well as (2) substance, with the court using its “own independent business judgment”In re Oracle Corp. Derivative Litigation (DE) – Independence is a question not only of financial conflicts, but also social and political relationsc. Indemnification and Insurance Indemnification - Indemnification is making, or agreeing to make, a person whole in light of possible or anticipated losses and expenses. Depending on the circumstances, a corporation may indemnify directors and officers against judgments, amounts paid in settlement, and attorney's fees…Indemnification statutes generally contain provisions for mandatory and permissive indemnificationMandatory Indemnification - Under the mandatory statutory provisions, corporations must indemnify those individuals who satisfy certain statutory prerequisites.See, e.g., DGCL 145(c) (where a D or O “has been successful on the merits or otherwise in defense of any action…such person shall be indemnified against expenses (including attorneys’ fees) actually and reasonably incurred…”)Permissive Indemnification - The permissive statutory provisions, on the other hand, grant corporate boards some discretion in determining whom to indemnify, and typically require that a specified standard of conduct be met.See, e.g., DGCL § 145(a) and (b)DGCL § 145 – Indemnification of officers, directors, employees and agents; insurance §145(a) Indemnification in what types of actions? – “civil, criminal, administrative or investigative (other than an action by or in the right of the corporation) . . ..”Against what losses? – “expense (including attorney’s fees), judgment, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding . . ..”Qualification? – “if the person acted in good faith an in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful.”§145(b)What actions? – “threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor . . ..”Against what losses? – “expenses (including attorney’s fees) actually and reasonably incurred by the person in connection with the defense or settlement of such action or suit . . ..”Qualification? – “if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation and except that no indemnification shall be made in respect of any claim, issue or mater as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the [Court of Chancery finds otherwise.]”§ 145(d)How is the permissive indemnification decision to be made? – “Any indemnification under subsections (a) and (b) . . . shall be made by the corporation only as authorized in the specific case upon a determination that indemnification of the present or former director, officer, employee or agent is proper in the circumstances because the person has met the applicable standard of conduct set forth [in (a) & (b)].”Who makes it? - “Such determination shall be made, with respect to a person who is a director or officer of the corporation at the time of such determination:(1) By a majority vote of the directors who are not parties to such action, suit or proceeding, even though less than a quorum; or(2) By a committee of such directors designated by majority vote of such directors, even though less than a quorum; or(3) If there are no such directors, or if such directors so direct, by independent”§ 145(e)Why would D and Os care about this provision? – Expense, including attorney’s fees, can be paid in advance of the action ending. Directors don’t have to go out of pocket to defend themselves.§145(f)Statute is not exclusive and does not bar other rights to indemnification through bylaws, agreement, vote of stockholders or disinterested directors or otherwise (courts have use public policy considerations to set outer bounds though)§145(g)A corporation may buy insurance with coverage broader than permissible indemnificationD & O Insurance - All, or nearly all, public corporations carry D & O insurance, and a large percentage of private companies do. But it is often expensive and sometimes difficult or impossible to obtain.Policies may have high deductibles, maximum coverages, and/or exclusions (e.g., for reckless conduct, intentional torts, violation of certain types of laws, etc.).Some corporations have established trust funds to pay damages or expenses – Self insuranceTo the extent that insurance covers a director’s payment to the corporation, funds make a round trip: from the corporation (in the aggregate over time) to the insurance company, and from the insurance company back to the corporation.D & O Insurance Commonly has different parts: An executive liability part (“Side A”), which pays directors and officers directly for loss (including defense costs) when corporate indemnification is unavailable;A corporate reimbursement part (“Side B”), which pays the corporation for any money it has paid as indemnification to the insured directors and officers.Corporate entity coverage for securities claims (“Side C”)Attorney’s Fees in Derivative ActionsPlaintiffs’ attorneys in derivative actions seek payment of their fees from the corporation using 1 of 2 rationales:“Common fund theory”—where the action produces monetary recovery“Substantial benefit”/“Common benefit”—a case outcome that confers a substantial benefit on the corporation (e.g., injunction resulting in improved disclosure, amendment to bylaws, adoption of a code of conduct or of a policy statement governing management, etc.)Courts liberally construeComputation based on either lodestar or percentage of recovery methodsRemember that Courts Must Approve Settlements of Litigation2. Shareholder Voting, Proxy Fights, and Proposals Survey of Shareholder Voting Laws:State corporation lawShareholder voting for directors, on major transactions, amendment of certificate and bylaws Fiduciary duty of disclosure1930’s securities lawsRegulates disclosure of information in connection with shareholder votingProvides for shareholder proposalsRecent few years—trend to increase shareholder powerShareholder proposals on majority voting (vs. plurality default)Shareholder proposals on proxy access (after D.C. Cir. struck down the SEC’s mandatory rule for this post Dodd-Frank; see KRB p. 549-553)Dodd-Frank’s non-binding “say on pay” voting regarding executive compensationSEC AuthoritySEA § 14(a) - It shall be unlawful for any person to solicit a proxy “in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”The SEC promulgated proxy solicitation rules under this authority, applicable to registered securities (public companies) = Exchange Act Rule 14a: specifies required proxy disclosures and the manner in which the material must be presented (see example proxy statement on TWEN)prohibits false or misleading statements as to any material fact or the misleading omission of a material factrequires a corporation to provide specified proxy assistance to requesting shareholders and allows shareholders to submit shareholder proposals Enforcement of § 14(a)Rule 14a-9 prohibits false or misleading statements or omissions as to a material fact in connection with soliciting proxiesPublic enforcement: SEC can sue for violations of § 14(a)Private enforcement (J.I. Case Co. v. Borak (U.S. 1964))Private parties have a cause of action for § 14(a) violationsSuit can be derivative (e.g., corporation harmed by misinformed vote) or direct (e.g., shareholder’s voting rights infringed by misrepresentation)Elements of a § 14(a) action:Violation, injury, causation (we will not go into details)Voting RulesWhoShareholders of record—the holders on the “record date” vote (DGCL § 213)That person can vote by “proxy” (DGCL § 212(b))ProxyAgent is called the “proxy holder”, “proxy agent,” or “proxy”Document for appointing the agent and voting is the “proxy card” or “proxy”The information disclosure is the “proxy statement”WhenAnnual shareholder meetings (DGCL § 211)Can be held anywhere, as designated in the certificate or bylawsUnless directors are elected by written consent, an annual meeting shall be held for the election of directors on a date and at a time designated by or in the manner provided by the bylawsAny other proper business may also be transacted at annual meetingsCourt can call a shareholder meeting if no meeting was called for 13 monthsSpecial meetings may be called by board, or by shareholders if certificate or bylaws allowAdvance notice of meetings required (DGCL § 222)Written consent (DGCL §§ 211(b), 228(a))§ 228(a) provides shareholders may take action without a meeting, unless certificate provides otherwise “shall be signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted…”§ 211(b) provides that shareholders may act by written consent to elect directors in lieu of an annual meeting only if (i) the action is by unanimous written consent or (ii) the action by non-unanimous consent is exclusively to fill director vacanciesHowThey vote either in person or by proxy (DGCL § 212(b))Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her shares at the meetingAppointment effected by means of a proxy (a.k.a. proxy card)Can specify how shares to be voted or give agent discretionRevocable (default)Depending on what is being voting on, the proxy card or voting instruction form gives a choice of voting “for,” “against,” or “abstain,” or “for” or “withhold.” Weight of VotesDefault rule is one share – one vote, unless otherwise provided in the certificate (DGCL § 212(a))Corporation could have classes of stock with different voting rights—e.g., a class could have 10 votes per share—but that must be provided for in the certificate (vocab: “dual class stock”)What to Vote on / Required Votes (Note: Remember to look at what constitutes a quorum and then consider what is the vote required to elect/approve. Also note jurisdictions vary on these rules.) DirectorsDefault is a plurality of votes present or represented by proxy and entitled to vote* (DGCL § 216(3)) Cumulative voting (on opt-in basis, only if certificate provides) (DGCL § 214)Majority voting (on opt-in basis, if in certificate or bylaws) (DGCL §§ 141(b), 216) Classified (“staggered”) board (on opt-in basis, if in certificate or sh-approved bylaws) (DGCL § 141(d))Bylaw Amendments, Precatory Shareholder Proposals, Non-Binding “Say On Pay”Majority of shares present or represented by proxy and entitled to vote* (DGCL § 216(2))Certificate AmendmentDirectors adopt a resolution and holders of a majority of outstanding shares entitled to vote must vote in favor of amendment (and by classes if applicable) (DGCL § 242(b)(1))Major Transactions (E.G., Mergers)Per applicable statutory provision, generally majority of outstanding shares entitled to voteQuorum for Shareholder VotingHow many shares must be present in person or represented by proxy for a valid shareholders meeting?Default is a majority of shares entitled to vote (DGCL § 216(1))Certificate or bylaws can opt out of default, but never less than ? (DGCL § 216)PluralityPlurality = whoever gets the most votes for the seatExample 1: more nominees than available seatsOne board seat open for election and 3 nominees: Al, Beth & CarolAt shareholder meeting, Al receives 35% of votes, Beth 40%, Carol 25%Who wins? - BethExample 2: single nominee for the seatOne board seat open for election and 1 nominee. – Nominee still gets the seatCumulative VotingIn cumulative voting, each shareholder’s # of votes is multiplied by the number of director positions up for election and the shareholder can split their votes any way they like between the nominees or vote all for one single nominee.The nominees with the highest number of votes are elected.Delaware: To allow for board representation of minority shareholders, corporations may adopt cumulative voting for director elections. Must be in certificate. (DGCL § 214)California: Cumulative voting is the default for shareholder elections of directors. Cumulative voting cannot be denied in the articles or bylaws, Cal. Corp. Code § 708(a); only publicly traded corporations may opt out of the requirement, Cal. Corp. Code § 301.5(a).Example:ABC Corp. has 3 shareholders:A who owns 250 sharesB who owns 300 sharesC who owns 650 sharesBylaws specify 4-member boardDelaware default voting rule is plurality, which would mean C would elect the entire board of directorsBut if ABC Corp. provided for cumulative voting in its certificate,A: 250 x 4 = 1,000 votes to use anyway choosesB: 300 x 4 = 1,200 votes to use anyway choosesC: 650 x 4 = 2,600 votes to use anyway choosesA & B nominate themselves and cast all of their votes on themselves, respectivelyC nominates herself and 3 other friendsBut C can’t cast her votes in a way so as to elect all 4 of her nomineesC might, for example, cast 1,201 for herself and 1,001 for friend #1, but that would not leave C enough to elect friend #2 and 3.Notice that even if B and C cumulated votes together, they could not prevent A from electing at least one directorDGCL § 141(k): Removal of directors – 2 Exceptions:CertifiedCumulative Voting, which has no effect if there is only one choiceDGCL § 223: Vacancies and newly created directorships(a) – Vacancies are filled by majority of directors(d) – Resignations are filled by BoardProxy Wars – Who Pays?Uncontested vote? – Corporation, as long as it is “reasonable cost incurred in good faith.”Contested vote?Who pays for incumbents?Levin v. MGM & Rosenfeld v. Fairchild Engine & Airplane – Corporation pays “Reasonable costs incurred in good faith”Who pays for insurgents?Rosenfeld v. Fairchild Engine & AirplaneIf Insurgents Lose, they pay (no reimbursement)If Insurgents Win – Reasonable expenditures incurred in good faith if shareholders ratify.See also DGCL §§ 112, 113 (providing for bylaws opt-in of proxy access and reimbursement)Shareholder Proposals – Rule 14a-8Shareholder may include a proposal on corporation’s proxy; expense thus borne by corporationQualifying shareholders:Own at least $2K or 1% of sharesOwned shares for at least 1 year and hold the shares through the date of the meetingSubmitted no more than 1 proposal per meeting Shareholder or her agent must submit within timing constraints and then appear at meeting to present the proposalProposal (including supporting statement) may not exceed 500 wordsCorporation may write in proxy statement an objection to the SH proposal (not limited to 500 words)Who Submits Proposals?Hedge and private equity fundsPension funds or other institutional investorsUnion (e.g., AFSCME)State and local employees (e.g., CALPERs)Individual activistsCharities What Topics Are Trending in Proposals?70s and 80s: divestment from South Africa (apartheid), environment, equal employment and affirmative action plans 90s and current: human rights, animal rights, climate change, renewable energy sources, global codes of conduct, sweatshop labor, unsafe products, sexual orientation non-discriminationAlso governance: eliminating takeover defenses (e.g., de-classifying board), majority voting, proxy access, board diversity and independence, disclosure of political spending, separate CEO and chairPossible Corporate Responses to Shareholder ProposalsAttempt to exclude on procedural or substantive groundsCorporation is required to include the proposal unless can prove to the SEC that it may be excluded under Rule 14a-8Include with opposing statementNegotiate with proponent - Wide range of possible compromisesAdopt proposal as submittedRule 14a-8(i) – ExclusionsImproper subject of action for shareholders under state corporate law (e.g., draft as a recommendation (“precatory”))Violation of law Violation of proxy rulesPersonal grievance or special interestRelates to operations accounting for less than 5% of assets or net earnings/gross sales, and not otherwise significantly related to the company’s business (see Lovenheim)Company would lack power or authority to implementRelates to ordinary business operationsRelates to director elections (enumerated issues or related to upcoming election)Conflicts with company proposalCompany has already substantially implemented the proposalDuplicationResubmissionsRelates to specific amounts of cash or stock dividendsRule 14a-8 Exclusion ExamplesTwo years ago, Leslie Knope bought $2,000 worth of stock in Crate & Box, a publicly traded company that sells home furnishings. Which of the following proposals from Knope would be excludable under the shareholder proposal rule (Rule 14a-8)?(a) A proposal that shareholders elect Knope.(b) A resolution stating that the shareholders desire that the board consider nominating women directors for the board. (c) A proposal to amend the bylaws to permit shareholders holding more than 5% of the company’s shares for two years to nominate up to 2 directors to the company’s 9-person board.(d) A proposal that the board sell a particular division of Crate & Box and distribute the proceeds as a dividend.(e) A proposal that the board form a committee to study whether the suppliers of kitchen linens sold by Crate & Box use child labor in their manufacturing processes.Procedures for ExclusionShareholder submits a proposal and asks the corporation to send it out in the proxyRule 14a-8(i) allows the corporation to exclude certain proposalsIf it intends to exclude, it must inform the shareholder of remediable deficiencies and give an opportunity for them to be curedIt also must file a statement of reasons for exclusion with the SEC (plus an opinion of counsel if any of the stated reasons rely on legal issues)When the company notifies the SEC, it usually requests a “no action letter”The SEC staff may issue the requested no-action letter or determine it should be included or take an intermediate position (not includible in present form, but can be cured)Shareholder can try to remedy the defect or could appeal to SEC commissioners or seek injunction in courtLovenheim v. Iriquois brandsCourt barred the exclusion of Lovenheim’s proposal to stop selling foie gras, even though it was less than %5 of the companies gross assets because it was “significantly related to the company’s business.”3. Shareholder Inspection Rights?Test for SH Inspection:SH, as owners of the corporation, for a proper purpose, are entitled to reliable information as to its condition and affairs and the manner of conducting its business, and, to secure such information, they are entitled, at common law, to inspect the books and records of the corporation containing such information, and that usually this right wil be enforced in behalf of a stockholder by mandamus, the inspection to be had at proper and reasonable times, considering the business and convenience of the corporation.2 Items Typically Sought in SH Inspections:DGCL § 219 Shareholders ListAvailable to shareholders for purposes germane to meeting2 Types of SH Lists:“CEDE” List – Lists the “Street Names” (e.g., brokerage)“NOBO” List – Specifies the Non-Objecting Beneficial Owners (i.e., whoever buys the stock)DGCL § 220 Books and RecordsUpon written demand stating the purpose thereof, shareholders may “inspect for any proper purpose” the “books and records”Recall Disney—“tools at hand”2 Typical Reasons for SH Inspections:For shareholder litigationA stockholder filing a derivative suit must allege either that the board rejected his presuit demand that the board assert the corporation's claim or allege with particularity why the stockholder was justified in not having made the effort to obtain board action. … If the stockholder cannot plead such assertions consistent with Chancery Rule 11, after using the “tools at hand” to obtain the necessary information before filing a derivative action, then the stockholder must make a presuit demand on the board. (Grimes v. Donald)For a proxy contestAn insurgent has the tools of state inspection statutes, state voting list statutes, and Rule 14a-7 to help get voting lists or mailing doneWhat Are “Books and Records”Bare minimum:Articles of incorporationBylawsMinutes of board and sh meetingsBoard or sh actions by written consentWhat about contracts, correspondence, and the like?The Delaware Supreme Court has held that a request to access such records must be very narrowly tailored: “A Section 220 proceeding should result in an order circumscribed with rifled precision.”4. Shareholder Voting Control; Control in Closely Held Corporations Closely Held CorporationsStock is typically held by a small number of shareholdersOften involved in managementStock is not actively traded on a market (“illiquid”)Few viable options to exit if shareholders become dissatisfiedPlanning – control devicesIssues Of Shareholder Control In Closely Held CorporationsShareholder voting trustsA voting trust is an arrangement whereby the shares in a company of one or more shareholders and the voting rights attached thereto are legally transferred to a trustee, usually for a specified period of time (the "trust period"). In some voting trusts, the trustee may also be granted additional powers (such as to sell or redeem the shares). At the end of the trust period, the shares would ordinarily be re-transferred to the beneficiary(ies), although in practice many voting trusts contain provisions for them to re-vested on the voting trusts with identical terms.Voting trusts were made popular in Delaware corporate law, but they have since been adopted widely by other states in the U.S.A. They have also been extensively adopted in offshore jurisdictions.Shareholder voting agreements (aka, vote-pooling agreements)Generally, a contract by an owner of corporate stock, under the terms of which the shareholder agrees to vote one's stock in a particular manner, is not, by its nature, invalid, but it is only when additional circumstances indicate that the contract was inspired by fraud that public policy requires that it not be given effect. Such agreements are valid if, without working a fraud on creditors or other stockholders and without violating a statute or recognized public policy, their purpose is the betterment of the corporation and the advantage of all stockholders; they appear to be particularly favored when they are made to induce new investment, to secure a purchase-money loan to one desiring to acquire shares, or in connection with a loan to the corporation.Shareholder management agreementsStatutes that validate shareholders' management agreements may apply only to shareholders of corporations that elect close corporation status or of corporations whose stock is not publicly traded.Delaware: Provides that owners of a majority of the outstanding stock entitled to vote can enter a management agreement.Other states require the agreement of all owners of outstanding shares.Delaware: One of the effects of a management agreement is to relieve the directors from liability for mismanagement and impose this liability upon those shareholders who are parties to the agreement. Delaware: A shareholders' agreement shall not be invalid because it attempts to give the corporation partnership-like characteristics or establish relations among shareholders similar to those among partners.Although shareholders' management agreements may be binding on the parties who sign them, they are not always binding on nonparty minority interests, the state, creditors or other third persons.Restrictions on share transfer and buy-sell agreementsIV. Securities Fraud and Insider Trading Federal Securities StatutesSecurities Act of 1933 (Primary Market – i.e., IPO Regulations)Regulates the sale of new securitiesDisclosure at the time of the public offeringDefinition of “security” – Not clear cut, can be many things besides stock (but for the purposes of this class, it will always be corporate stock)Securities Exchange Act of 1934 (Secondary Market)Regulates secondary trading activityRequires periodic disclosures by public companiesCreated the SECNotable sections:§10(b) Anti-fraud§14(a) Proxy solicitations and shareholder proposals§14(e) Tender offers§16 Short-swing trading by insidersA. Securities Fraud and Rule 10b-5 Exchange Act 10(b) - It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange—(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. …Note: Not self executing & very broadly phrased (covers private and public companies)SEC Rule 10b-5 - It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,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 the light of the circumstances under which they were made, not misleading, orTo engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,[in connection with sale or purchase of a security].Rule 10b-5 Standing / PartiesDOJ: Can bring a criminal action where there is a willful violation (see Securities Exchange Act § 32(a)).SEC: Can bring a civil action and can recommend that the DOJ bring a criminal action.Private parties:No express cause of action.The Supreme Court implied a private right of action in Superintendent of Insurance v. Bankers Life & Casualty Co. (1971), and it has been upheld since.Defendants: Rule 10b-5 has no privity requirement—Corporate officers or directors who make materially false or misleading statements about the corporation or its stock expose the corporation to 10b-5 liability, even though the corporation does not trade. Aiding and abetting liability for giving “substantial assistance” to the primary violator is only available in SEC enforcement actions, not private actions. Exchange Act § 20(e).Conduct In Violation of 10b-5Securities fraud or deception – see Basic v. LevinsonInsider tradingClassicTipper-tippee liabilityMisappropriation theoryVenue / ForumActions claiming 10b-5 violations must be brought in federal district court.State claims can be added under pendent jurisdiction.Exception: Class actions that also allege state corporate law breach of fiduciary duty breaches under state corporate law can be brought in state court. (Delaware Carve-out)The Private Securities Litigation Reform Act of 1995 (PSLRA) requires that in a 10b-5 class action the lead plaintiff be the “most adequate plaintiff” (presumably the one with the largest $ stake), and imposes heightened pleading requirements and other burdens.Prerequisites & Elements for 10b-5 Claim: (1) Jurisdiction; (2) Standing & Transactional Nexus; (3) Material Misrepresentation or Omission; (4) Reliance; (5) Causation; Scienter (6); and (7) Economic LossJurisdiction10(b) and Rule 10b-5: “by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange…”Often this is easily met as mail, phones, or a national securities exchange are used for trading.The Exchange Act treats intrastate phone calls as using an instrumentality of interstate commerce.(Just beware of tricky fact patterns that somehow don’t involve any instrumentality of interstate commerce…)Standing and Transactional NexusRule 10b-5: “in connection with the purchase or sale of any security”Transactional Nexus - The deception/fraud must be “in connection with” a securities transaction. The Court has explained that it need only “touch and concern” the purchase or sale. There is no requirement of privity; it applies even if not a party to the transaction so long as the behavior affects transactions.Standing - Only purchasers or sellers have standing to sue. This is known as the Birnbaum doctrine after a 2d Cir. case. The Supreme Court affirmed the purchaser-seller requirement in Blue Chip Stamps v. Manor Drug Stores. The Blue Chip plaintiffs decided not to buy due to a corporation’s fraudulent overly pessimistic statements. They had no standing to sue for securities fraud under Rule 10b-5.Material Misrepresentation or Omission - LevinsonReliance - LevinsonCausation – Two Types: (Typically Both are Required)Transaction causation - But for the fraud, plaintiff would not have entered the transaction or would have entered under different termsClosely related to relianceLoss causation - The fraud caused the plaintiff’s lossE.g., show a change in stock prices when the misrepresentations were made and then an opposite change when corrective disclosures were madeIf the stock price did not change with the corrective disclosure or the shareholder sold before the corrective disclosure, the plaintiff might be out of luck for showing loss causationAkin to proximate causeSome courts treat transaction causation as equivalent to reliance. In particular, where reliance is presumed, courts will also assume transaction causation is met.Omission casesWhere there is a presumption of fraud on the marketLoss causation is not presumedPlaintiff must show that he suffered losses as a result of his reliance (usually turns into a battle of the experts)Scienter - State of mind required (not motive)= intent to deceive, manipulate, or defraud (often the hardest thing to show)This means the defendant was aware of the true state of affairs and appreciated the propensity of his misstatement or omission to misleadSupreme Court left open whether recklessness suffices for scienter.Circuit courts have recognized that reckless disregard of the falsity of a statement suffices for scienterCircuits define recklessness differently; e.g., where the misrepresentations were so obvious that the defendant must have been aware of themProof of legitimate motive does not matterEconomic loss (damages)Rescission – in face-to-face transactions with identifiable partiesDisgorgement of defendant’s profitsOut-of-pocket damages – difference between the purchase price and the true “value” of the stock at time of purchase (courts often look to price at time of corrective disclosure to measure the “but for” price)PSLRA caps damage at difference between the transacted price and the average of the daily prices during the 90-day period after corrective disclosureBasic Inc. V. LevinsonMateriality and RelianceMaterialityGenerally - “whether there is a substantial likelihood that a reasonable shareholder would consider the fact important” TSC Indus., Inc. v. Northway Inc. (1976)In uncertain and contingent facts (Like this case) - “a highly fact-dependent probability/magnitude balancing approach”Probability – Indicia of interest in the transaction at the highest corporate levels. Without attempting to catalog all such possible factors, we not by way of example that board resolutions, instructions to investment bankers, and actual negotiations between principals or their intermediaries may serve as indicia of interest.Magnitude – Consider such facts as the size of the two corporate entities and the potential premiums over market valueFN 17 “Silence, absent a duty to disclose, is not misleading under Rule 10b-5.”“‘No comment’ statements are generally the functional equivalent of silence…” fn. 17When Does a Duty to Speak Arise? – a few situations:? have a relationship of trust and confidence with the πCompany is trading in its own securities (like a repurchase)When Does a Duty to Update Arise?Information that the company put out (and is still in circulation) is now falseAlso needs to correct things that other analysts make and the company comments onRelianceReliance must be reasonableReliance is presumed in omission cases if the undisclosed facts were material (Affiliated Ute Citizens of Utah v. United States (1972)).Fraud on the Market” Theory:Rebuttable presumption that investor relied on integrity of public trading market price when making investment decision—so investor need not have seen misrepresentationRationale/basis? - “The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business.”Invoked when?Material & public misrepresentationThe stock traded in an efficient market (for our purposes – if its publically traded it’s going to be efficientPlaintiff traded the stock between when the misrepresentations were made and when the truth was revealedHow can a defendant rebut the fraud on the market presumption?“[P]etitioners may rebut proof of the elements giving rise to the presumption, or show that the misrepresentation in fact did not lead to a distortion of price or that an individual plaintiff traded or would have traded despite his knowing the statements were false.”“Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.” For example . . . (Page 441)B. Insider Trading?Who May Be Liable?“Insiders” – “Classical Insider Trading”Directors and officers (Texas Gulf Sulfer)Employees (geologists, engineers)Temporary/Constructive Insiders – Modified “Classic Insider Trading”Corporate counsel, accountants, underwriters, consultants, etc. (Chiarella)Tippers and Tippees (Dirks, Newman, Salaman)Outsiders (Misappropriation - O’Hagan)Insider Trading PenaltiesCivil:InjunctionDisgorgement of profitsSEC can seek treble money sanctions, up to 3x profits realized or losses avoidedBecause the SEC can seek disgorgement and treble damages, an inside trader thus faces potential civil liability up to 4 times profit gained.Administrative proceedings for regulated market professionals (censure, suspension or revocation of broker/dealer licenses, etc.)Criminal: Prison up to 20 years Fines up to $5 million for individuals; $25 million for corporate defendantsRule Statement SummariesClassical Insider Trading - Corporate insider or temporary insider trades in the securities of his corporation on the basis of material, nonpublic information.Tipper Tippee LiabilityTipperTipper discloses info in breach of a duty:Fiduciary relationship of trust and confidenceDisclosed info for personal benefitTippeeTippee knows or has reason to know that there has been a breach. Tippee trades or causes others to trade.Misappropriation - Defendant misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the informationRule 10b5-1 Affirmative Defense- Rule 10b5-1 specifies that a purchase or sale constitutes trading “on the basis of” MNPI where the person making the purchase or sale was aware of MNPI at the time the purchase or sale was made. Rule 10b5-1 Plan – A written plan for trading securities that is designed in accordance with Rule 10b5-1(c). Any person executing pre-planned transactions pursuant to a Rule 10b5-1 plan that was established in good faith at a time when that person was unaware of MNPI has an affirmative defense against accusations of insider trading, even if actual trades made pursuant to the plan are executed at a time when the individual may be aware of MNPI that would otherwise subject that person to liability under Exchange Act § 10(b) or Rule 10b-5. 10b5-1 plans are especially useful for people presumed to have inside information, such as officers and directors.Exchange Act § 16(b) still applies to trades made pursuant to a Rule 10b5-1 plan.1. Rule 10b-5 and Classic Insider Trading SEC v. Texas Gulf Sulfur (2nd Circuit)Rule – “The essence of the Rule is that anyone who, trading for his own account in the securities of a corporation, has “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone” may not take “advantage of such information knowing it is unavailable to those with whom he is dealing,” ie., the investing public.”“Thus, anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”This isn’t good law anymore, because it was stated too broadly to cover “anyone”(See Chiarella)Material Inside Information – “The basic test of materiality . . . is whether a reasonable man would attach importance . . . in determining his choice of action in the transaction in question. This, of course, encompasses any fact “which in reasonable and objective contemplation might affect the value of the corporation’s stock or securities.”Not the modern test, but closeIndividual Employees – Every transaction they made was in violation of 15b-5Director – Although they had disclosed the information, it had not been disseminated – so he is liableCorporation – Remanded the issue, because they were not sure whether there were material misleading information. (See page 474)Chiarella v. United States (S. Ct.)Chiarella worked at a printing company and was able to target the company that was about to be acquired and buy stock before the tender offer.Holding – “Chiarella’s conduct was not a violation because he was not an “insider” of the corporation whose shares he had traded (that is, the target corporation).”“There can be no duty to disclose where the person who has traded on inside information ‘was not [the corporation’s] agent . . . was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence.”The court concluded that the duty to abstain arises from the relationship of trust between a corporation’s shareholders and its employees. Since there was no relationship of trust between Chiarella and the shareholders of the corporations whose shares he traded, he had no duty to “disclose or abstain.”No relationship of “trust and confidence” as Prof. Pollman puts itNo duty arises from a mere acquisition of inside information“[N]ot every instance of financial unfairness constitutes fraudulent activity under § 10(b).”Would have violated the misappropriation theory, but not in 19802. Tipper/Tippee Liability?Dirks v. SEC (S. Ct.)Outsider Liability – Tipper Liability - Tipper discloses info in breach of a duty?Did the tipper (Secrist) have a fiduciary duty to Equity Funding? - √Did Secrist disclose the info for an improper personal benefit? –X If there is no improper benefit, there can be no tipper liability and thus no derivative tippee liabilityTippee Liability - Tippee (Dirks) knows or has reason to know that there has been a breach? - XIf so, then tippee inherits the tipper’s duty - XTippee trades or causes others to trade? - √This is why Dirks could potentially be liable even though he did not trade himselfNote there can be a chain of sub-tippees (“remote tippees”), following the same rulesWhat Constitutes a Personal Benefit“[T]he initial inquiry is whether there has been a breach of duty by the insider. This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure such as a pecuniary gain or a reputational benefit that will translate into future earnings. . . ‘The theory is that the insider, by giving the information out selectively, is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself. . . A quid pro quo. . . An intention to benefit the particular recipient . . . also . . . when an insider makes a gift of confidential information to a trading relative or friend.” “Constructive Insider” – Fn 14 (Pg. 481)Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes. When such a person breaches his fiduciary relationship, he may be treated more properly as a tipper than a tippee. For such a duty to be imposed, however, the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty.QuestionsWhat is the scope of the Court’s doctrine on breaches of fiduciary duties? What if Secrist had routinely exchanged stock tips?Yes, it’s a pattern of exchanging and it’s implied that the Secrist will receive tips later (personal benefit)What if Secrist had disclosed the Equity Funding fraud in part because he had been fired over an unrelated matter?Yes, revenge might be a personal benefit (this is not a clear cut answer)Note: The duty of confidentiality carries on post employment, unlike other fiduciary duties (loyalty, care, etc.)What if Dirks merely overheard Secrist describing the fraud in a public elevator?No improper benefitSuppose Secrist had disclosed inside info (not involving fraud) to Dirks because of a bribe from Dirks. Dirks then advised his clients to sell their Equity Funding stock. Dirks, of course, would have violated Rule 10b-5. Would his clients also have violated the rule?Nope, no reason to know they Switzer – Not liable, he was an eavesdropperThe Role of Financial Analysts - Regulation FD, adopted by the SEC in 2000SEC concluded that selective disclosure to analysts undermined public confidence in the integrity of the stock marketsSEC concluded the Dirks tipping regime inadequately constrained tipping because of difficulty proving the tipper received a personal benefit from the disclosure“Reg FD” restricts selective disclosure of MNPI by someone acting on behalf of a public corporationIf a corporation discloses MNPI to securities market pros or shareholders who may trade on that info, the corporation must disclose the information to the public, to widely disseminate the newsIntentional disclosures must be disseminated simultaneously; unintentional disclosures “promptly,” within 24 hours or start of next trading day on NYSEMNPI – Material Non-Public InformationUnited States v. Newman (2nd Circuit)Circuits are Split – This is the 2nd Circuit’s take on DirksFacts: (Newman & Chiasson were the Defendants)Dell tipping chain:Rob Ray of Dell tipped information to Sandy Goyal an analyst who he was not “close” friends with, but whom he had known for years, having both attended business school and worked at Dell together. Further, Ray had sought career advice and assistance from Goyal before Ray had given tips about Dell’s earnings – Goyal had given this career advice, which the court said “was little more than the encouragement one would generally expect of a fellow alumnus or casual acquaintance.” Goyal in turn gave the information to a different analyst who in turn relayed the information to his manager Newman and other analysts who told Chiasson. (3 and 4 levels removed from the inside tipper)NVIDIA tipping chain:Chris Choi of NVIDIA tipped information to Hyung Lim, whom Choi was “family friends” through church and occasionally socialized together. Lim passed the info to an analyst who told a group of analyst friends who in turn gave the information to Newman and Chiasson. (4 levels removed from the inside tipper)Interpretation of Dirks“Dirks clearly defines a breach of fiduciary duty as a breach of the duty of confidentiality in exchange for a personal benefit. Accordingly, we conclude that a tippee’s knowledge of the insider’s breach necessarily requires knowledge that the insider disclosed confidential information in exchange for a personal benefit.”“No reasonable jury could have found beyond a reasonable doubt that Newman and Chiasson knew, or deliberately avoided knowing, that the information originated from corporate insiders.”“To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee… we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”“[T]he mere fact of friendship, particularly of a causal or social nature” is not enough to prove a personal benefit.United States v. Salman (9th Circuit)Circuits are Split – This is the 9th Circuit’s take on DirksFactsChain:Maher Kara (worked at Citibank investment-banking group) Michael Kara (Maher’s brother) Bassam Salman (Maher’s brother in law)Salman traded through a brokerage account held in the name of his wife’s sister and her husband, Karim Bayyouk. Salman shared the inside information with Bayyouk and the two split the profits from Bayyouk’s trading. The brokerage records showed that on numerous occasions Bayyouk and Michael Kara executed nearly identical trades in securities issued by Citigroup clients shortly before the announcement of major transactions.Close fraternal relationship between Maher and Michael, that Salman was aware of, and the Salmans and Karas were tightly knit families.Interpretation of DirksQuoting Dirks: “The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.”“To the extent Newman can be read to go so far [as to require that the exchange of information must include at least a potential gain of a pecuniary or similarly tangible, valuable nature], we decline to follow it.”“In our case, the Government presented direct evidence that the disclosure was intended as a gift of market-sensitive information . . .Proof that the insider disclosed MNPI with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.”3. Misappropriation Theory Rule 14e-3 – Tender Offer Rule Discussed in O’HaganProhibits insider trading during a tender offer and thus supplements Rule 10b-5. Once substantial steps towards a tender offer have been taken, Rule 14e-3(a) prohibits anyone, except the bidder, who possesses material, nonpublic information about the offer from trading in the target’s securities.Rule 14e-3(d) prohibits anyone connected with the tender offer from tipping material, nonpublic information about it.Rule 14e-3 is not premised on breach of a fiduciary duty.O’Hagan upholds it anyway.United States v. O’HaganMisappropriation Theory - O'Hagan arose out of the prosecution of a partner in a law firm that was retained by a would-be tender offeror. The attorney, after having learned of the firm's client's planned takeover, purchased call options in the target company prior to the announcement of the tender offer. The indictment charged that the attorney had violated Rule 10b–5 and Rule 14e–3, which prohibits trading in advance of a tender offer; he was also charged with violating the mail fraud statute. Procedural History - The Eighth Circuit overturned a conviction on all three counts. The court of appeals' rejection of the Rule 10b–5 claim was based on two grounds:First, the court stated that Rule 10b–5 requires a misrepresentation or nondisclosure. Secondly, the Eighth Circuit held that a duty owed to the source of the nonpublic information was not sufficient to satisfy section 10(b)'s requirement that the fraud be “in connection with the purchase or sale” of a security.Two Issues:14e-3MisappropriationTwo HoldingsMisappropriation is validMisappropriation Theory 10b-5 - Defendant misappropriates confidential info in breach of a duty owed to the source of the info. (“The “misappropriation theory” holds that a person commits fraud “in connection with” a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”)How do we determine whether the defendant had a fiduciary duty?Does the corporation expect the outsider to keep the information confidential?O’Hagan: Lawyer’s ethical codes, Lawyer’s position/roleOther guidance: Rule 10b5-2 (see below)How could O’Hagan have avoided liability?Abstain from tradingDisclosure to the source of the info (Grand Met; Dorsey & Whitney)O’Hagan had a duty to both parties as a lawyer and as a partnerPractical impact:Disclosure vs. consent (Disclosure might get O’Hagan out of 10b-5, but if there isn’t consent then there still might be liability under 14e-3); O’Hagan would have to disclose to both the law firm and Grand Met.Federal vs. State law (O’Hagan could still be liable under state law claims of breach of fiduciary duty)14e-3: even if O’Hagan had gotten consent from the firm, the Law Firm may still be liable for a violation of 14e-3Rule 10b5-2 - Rule 10b5-2 provides a non-exclusive list of three situations in which a person has a duty of trust or confidence for the purpose of the misappropriation theory:1.Whenever a person agrees to maintain info in confidence;2.Whenever the person communicating info and the person to whom it is communicated have a history, pattern or practice of sharing confidences, such that the recipient of the info knows or reasonably should know that the person communicating the info expects the recipient to maintain confidentiality; or3.Whenever the info is obtained from a spouse, parent, child or sibling, unless recipient shows that history, pattern or practice indicates no expectation of confidentiality.Why Didn’t Classic Insider Trading Theory Work? – Because O’Hagan was not an insider to Pillsbury, if he was trading in Grand Met it would be different.Is this decision consistent with Chiarella/Dirks? – Pg. 492Not entirely consistent with Chiarella and Dirks, but it is a small enough point that it hasn’t been brought up in court.Small doctrinal pointBig Point – What misappropriation is and who a fiduciary is (10b5-2)C. Section 16(b) Liability for Short Swing Trading Exchange Act § 16 – Extremely Robotic, Mechanical Rule(a): Reporting obligations(b): Bright-line short-swing trading rule (over- and under- inclusive for insider trading)Exchange Act § 16(a)“Every person who is directly or indirectly the beneficial owner of more than 10% of any class of any equity security . . . or who is a director or an officer of the issuer of such security . . . shall file with the Commission . . . a statement…” disclosing trades within a certain period of time following the transaction.SOX accelerated the deadlines for reporting insider transactions.Exchange Act § 16(b)“any profit realized by [such beneficial owner, director, or officer] from any purchase and sale, or any sale and purchase, of any equity security of such issuer . . . within any period of less than six months . . . shall inure to and be recoverable by the issuer”Short Swing Trading - HighlightsStrict liability that requires disgorgement to public corporation of profits made:Within a 6 month periodBy certain insiders & beneficial ownersIntent is irrelevantThe courts match stock sales and purchases in whatever way (within the confines of the rules) maximizes the amount the company can recover.§ 16 applies only to officers, directors, or shareholders with more than 10% of the stockOfficer: SEC definition includes president, CFO, chief accounting officers, VPs of principal business units and any person with significant “policymaking function.”Stock classes are considered separately“Deputization”: If Corp X authorizes one of its officers to serve on the board of Corp Y, and Corp X profits on Y stock within 6 months, Corp X may be liable under § 16(b)Directors and officers:You cannot match a transaction made prior to appointment to one made after appointment.You can match transactions that occur after he or she ceases to be an officer or director with those made while still in office.Beneficial owner:§ 16(b) liability only if she owned more than 10% both at the time of the purchase and of the sale.Reliance ElectricForemost-McKesson§ 16 applies only to companies that must register under the Exchange Act = Public companiesCompanies with shares traded on a national exchange (e.g., on NASDAQ or NYSE), or Companies that are forced to go public under the § 12(g) threshold § 12(g) threshold (post-JOBS Act): Companies with $10 million in assets and more than 2,000 shareholders (excluding people who became holders via stock options, and only up to 499 can be “unaccredited” investors)Compare Rule 10b-5, which applies to all issuers (regardless whether public or private)Equity securities§ 16 applies to stocks, convertible debt, and options to buy or sell (a “call” or “put”)Compare Rule 10b-5, which applies to all securitiesSale and purchase§ 16(b) applies whether the sale follows the purchase or vice versaCourts interpret the statute to maximize the gains the company recoversHence, shares are fungible for purposes of § 16(b)If the trader sells 10 shares of stock and then within six months buys 10 different shares of stock in the same company at a cheaper price, he or she is still liableBut the sale and purchase must occur within six months of each otherRecoveryAny recovery goes to the company§ 16(b) profits can be discovered through SEC filingsShareholders can sue derivatively, and a shareholder’s lawyer can get a contingent fee out of any recovery or settlementStatute of limitations = 2 yearsAnalysis of 16(b) Problems:Is the company public?Is the defendant a director, officer, or beneficial owner of the company?D and Os - you can match any transactions within 6 months while in position; and transactions that occur after he or she ceases to be an officer or director are matchable with those made while still in office, within 6 month period.Beneficial owner - only if she owned more than 10% both at the time of the purchase and of the sale, and within 6 months.Can you match any purchase(s) and sale(s) within a 6 month period that would yield profits?Buy low and sell highSell high and buy lowReliance Electric v. Emerson ElectricFacts - In this case, the respondent, the owner of 13.2% of a corporation's shares, disposed of its entire holdings in two sales, both of them within six months of purchase. The first sale reduced the respondent's holdings to 9.96%, and the second disposed of the remainder. The question presented is whether the profits derived from the second sale are recoverable by the Corporation under s 16(b). We hold that they are not.June 16: Emerson buys 13.2% of DodgeAug 28: Emerson sells some shares; reducing holdings to 9.96%Sep 11: Emerson sells remainderMatching – You have to match a sale and a purchase or a purchase and saleHoldingsWas the June 16 purchase a “matchable” purchase?S. Ct. declines to answer (See Foremost McKesson)Assuming the June 16 purchase is matchable, can it be matched with the Sept. 11 sale?No. Emerson was not a more than 10% owner on Sept. 11.Form over substance.Foremost-McKesson v. Provident SecuritiesFacts - Provident Securities Co., was a personal holding company. In 1968 Provident decided tentatively to liquidate and dissolve, and it engaged an agent to find a purchaser for its assets. Foremost-McKesson, Inc., emerged as a potential purchaser, but extensive negotiations were required to resolve a disagreement over the nature of the consideration Foremost would pay. Provident wanted cash in order to facilitate its dissolution, while Foremost wanted to pay with its own securities. They eventually came to an agreement, with the following pertinent terms/facts:Oct 20: Provident acquires debentures convertible into more than 10% of Foremost stock (Not matchable, because they didn’t own more than 10% when they got the initial stock)Oct 24: Provident distributes some debentures to shareholders, reducing convertible debt holdings to less than 10% (Matchable)Oct 28: Provident sells remaining debentures, then distributed cash proceeds to shareholders and dissolved. (Not matchable, because they were not beneficial owners)AnalysisIssue: Can we match the Oct. 20 acquisition with the Oct. 24 disposition?Note: This is the issue that was left open in Reliance“This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved”HoldingsIn a purchase-sale sequence, the transaction by which the shareholder crosses the 10%+ threshold is not a matchable purchaseOnly purchases effected after one becomes a more than 10% shareholder are matchableShort Swing Trading ProblemsProblems 1-3, Pg. 502 – Answers in the Class 22 slidesBill is chief executive officer of SCLaw (SCLI), a chain of proprietary law schools in southern California. SCLI stock is registered under the 1934 Act, and 1,000,000 shares are outstanding. On January 1, Bill purchased 200,000 shares of SCLI common stock for $10 per share. Determine his liability, if any, under § 16(b):If he sells all 200,000 share on May 1 for $50 per share.If he sells 110,000 share on May 1 for $50 per share, and the remainder on May 2 at the same price.If he sells 110,000 share on May 1 for $50 per share, resigns from SCLI, and sells the remainder on May 2 at the same price.Renee is a shrewd investor with 200,000 shares of SCLI stock that she has held for several years. She is not an officer or director of the company. Determine her liability, if any, under § 16(b):If she sells her entire holding of SCLI shares (200,000) on January 1 at $50 per share, buys 50,000 shares on May 1 for $10 per share, and buys 110,000 more shares on May 2 at the same price.If she sells her entire portfolio of SCLI shares (200,000) on January 1 at $50 per share, buys 110,000 shares on May 1 for $10 per share, and 50,000 more shares on May 2 at the same price.If she sells 110,000 shares on January 1 at $50 per share, sells the remainder of her shares (90,000) on January 2 at the same price, and buys 300,000 shares on May 1 for $10 per share.Bill, still the SCLI CEO, buys 100,000 shares on March 1 at $10 per share, 700,000 shares on April 1 at $90 per share, and sells all his shares on May 1 at $30 per share. Did he make any money? For what amount, if any, is he liable under § 16(b)?V. Limited Liability Companies (LLCs)?LLCs In GeneralLLCs are their own unique form of business organization. They are not partnerships nor corporations.LLCs are not subject to the restrictions applicable to S corporations (e.g., 100 shareholders, U.S. citizens or residents).They typically have characteristics of both partnerships and corporations.Tax advantages (can choose to be taxed like a partnership or a corporation; partnership = flow through tax)Limited liability like corporationsA hallmark characteristic of LLCs is flexibility. They are premised on a notion of private ordering. A LLC is “as much a creature of contract as of statute.” (RULLCA § 110 cmt.) Except as expressly limited by statute, the “operating agreement” (aka “LLC agreement”) sets the rules for the LLC (See, e.g., Elf Atochem case in the reading)California LLCsOn Sept. 21, 2012, Gov. Jerry Brown signed into law S.B. 323, the California Revised Uniform Limited Liability Company Act (“RULLCA”).RULLCA took effect on Jan. 1, 2014, and applies to all existing California LLCs as well as all foreign LLCs previously registered with the Secretary of State as of that date.Licensed professionals cannot operate through LLCs in California.In choosing between form of business, consider tax and fee issues (and take the Business Planning course!). E.g., California has a “gross receipts fee” that apply to LLCs (but not corporations); depreciation deductions; etc.LLC BasicsState LLC laws vary widelyLLC law is generally not well developed yetThe “operating agreement” is the key document for an LLC; courts have drawn on contract principles as well as partnership and corporate law principles in resolving disputesLLC FormationChoose state of organization and reserve the LLC nameDraft articles/certificate of organization/formation consistent with statutory requirements and file with the Secretary of State, paying filing fees and the franchise tax. Tax arrangements (prepare and file IRS Form and get a Tax Identification Number).Designate office and agent for service of process.Draft and enter into an operating agreement.In California, file a “Statement of Information” with the Secretary of State, within 90 days after the filing of its original articles of organization.Articles of OrganizationCheck the statutory requirements of what is required and file with Secretary of State’s OfficeE.g.:the LLC’s name;the LLC’s purpose;the agent for service of process;a description of the type of business that constitutes the principal business activity of the LLC (or “any lawful business”);If the LLC is to be managed by 1 or more managers and not by all its members, the articles shall contain a statement to that effect.Operating AgreementThe basic contract governing the affairs of a LLC and stating the various rights and duties of the membersE.g.: Each member’s units/interests in the company Rights and duties of the members (including management structure and rights, voting rights and requirements)The manner in which profits and losses are divided, and distributions are madeAmendment of operating agreement (default is unanimous consent)Remedies in the event that the members disagree on the direction of the companyExit provisions (e.g., withdrawal, dissociation, admission) and dissolutionIn California all LLCs are required to have a LLC Operating Agreement (code § 17050)Management RightsVariable management structure: can choose member-managed or manager-managed and can customize governanceThe default is member-managed (e.g., RULLCA 407)Ordinary matters are decided by majority voteStates vary regarding whether the default allocation is by ownership interests in the company or one-person/one-vote Significant matters require unanimous consentE.g., merger, admission of new member, dissolution, etc…Although LLC statutes generally allow for free transferability of an owner’s financial interest, they do not always provide for the ability to freely transfer one’s management right as a default ruleManager-managed LLC option availableManagers need not be membersCan be structured as a committee, “board of directors,” a CEO, etc.Some statutes require that the choice be specified in the articles/certificate of organization (California requires both the articles and operating agreement to explicitly state manager-managed if want to establish that structure) Financial InterestsAllocation of Profit and Loss SharingStatutes take a variety of approaches such as on the basis of ownership interests in the company, equal share rules like partnership, or are silent and do not provide a default. Put it in the operating agreement! TransferabilityUnless otherwise provided in the LLC’s operating agreement, a member may assign her financial interest in the LLCAn assignee of a financial interest in an LLC may acquire other rights only by being admitted as a member of the company if all the remaining members consent or the operating agreement so provides. (e.g., RULLCA §§ 501-503)Analogous to partnership rules; some statutes provide majority of membersDistributionsTransfer of LLC property (usually cash) to members Statutory restrictions on paying distributions (analogous to rules on dividends in corporations)Operating agreements set out the company’s agreed-upon rule, e.g., managers decide or distributions sufficient to cover tax liabilities on profits allocated to membersFiduciary DutiesManager-managed LLCsThe managers of a manager-managed LLC have a default duty of care and loyalty*Usually, members of a manager-managed LLC have no fiduciary duties to the LLC or its members by reason of being membersMember-managed LLCsAll members of a member-managed LLC have a default duty of care and loyalty**The standard of care varies widely by statute – some have an ordinary care standard, some gross negligence, and RULLCA takes a hybrid approach of ordinary care expressly subject to BJR.Derivative ActionsMember may bring an action on behalf of the LLC to recover a judgment in its favor if the members with authority to bring the action refuse to do soFreedom of ContractULLCA and RULLCA permit modification, but not elimination, of fiduciary duties (“manifestly unreasonable” standard).Some courts (like Delaware) have allowed for elimination of fiduciary duties if clearly and expressly provided in the operating agreement.The implied contractual covenant of good faith and fair dealing is non-waiveable. LiabilitiesGeneral rule of limited liabilityE.g., No member or manager of a limited liability company is obligated personally for any debt, obligation, or liability of the LLC solely by reason of being a member or acting as a manager of the limited liability company. (RULLCA § 304)But some courts have allowed for piercing the LLC veilSome LLC statutes expressly mandate application of corporate veil piercing case law (e.g., California has a statute imposing personal liability on LLC members “under principles of common law of this state that are similar to those applicable to business corporations and shareholders in this state.”)Even where that is not the case, some courts have applied corporate law standards to LLC veil-piercing cases.Dissociation & DissolutionRULLCA is similar to RUPA with one big exception—the unilateral withdrawal of a member does not result in a dissolution.RULLCA thus creates more stability (like a corp) by making it far harder for a member to force a dissolution and winding up than in a partnership.Each state differs, however (e.g., the Delaware statute does not provide a mechanism for expulsion), and the operating agreement can provide customized rules.Choosing a Business FormFormalityHow formal do the parties want the relationship to be?Ability to raise capitalWill the business want to raise capital by selling securities in the near future?What business forms are investors comfortable with?Which default rules do the parties prefer?Which “off the rack” form would require the least customization for the governance the parties want? Can the parties achieve the rules they want with that form?Is limited liability important?How will the business be managed? How will control be allocated?How long do the parties expect to stay in business together?Do the parties want their interests to be freely transferable?Taxation and feesWhich form of taxation do each of the parties prefer (based on their own income, goals, expectations about future revenue/assets)?Filing fees, franchise fees, gross receipt fees?VI. Social Enterprise (e.g., Benefit Corporations)Social Enterprise:New for-profit business entity forms have emerged in the last several years that clearly enable and mandate the pursuit of social and environmental goals: L3Cs, flexible purpose corporations, benefit corporationsSocial mission is central; pursuing social and financial returnsL3CsNew form of for-profit business entity (low profit LLCs with a charitable or educational purpose)In 2008, Vermont was the first state to allow a company to register as a L3C, built on the LLC framework with the aim of giving for-profit companies with social missions the ability to raise philanthropic funds.The L3C form was passed by 9 states, but has slowed and even regressed.Benefit CorporationsNew form of for-profit business entityLegislation varies by jurisdiction; is available in California, Delaware, and some other states; is on the rise (~ 30 states)Most statutes are based on a model statute proposed by B Lab, a nonprofit corporation that runs a certification serviceBenefit corporation vs. B CorpBenefit corporation: specific legal corporate structureB Corp: a certification by a third-party certifying companyIn making business judgments, the directors must consider the impact of their decisions on nonshareholder interests (e.g., the environment, society)Benefit PurposeA benefit corporation must:have a corporate purpose that involves creating or pursuing “a general public benefit” (= “a material positive impact on society and the environment”); can also have a specific benefit purposeproduce, file with the state, and make publicly available an annual benefit report that describes how it pursued the general public benefit and the success of that pursuit.Assessment must be done by reference to a comprehensive, credible, and transparent third-party standardMust have a “benefit director,” independent of the corporation, who prepares an opinion to be included in annual benefit report about whether corporation acted in accordance with its public benefit purpose and if not how it failed to comply“Benefit enforcement proceeding” may be brought by the corporation or derivatively by a shareholder, director or others specified for failing to pursue or create a general public benefit.Remedy? Removal of director?No case law on how courts should analyze these proceedings or how the fiduciary obligations should be assessedSome CritiquesIneffectual or unnecessary Managerial discretionDirectors already have leeway under traditional corporate lawOnly matters when there is clear tension between profit maximization and social performanceIf a benefit corporation were to go public, share price could put pressure on directors and managers to increase profitsAccountabilitySocial performance is difficult to measure and evaluateDifficulties implementing assessments, benefit director opinion, etc.Directors and managers have wide discretion – “broad cover” to act selfishly or with less commitment to social impact or financial gain than investors prefer, could just be “greenwashing”B LabPromotes model legislation for benefit corporation statutes to be adopted by state legislaturesCertifies a qualifying corporation as a “Certified B Corporation” – meaning it has met B Lab’s standards as a socially responsible corporation; this is a private standard ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download